Tag Archives: hedge fund performance allocation

Hedge Fund Taxes May Increase under Obama

Obama to Propos Taxing Hedge Fund Carried Interest

Groups such as the New York Times and Daily Finance are reporting that Obama’s proposed fiscal 2010 budget, which will be released tomorrow, will include provisions which will increase taxes for hedge fund managers (and private equity fund managers).   Such a provision would likely be written to provide that a carried interest (also called a performance allocation) paid to a management company would be characterized as ordinary income instead of capital gain (to the extent the underlying profits were long term capital gains which are subject to a lower tax rate).

Hedge fund managers are not likely to receive much sympathy from the general public, but this is a hot button issue which will likely incense many of Obama’s supporters.  Hedge fund taxation has been an issue batted around in the media and was especially popular a year and a half ago when the Blackston group was preparing to go public (see Bloomberg article).  The issue has been smoldering for a while (see Hedge Fund Tax Issues 2007), but groups are beginning to examine and analyze this issue (see the abstract of an academic report below) rather than react in a knee-jerk manner.

What we will ask of the President, lawmakers and regulators is that they examine the issue from an academic perspective and make informed decisions.  Hopefully reports like the one below will persuade lawmakers to ultimately keep the carried interest tax preference for hedge funds and private equity funds.

We will continue to report on this issue and will release any applicable information once the fiscal budget is released.  Please feel free to contact us if you have any questions if you have any hedge fund law questions.


Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation

Karl Okamoto
Drexel University College of Law

Thomas J. Brennan
Northwestern University School of Law

February 26, 2008

Drexel College of Law Research Paper No. 2008-W-01


A debate is raging over the taxation of private equity and hedge fund managers. It is being played out in the headlines, in Congress and among legal scholars. This paper offers a new analysis of the subject. We provide an analytical model that allows us to compare the relative risk-reward benefit enjoyed by private equity and hedge fund managers and other managerial types such as corporate executives and entrepreneurs. We look to relative benefits in order to determine the extent to which the current state of the world favors the services of a private equity or hedge fund manager over these other workers. Our conclusion is that private equity and hedge fund managers do outperform other workers on a risk-adjusted, after-tax basis. In the case of hedge fund managers, this superiority persists even after the preferential tax treatment is eliminated, suggesting that taxes alone do not provide a complete explanation. We assume that over time compensation of private equity and hedge fund managers should approach equilibrium on a risk-adjusted basis with other comparable compensation opportunities. In the meantime, however, our model suggests that differences in tax account for a substantial portion of the disjuncture that exists at the moment. It also quantifies the significant excess returns to private fund managers that must be taken into account by arguments in support of their current tax treatment by analogy to entrepreneurs and corporate executives. This analysis is important for two reasons. It provides a perspective on the current issue that has so far been ignored by answering the question of how taxation may affect behavior in the market for allocating human capital. It also provides quantitative precision to the current debate which relies significantly on loosely drawn analogies between fund managers on the one hand and entrepreneurs and corporate executives on the other. This paper provides the mathematics that these comparisons imply.

Other hedge fund tax and law articles include:

Hedge Fund Fees | Discussion of Future Trends

The following article is by Christopher Addy, President and CEO of Castle Hall Alternatives, a hedge fund due diligence firm.  We have published a number of pieces by Mr. Addy in the past (please see Hedge Fund Due Diligence Issues, Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).  The following post can be found here.


Hedge Fund Fees: Is It Worth It To Pay For A Star Hedge Fund?

An article in the current week’s edition of the Economist asks whether one-and-ten will become the new two-and-twenty.

The discussion notes that there will be clear fee pressure on fund of funds.  We will return to the question of fund of funds in a later post: as a quick precis of our views, while Madoff has raised long overdue questions about whether fund of funds really complete due diligence (saying no always gets in the way of making money) we still see plenty of room for fund of funds who genuinely can serve as expert intermediaries.  Fund of funds as a provider of expertise rather than a provider of capacity, and, separately, fund of funds offering funds of managed accounts, both seem like valid models going forward.

For single strategy managers, the Economist makes several points in a single paragraph:

“Those funds with excellent records will manage to maintain their fee rates. Big diversified managers with mediocre performance will have to cut fees to hold on to their assets. Given the “high watermarks” in place, which require that losses be recouped before performance fees can be charged, they may struggle to retain top staff, although they should at least be able to stay in business. The real threat is to smaller operators—half of all hedge funds manage less than $100m. Lower management fees may not cover their fixed costs, such as salaries, accommodation and IT. The era of hedge-fund managers being unable to pay the rent may soon be dawning.”

While these points are valid, we remain very unconvinced by the argument that “those funds with excellent records will manage to maintain their fee rates.”  More precisely, we agree that the largest funds with good performance will likely keep their fee schedules: but we are unconvinced that those fees are worth it when they are above 2 and 20.

If 2008 has shown us anything, it’s that – as we noted in our last post – you can’t rely on a “best of the best” hedge fund to deliver guaranteed performance.

