More Than You Probably Want To Know About Carried Interest

banker 3One of the more controversial parts of the U.S. tax code concerns “carried interest.”

Definition –  The standard definition can be found in Investopedia, and goes as follows:

“A share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds. This method of compensation seeks to motivate the general partner (fund manager) to work toward improving the fund’s performance.”

The statement serves as both a definition and a rationale for the compensation format for hedge fund managers.   So, first we need to know how hedge fund managers are paid.

Compensation – The most common formula is called “2 and 20.”  This combines the ‘management’ fee and the ‘performance’ fee.   The fund managed takes 2% of the annual assets and 20% of the gains over a specified base, which in financial-speak is often designated a “hurdle rate.”   The 2% is relatively easy to understand,  the management gets 2% of the assets under management.  The hurdle rate is a bit trickier to explain.

Think of the hurdle rate as a benchmark.  Forbes (Sham Gad) provides a simple hypothetical example of hedge fund operation (with slightly different arithmetic)  and includes a brief mention of how these benchmarks are applied.  Let’s try to make it even simpler (at the risk of obfuscating some of the more esoteric parts of the system.)

Desert Beacon forms an an investment partnership, DB is the fund manager and general partner.  The other members are limited partners.  The limited partners contribute the money, and DB as the general partner, manages it.   The Forbes example incorporates a very common formula — Desert Beacon drafts an operating agreement to which to limited partners sign on.  The agreement calls for DB to get 25% of the profits 0n the investments over 5% per year.   Once all the agreements are signed, and the money is transferred into the DB account, DB calls the broker and buys “stuff.”  The 5% is the “hurdle rate.”  Why?

Because that first 5% belongs to the investors (limited partners.)  Anything above the 5% “hurdle,” gets split — DB gets 25% and the limited partners (investors) get their split of the remaining 75%. (1)

Thus, it’s believed that the more profits generated by the investments made by DB’s fund, the more diligent DB will be about making wise investment decisions.  After all, the more profits over the hurdle rate, the bigger that 25% piece of the pie is going to be — because the pie is bigger.  For an explication of how the arithmetic works out, refer back to the Forbes Magazine example.

Taxation – The key here is to remember that hedge funds are partnerships.  (2) The following is one of the clearest explanations I’ve found so far of the basis structure of hedge funds:

“Hedge funds are typically structured as limited partnerships (LPs) or limited liability companies (LLCs). Both LPs and LLCs are taxed as partnerships by default, which means that they are pass-through vehicles for tax purposes. This means that there is typically no tax at the entity, or fund, level and investors will be distributed their proportionate share of the fund’s gains and losses for tax purposes. Investors will report these gains and losses on their individual tax returns and will pay tax on items of income and gain according to the character of the income or gain reported on a K-1 form provided by the fund.”  [ILG]

Catch that?  The Hedge Fund itself is a “pass through” vehicle.   The profits are divided up according to whatever formula was agreed to in the operating agreement, and investors report this income on their individual returns.

And here is where the fun begins.

Part of the problem is that we’ve created an artificial categorization of what constitutes labor.  We all know what income is … it’s earning from work, labor.  Work/labor is landscaping a yard, building automobiles, supervising children in a day care center, providing legal advice and representation, selling insurance policies, and providing consulting services running the gamut from “life coaches” (whatever that might be) to giving financial advice.

Let’s go back to the operating agreement, and assume it’s the common “2 and 20” format, and then notice the problem with the current system as described by the Economic Policy Institute, because “Investment Advisers” are different: (3)

“These investment advisors and hedge fund managers can take advantage of this tax structure because they are often compensated through a scheme that, in part, pays them according to the returns on the fund. The industry standard for hedge fund managers is “two and twenty,” which is shorthand for an “overhead” fee of 2% of capital under management plus carried interest (often called a “carry”) of 20% of the returns on the fund. Thus a $100 million fund earning 20% would pay its fund manager $2 million for overhead and $4 million in carry. The carry portion of their compensation is treated under the tax code as capital gains for the fund manager and is taxable at the much lower capital gains tax rate of 15%.” [EPI] (emphasis added)

It’s the $4 million we’re looking at.  Instead of being taxed as income earned from ‘management’ (the 2%), the 20% is taxed at a lower capital gains  rate, 15%.     If DB were the administrator of a pension fund, or a trust fund, or an endowment fund then the same tax rate on my income as any other financial manager would apply.  However, because I am a Hedge Fund manager, doing essentially the same kind of labor/work as the endowment fund manager,  I get that bountiful 15% rate.

The British have about had their fill of this kind of practice, and as of December 6, 2013 Reuters reported that the current government is seeking ways to close hedge fund loopholes.  [Financial Times, May 26, 2013]

Questions?

Recall that in the original definition, that  tax break for the hedge fund manager was supposed to be an incentive for good investment management.  If this is the case, then why is an endowment manager at a major university, or a pension fund manager for a labor union or corporation, or an investment adviser for a small business not allowed the same “incentive?” Don’t we expect ALL of them to provide the best management possible for endowment, pension, and trust funds?

If the answer to this is, ‘because the hedge fund manager takes on more risk,” then we could properly ask — isn’t the risk factored into the hurdle rate?

Unfortunately, the appearance the average person is left holding is that the hedge fund managers have rigged the game.  Perhaps this is one of the reasons t he message from Senator Elizabeth Warren (D-MA) resonates with so many Americans?

“People feel like the system is rigged against them. And here’s the painful part: they’re right. The system is rigged. Look around. Oil companies guzzle down billions in subsidies. Billionaires pay lower tax rates than their secretaries. Wall Street CEOs—the same ones who wrecked our economy and destroyed millions of jobs—still strut around Congress, no shame, demanding favors, and acting like we should thank them.”  [HuffPo]

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(1) For those who wish to get deeply into the weeds, here are a few articles concerning how hurdle rates are established:   Aswath Damodaran, “The Investment Principle, Estimating Hurdle Rates,” NYU, Edu. (pdf)  PWC, “Approaches to Calculating Hurdle Rates,” December 11, 2011. (pdf)  Meier and Tarhan, “Corporate Investment Decision Practices And the Hurdle Rate Premium Puzzle ,” Loyola University, (pdf)

(2) The Investment Law Group is the best place to start for further information on the taxation of hedge funds. This is what a  K-1 Form looks like. (pdf)

(3) Googling “hedge fund loophole,” will yield a plethora of articles and posts, as in 544,000 in 40 seconds.   Start with “Tax Breaks for Billionaires,” from the Economic Policy Institute, July 24, 2007.   See also: Nicholas Kristof, “Taxes and Billionaires,”  New York Times, July 6, 2011.   Henry Blodget, “The Hedge Fund Tax Loophole Is Outrageous,” Business Insider, January 21, 2012.  Center for American Progress, “Congress Should Close the Hedge Fund Loophole, December 18, 2012.

Better still the hedge fund managers have discovered all manner of other tricks.  ZeroHedge caught how “Goldman Sachs Quickly Found the Volker Rule Loopholes,” and Forbes noticed the same thing.

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