3 Sep | Written By Hailey Ng
The Private Equity (PE) industry is facing a significant shift as the UK government proposes changes to the way carried interest is taxed. With carried interest currently benefiting from a lower capital gains tax rate, these changes could have wide-reaching effects on how PE firms operate, how they attract talent, and their overall role in the UK economy. In this post, we’ll break down how PE firms make money, what carried interest is, why the government is increasing the tax, and what that could mean for the future of PE in the UK.
How Private Equity Firms Make Money
Unlike typical investors, PE firms don’t just buy shares; they buy entire companies, improve them, and then sell them at a higher price — a process known as a leveraged buyout (LBO), where they use a mix of borrowed funds (i.e. debt) and equity to acquire companies.
PE firms earn money primarily in two ways:
- Management Fees: PE firms charge a fee, typically around 2% of the total money they manage. This fee provides a stable income, regardless of the fund’s performance.
- Carried Interest: The real profits come from carried interest, which is a share of the profits (typically around 20%) that a PE firm earns when it sells a company for a higher price than it bought it for. For example, if a PE firm buys a company for £100 million and later sells it for £200 million, the carried interest could be £20 million.
What is Carried Interest Tax?
Carried interest refers to the profit that PE managers earn after successfully exiting an investment. The key point is that carried interest has traditionally been taxed at the capital gains rate, which is lower than income tax. Currently, in the UK, carried interest is taxed at 28%, but the government is now considering raising this.
- Capital Gains Tax: This is a tax on the profit you make when you sell something that’s gone up in value, like shares or property. It’s lower than income tax, which is why PE managers currently pay less tax on carried interest than on regular income.
- Why It Matters: The lower tax rate on carried interest has allowed PE managers to keep more of their profits, making the private equity industry attractive for top talent and high-net-worth investors.
Why is the Government Increasing the Carried Interest Tax?
The Labour-led UK government plans to raise the tax on carried interest, aligning it closer with income tax rates, which could go as high as 45% plus national insurance contributions. This would mark a significant rise from the current 28% capital gains tax that PE managers pay.
The government and critics argue that carried interest is essentially income, as it’s the payment PE managers receive for doing their job — buying, improving, and selling companies for profit. Since it functions like a performance bonus, they believe it should be taxed at the higher income tax rate, rather than benefiting from the lower capital gains tax rate.
Prime Minister Keir Starmer has signalled that wealthier individuals should “bear the heavier burden” to help address the £22bn hole in public finances. By increasing the tax on carried interest, the government aims to raise more revenue and create a fairer tax system, ensuring that PE managers pay taxes similar to what regular employees pay on their earnings.
How Will This Impact the Private Equity Industry?
The proposed tax increase on carried interest could have significant consequences for PE firms, affecting both their profitability and the attractiveness of the industry.
1. Impact on Profits and Talent
If carried interest is taxed at a higher rate, PE managers will see a significant reduction in their take-home profits. This could make the industry less attractive to top talent, as the financial rewards will be lower.
2. Changes in Investment Strategy
With lower after-tax profits, PE firms may become more risk-averse. Currently, PE is known for investing in high-risk, high-reward turnarounds, where firms buy struggling companies and transform them. However, with higher taxes cutting into profits, PE firms may shift towards safer investments with predictable returns. This could reduce the number of bold deals and slow innovation in sectors that rely on PE for growth.
3. Impact on Investors
The increased tax burden might also be passed on to investors. Pension funds and endowments, which rely on strong returns from PE, could see lower payouts as more profits are directed to taxes. With reduced returns, institutional investors may start looking for alternative investment opportunities, potentially weakening the attractiveness of PE funds.
Will This Affect the UK’s Competitiveness?
The proposed tax changes could threaten the UK’s status as a global financial centre for PE. The UK has long been a hub for PE, but if carried interest taxes rise too high, firms may begin relocating to countries with lower tax rates, such as the US, where carried interest is still taxed at a lower capital gains rate. Rob Lucas, CEO of CVC Capital Partners, highlighted that the industry is highly mobile and could easily shift operations abroad if the UK becomes less tax-friendly.
PE’s Impact on the Economy
Private equity plays a significant role in the UK economy by financing job creation and driving innovation. If PE activity slows or firms relocate, it could hurt the broader business landscape. Fred Watt, CFO of CVC, stressed the need for the government to balance tax reforms carefully to avoid discouraging investment, which could have a ripple effect on the economy
Concerns from the Tech and Venture Capital Sectors
The venture capital (VC) and tech sectors have also voiced concerns about the tax hikes. Unlike PE, VCs invest in early-stage companies, which carry higher risks and longer investment timelines. Leading figures like Taavet Hinrikus (co-founder of Wise) and Matthew Scullion (founder of Matillion) argue that higher taxes on carried interest and capital gains could stifle investment in the UK’s tech sector.
The UK is currently Europe’s leading VC hub, but these tax changes could drive away founders and investors, causing the UK to lose its competitive edge. Countries with more favourable tax regimes are already attracting high earners, particularly since the UK abolished the non-dom tax regime, which previously allowed foreign nationals to avoid paying tax on overseas income.
Conclusion: What’s Next for the Private Equity Industry in the UK?
The carried interest tax increase is likely to have a significant impact on the PE industry in the UK. While higher taxes may generate crucial revenue for the government, they also risk reducing the profitability of private equity firms, discouraging high-risk investments, and driving talent and capital abroad.
As the October Budget approaches, the UK government faces the challenge of balancing its need for increased revenue with the risk of weakening its global competitiveness. The outcome could shape the future of the UK’s investment landscape for years to come.
Leave a Reply