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October 29, 2015

The Breaking Health Podcast

I am hosting a weekly podcast called Breaking Health where I interview the cutting edge CEOs of todays Digital Healthcare companies.  I’ve been fortunate to have a series of excellent guests including Robert Mittendorff of Norwest Ventrues, Dan Burton CEO of Health Catalyst and Steve Wiggins CEO of Remedy Partners.

The podcast is part of Healthegy’s Digital Health Innovation Summit and Breaking Health newsletter, and is produced by Healthegy’s Content Director Tom Salemi.

New interviews will be coming out weekly and I will be posting updates here, on my twitter account (@Steve_Krupa) and on LinkedIn.

Here’s a direct link to the Breaking Health podcast website, and you can also subscribe to the podcast though iTunes.

I hope you get the chance to listen.

SK

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October 1, 2014

Psilos Healthcare Outlook Fall 2014

Filed under: Healthcare,Venture Capital — Steve Krupa @ 4:26 pm
Tags: ,

At Psilos we have been predicting the oncoming wave of consumerism in the health insurance market for sometime, and for that matter we have invested behind our beliefs.  But over the last couple of years it occurred to us that it may not be exactly clear what this reality means for insurance companies. This is the subject of this year’s Outlook, titled: A Race to Embrace the Consumer Business Model: Insurance companies must change or face obsolescence.

In our 2011 Outlook we wrote the following:  “Psilos believes that the PPACA [a/k/a Obamacare] will accelerate sweeping changes to consumer-oriented business models and distribution channels, as well as increase the competition among insurance companies… These changes are already beginning to occur, but they will accelerate rapidly post- 2014 [emphasis added], when the number of Americans shopping for their own health insurance will increase exponentially at the expense of the current model, in which most people either have their health insurance provided to them by their employers or simply remain uninsured.”

Post-2014 is now upon us, and it would seem that we are in the midst of much of what we predicted three years ago.

To us the most interesting question for investors in the HCIT and services space is exactly how will insurers adapt to the new reality.  And so this is the focus of our 2014 Outlook.

The fact is that insurers are not set up as a business to service individual consumers, especially the version of the individual consumer that is born from our current information age, where almost any transaction and piece of relevant information is available to us at will, through the internet and on our mobile devices: except of course our health insurance and our healthcare information.  Why?  Because the infrastructure of the industry is not set up to service individual consumers, in large part because those consumers have not historically been a primary customer; however, they are now.

Our report takes a broad Michael Porter-esque view of the insurance company value-chain, which today is set up to service their employer customers, and argues it must be completely re-thought and re-engineered to service individual consumers.  Within these changes lie ripe opportunities for investors, and those insurance companies that successfully establish a value-chain built for the consumer business have the opportunity for material gains in market share and profitability.

You can read through the entirely of our report here.

If you find it interesting, which I think (hope) you will, I would love some feedback.

SK

May 5, 2011

Psilos Group’s 2011 Outlook on Healthcare Economics & Innovation

Filed under: Finance,Healthcare,Venture Capital — Steve Krupa @ 2:01 pm

It’s been a while since I’ve written, and my excuse is typical, I’ve found any number of work projects overwhelming my time to sit, and write, and blog.  One such project was the composition of Psilos Group’s 2011 Outlook on Healthcare Economics & Innovation, which I put this together with one of my business partners (and awesome blogger) Lisa Suennen (you can check out Lisa’s blog, Venture Valkyrie, here, where she proves to be a much more consistent correspondent than yours truly).

For those of you that come to these pages for the pop-culture commentary (more to come on that too, I promise), you may note that I manage to get a few words in on healthcare and investing, and after all, this is what I spend the majority of my time on.  With that, the Psilos Group report outlines what we see as some of the most significant impacts on healthcare investing of the implementation of the new health reform law.

Chief among these are:

  • The reality that we should expect a doubling, and potentially a tripling of the individual health insurance policy market, which will result in a dramatic shift in the relationship between insurers, employers and consumers.  In many cases, employers will simply stop buying group health insurance, leaving the consumer to directly purchase coverage (partially or fully funded by the employer) on their own through a newly established public or private health insurance exchange.
  • Health insurance plans will have to become superior consumer marketing and service organizations to thrive and survive, acting more like Starbucks or Apple if they are going to expand consumers’ trust in their brands and grow while their sales process evolves from a primarily business-to-business market towards a much larger business-to-consumer market.
  • Health plans will have to proactively manage clinical and financial risk through active care coordination for those with chronic illnesses.  This dovetails with the need for such organizations to make a quantum leap forward in their commitment to utilize modern information technology to change their business dynamics.
  • Provider organizations who seek to become Accountable Care Organizations will have to learn to think and act like next generation insurance companies (financially, clinically, technologically) to avoid becoming a repeat of yesteryear’s physician practice management debacle.