Plenty of articles have been published commenting on the relative performance of some of the industry’s largest funds – Bloomberg in this piece commented on a variety of funds: while there were winners such as Paulson, Brevan Howard and Winton, there were also plenty of losers, notably Citadel.  Another excellent Bloomberg article on Fortress noted that the firm’s Drawbridge Global Macro was down -26% while Drawbridge Special Opportunities lost 18%.  This article from early November commented on performance from a number of funds: it only got worse by year end.  Any hedge fund investor looking down their portfolio sees the same pattern of apparently random winners and losers among what were previously Top 100, star managers.

Ex post, therefore, some big funds funds have proved themselves to be worth their fees.  Plenty of them, however, have proved not to be.  Investors couldn’t predict the winners and losers beforehand during this market crisis: will they somehow be better at picking the big hedge funds that will be winners rather than losers when we have the next Black Swan event?  Why should investors pay, ex ante, excess fees to any hedge fund based solely on a historical track record?

This line of thinking raises some broader questions.  From our side, we have always been very skeptical of the largest hedge funds.  Indeed, back in early November 2007 we wrote a post called “People are spooked…so let’s invest in big hedge funds.  Is there really a flight to quality?” In that post, we wrote the following:

“This redirection of capital inflows [towards the biggest hedge funds] does seem to be driven by institutional investors.  If we were to ask ourselves, however, what are the three most important issues for institutions considering a hedge fund allocation, we expect the answer would be:

1) Transparency
2) Fees
3) Independent oversight

But…the Top 25 hedge funds now receiving such large allocations of institutional capital have the most restrictive transparency, the highest fees and no independent oversight (virtually all do not appoint an independent administrator, meaning that investors must rely on the manager to calculate each NAV and price all the assets with no third party check.)

We’re really puzzled by this paradox – there’s obviously a big difference between what institutions say they want, and what they are prepared to invest in.

Why is this?  Obviously, there’s strength in numbers, and it’s easy to justify an allocation to a firm if pretty much everyone else in the industry has already invested.  But, to point out the obvious again, the Bear Stearns funds were run by the Wall Street house with the reputation for the greatest expertise in mortgage and structured securities available in the industry.  Amaranth was one of the most sophisticated multi strategy funds available.  Sowood was formed by superstar managers from the Harvard Management Company.  Basis Capital in Australia had the highest possible, 5 star rating from Standard & Poors.  The list goes on, and on.

The lesson, therefore, is simple and obvious: do not to take anything for granted.  Certainly, asking hard questions – and being prepared to walk away – would have served potential investors in the above funds well.  This is not the last time hedge fund investors will learn this lesson.”

Well yes.

As we noted nearly 18 months ago, the biggest firms typically have the highest fees, have limited transparency and often don’t have independent oversight over their NAVs.  We would also add that it is typically the largest firms that ask for the longest lock ups: investors who signed up in ’06 and ’07 to 3 and 5 year lock classes must be pretty unhappy right now.  Moreover, the biggest firms usually have the tightest gates and most restrictive redemption provisions in their offering documents: 2008 has shown that many (most?) of the industry’s largest funds have chosen to suspend redemptions, impose involuntary restructurings etc.

Where does that leave investors?  We don’t deny that some of the largest hedge funds remain deeply resourced, highly skilled money managers.  On the other hand, our point is not to write off the small guy.

For many reasons, we believe that there is a real value in being a “bigger fish in a smaller sea”.  Thinking of operational issues, a larger investor in a smaller fund has so much more leverage:

  • Power to negotiate fees
  • Power to influence the terms of the offering document, and particularly to impact provisions related to gates, suspensions, side pockets etc.
  • Better operational transparency
  • Ability to engage in a constructive dialogue about operational controls: smaller funds are, for example, much more likely to have an administrator.  Smaller managers typically also give more information about their procedures, enabling investors to get a better understanding of key controls such as valuation.  Moreover, if a small firm needs to improve, they are much more likely to listen to a large, strategic investor – in fact, they are much more likely to listen full stop.

Investing in a smaller hedge fund – particularly now – gives the investor much better power to enter into that investment in a spirit of partnership.  It also provides more flexibility on the way in and on the way out.  That is massively different from going to a large multi strat and still facing an unappetizing menu of terms such as a 3 year lock class, a 8% rolling quarterly redemption provision, a 2 and 25, 3 and 30 fee structure et al et al.

One of the questions we always ask ourselves when we visit a hedge fund is about the culture of the manager.  Put simply, does it feel as if the manager thinks we are doing him a favor by giving him our capital, or is there a sense that the manager feels he is doing us a favor by letting us in.

Right now, we would always pay less for a receptive manager than pay more for a fund which still thinks that that we need them more than they need us.

Hedge Fund Operational Due Diligence

Hedge Fund Taxation – Law School Professor Perspective

Overview of Hedge Fund Taxation

The following is a reprint of the Joseph Bankman’s testimony before Congress.  Mr. Bankman is a professor at Stanford Law School.  While the testimony has a bias against the current hedge fund taxation structure, it provides a great overview of hedge fund tax issue, specifically the taxation of the hedge fund performance fee (also known as a “performance allocation,” “carried interest” or “carry”).  Ultimately the future of the hedge fund taxation regime will be decided in the political arena, but this article provides a good overview of the arguments for changing the current tax code.  Continue reading