Simon Johnson takes on the hedge fund industry’s lobbying efforts in today’s Baseline:
if hedge funds dig in too deeply with “the crisis was not our fault” position, that is just asking for trouble – and to be scapegoated – down the road. It would be much smarter to get out ahead of the political dynamic, and to propose ways to measure, control, and regulate risk.
Simon is completely correct that there is very little overlap between the political interests of banks and hedge funds. The “systemically important” banks are the favored children of the Obama Administration; regulation is their friend. Not only will any potential rules be discussed in advance with Citi/BofA/JPM/Wells/GS, if one of the rules should prove inadvertently harmful the banks can rest assured it will be changed. The hedge funds, as displayed in the auto bankruptcies, should expect no quarter.
On the other hand, the hedge funds have a fantastic advantage over the currently interventionist government regime: they are faster and more flexible than the state. Let’s take a step back and think about what a hedge fund, at its core, consists of: a manager who advises a series of investors he has gathered. In almost all cases the number of investors is small and the investors have some claim to professional knowledge. For the purposes of argument, let’s include in the “hedge fund” world all structurally similar funds – private equity funds, oil and gas exploration partnerships, venture capital funds.
Suppose the government went ahead and decided to regulate the funds, either by going after the managers – raising taxes on carried interest, requiring more disclosure/compliance work, etc – or by going after the investment partnerships – limiting the types of assets they can purchase, amending regulations on feeder funds, etc.
The regulatory process is long and bends toward complexity; you can be confident that the outcome will not be “interest expenses are no longer deductible in any circumstance and there is no longer a distinction between capital gains and ordinary income.” A public company – obviously the big banks, but also the publicly-traded investment groups – is a sitting duck; it cannot easily change its corporate form. But a fund is an amorphous thing. It can easily be dissolved and reestablished in a more tax-efficient fashion.
Time was, most funds were Delaware limited partnerships. Then folks started investing overseas, and discovered the hassles of controlled foreign corporation tax rules. It takes a few weeks and a couple hundred thousand dollars to close an old fund and start over with the same people investing the same capital with a Cayman Islands LLC. Suppose carried interest ends. Fine; close your old fund, reissue fund documents provided that the general partner investment will be accompanied by warrants that are voided if the share price dips beneath cost basis, and move on.
To put it in game theory terms, the fund always has the opportunity to move second, after the regulator first puts the rules on paper. I find it exceedingly hard to believe that the funds will not be able to reshape themselves to defeat the interest of any regulation, especially as politicians have a much larger obstacles to consider. It’s all good and well to talk about the carried interest of Stevie Cohen or Henry Kravis, but just about every family restaurant or dry cleaner in the country features people who compensate themselves for their managerial efforts largely in terminal equity value that they expect to have taxed at capital gains rates. A regulator who tried to avoid hitting all of these small businessmen is going to find it quite hard to distinguish the tycoons among them. The industry should probably save its lobbying expenses and just lay low.
(Skip ahead to 2:10)
Fine; close your old fund, reissue fund documents provided that the general partner investment will be accompanied by warrants that are voided if the share price dips beneath cost basis, and move on.
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Sure, but there are limits to such game playing. If options are granted for free, IRS will try to tax grant as compensation at ordinary rates. If options are purported to be issued for cash, IRS can argue price was too low and the discount is compensation taxable at ordinary rates. Likewise if the GP is lent money non-recourse by a GP to buy a fund interest or if the GP contributes a non-recourse note to buy an interest in the fund and the loan/note is secured solely by the GP’s interest in the fund, risk that the IRS claims the loan and fund interest are in substance a carried interest.
A good point, except that trying to hard to challenge option grants at cost runs into the tech industry and corporate America, which tend to expect favorable tax treatment on options (eg receiving an option with a strike equal to the share price at grant date does not create taxable income, even though the option could be sold for a nonzero number).
There are also more complicated alternatives: incorporate your management company overseas with a bunch of foreign directors. Treat your management company as an operating company (ie don’t check the box) for US tax purposes. Depending on the tax treaty between where you incorporate and the US, you might be able to get both nominal corporate tax locally on the inflows and dividend tax treatment in the US on the outflows, with the added benefit of the IRS not looking through the foreign management company to see its fee arrangements with the foreign partnerships it manages.
More broadly, the fund benefits by being able to reshape its form with virtually no impact on its actual substance or operations, and therefore mimic other businesses that have more political clout. No need to try to convince lawmakers to have sympathy for hedge funds when the hedge funds can pretend to be realtors or cotton farmers and watch the government close its eyes.