Tax deferrals - will changes to the US tax code be the death knell for hedge fund corporate governance?
A key recent change to US tax provisions, contained in the "Emergency Economic Stabilization Act" of 2008, is the long threatened and now real elimination of tax deferrals for US hedge fund managers.
Under this mechanism, US managers were able to defer incentive and / or management fees earned in their offshore funds for up to 10 years. As such, the fee income could grow on a tax free basis.
We have commented on this structure before. Our particular concern has always been that some managers have adopted very elaborate deferral schemes. At face value, most investors simply assume that when a hedge fund manager says that they have, say, $100 million in deferred fees invested in the offshore fund, that those funds are invested alongside external shareholders and are at risk with the fund's strategy pari passu.
Not so. Some managers take advantage of an ability to reference deferred fees to "other assets" (as another example of "prospectus creep", most leading law firms now automatically write this provision into fund offering documents.) As such, the deferral can be linked to unrelated assets anywhere from treasuries and S&P futures to a portfolio of other hedge funds - this leaves the fund in the bizarre position of having a fund of funds portfolio on its balance sheet which is only allocated to the manager. While US tax lawyers may choke on this "emperor has no clothes" comment, this is pretty close to blatant tax fraud: you have basically turned an offshore hedge fund into a tax shelter for completely unrelated investment assets.
Going forward, the new US legislation eliminates new deferral structures from January 1, 2009, thankfully removing this abuse. Managers do still have a comfortable decade to take advantage of current arrangements, however.
Unsurprisingly, there is a way round the new legislation. If a general partner (i.e. the manager) receives a partnership "allocation" rather than fee income, then it is possible to create a US tax argument that the 20% incentive fee is really an investment return and not a fee. This is possible if the fee paying entity is structured as a partnership, not a corporation, and the manager receives an allocation of partnership income not an incentive "fee".
Firstly, to state the obvious once more, the 20% of investment returns paid by investors to the hedge fund manager is a fee and is not in any possible way, shape or form an investment return. If I have a $1 million investment and make a 10% return, the manager receives $20,000, being 20% of the $100k gain. The $20,000 is a fee: it would only have been an investment return if the manager had originally invested $200,000 - 20% of the original $1m of capital. Actually, this is a pretty good example of hedge fund alchemy: how to turn no original investment into a 20% return. It's this "alchemy" across the finance industry as a whole that has, of course, got us into the mess we're now in.
Back on the subject of tax structuring, we received yesterday a tax alert published by PwC - and we're sure all the leading accounting and legal firms are providing similar guidance. The message is to turn offshore funds into "mini masters" where the underlying master fund is a limited partnership, create intermediate feeder funds which are structured as partnerships or look at similar structures.
Traditionally, a hedge fund master / feeder structure has been created with an onshore Delaware LP feeder, an offshore Cayman corporation feeder, both investing into a master fund also structured as a Cayman corporation. Going forward, we predict that many hedge funds run by US managers will rapidly restructure so that the master fund which actually holds the assets will be turned into a partnership. As such, the manager will be able to receive their 20% fee as a partnership allocation, thereby avoiding these new tax rules.
There is, however, one slight snag. Limited partnerships, while standard in the US (again, for legacy tax reasons) are awful structures when thinking of how best to create a pooled investment vehicle. The problem is simple: the partnership is controlled by the general partner, who is the investment manager themselves. There is no board of directors and, consequently, no corporate governance.
We agree that, in practice, current offshore hedge fund boards have not done an effective job: hiring Cayman corporate secretarial firms at $5,000 each is hardly the best route to vigilant corporate governance. However, we need to split current practices from the broader principle: it remains emphatically necessary for the ultimate decisions governing a hedge fund's operations - valuation, decisions to suspend redemptions, actions which could lead to liquidation - to be taken by third parties independent of the investment manager. Indeed, in our view, we believe that effective corporate governance is one of the biggest priorities for the hedge fund industry as it navigates the current financial crisis and faces the very new and very different world we will see on the other side. We will return to this topic shortly.
Having made this comment, it is very clear that this US tax issue could remove any chance for effective corporate governance at a stroke. While the offshore feeder entity would remain a corporation with a board, this becomes completely irrelevant - the actual assets are held in an underlying partnership controlled by the manager. Corporate governance, does, of course, need to take place at the entity where the assets reside not at a shell conduit sitting above the asset pool.
As a side point, it is also very disappointing to read the PwC paper (as above, we're not picking on PwC - we're sure all the accounting and legal advisers will be saying the same thing). It is very clear how the audit firms orientate their advice and services towards what is beneficial for the manager, rather than towards what is beneficial for investors - there is absolutely no mention of this paramount corporate governance issue anywhere in PwC's text. The irony, of course, is that all the fees for fund restructuring paid to the accountants and lawyers - the only purpose of which is to save the manager tax - will be charged to the fund, and paid by investors.
And therein lies the rub. This is absolutely the mindset, as we said above, which has brought the global financial industry to the brink of utter failure. Finance industry participants seem to think that a different set of rules apply and that any mechanism is acceptable to avoid personal tax and game compensation. To rapidly change the standard corporate form of potentially thousands of hedge funds, purely for personal tax reasons and without any consideration of investor preferences, could not give us a better analogy of the "finance culture".
The response, here, falls to investors. Ultimately, the world's larger institutions need to rapidly focus on this issue and communicate clearly that they are not prepared to allocate to hedge funds (often with tickets in the hundreds of millions of dollars) unless assets are deployed within a structure which provides for effective corporate governance.
If no-one is prepared to step up to the plate, then we get what we deserve.