Tag Archives: carried interest

Hedge Fund Law Blog Notes For Week

Adviser Registration, Accredited Investors, Carried Interest, Insider Trading, Cap and Trade

Below are some thoughts on some of the major issues over the last couple of weeks.

Have a great Memorial Day Weekend!


Hedge Fund Regulation and Registration – While the Private Fund Investment Advisers Registration Act of 2010 was passed this month in the Senate, there has not been as much discussion in the news about this issue and manager registration.  I expected that we would hear more, especially with regard to the following issues:

  • Section 407 – Exemption of VC Funds
  • Section 408 – Exemption from Reporting Requirements for Private Equity Funds
  • Section 410 – State Authority for Managers with AUM of up $100MM (this is generally a bad idea in my opinion and we will be writing a post about this soon…)
  • Section 412 – Adjusting Definition of Accredited Investor (see also below)

I imagine we will hear more as the Senate and House begin to reconcile their two bills and before President Obama signs the final Financial Reform bill into law, which some think may happen before the July 4th holiday.


Definition of Accredited Investor – The Senate version of the Financial Reform bill will change the definition of an “accredited investor” in the future.  Generally “accredited investors” are those individuals with a net worth of $1,000,000.  Under current regulations, individuals can include the equity in their private residence when determining their net worth.  In the future, they will need to exclude the equity in their private residence when determining their net worth.  This potentially may have a deleterious effect on the hedge fund industry, but also on other industries which rely on private placements.

According to some sources, at least one Senator is asking that the definition of accredited investor be expanded to include state and local governments.  I agree with this approach – if the Senate is taking the time to mess with the definition right now then the Senate should spend a little time addressing other issues.  For instance, the definition of accredited investor should also be expanded to include Native American Tribes.  I have specifically talked with the SEC staff about this issue a couple of years ago and they have categorically refused to issue a no-action or other interpretive release on this issue – we believe that now is the time to include Native American Tribes in the definition of accredited investor.

For more information, please see the Native American Capital, LP policy briefing and the National Congress of American Indians letter to the SEC on this issue.

See also Perkins Coie discussion of this issue.


Carried-Interest Issue -it looks like the carried interest tax laws will be changing in 2011.  In addition to hedge fund managers, managers to other pooled investment vehicles will be greatly affected (such as VC and private equity fund managers, as well as real estate fund managers).  The change in the laws will likely affect more VC and PE managers than hedge fund managers because of the nature of the underlying gains in the respective investment vehicles (VC and PE fund managers typically have mostly long term capital gains and hedge fund managers may have a combination of long term and short term capital gains).  There is likely to be a large number of industry groups which come out in opposition to the changes in the next couple of weeks.

We do not agree with the proposed changes – it seems as though Congress is specifically attacking an easy target  in the investment management community.


Insider Trading Issue – just today the SEC announced an insider trading case brought against a hedge fund manager Pequot Capital Management, Inc., and its Chairman and CEO Arthur Samberg.  This issue has been thoroughly discussed most recently after the Galleon affair.  Hedge funds managers and compliance personnel need to be even more vigilant about establishing comprehensive compliance programs and making sure that traders are not engaging in insider trading.  Please see our previous thoughts on Hedge Funds and Insider Trading.


Green Tech/ Cap and Trade – clean and green tech continue to gain traction in the investment management industry as a bill which would create federal carbon cap and trade system was introduced recently.  Next weekend the South Asian Bar in San Francisco will have a panel discussion. entitled “Green 2 Green: Carbon Credits, Renewable Energy Certificates and the New Markets driving the Clean Energy Economy”.  According to the program,

Attendees will receive a quick primer on market-based regulatory responses to climate change designed to foster the development of renewable power plants and spur long term investment in clean and sustainable energy. Panelists will address state and federal legislation setting green house gas emission caps, establishing renewable portfolio standards, and creating new markets for carbon credits and renewable energy certificates. We’ll discuss the regulatory origins and key characteristics of these and other green commodities, as well as the structure and rules of markets created to transition industry and consumers from the present carbon economy toward tomorrow’s clean energy economy.

Mallon P.C. will be represented at the panel discussion so please come and talk to us there.


Other related hedge fund law articles:

Cole-Frieman & Mallon LLP works with many managers who invest in various commodities and with groups who work in the clean tech space.  Mallon P.C. is a top hedge fund law firm which provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Hedge Fund Carried Interest Tax Increase?

