HEDGE FUNDS: MORE RICHES FOR THE RICH OR TAXES FOR THE GOVERNMENT? Arthur C. Gudikunst, Ph.D. Associate Professor of Finance Christopher Newport University Presentation to CNU Faculty at Teaching, Scholarship, Research and Learning Seminar, August 21, 2007
Outline of Presentation
1. Description of Mutual Funds, Hedge Funds and Private Equity
2. Hedge Fund Investment Strategies- Overview
3. Investor Qualifications for Hedge Fund Investing
4. Compensation for Managers of Hedge Funds
5. Taxation of HF/PE Profits
6. Politics and Taxation of Hedge Funds
Mutual Funds, Hedge Funds and Private Equity Funds
Mutual Funds- registered pools of funds under Investment Company Act (40), regulated by SEC for retail investor protection.
Hedge Funds- unregistered pools of managed funds open only to “qualified” investors based on wealth and/or income.
Private Equity Funds- unregistered pools of capital for direct investment in purchase of entire companies and business units, “qualified” investors only.
Why investor interest in Hedge and Private Equity Funds?
Advantages Presumed for HF/PE:
Higher rates of returns can be earned.
Riskiness of returns is lower in HF/PE.
Improved diversification of portfolios by including new assets with lower correlations with existing assets.
CREDIT SUISSE / TREMONT HEDGE FUND INDEX
Ten sub strategies track every major style of hedge fund manager:
Convertible Arbitrage: Exploiting price inefficiencies between convertible securities and stock.
Dedicated Short Bias: Equity and derivatives portfolios with net short, “bearish” focus.
Emerging Markets: Equity and fixed-income investments in emerging markets worldwide.
Equity Market-Neutral: Offsetting long and short equity positions that are beta-neutral, currency-neutral, or both.
CREDIT SUISSE/TREMONT HEDGE FUND INDEX Hedge Fund Manager Style (continued) Event-Driven: Corporate strategies focused on distressed securities, high-yield debt, Regulation D, and risk arbitrage. Fixed-Income Arbitrage: Exploiting price inefficiencies between related debt securities. Global Macro: Directional macroeconomic strategies. Long-Short Equity: Directional equity and equity derivative strategies. Managed Futures: Listed futures strategies often driven by technical or market analysis. Multi Strategy: Multiple strategies from styles above.
Hedge Fund “Accredited” Investors
Exemption from Securities Acts of ’33 ’34 and ICA and IAA of ’40 requires that investors meet the following:
Single investor- two years of income over $200,000 per year
Married investor- two years of joint income over $300,000
OR Net worth of invested assets over $1 million, excluding personal real estate
Mutual Fund ICA’40 Regulations
Liquidity and portfolio diversification
Restrictions on use of debt leverage
Short selling restrictions
Management fee arrangements
Disclosure and reporting requirements
Exempt Hedge Funds Operations
Trade any security or financial instrument
Operate in any security market in world
Unlimited use of derivative securities
Unrestricted use of short selling
Unlimited use of debt leverage
Hold concentrated positions
Set own investor redemption policies
No extensive disclosure requirements
Hedge Fund Fee Structures
Exemption under ICA ‘40 allows:
Any fee structure desired.
This means that fund managers are allowed to set fees based on assets under management, and performance fees that may be “asymmetric” (i.e., heads I win if returns are positive, tails I do not lose if returns are negative). (see next table)
Three Regulatory Concerns About Hedge Funds
Investor Protection due to growth of HF industry, instances of increasing fraud and broadening exposure of institutional investors in HF investments.
Systemic risk to other regulated financial institutions caused by HF failures.
Market Integrity risk caused by HF activities in the financial markets.
Taxation of HF/PE: Basic Structure
1. HF/PE in USA is typically structured as a limited partnership, the general partner being the HF management company.
2. Partnerships are not taxed directly as an economic entity (i.e. not a legal corporation)
3. Profits earned in partnership are reported to individual partners as income subject to their Personal Income Tax filings (the good ole Form 1040)
Tax Issue under Debate
1. General Partner earns “carried profits” from managing funds, as major source of income for their services.
2. Carried profits are not taxed as income for services rendered (i.e. wages and salary), but rather as investment income subject to Long and Short Term Capital Gains.
3. Partners do not pay highest personal marginal tax rate (35%) but only 15% rate on Long Term Capital Gains. (STCG taxed at 35% marginal)
Illustration of Taxation Issue
Case Study: assume HF earns $5 million of profits in year 2007. The profits are $3 million in LTCG, and $2 million in short term gains.
