HEDGE FUNDS: MORE RICHES FOR THE RICH OR TAXES FOR THE GOVERNMENT

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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

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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

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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.

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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.

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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.
•  

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  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.
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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

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Mutual Fund ICA40 Regulations

• Custodial requirements
• Liquidity and portfolio diversification
• Restrictions on use of debt leverage
• Short selling restrictions
• Management fee arrangements
• Redemption requirements
• Disclosure and reporting requirements

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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

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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)

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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.

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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)

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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)

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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?

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Case Study Taxes
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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.

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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.

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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!

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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.

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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.

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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.

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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 Equ
ity Market Neutral 11.15 Event
Driven 16.73 Distressed 15.58 Mult
i-Strategy 16.38 Risk Arbitrage 8.15 Fi
xed Income Arbitrage 8.66 Global
Macro 13.53 Long / Short
Equity 14.38 Managed Futures
8.05 Multi-Strategy 14.54     SP
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  
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