We like golf because the game is fair – if you don’t play well, you don’t make any money. Hedge funds are like golf players.
We’ve seen recently that politicians don’t understand the hedge fund industry. They have tried to characterize this vital source of capital as structures used by the rich to hide wealth and avoid taxes. This incorrect and misguided view has lead to Pres Obama’s proposal to tax “carried interest” which could have disastrous effects.
In a hedge fund, a General Partner (GP) invests the money of Limited Partners (LPs) according to a specific strategy such as long/short equity positions, arbitrage opportunities, etc. The GP makes money from management fees and carried interest.
Management fees are charged quarterly as a 1-2% of the limited partners’ capital balance to fund operations (Ok - 2% on $500M goes farther than just paying the electric bill). Management fees are taxed as ordinary income to the GP.
The real money for the GP comes from “carried interest” which is only earned when the fund performs well. Each year, if the fund achieves a specified hurdle rate (i.e. a 10% return), the GP is entitled to 10-20% of the profits over that hurdle. This is called “carried interest” as the investments which created these profits are not liquidated at this time. (Really, an accounting adjustment is made to “carry” a portion of each LPs balance to the GP.)
When the investments are sold, and the profits allocated, they are taxed as capital gains at 15%, instead of as ordinary income at 34%… the same as if you or I bought and sold stock for a profit.
The proposal of Obama to tax carried interest, received by the GP, as ordinary income does not make sense. Especially since the LPs would continue to get the favorable rate on profits from the exact same investment. Ultimately, I think this could have several negative effects:
- Fewer good GPs are willing to run hedge funds = less capital in markets and/or those who remain are less experienced
- Greater risks will be taken by GPs to offset the 19% loss of profit = bad for LPs
- Higher management fees or more aggressive incentive allocations = hedge funds are less desirable to LPs
- More fund of funds investment vehicles start = greater concentration of capital in an area means that a downturn in a single industry could have broader impact
While the government begins picking industry winners and losers, consider what John Paulson, President of Paulson & Co, said at a November meeting with the House Oversight Committee, “We receive no taxpayer subsidies…Despite good performance and bad, not one dollar [of federal money] has gone to a hedge fund.” Whose the real winner?
Last 3 posts by Eric B.
- Nassim Taleb on the Economy - June 25th, 2010
- Full Circle - May 3rd, 2010
- The Dark Side :) - April 5th, 2010
I’ve got to disagree with your reasoning, yet I come to the same conclusion. I don’t feel bad for hedge funds. They make a ton of money and the truth is most of the people running them aren’t much brighter than anyone who posts on this blog. Honestly it’s too easy to make too much money in a hedge fund. You don’t even really have to be that good to make a ton of money. I don’t think higher tax rates will discourage many from going into a hedge fund. The difference in after-tax salary is still staggaring compared to the next best alternative. My problem is the fairness issue. I don’t like when we make different rules for different people. We should all play the same game with the same rules and let the chips fall where they may. Let’s not pick on a small minority just because they make a lot of money. This is the same thing that drives me crazy when Obama says he wants to make the tax code more fair. It’s already completely unfair. It would only be fair if everyone paid the exact same % of their income.