Legislation Introduced to Eliminate Carried Interest “Loophole”

As we are all well aware, the partnership structure of hedge funds allows the management companies of these funds to receive an “allocation” of the fund’s income.  Under general partnership taxation principles, this allocation is taxed to the management company (and the other investors in the hedge fund) according to the characteristic of that income (at the partnership level).  That is, if the income was long-term capital gain at the partnership level, such income would be allocated to all partners (including the management company) and would retain such characterization.  Long-term capital gains are currently taxed at 15% (as compared to a 35% tax rate for most ordinary income).

Last week Representative Sander Levin reintroduced legislation to tax the carried interest at ordinary tax rates.  The tax would only apply to the managers of partnerships to the extent that such managers did not have an underlying investment in the fund.  I will not introduce any political opinions regarding such a tax, but I will note that I take issue with the way that the press and lawmakers define the issue.  The most glaring omission in all of these reports is that the carried interest (or performance allocation) is only taxed at long-term capital gains rates if there are underlying long-term capital gains.  These articles (including the press release reprinted below) insinuate that all allocations made to a manager will be subject to long-term capital gains rates.  Not all income to hedge funds is long term capital gain – in fact, many hedge funds have no long-term capital gains at all because their programs focus on short term or intermediate term trades.

We have discussed this issue a number of times before and believe that the best way for this issue to be addressed is through the political process and we hope that all lawmakers involved take a considered and academic approach when crafting any future tax legislation (see Hedge Fund Taxes may Increase Under Obama).

The press release below is from the office of Representative Sander Levin and provides a sort of question and answer regarding the proposed legislation.  I am interested to read your comments on this issue below.


For Immediate Release
April 3, 2009

Hilarie Chambers
Office: 202.225.4961

Levin Reintroduces Carried Interest Tax Reform Legislation

Bill to Tax Fund Managers’ Compensation at Same Rates as All Americans

(Washington D.C.)- Rep. Sander Levin today reintroduced legislation to tax carried interest compensation at the same ordinary income tax rates paid by other Americans.  Currently, the managers of private investment partnerships are able to receive compensation for these services at the much lower capital gains tax rate rather that the ordinary income tax rate by virtue of their fund’s partnership structure.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money.  They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%.  The President’s budget recognizes that this is unfair.  The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law.”

The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.

“This proposal is not about taxing investment, it’s about ensuring that all compensation is treated equally for tax purposes.  Anyone who actually invests money in these funds will continue to receive capital gains treatment, including the managers.  So there is no reason to expect that the amount of capital available for these kinds of investments will be reduced,” concluded Levin.

Levin introduced similar legislation in the 110th Congress, which was subsequently included in several tax packages approved by the Ways & Means Committee and the House of Representatives.  A similar proposal is also included in President Obama’s FY 2010 budget request.


Levin Carried Interest Legislation – H.R. 1935

H.R. 1935 would treat the “carried interest” compensation received by investment fund managers as ordinary income rather than capital gains.  In exchange for providing the service of managing their investors’ assets, fund managers often they receive a portion of the fund’s profits, or carried interest, usually 20 percent.  H.R. 1935 clarifies that this income is subject to ordinary income tax rates rather than the much lower capital gains rate.

Carried Interest: The Basics

Why is Congress concerned about this issue?

Many investment funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner.  The managers often take a considerable portion of their compensation for managing the funds’ investments as a share of the funds’ profits using a mechanism called “carried interest.”  Partnership profits are taxed not to the partnership; instead partners are taxed on allocations of partnership income, and the nature of that income (capital or ordinary) “flows-through” to the partners.  As a result, the investment managers are able to have income for performance of services taxed at the 15% capital gains rate.  Essentially they are able to pay a lower tax rate on income from their work than other Americans simply because of the structure of their firm.

What does the legislation do?

It clarifies that any income received from a partnership, capital or otherwise, in compensation for services is ordinary income for tax purposes.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested in the partnership.

What kinds of investment firms will be affected?

This is part of a broad consideration of tax fairness.  The principle at work is that compensation for services should be treated as ordinary income and taxed accordingly, regardless of its source.  Any investment management firm that takes a share of an investment fund’s profits as its compensation (i.e. in the form of carried interest), will be affected.  This will apply to any investment management firm without regard to the type of assets, whether they are financial assets or real estate.  The test is the form of compensation, not the type of assets the firm is managing, its investment strategy, or the amount of compensation involved.

What is the effective date of the legislation?