If these subjects are of interest to you, the entire Psilos 2011 Outlook on Healthcare Economics & Innovation can be found by clicking HERE.  Let me know what you think.

September 24, 2010

Talkin’ Health Insurance Rate Increase Blues

 A super-enormous spending bill gets press attention, so I’ve been talking with the media these days (1) regarding recent health insurance premium rate increases following the enactment of health reform, which is estimated to cost approximately $250 billion per year once fully realized.  While rate increases by Aetna and certain Blue Cross and Blue Shield plans correlate with the recent passage of health reform, it is hard to believe health reform is the cause, at least not entirely.  The fact is that health insurers have been raising premiums at hard-to-believe rates for well over a decade.  The primary cause then and now is runaway healthcare inflation.  It is true that for the most part insurers, like any other business, look to maximize profits, but most markets for health insurance are extremely price competitive.  Generally it is the increase in expected medical expenses that drive rate increases, and unfortunately demand for medical care has been increasing at approximately 3x the rate of general inflation.  From what I can tell this will continue forever until fundamental structures in the healthcare system change, so expect ongoing rate increases from insurers to persist, despite the political pressure.

A recent study by the Kaiser Family Foundation, while subtle in its presentation, is astounding in its exposition of runaway medical inflation’s impact on health insurance premiums.  Take a look at the charts below.

       

Compounded Annual Growth

   

Absolute 10 Year Growth

Total Health Insurance Premiums   7.8%   114%
Employee Contribution to Insurance Premium   9.5%   147%
Employer Contribution to Insurance Premium   7.3%   103%
US Inflation   2.4%   26.8%
US Real GDP (2000-2009)   1.6%   15.3%

From just this small amount of data it is clear that health insurance premiums have been sky rocketing for almost two decades.  US inflation averaged 2.4% per year, while health insurance inflation has averaged 7.8% per year, with the brunt of this premium increase being absorbed by employees at an average rate of 9.5% per year.  Wage increases have essentially kept up with inflation, meaning the annual disposable income of the average insured family, in real terms, was reduced by nearly $2,000 over the past decade as a result of medical inflation.  W/r/t employers, their bills rose at 7.8%, about 3.25x their ability to raise prices.  Result: employees and shareholders are getting squeezed.

Why so much medical inflation?

There are lots of little reasons that emanate from one major trend: we (the US and its medical profession) keep getting better and better at keeping people alive.

There are many definitions of the word “doctor,” the most relevant to understanding medical inflation being (from MWD – free version):

Doctor : (n) a person who restores, repairs, or fine-tunes things

Today there are an astounding number of ways to restore, repair and fine-tune humans. “Take two aspirin and call me in the morning” is all but gone.  We now understand thousands of causes of the headache, from too much protein in the diet, to brain tumors, to meningitis, to stress, to something called Syringomyelia ($1 to the first reader that knows what this is, and no fair if you are Neurologist), and so on. 

We now know so much that we are increasing exponentially the things that doctors can restore, repair and fine-tune, creating treatments for ailments, many of which were once life-threatening that are now survived regularly, leaving us with an older and sicker population that costs more and more to fine-tune every year.  In short, much of our medical inflation is a symptom of our amazing technology and our wealth.  Modern medicine, while an awesome exposition of human inventiveness, is slowly and steadily eating away at the more productive sectors of our economy that created the means for such inventiveness in the first place.

Will it end?

If the “it” is invention, the answer is clearly no.  We will forever be extending our life expectancy and reducing the health and fitness levels necessary to achieve it.  Medical invention will not be stopped.

If the “it” is medical inflation, the answer is not anytime soon.