How will this profit be taxed under both the Corporate Taxation model or as a Limited Partnership?
How will an individual investor with 10% ownership of the HF profit after taxes?
Case Study Taxes (higher LTCG, lower effective tax rate) Personal Taxes $ 0.495 mil Total Tax $2.195 mil (43.9%) Effective Tax rate= 23% Dividends paid $3.3 mil Total Taxes $1.150 mil Effective Tax Rate= 34% Tax STCG(.35) $ 0.700 mil After-tax Profit $3.3 mil Tax LTCG(.15) $ 0.450 mil Fed Corp Tax $ 1.7 mil Pre-tax profit $ 5.0 mil Pre-tax Profit $ 5.0 mil Partnership: Corporation:
Case Study: 10% Investor
Under Partnership taxation, 10% equity owner pays $115,000 in personal taxes, with net gains of $385,000 after taxes.
Under Corporate taxation, 10% equity owner receives $330,000 in dividends and pays additional $49,500 in personal taxes. Net gains to investor is $ 280,500 after tax.
Political Taxation Response
Congressman Levin (H.R. 2834) bill proposes that HF/PE managers income be taxed at 35% rate, eliminating 15% LTCG treatment.
Sen. Baucus and Grassley (S. 1624) bill would remove ability of publicly-traded partnerships (only for HF/PE) income to be taxed under partnership rules, hence taxed as Corporations.
Politics of Taxation
Philosophy 1: The federal (and state) governments should increases taxes on the rich, especially those earning money just from investments in paper assets.
Philosophy 2: Lowering taxation on invested assets spurs increased economic performance, and actually increases tax collections in the future.
WHICH IS CORRECT? You debate!
Investor Protection and Regulation
Basic attitude of SEC regarding HF investors is “let them fend for themselves”.
SEC, in Dec., 2006, adopted rule 203(b)(3)-2 that requires most HF advisors to be ‘registered’ under IAA ’40. This will allow SEC oversight regarding 1) conflicts of interest,
2) anti-fraud provisions, 3) more disclosure of financial records, 4)limits on advisor fees based on performance (i.e., no “asymmetric” performance fees).
Only HF with “qualified” clients (net worth over $1.5 mil or min $750,000 invested with advisor) can maintain the “asymmetric” performance fee structure.
Other HF limits and restrictions not set by SEC, but rather by contractural relationships with INVESTORS and the market discipline of CREDITORS and COUNTERPARTIES.
Systemic Risk of Hedge Funds
The possibility of a series of Hedge Fund failures and defaults that are highly correlated with resulting defaults inflicted on lenders (banks) and other securities brokerage firms, that occurs over a short period of time. This may also be caused by a single major event in the markets or economy.
Causes by be:
Illiquidity of assets held by HF due to being non-market traded, long time to find opposite trade, and asset being too large to sell to single buyer.
2. Hedge funds may have high serial correlations with performance in past time periods. This raises potential that loss in one month may be continued for many subsequent months.
Retailization of the Hedge Funds
Methods by which retail investors, below the “accredited” standards, can invest in the Hedge Funds:
More households are meeting “accredited” standards (i.e., in 2002 5.2 million households qualified, and in 2006, 8.9 million households did).
Fund of Funds allow lower investments by retail customers because the FOF is the “qualified” investor in the individual HF. However, the FOF advisers charge their advisory fees on top of fees paid to the individual HF advisors.
Buy shares in a Hedge Fund Management Advisory company when it goes “public” in IPO. (see Fortress Investment Group IPO in Feb 9, 2007, at price of $18.50 per share, ending after first day at $31 per share on NYSE)
4. Pension plans (private and public) are investing in HF on behalf of the many retail customers that are in the pension plan.
Credit Suisse/Tremont Hedge Fund Index (year 2006) YTD Index / Sub Strategies Return Credit Suisse / Tremont Hedge Fund Index 13.86% Convertible Arbitrage 14.30% Dedicated Short Bias -6.61% Emerging Markets 20.49% Equity Market Neutral 11.15% Event Driven 16.73% Distressed 15.58% Multi-Strategy 16.38% Risk Arbitrage 8.15% Fixed Income Arbitrage 8.66% Global Macro 13.53% Long / Short Equity 14.38% Managed Futures 8.05% Multi-Strategy 14.54% S&P 500 15.79% Merrill Lynch All US Convertibles Index 12.83% Goldman Sachs Commodities Index -15.09% Credit Suisse High Yield Index 11.82% Citigroup World Government Bond Index 5.99% Dow Jones World Index 18.52% Dow Jones World Emerging Index 26.15%