This legislation is designed to create a structure under which this income should be taxed.  Decisions on the effective date will be made as part of the legislative process.

Carried Interest: Myths vs. Facts

Myth: This is a tax increase on investment that will hurt economic growth.

Fact: Investors are not affected by this legislation at all.

Any person or institution who invests money in a fund whose managers receive a carried interest will continue to pay the capital gains rate on their profits.  In fact, the bill explicitly protects the investments that fund managers make themselves.  To the extent they have put their own money in the fund, managers still get capital gains treatment, but to the extent they are being compensated for managing the fund, they will have to pay ordinary income tax rates like other service providers.   Since investors are not affected, there is no reason to believe that the amount of capital available for these kinds of investments will be reduced at all.

Myth: Taxing carried interest is just about raising revenue.

Fact: Fairness requires treating all taxpayers who provide services the same.

This proposal would raise revenue, but it is not just an offset.  Congress has a responsibility ensure that our tax code is fair, that it makes sense.  A broad spectrum of experts, including the Chairman of the Cato Institute and senior economic advisors to the last three Republican Presidents, agree that carried interest really represents a performance based fee that investors are paying to fund managers and that it should be taxed accordingly.  Allowing some service providers to pay the 15 percent capital gains rate on their income when everyone else has to pay up to 35 percent risks undermining people’s confidence in our voluntary tax system.

Myth: Fund Managers are just like entrepreneurs who get founder’s stock in their company, so they too should be taxed at the capital gains rate.

Fact: Fund Managers are fundamentally different than the founder of a company.

When someone starts an enterprise, he or she actually owns that business.  Sometimes that business becomes enormously valuable, but quite often it fails altogether and the entrepreneur loses her business. When an investment partnership purchases an asset, be it a stake in a small start-up company, a large corporation that wants to go private, a portfolio of securities, or a piece of real estate, the partnership does truly own those assets.  The general partner or fund manager though is really only an “owner” to the extent he or she has contributed capital to the partnership.  The carried interest the general partner receives for managing the fund’s assets is a right to a portion of the fund’s profit, not to the fund’s actual assets: the manager has no downside risk.  If the fund fails completely and all of the partnership’s assets are lost, the limited partners have lost their money.  The manager has lost the time and energy he has put into the running the fund, and the potential to share in the profits, but he is not actually out of pocket.

Myth: Fund managers deserve capital gains treatment because a carried interest is risky.

Fact: Many other forms of compensation are risky, and they are all ordinary income.

When a company gives its CEO stock options, it is trying to give her an incentive to increase the company’s share price, to growth the value of shareholders’ investment.  If the CEO does a good job and the share price goes up, she pays ordinary income tax rates when she exercises those options.  Real estate agents only make money if they actually sell a house, no matter how hard they work.  Authors receive a portion of their book’s profits.  Waiters get tips based on the quality of the service they provide.  All of these people pay ordinary income tax rates on their compensation.  Only private equity and other fund managers get to pay capital gains rates on their compensation.

Myth: Taxing carried interest will hurt the pension funds that invest in these funds.

Fact: This has nothing to do with pension funds and their returns will not be affected.

One pension trustee, who also happens to be a hedge fund manager, called the idea that this debate is about workers’ pensions “ludicrous.”  As tax-exempt investors, pension fund certainly will not be affected directly, and the assumption that fund managers can charge higher fees than they do today as a result of their having to pay ordinary income rates is extremely questionable. In fact, an attorney representing the hedge fund industry testified before the Ways & Means Committee that investors would be unlikely to accept increased fees.  The National Conference on Public Employee Retirement Systems has said that its members do not believe this legislation will affect them.

Myth: This change to the taxation of carried interest will harm every “mom and pop” partnership in America.

Fact: The change would only affect those partnerships where service income is being improperly converted to capital gains.

This legislation would have no effect whatsoever on the vast majority of partnerships that are engaged in ongoing businesses and whose profits are already being properly taxed an ordinary income tax rates.  It does apply to investment fund partnerships where the investors in the fund choose to compensate the people managing their assets through a carried interest.  In practice, this means hedge funds, private equity funds, venture capital funds and real estate partnerships.  The reality is that the fund managers and general partners who would be asked to pay ordinary income tax rates on their compensation are a very small, very well-paid group of professionals.  It is also important to note that the bill does not discriminate among partnerships based on the kind of assets they purchase.


Other related hedge fund tax articles:

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.

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