Much of the healthcare chat on this blog, and that of my business partner Lisa Suennen, involves the many structural changes that must take place within the healthcare economy in order for medical inflation to come under control without the government resorting to over-reaching measures like rationing of care and reimbursement controls.  Many changes are underway, and everyday we meet new companies designing new systems and technologies created to both reduce healthcare costs and improve quality.  Unfortunately it will be many years, perhaps decades before the healthcare system begins to function primarily around a cost/quality paradigm.  I would look for measureable changes in the following areas before expecting any meaningful downward shift in the medical inflation trends:

  1. Patients evolve toward more active, cost and quality conscience consumers of healthcare and health insurance.
  2. Insurers evolve to managers of health risk rather than pure underwriters.
  3. Providers evolve their business models from a strict fee-for-service reimbursement model to a more pay-for-performance model, like most advanced industries (will doctors offer one-year warranties? – why not?).

 Such an evolution spawns subsets of ideas like wellness, care management, value-based health insurance, healthcare information exchanges, insurance exchanges, provider pricing based on quality scoring, telemedicine, and on and on.  I have been and will be discussing them all with the understanding that without meaningful progress medical inflation is here to stay.  Expect it (healthcare inflation) to continue at about 8%, so in 5 years our average family will cost about $20,000 or more a year to insure.

 ___________________________________

 (1) Here are a couple of links.  First an brief piece on medical inflation from TheStreet.com along with a podcast interview (download the podcast titled “Best (and Worst) Bonds, Insurers and Obama, Gold’s Rush” – my segment comes in around the 23:00 mark).

August 4, 2010

PPACA and the Medical Loss Ratio

 

The role of the health insurance company is changing rapidly, accelerated by many of the provisions in PPACA, including new regulations regarding Medical Loss Ratio.

What is Medical Loss Ratio?

One of the key tenets to healthcare reform is the requirement that health insurers maintain a minimum Medical Loss Ratio, which historically has been defined as the ratio of medical expenses to total insurance premiums (it should be called the medical expense ratio, but claims expenses in the insurance industry have been called “loses” since, well,  forever, and hence the convention sticks).  Insurers that fail to achieve a minimum MLR, expected to be somewhere in the range of 80-85% depending on whether the plan is large group (85%) or small group/individual (80%), will be required to provide a refund to policy holders.

Some numbers, please…

Suppose that in a given year a health insurer has 20,000 members that are charged an average premium of $4,800 per year ($400 per member per month or PMPM in industry parlance), equating to Annual Premium Revenue of $96 million per year.

If the regulated MLR is 85% the amount of money this health plan is required spend on medical expenses equals $81.6 million per year (85% of $96 million).

Suppose it turns out that medical claims actually equal $74.8 million or 78% of premium for that year.  Prior to healthcare reform the excess $6.8 million would be considered profit for the health insurance company.  Under reform the $6.8 million must be refunded ratably to the policy holders for that year, resulting in an average rebate of  $340 per member ($6.8 million divided by 20,000).

If the opposite occurs and medical claims are $88.4 million (92% of premium), the insurance company covers the $6.8 million shortfall out of its capital (profits).

This brief, simplified example illustrates an important aspect of MLR regulation, it effectively eliminates any potential for unexpected upside to the health insurer for underwriting the risk.  If the insurer does better than expected, i.e., the MLR is low, the excess profits inure back to the policy holders.  This has similarities to the model of a mutual company, wherein the policy holders are actually owners of the company, without the downside of unexpected losses accruing to policyholders.

Purpose

The purpose of Minimum MLR is to regulate the “value” provided by health insurance companies.  The theory is an insurance company provides greater value to its policyholders when a higher percentage of premiums is used for healthcare costs, versus, say administrative expenses or profits.  By demanding a minimum MLR legislators and regulators believe they are protecting consumers from potentially uncompetitive or collusive insurance markets, among other things.

Issues Arise

This regulation presents a myriad of issues, some of which are actuarial, but most of which derive from the definition of Medical Expense.  The exact components of Medical Expense are left to HHS to decide, but PPACA (specifically Sec.2718. BRINGING DOWN THE COST OF HEALTH CARE COVERAGE) does provide some guidance, declaring Medical Expense to be equal to (paraphrased): (i) reimbursement for clinical services provided to enrollees plus (ii) costs for activities that improve health care quality.  It is very clear what (i) above means, i.e., the money paid for medical claims.  It is in (ii) where the debate begins.

Defining “Costs for Activities that Improve Health Care Quality” will be left to the bureaucrats, and from what I can tell they are taking an open minded approach to the types of services that will be included.  Over the weekend the Wall Street Journal published an Op-Ed piece by Newt Gingrich and David Merritt titled Who Decides on Health-Care Value? (New rules to micromanage insurance companies could cost patients).  I present it to you not as a position that I support but rather as an introduction to the debate on this subject.  Please give it a read (along with some of the comments, pro and con) and I will come back to this subject soon to take a look at some of its ramifications for investors in the healthcare sector.

