Alternative Hedge Fund Compensation Structure
At the very beginning of this year there was much discussion about the hedge fund compensation structure in light of the horrible returns from 2008. Many funds lost money but managers aren’t typically subject to the same types of clawback provisions as private equity fund managers. Additionally some funds had to close shop because of talent retention issues or because the manager realized that reaching a previous high water mark would take too long. Generally investors who have lost money will prefer to stay in a fund (all else being equal) because of the high water mark – when investors go into a new fund, there high water mark is their initial investment which means they are going to be subject to hedge fund performance fees sooner than in a fund which has previously lost money.
As an alternative to the traditional performance fee/ allocation structure, some hedge funds are instituting a different compensation structure called fund appreciation rights (FARs). Generally this structure provides a more aligned incentive structure for the manager. Essentially the FARs provide an option like mechanism for the manager. This option also has the potential to allow the manager to defer recognition of income which may be an added tax benefit for the manager. [Note: a longer discussion on this issue will be forthcoming shortly.]
Issues with FARs
FARs are new. It is not known how many groups have implemented FARs or whether they will catch on (or become the next standard). It is likely that any movement in this area will be driven by the demand (if any) by institutional investors for such products. FARs are also untested and it is not clear how they will be viewed by the IRS. As we have recently seen, there has been a big push to disallow the tax advantages of the performance allocation to hedge fund managers and in the current political climate it is likely that the IRS will scrutinize such transactions.
We will continue to research and report on this and other tax structures for hedge fund managers.
Other related hedge fund law articles:
- Perspectives on Hedge Fund Tax Issues
- Revising the Hedge Fund Compensation Structure
- Is it time to rethink the high water mark?
- Forex Registration
Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog. He can be reached directly at 415-868-5345.