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  President Barack Obama’s budget proposal to change the tax treatment of carried interest, the latest in a string of alternative investment initiatives in Washington, is bringing predictions of dire consequences from industry sources.

But investors aren’t so sure.

While many industry players and observers don’t expect institutions to stop investing in alternatives any time soon, one private equity industry group sees a darker picture.

The Private Equity Growth Capital Council, Washington, claims that a tax hike would have a negative effect on private equity firms and their ability to produce high returns. That, in turn, would cause investors to review their investments.

“While it comes as no surprise that the president has included a carried interest tax hike in his budget proposal, the fact is that raising taxes on private equity investments would discourage the risk-taking required to start, grow and save companies,” council officials said in a statement.

Ken Spain, vice president of public affairs and communications, did not return phone calls seeking further comment.

Investors have a different perspective. Officials at the California State Teachers’ Retirement System, West Sacramento, have not made any changes in its alternative investment program in response to the initiatives in Washington, said Ricardo Duran, spokesman for the $144.8 billion system. But he added: “We are keeping our eye on it.”

The president’s proposal for the fiscal year 2013 budget, as well as a bill introduced last week by Rep. Sander Levin, D-Mich., ranking member of the House Ways and Means Committee, are just the latest efforts to increase the tax paid by general partners in private equity and other alternative investment firms. If approved, such a proposal would eliminate the lower carried-interest tax rate they now pay, and instead apply ordinary income tax rates.

But investment consultants say the impact of the carried interest debate has been overstated.

“The tax treatment of the carried interest issue is overblown on a fiscal basis, as it will not make a dent in the federal deficit, and on a private equity basis, as it will not materially impact private equity behavior or performance,” said Thomas Lynch, senior managing director in the New York office of alternative investments consultant Cliffwater LLC.

Jeffrey MacLean, CEO of Seattle-based consulting firm Wurts & Associates, agrees about investor behavior. “I don’t see that affecting investors’ appetite at this point. It’s something that may happen in the tax law and there are so many things that are involved in the decision to allocate to private equity.”

Other issues

But carried interest is not the only issue on the table in Washington that affects alternative investments.

One is an investigation by the Securities and Exchange Commission into private equity’s valuation and performance reporting practices. Another is the so-called Volcker Rule, which limits certain banking entities’ ability to make illiquid investments such as alternatives as well as to retain in-house alternative investment management groups. The rule is included in the Dodd-Frank Wall Street Reform and Consumer Protection Act. In particular, the Volcker Rule restricts banks and finance companies from engaging in proprietary trading and having certain interests in or relationships with a hedge fund or private equity fund.

In a statement, the Private Equity Growth Capital Council said: “Although the PEGCC’s members are not themselves directly subject to the Volcker Rule, the Volcker Rule will impact the ability of private equity firms to raise capital from certain groups of investors.”

Some alternative investment funds of funds have been sponsored by groups embedded in financial institutions, explained Andrew McCune, Chicago-based partner and co-head of the private equity practice at international law firm McDermott Will & Emery LLP.

These funds of funds were able to raise a lot of capital, including chunks invested by the financial institutions. Believing that something like the Volcker Rule would eventually come into effect, many financial institutions have already reorganized, he said.

“In many cases they’ve taken an internal group and spun out as an independent firm,” Mr. McCune said.

These new firms will not have a parent to augment their capital nor, as a new firm, the ability to raise as much capital. This means there is less capital in general to invest in private equity funds, which affects the fundraising ability of all private equity managers, he said.

“We have already seen a significant decline in liquidity in certain markets as banks have stepped back from market making and principal activity,” said Cliffwater’s Mr. Lynch. ”Hedge fund credit strategies and distressed debt-oriented private equity funds have already seen the negative impact.”

Lousy timing

The timing couldn’t be worse. Fundraising has been a horror show. Private equity firms, for example, raised $263 billion in 2011, a fraction of the $600 billion raised annually in the pre-crisis boom years. It took the average fund 16.5 months to raise a fund in 2011, compared to less than a year during the boom years, according to Preqin, the London-based alternative investment research firm.

What’s more, private equity posted a negative return, -4.3%, in the third quarter of 2011, after nine quarters in positive territory, according to a report released last week by Cambridge Associates, Boston. The return for the year ended Sept. 30 was 13.8%, Cambridge reported. In addition, private equity funds distributed $18 billion in the third quarter, down 22.4% from the previous quarter, the research firm stated.

Interestingly, the additional rules and regulations that came out of the financial crisis have been a boon for managers that invest on the secondary market, largely because financial institutions have had to jettison investment management businesses and assets in advance of the rules.

“The rules on financial institutions, Basel III, Dodd-Frank, have had a big impact. There are a lot of sellers out there who would not otherwise have sold,” said Stephen Can, managing director and global head at CS Strategic Partners, New York, Credit Suisse’s private equity arm that invests on the secondary market.

Financial institutions “need to reduce their book of illiquid assets to make them more compliant with the new rules,” he added.

Meanwhile, the SEC’s investigation into private equity valuations might prove to be a positive development for investors by requiring managers to provide better transparency and compliance as well as uniform reporting and valuation practices, Cliffwater’s Mr. Lynch said.

In the past, the SEC was more focused on protecting individuals rather than “sophisticated investors” such as pension plans, endowments and foundations, Mr. McCune said. “It would not surprise me if the SEC tried to put more explicit regulations on the presentation of valuation to institutional investors.”

Espen Robak, president of alternative investment valuation firm Pluris Valuation Advisors LLC, New York, said private equity firms could follow in hedge funds’ footsteps. After the SEC started shining its spotlight on hedge funds, many firms began hiring outside valuators to ensure impartiality of the data they were providing investors.

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