July 27, 2010

Government Innovation?

Filed under: Healthcare,Venture Capital — Steve Krupa @ 5:26 pm

Once again Lisa Suennen is generating discussion on the Health Care Blog, this time regarding the government’s role in stimulating innovation in the US healthcare system.  Please check it out here, they’re talking about some interesting stuff.

In the meantime, the phrase “Government Innovation” reminded me of the late-great George Carlin, and so I thought you might get a laugh out of the following list of Carlin’s odd expressions and the accompanying video of GC taking our modern vocabulary to task.       

  1. authentic reproduction
  2. business ethics
  3. death benefits
  4. forward lateral
  5. friendly fire
  6. genuine veneer
  7. highly depressed
  8. holy war
  9. jumbo shrimp
  10. lethal assistance
  11. limited lifetime guarantee
  12. live recording
  13. mandatory options
  14. mercy killing
  15. military intelligence
  16. mutual differences
  17. new tradition
  18. nondairy creamer
  19. open secret
  20. original copy
  21. partial cease-fire
  22. plastic glass
  23. resident alien
  24. silent alarm
  25. standard options
  26. true replica
  27. uninvited guest
  28. wireless cable

July 6, 2010

Inside Value-Based Healthcare – Part 2: Who Pays for Health(care) Insurance

In my previous post, Value-Based Healthcare Part 1, I talked about the two primary business risks faced by insurers, Moral Hazard and Adverse Selection.  Recall that for health insurance markets to work effectively they must be structured to mitigate Adverse Selection (i.e., the reality that the very fact that someone is seeking insurance might make them uninsurable in the first place).  This means that the healthiest people must stay in the market as part of the risk pool, otherwise the underwriting will not work at affordable premium rates.  As such, employer-based Group Model health insurance has evolved as the prevalent distribution method.

So who pays for employer-based health insurance?

Today health insurance costs average about $4,800 per person per year.  While this expense is paid for by employers, it is essentially part of salary costs, and so it is really money that would otherwise be paid to employees were it not for the mandatory participation required in most Group Model plans.

Employers offer to buy the coverage on behalf of employees because they believe that having their employees insured improves productivity and it is viewed by prospective employees as a competitive perk.  This works out well from a risk pooling perspective, making Group Model insurance less expensive on average.  But what really drives the Group Model is its income tax subsidy.  The federal government does not assess income taxes on the value of Group Model health insurance (this subsidy does not exist for individual purchases of health insurance).

This tax subsidy is massive.  The average employee is in the 25% federal income tax bracket, making the subsidy worth about $1,200 per year (25% of the $4,800 average annual premium).  Approximately 180 million people participate in Group Model plans, meaning the total amount of this annual subsidy is about $216 billion per year.

So who pays for employer-based health insurance?

According to these calculations 180 million employees cost a total of approximately $864 billion, $648 billion is paid for by employees through payroll deductions and about $216 billion is paid for by the federal government through income tax subsidies.  These amounts exclude out-of-pocket expenses, which are by enlarge paid for by employees.

_________________________________________________

Let’s get back to Moral Hazard.

Have you ever noticed that people are very hesitant to make claims on their automobile and property insurance?  Rarely do the costs of minor fender benders result in an insurance claim.  Why?  Because people fear that claims on their auto policies will result in either their premium increasing or their policy getting cancelled.  People tend to reserve that type of insurance for major catastrophes, paying the cost of minor accidents out of their own pockets.

Most people do not behave this way when it comes to health insurance.  A very high percentage of healthcare expenses become insurance claims.

Few people lose their insurance because of high insurance claims.  As claims increase, the burden of the higher premium is shared among the risk pool.  As a result, Moral Hazard (changing your ethics because you don’t pay for the consequences of your bad behavior) in Group Model plans is severe, and many believe it contributes significantly to the 8-12% average annual healthcare inflation rate.  Despite the reality that employees pay for more than 75% of the cost of their health insurance, they are fearless when making insurance claims.

________________________________________________

So, returning to the thread that ended Value-Based Healthcare Part 1.

