Thursday, July 26, 2007

Hedge funds / carried interests

During my month out of the country, I was sufficiently in touch via the Internet & e-mail to realize how dominant the hedge funds / carried interests issue has remained in Washington tax policy thinking. This bemused me a bit, on the view that, of all the important things in our society that tax policy can affect, this doesn't necessarily rise to the top as Issue # 1. As always happens when an issue takes off politically, symbolism is clearly an important part, here relating to the general trend of rising inequality in the U.S., in particular or at least at the very top, and the policymaking trend in recent years of doing less to address inequality rather than more. The hedge fund managers with their multi-million dollar paydays and deferred 15 percent tax rate are just one piece of the larger picture, but are naturally felt to stand for the whole thing.

Not to deny that there is significant money at stake here. And the transactionally related issue of the Blackstone IPO slicing a big hole in the previously prevailing rule that publicly traded entities are taxed as C corporations adds to the importance of what's going on with the hedge funds, as that could conceivably reshape the choice of entities landscape a bit. So the issues certainly merit attention, even if their comparative prominence is a bit peculiar.

While I feel strongly impelled to comment on publicly prominent tax issues like this one, I do have an "art for art's sake" side that prefers issues to be intellectually interesting rather than publicly prominent (albeit that actual social importance counts heavily in my metric as well). But I am starting to think that the issues here are indeed pretty interesting for their own sake, on the conceptual as well as the practical design level.

One seemingly under-appreciated issue in debate so far concerns the significance of the corporate tax to how we think about the hedge fund managers who pay little tax on huge compensation deals. Suppose the manager gets $100 million, is taxed only at the 15 percent capital gains rate, perhaps a couple of years down the road, and that the other partners are tax-exempt so that their not deducting the fee is irrelevant. There is still one more level to consider, if what the partnership does is invest in C corporations. What about the corporate-level tax on those corporations? Does it matter to the analysis?

Let's start outside the hedge fund realm with Bill Gates. He builds a hugely profitable company (and suppose for simplicity that he owns 100%), but suppose further that he pays himself no salary or dividends and profits purely from stock appreciation. We then have a rising billionaire who appears to be paying no tax.

Suppose, however, that Microsoft is being taxed on its annual economic income at the full statutory rate. This would seem to make the problem go away (leaving aside the question of whether the rate structure is progressive enough). After all, if we taxed Microsoft under a flow-through approach like that used for partnerships, we would think of Gates as reporting all its income and paying tax on it. Likewise if we had an integrated corporate tax with shareholder-level credits for corporate-level tax paid, assuming the corporate rate and his were the same. So the only reason Bill Gates appears to be getting away with murder, under actual law, is that he does not bear the nominal incidence of the corporate tax since Microsoft is treated as a separate taxpayer. (Questions of the economic incidence of the corporate tax would be unchanged by placing the nominal incidence of the tax on him as in the flow-through or corporate integration scenarios.)

Obviously, this view places heavy emphasis on Microsoft's being fully taxed. Corporate-level tax planning might defeat this result. Also, it assumes that we have no reason to like a two-level corporate tax.

How does it apply to hedge funds and carried interests? I am still learning (from Victor Fleischer and others) about what's really happening on the ground in this area, and I note Victor's comment, from his widely-circulated "Two and Twenty" draft, that a hedge fund is a "compensation scheme masquerading as an asset class." But let's consider for now four categories of business activity that fairly commonly use this structure. Two that have been less commented on are oil and gas activities and real estate activities, on which it is enough for now to note that these activities often receive highly preferential tax treatment - weakening the argument that corporate-level taxation does the trick, although arguably converting the nature of the problem from inequity to inefficiency.

The other two categories that have been widely mentioned are (1) the classic hedge funds that try, a la Long-Term Capital Management, to exploit market inefficiencies in stock pricing to generate profits for the investors, and (2) private equity funds that take ownership positions in under-performing companies, raise the stock value, and then flip the stock. In distinguishing these two, I don't mean to imply either that everyone is a clean case of one or the other, or that statutory rules could be drafted that conveniently and accurately sliced the world into these two categories - only that they are conceptually different.

In both cases, the carried interest rule may mean that the manager, who has the market power vis-a-vis his investors to extract most of the economic return, conceptually has labor income on his efforts that is taxed at only the 15 percent capital gains rate. But does the corporate-level tax on the companies that issued the underlying stocks make up for this?

I'm still just starting to think about this, and reader feedback is welcome. But the private equity fund case strikes me as pretty close to the Bill Gates example. The restructuring generates extra corporate-level income that is taxed if the corporate tax is well-functioning. If this is fine when you continue to hold the stock, selling it and paying tax at 15 percent while the corporate-level tax continues certainly doesn't make things worse.

But the hedge fund manager who outsmarts the market by anticipating in advance where value is headed looks to me a bit different. He (or she) hasn't increased corporate profitability, but merely discerned it faster. This may have social benefits, as it is part of having an efficient marketplace in which people can get the portfolios they want and in which money moves around to track true value, but the private gain from being one second faster than anyone else (and thereby generating a huge profit) substantially exceeds the social gain. Lots of it is simply an externality, via the shift of profits from those who discern value a bit more slowly to those who discern it a bit faster. And this analysis doesn't apply to the private equity fund case unless we view that as a tournament-style competition to be the one who gets to add the value.

