Plan to hike taxes sounds alarms in VC industry

A proposal to boost taxes on private equity and hedge funds is setting off alarms in the venture capital industry and threatens to split venture capitalists from buyout specialists on an issue that has put private financial partnerships under an uncomfortable spotlight.

Venture firms were surprised by a bill introduced in the House of Representatives in June that would sharply increase the tax rate for the private partnerships.

The 20 percent fee they collect on their profits -- known in the industry as "carried interest," or simply "the carry" -- is now taxed at the capital gains rate of 15 percent.

Under a bill cosponsored by Democratic representatives Sander Levin of Michigan, Charles Rangel of New York, and Barney Frank of Newton, the carried interest would be taxed at the ordinary income rate of up to 35 percent.

The higher tax would apply to venture capital, along with private equity and hedge funds and similarly structured funds for real estate and oil and gas investments.

"It just doesn't make sense to me that these firms that invest other people's money are treated differently from others and taxed at a lower rate," said Rangel, chairman of the House Ways and Means Committee, who plans to hold hearings on the bill next month. "It appears on the surface to be an inequity, a tax break that's undeserved."

Venture capitalists, who invest some of their own money but mostly funds pooled from limited partners, such as university endowments and pension funds, are pressing a lobbying campaign to convince lawmakers the bill -- as least as it applies to them -- has the potential to dampen entrepreneurship, put the United States at a competitive disadvantage, and drive the brightest graduates a way from a business that bootstraps risky start-ups and nurtures new technologies.

"There is a potential for a lot of unintended consequences," warned Ted Schlein, managing partner at the Menlo Park, Calif., venture firm Kleiner Perkins Caufield & Byers and chairman of the National Venture Capital Association. Schlein has been shuttling back and forth between Silicon Valley and Washington, D.C., throughout the summer for meetings with members of Congress.

Boston-area financiers have been following the proposal closely. The area hosts the second-largest concentration of venture firms in the nation, after Silicon Valley. Venture firms in the Boston area had $39.8 billion under management at the end of 2006, roughly one-sixth of all US venture capital. The area is also home to some large buyout firms.

The bill was drawn up just before the $1.43 billion initial public offering for Blackstone Group, a New York buyout firm whose IPO registration opened a window on a compensation structure little known outside the financial world. Around the same time, a Wall Street Journal profile of Blackstone cofounder Stephen Schwarzman, noting his taste for stone crabs at $40 a claw and his professed desire to "inflict pain" on his competitors, raised the profile of the buyout king -- and the private equity industry -- in an unflattering way.

Though they're nominally part of the private equity sphere, venture capitalists view themselves as a separate breed that is being tarred with the same brush as the buyout funds.

Those funds typically take controlling interests in established companies, restructure them, and sell them off for big profits. Venture funds, in contrast, invest in high-tech start-ups, work closely with their executives, and help them grow and fine-tune their businesses before they're sold or go public.

"Venture capital isn't just about writing checks," said Terry McGuire, cofounder and managing general partner at Polaris Venture Partners in Waltham. "It's about a lot of legwork."

A fear among venture and buyout firms alike is that legislators will be drawn to the plan for raising taxes on carried interest as one way to offset revenue losses if Congress moves to repeal the alternative minimum tax, a growing burden for middle-class taxpayers.

Frank, chairman of the House Committee on Financial Services, said increasing the tax on carried interest could be part of a larger tax reform. "Massachusetts is one of the states that's hit hardest by the alternative minimum tax," he said. "You can't fix the alternative minimum tax without paying for it" by raising other revenue.

But the proposed change in the rate at which carried interest is taxed is aimed primarily at hedge funds, Frank said.

He called such funds "a much less socially useful business" than venture capital, and said he'd consider carving out an exemption for partnerships focusing on risky investments in early-stage innovative companies.

Buyout firms, venture capitalists, and other partnerships are presenting "a united front in opposition" to the carried interest change, suggested Robert W. Stewart, vice president of public affairs at the Private Equity Council, a group formed in February to promote the interests of buyout giants like Blackstone, Kohlberg Kravis Roberts & Co., and Boston's Bain Capital and Thomas H. Lee Partners. "This bill would affect private equity in all its variations," Stewart said.

The venture trade group is pursuing its own lobbying effort, without explicitly distancing itself from the buyout industry. "We have made a conscious decision not to be part of any coalition," said Mark Heesen, president of the venture association. "We have been telling our story up on the Hill for over 33 years now, and we have a lot of credibility on our own."

Robert Weisman can be reached at weisman@globe.com.