Employer-based health insurance suffers from Moral Hazard.  Despite the fact that it seems obvious that employees pay the most of the tab, the cost is not individualized and the consequences of bad behavior are not perceived as even remotely severe.

Research backs the notion that when an insured party pays a higher percentage of the total cost of the service Moral Hazard reduces.

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption why not just increase the out-of-pocket payments and reduce Moral Hazard?

In some cases higher out-of-pocket costs can lead to Unintended Consequences, namely people forgoing necessary treatment.  For example, the medicines necessary to treat Type-2 diabetes are much less expensive than the costs associated with the side-effects of untreated diabetes like heart attack, stroke, amputations, blindness, etc.  A health insurer wants Type 2 diabetics to take their medications, however high out-of-pocket charges often impose barriers to compliance.

Medications like Glucophage, a treatment for Type 2 diabetes, have a high value.  The treatment costs about $400 per year, real money for an individual, but a small investment for a health insurer given that compliance with the drug should mitigate a number of side effects of Type 2 diabetes, saving money on hospitalizations and other forms of expensive healthcare.  Further, Type 2 diabetics should see podiatrists and ophthalmologists regularly.  Again, high co-pays for these services could mitigate compliance and increase adverse events within an insured diabetic population.

Value-Based Healthcare: Definition #2:

Value-Based Healthcare involves designing insurance benefits with economics that encourage (or remove the barriers to) the utilization of high-value healthcare services.

So why is Value-Based so new?  What are the barriers to implementing Value-Based?

These questions will be covered in future posts.

To leave you with something to think about, it was only until recently that the information technology necessary to begin experimenting with the implementation of Value-Based Healthcare became available.

June 25, 2010

Inside Value-Based Healthcare – Part 1: Moral Hazard

Value-Based Healthcare.  There, I said it…

I had fun on Wednesday sitting on the healthcare reform panel at the Dow Jones Limited Partners Summit.   The conversation centered on investment trends in healthcare as updated for the passage of PPACA, during which I blurted out the concept of value-based healthcare, a pretty complex and to some extent novel concept, and a cornerstone to many of Psilos’ VC investment strategies.  This was subsequently reported, and to Jennifer Rossa’s credit, she provided enough detail around my comment to correctly convey the concept.

There are important nuances, however.  This post is the beginning of a series that will explore the ins-and-outs of Value-Based Healthcare.

Value-Based Healthcare: Definition #1:

Value-Based Healthcare, or more specifically, Value-Based Health Insurance Design, its sobriquet being simply, Value-Based, intends to mitigate the Moral Hazard inherent in low cost-sharing health insurance coverage.

If we were to take an insurance or advanced finance class together we would spend a lot of time talking about Moral Hazard and Adverse Selection, the two primary business risks that underpin managing financial institutions, insurance companies and banks included.  Failure to manage these risks properly can lead to disaster (in fact, recently Moral Hazard and Adverse Selection got the better of the mortgage banking business, a primary cause of the financial crisis).

Moral Hazard reflects the reality that a party insulated from a risk (like an insured or a borrower) will behave differently than if it were fully exposed to the risk.

Adverse Selection reflects the reality that the very nature of a party’s desire to seek insulation from risk reflects a greater risk of loss.  For example, parties that are either sick or expect to get sick have a higher demand for health insurance.  Similarly, parties in the market for a mortgage that have a concern that they may default are more attracted to low-down-payment mortgages.

Underwriting models are designed in part to set prices to countervail the risks of Moral Hazard and Adverse Selection.  This is more easily accomplished in an underwriting model where each policy gets priced individually, like automobile insurance.  In this model individuals are placed in broad price cohorts based on age, gender, style of car, etc., and then adjustments to the policy price are made based on individual attributes like historical driving record.  Moral Hazard and Adverse Selection are less prevalent in insurance markets where policies are individually underwritten and where the underwriter will be the party that ultimately pays the claims on any policy.  Absent these conditions the risks of Moral Hazard and Adverse Selection will always be lurking.

Such is the case in the current market for employer-based health insurance (also called Group Model health insurance).

Let’s start with Moral Hazard.  Today many employer-based health insurance models feature low cost-sharing, meaning that patients pay a very small amount of the health resources they consume.  Here the economic question is whether the value of a healthcare service exceeds the out-of-pocket cost to the patient, which is a small fraction of the actual costs.  Moral Hazard comes into play because the insurance insulates the patient from full payment, thus altering behavior toward increased healthcare consumption, a phenomenon some believe is encouraged by the fact that providers (doctors and hospitals) are generally not at risk either and are paid on a fee-for-service basis.