One way of looking at it is that the private equity fund manager's efforts really are taxed by the corporate tax system (again, assuming its effectiveness), while the hedge fund trader's efforts aren't taxed in this sense. But, since we could easily start splitting hairs about whether it matters that the values discerned by the hedge fund manager are after-tax values (since this is what investors presumably care about), perhaps it's clearer to say instead that there is an incentive to over-invest in what the hedge fund manager does, but not necessarily in what the private equity manager does, so we should want to tax the former at a higher rate than the latter. Once again, of course, I have transmuted the distributional issue into one of efficiency, reflecting that, when activities are lightly taxed, they attract extra input that may bid down the pre-tax return.

Final point for now: the point about inequity being converted into inefficiency depends on efficient markets. But is this entirely the right assumption here? Capital markets do strange things that the standard Chicago-style ECMH (efficient capital markets hypothesis) cannot easily explain. The hedge fund managers, of course, are directly posited to be exploiting market inefficiencies. Or else perhaps they are being paid in some cases on the fiction that they can do better than monkeys throwing darts at the wall to determine investment choice. In general, how competitive is this market, with its arguably strangely uniform structure for arranging compensation? I don't want to argue here against using conventional economic tools to understand what is going on here, but the possibility of big anomalies should not be prematurely ruled out.


Bill Klein said...

Interesting and insightful. I suggest a further refinement (though it may be purely academic, with no siginficant policy implications). The source of Gates's untaxed capital appreciation might be divided into three elements. (1) Retained earnings. These have been taxed at the corporate rate so if you buy the arguments for integration (as I do), there appears to be no problem--except for the fact that millions of other investors in corporate equities will in fact be subject to the dual tax (on distributed earnings). (2) The value of Gates's services. No problem here since the effect, with no salary deduction, is that Gates is currently taxed at the corporate rate. (3) The value of intangible assets. I suspect that in the case of Microsoft this is the largest element. This value should equal the discounted present value of the future earnings stream attributable to the intangibles. That earnings stream will ultimately be taxed, so what is at stake is deferral, not exemption (though the deferral is a substantial tax benefit, as we all recognize). But note that if Gates gives his stock to a charitable organization, it will in effect wind up paying the tax--at the corporate rate (reduced, I suppose, by the value of the deferral).

Another, unrelated, observation: Much of the gain attributable in private equity deals to reducing costs comes from firing part of the labor force. So the hedge fund operators and their investors benefits at the expense of these workers. That might be acceptable--it is a function of the operation of a capitalist system, after all, with all its virtues and vices--except to the extent that involves breach of implicit (not legally enforceable) "contracts." To that extent it imposes costs on future economic transactions by undercutting the value of trust and thereby increasing transactions costs and reducing efficiency.

Daniel Shaviro said...

Thanks, Bill. These are very helpful points, which I will keep in mind if I end up writing about this stuff (as I am starting to think I will if time permits).

C. Winters said...


I'm glad you pitched in. I understand that we're talking here about corporations paying the statutory rate (assuming the effectiveness of such), but an article from today's (Fri., 7/27) WSJ front page discussed private equity firms' use of corporate-level debt to "pay out" or return to PE firms (as a dividend) their initial cash investment soon after taking a company private. This, of course, reduces taxable income at the corporate level (which presumably would be taxed at the statutory corporate rate) and allows those forgone corporate profits to be taxed at the lower LTCG rate within the PE partnership tax scenario. Does this affect your analysis at all? I'm also led to believe that PE funds are structured in such a way to avoid immediately realization at the LTCG rate of those debt-funded dividend payments.

Finally, to echo Bill's point, PE firms, once their initial cash contribution is returned through this device, may then run the company in a less risk adverse manner -- with regard to both debt-default risk and with regard to layoffs that are triggered by the need to improve cash flow to make interest payments -- than the managers who ran the corporation prior to the PE buyout (the PE funds have less "skin in the game," don't they?). Moody's earlier this month warned of exactly this problem, which they also noted often led to creditors/PE funds breaking debt covenants with bondholders when they do such a thing.

I'd love to hear your thoughts on this.

Here's a news report on the Moody's white paper:

Daniel Shaviro said...

Thanks, Craig, and these are interesting & important pieces of the puzzle. I start out from the position of wanting to tax these things, but finding the C corp tax an issue that needs to be considered before one reaches the bottom line. You're showing additional ways the C corp tax may fail to do the job, and you're adding to the story the debt-equity problem, whereby tax incentives to strip out corporate earnings through debt without the interest's being taxable at the corporation's deduction rate makes it positive sum for the TPs, and where the excess debt then in turn creates incentive problems in corporate investment choice. The perspective you add makes the overall story more complicated by suggesting that the serious defects in the corporate tax (in particular the debt-equity distinction, with the former being held by tax-exempts and the latter by taxables) are critical here

Shibu said...

I think the true focus of the issue is the inaccurate guidance of Rev Proc. 93-27 that states receipt of a profit interest is a not a taxable event.

The procedure was issued in response to court ruling in Campbell v Comm that found a profit interest was not taxable because the interest was too speculative. The court did assert that a profit interest is income to the partner, and had the court been able to figure out FMV a taxable event would have been held (Reg 1.721-1(b)).

The IRS should have recognized the earning of a profit interest as a taxable event, and deferred the tax event until realization (liquidation/redemption). This would be consistent with the code and the intention of Congress to realize the interest in receivables and inventory on the sale of capital a capital interest. Exception in the case of a profit interest would be deferral.

Recognizing a profits interest does two things:
1. Establish date a Profit Interest in earned (ordinary income), and
2. Establish the date a Carried Interest begins accruing (now treated as a capital interest).

The argument of speculation for a hedge fund is defeated upon realization, and the fact that the fund makes a re-allocation based to facilitae allocations establishes recognition. Once a partner makes a redemption (gets paid) the proceeds should first be income, then capital.

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