{The following is merely a tongue-in-cheek attempt at an imaginary letter I could write to President François Hollande. Its opinions are purely personal and do not necessarily reflect those of my employer or my industry.}
Dear Mr. President,
First off, thank you for opening my mail. If you’re reading this letter, you would be the first politician on either side of the Atlantic to waste precious time on my meandering drivel. I also should congratulate you on your presidential election win. Albeit a close second round, the process was open, universal, and honest, with a voter turnout that should put my native U.S. to shame.
Now, if you would kindly forgive me in advance for being a Rude VC, there are a few things I need to get off my chest.
For starters, I have to say that when it comes to the fiscal policy of your new administration, I sometimes wonder if you’re leaking seemingly half-baked ideas to the public in order gauge their popularity before making legislation. Coincidentally, this is a technique I recommend to my startups when evaluating the market for a new offer (we call it MVP – minimum viable product), but I question its relevance for what will inevitably become unpopular tax initiatives necessary to govern a country in crisis. But hey, not wanting to miss a chance to weigh in, here are my € 0.02 on some of the latest tax policy rumors related to France’s private equity sector. Let’s take some of your alleged policies one by one…
Confusing Private Equity LBO funds with Venture Capital
If there’s any credence to the rumors, your administration seems to be grouping VC funds together with LBO funds. Don’t worry, the U.S. government fell under the same confusion at first until they were enlightened by the American VC associations. While it’s true that both VC and LBO fall under the same ‘Private Equity’ umbrella, they warrant consideration for different tax treatment.
The raison d’être of an LBO fund is to acquire a company with mostly borrowed money, implement operational efficiencies in the acquired firm, repay the debt with the acquired firm’s own cash flow, and ultimately re-sell the firm to an industrial buyer or even another LBO fund. Even if the firm is sold at the same price at which it was originally acquired, the original LBO fund will still make a tidy profit since the borrowed money was repaid by the underlying firm itself. In other words, an LBO is essentially an exercise in financial engineering, with no understanding of the underlying business required. In venture capital we have a joke the goes something like: “Q: what does it take to run an LBO fund? A: a pulse.“
Venture Capital, in contrast, is about investing in small companies, helping them grow, and re-selling the investment once the company has hopefully substantially increased in value. Value creation in small companies translates into job creation in the nation’s economy. Whereas a successful LBO may often reduce headcount, a successful VC investment usually results in a lot of hiring. As one of my colleagues likes to put it: In an LBO transaction, the cash goes into other shareholders’ pockets; whereas in a VC transaction, the cash goes into the company.
Please keep this distinction in my mind before penalizing an essential engine of economic growth and employment – SMEs – by handicapping France’s VC sector.
Abolishing fiscal unity
The generally accepted accounting practice of fiscal unity allows a subsidiary and its holding company to behave as a singular tax entity. This practice is a boon to LBO funds because it allows them to deduct interest payments on their acquisition debt from the profits of the company they acquired, thus reducing taxes. I can appreciate your wish to close this quasi-loophole, which gives these transactions an effective tax subsidy of 33%, but implementing it in practice may be tricky. Such a move however, would not directly impact VC transactions, so I won’t stand in your way.
Raising capital gains tax up to income tax rates
The alleged rumor is that you’re considering raising the capital gains tax to the level of income tax by treating capital gains as salary. This would have a direct and unwelcome impact on a core motivational component of fund professionals: their carried interest. Carried interest represents the pot of gold at the end of the rainbow for investment professionals. The reason we work our butts off for our portfolio companies while earning relatively modest salaries is the hope of a future gain resulting from the value we create for the fund over time. Carried interest is more like a profit-sharing scheme than a bonus, in that it is not at all guaranteed. It comes only after several years of toil, and only once the fund’s investors have fully recovered their entire investment plus a minimum profit. France already boasts the highest capital gains tax rates in Europe (over 33% when you include CSG/CRDS). Further penalizing investment professionals on their only carrot will erase any rational preference for an uncertain gain (read: performance) over a salary (read: risk aversion).
Capping tax deductions and reducing the tax credit in retail VC funds
If you’ve been advised that France’s VC sector needs fixing, your rumored solution on this point would involve taking a sledgehammer to something that perhaps a screwdriver could fix. Your budget minister’s announcement to limit all tax deductions of any variety to € 10k per household while simultaneously reducing the credit taxpayers receive when investing in a retail VC fund (an FCPI or FIP) will single-handedly crush overnight the retail VC model as we know it.
Despite being somewhat biased on this topic, I believe that I’ve objectively argued that France’s retail VC model needs improvement. However, a precipitous implementation of your budget minister’s suggestion would send deadly shockwaves to the hundreds of SMEs currently financed by these vehicles.
I appreciate that as Président de la République you’re facing some dire problems, and that solutions to these challenges will inevitably involve pain and sacrifice. But I hope you’ll also take into consideration the undesirable consequences of your rumored tinkerings before making rash decisions. Moreover, I submit that better alternatives exist, for example:
a) Nudge the investment case for retail VC funds to be based on performance rather than tax deductions. This will enable you to accomplish the same objectives over time, but with the benefit of forcing investment professionals to deliver superior value creation and hence economic growth. You could do this for example by improving transparency of funds’ preformances by defining standards for calculating investment returns.
b) Use tax policy to discourage the practice of funds getting rich off management fees. Typically ranging from 2~3% for an investment fund, annual management fees are meant to pay the ongoing costs of operating a fund (e.g. salaries, rent, travel, etc.). They were never intended to be a source of wealth generation for investment teams. Retail VC funds in France tend to be the biggest abusers, mainly because, unlike their counterparts at institutional VC or LBO funds (e.g. FCPR structures), retail VCs don’t have to worry about powerful, sophisticated institutional investors scrutinizing their budgets.
c) Require full disclosure of where the fees go. On a related note, the taxpayers that invest in retail VC vehicles may see upwards of 5% of their investment go up in smoke annually in the form of fees that are paid to various intermediairies. Bringing more sunlight into these dark corners will undoubtedly disinfect.
d) Don’t necessarily reduce the allocations of subsidies to innovation, but make them smarter. France dispenses almost € 2 billion annually on subsidizing innovation plus another € 9 billion in guaranteed loans for SMEs. Bravo! But since € 11 billion might seem like a fatty morsel, before you even think of trimming it, I can assure you that there are myriad inefficiences that would render these badly-needed allocations to be even more effective.
These are just a few ideas to get you started. But by all means feel free to solicit the advice of your experts too; don’t just take my word for it. After all, I’m just a normal VC.