Consider what might happen if the out-of-pocket costs to the patient were raised.  In insurance markets where patients could opt out and choose not to buy insurance, an increase in out-of-pocket costs would certainly result in some people, probably the healthiest, declining coverage.  This would cause premiums to rise, because the insured pool would be sicker on average, causing more of the healthiest people to decline, increasing the risk of the pool, increasing the premiums, and so on, into an Adverse Selection spiral.

In health insurance markets we need the healthiest people to stay in the market in order for the underwriting to work at reasonable levels of insurance premium.  This is one of the reasons why health insurance is provided by employers.  Employers, or coalitions of employers, are able to deliver large enough populations of sick and healthy people for the underwriting to work.  The participation of large numbers of employees mitigates Adverse Selection and as a result many large employers choose to self-insure (tax incentives is another reason employer-based health insurance dominates – more on this another time).

Nonetheless, in employer-based health insurance we are still left with Moral Hazard, and research seems to back the notion that its degree is inversely correlated with the percentage out-of-pocket paid by patients (low out-of-pocket = high Moral Hazard = high healthcare consumption).

So the question becomes, if we are looking for an employer-based health insurance model that will counter increased healthcare consumption (and believe me, we are), why not just increase the out-of-pocket payments and reduce Moral Hazard?

It turns out not to be that simple.  Please give this some thought and we’ll dig a little deeper next time…

June 2, 2010

The OmniGuide Laser

Filed under: Healthcare,Technology,Venture Capital — Steve Krupa @ 7:34 pm
Tags: , , ,

Happy Physicist Yoel Fink

Here’s a fun shot of a very happy (and brilliant) CEO Yoel Fink, who runs one of our (Psilos’) portfolio companies, OmniGuide.  This picture was featured in a massdevice.com article that just came out and it reminded me that I have yet to post on Yoel’s company.

OmniGuide falls into the medical device segment of our healthcare investment portfolio.  Over the past 40+ years VCs have invested in incredible medical devices and diagnostic inventions that have led a revolution in medicine, extending life and improving lifesyle.  Unfortunately, our current healthcare related financial crisis is one of the unintended consequences of this revolution.

In anticipation of an era of financial constraints on the healthcare system, our investment approach is to back new medical devices that not only provide a new standard in quality outcomes, but also reduce cost to the health system and align the economic incentives of payers (insuers, gov’t, consumers), providers (doctors and hospitals) and patients (consumers).  OmniGuide’s BeamPath laser technology is a product that does just that and more.

Below is a 5 minute video of a report on CNN on how a Wake Forest surgeon found OmniGuide’s BeamPath and used it to remove what was believed to be an inoperable brain tumor.

What I think you pick up from this video is that OmniGuide has developed a one of a kind medical invention that saved a life that was unlikely to have survived previously.  While this is incredible, we were attracted to investing in the company because the CO2 laser operates with virtually no collateral damage, making it the perfect scalpel for operating near sensitive tissue (think the brain, the prostate, the uterus, the ear, the eye, etc.).  Also, the newfound ability to bend this laser enables its use as a minimally invasive surgical method.  These two features together reduce the trauma from a procedure and improve the surgical efficiency, producing better outcomes (higher qualilty) and better productivity (reduced hospital costs).

In this case, it just so happens that OmniGuide’s technology is also groundbreaking in and of itself.  Yoel figured out how to bend a CO2 laser without energy loss, something that was thought to be near impossible, and then manufacture his perfect mirror to a size that produces a 10s micron laser profile, enabling its use in minimally invasive surgery.

For more on OmniGuide, click here.  Awesome.

May 25, 2010

Defending the Carried Interest (Capital Gains) Tax Incentive

Filed under: Finance,Venture Capital — Steve Krupa @ 8:41 pm
Tags: , , ,

Today I intended to write an editorial, of sorts, in opposition to the US government’s proposal to raise the tax rate on Carried Interest earned by investment partnerships.  This tax increase targets partners of VC and Private Equity funds and is imbedded in a current bill proposed by the House of Representatives called The American Jobs and Closing Tax Loopholes Act of 2010 (H.R. 4213).

Under the category of closing individual loopholes, the House provides the following summary of the provision:

Taxation of carried interest.  The bill would prevent investment fund managers from paying taxes at capital gains rates on investment management services income received as carried interest in an investment fund… the bill would require investment fund managers to treat seventy-five percent (75%) of the remaining carried interest as ordinary income (50% for taxable years beginning before January 1, 2013). This proposal is estimated to raise $18.685 billion over 10 years.”

In the course of my beginning to research this topic, I remembered that my partners and I had already addressed this issue in a letter we wrote back in March of 2009.  Below is an edited version of that letter, altered slightly to bring it up to date.  It reads much like an editorial, but I believe it succeeds in making its point.

 ________________________________________

Venture Capital and Carried Interest 

The Congress proposes to increase the capital gains tax rate on Carried Interest earned by principals of venture capital firms from the current standard capital gains rate to a hybrid rate weighted more toward the marginal tax rate on ordinary income.  As with all tax rate increases, we believe that this one will serve as a long-term disincentive, in this case to the formation of capital around innovative start-ups, one of the key historical drivers of job creation in the US economy (according to National Venture Capital Association, in 2005 companies that received venture capital from 1970-2005 accounted for 10 million jobs – approximately 9% of the private workforce – and $2.1 trillion in revenues – approximately 17% of GDP).

Unlike other forms of investing, venture capital investment does not involve intricate financial engineering and it does not rely on financial leverage and market arbitrage to generate gains.  Venture capital is about investing equity in young companies for long-term results.  Most venture capital investments are made in companies with less than $50 million in revenues and are held for periods between 5 and 7 years (although some are held much longer), distinguishing them as intrinsically unique, long-term, growth oriented equity investments.

It is expected that for the foreseeable future venture capital will be deployed in clean and alternative energy technologies, a host of computer science-oriented businesses, bio-medical technology and healthcare services and information technology.  These are the precise areas of innovation necessary to solve some of the key issues in our economy and these are the very businesses that seek employees with advanced skills in biology, mathematics, engineering and computer sciences, a major thrust of our government’s education initiative.

In a well-run investment model the venture capitalist operates in partnership with the entrepreneur, focusing on long-term company building, as opposed to the buying and selling of portfolio securities.  The venture capitalist puts its own capital at risk and raises additional funds by advocating investment in the sector to large institutional investors, many of which, like endowments and pension funds, are tax-exempt.  Once the funds are raised, the venture capitalist screens an enormous pool of new ideas to tease out those with the best investment prospects (less than 1% of venture ideas ultimately get funded by venture capitalists).  After the initial investment is made, the venture capitalist supports each new company and its entrepreneur by providing follow-on financings and working with the company as a board member and advisor on matters of strategy, human resources development, sales, marketing, finance and business development.  It is not until the long-term success of the company is achieved that the venture capitalist earns a financial reward for its efforts in the form of a capital gain, known primarily as Carried Interest.  Along the way there are plenty of chances for failure.  Despite the best efforts of all involved, most venture-backed companies ultimately fail, but those that do succeed pay-off well in excess of the failures, rewarding entrepreneurs and venture capitalists for working through substantial financial and operating risk.  Venture capital investment represents absolute value creation, not “zero-sum” value transfer.  The resultant output to the nation is permanent innovation and job creation. 

So why would the House propose to penalize venture capitalists with a tax increase to Carried Interest?  It seems counter productive and will not lead to stimulating innovation (further in and of itself it doesn’t raise much money – $18 billion over 10 years is less than 0.04% of the federal budget over that same period time).  During the campaign President Obama committed to eliminating the capital gains tax for investment in small businesses, clearly supporting the notion that tax incentives stimulate investment activity.  Yet, a carried interest tax increase on venture capitalists would operate in complete opposition to this goal.  The truth is, the venture capitalist and the entrepreneur are long-term partners and should be treated the same.

Today venture capital is a highly competitive global business.  Innovation will develop where there is unity between the talent available to build new innovative businesses and the incentives for capital investment.  We see other countries narrowing the global education gap and providing very compelling capital incentives (e.g. – China is investing heavily in education and does not tax capital gains at all).  Currently, the United States has the most advanced and effective venture capital infrastructure in the world and we believe that this is one of this country’s great competitive advantages, portending future success beyond our current financial difficulties.  As such, we would urge Congress to look for ways to maintain and enhance venture capital as the National Asset that it is and not to penalize suddenly those venture capitalists whose past and ongoing work is in complete harmony with America’s long-term economic objectives.

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