The tax status of so-called “carried interests,” held by private equity fund sponsors (and benefitting, in particular, the individual managers of those sponsors) is the subject of this post. A decision by the U.S. Court of Appeals for the First Circuit holding that a private equity fund was engaged in a trade or business for purposes of the withdrawal liability provisions of ERISA (Employee Retirement Income Security Act) has caused considerable comment on the issue of whether a private equity fund might also be held to be in a trade or business (and not just a passive investor) for purposes of capital gains tax treatment on the sale of its portfolio companies. Proposed federal income tax legislation, beginning in 2007 and continuing into 2013, also has raised concern as to the status of capital gains tax treatment for holders of carried interests. The following post addresses both of these developments.
Posts Tagged ‘Fund managers’
In our recent NBER working paper, Valuing Private Equity, to value PE investments, we develop a model of the asset allocation for an institutional investor (LP). The model captures the main institutional features of PE, including: (1) Inability to trade or rebalance the PE investment, and the resulting long-term illiquidity and unspanned risks; (2) GPs creating value and generating alpha by effectively managing the fund’s portfolio companies; (3) GP compensation, including management fees and performance-based carried interest; and (4) leverage and the pricing of the resulting risky debt. The model delivers tractable expressions for the LP’s asset allocation and provides an analytical characterization of the certainty-equivalent valuation of the PE investment.
The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.
In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.
In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.
It is a privilege to appear before a group that is so important to the strength and integrity of the fund industry. Independent directors have significant responsibilities, and it requires tremendous effort and time on your part to do your job well. I applaud your efforts to learn from the professionals who are participating in this conference. The insights of the panels you heard yesterday and this morning, and those you will hear after lunch will provide valuable information.
The importance of mutual funds in the lives of American investors is clear. Mutual funds hold close to $14 trillion of the hard earned savings of over 53 million American households. The majority of Americans access the markets through mutual funds. They invest in funds, and hope their investments will grow, for many reasons—to make a down payment on a house, to save for a college education, and ultimately to pay for a retirement.
The UK Treasury has recently published a new, and near final, version of the implementing Regulations for the Alternative Investment Fund Managers Directive (the “AIFMD”). (We have commented on the consequences of the AIFMD for EU managers and non-EU managers in our 4 January, 11 January, 27 February and 27 March client alerts.) This updated version of the implementing Regulations represents a considerable improvement for managers compared to the initial draft.
In summary, with effect from the implementation date (22 July 2013), European managers of Alternative Investment Funds (“AIFs”) – essentially:
- (a) any European manager of a PE, VC, hedge or real estate fund will need to be authorised in its home member state and comply with various requirements regarding the funds that it manages concerning information disclosure and third-party service providers; and
- (b) any non-European manager of a PE, VC, hedge or real estate fund will need to comply with various marketing and registration restrictions if it wishes to obtain access to European investors.
This post discusses the major changes to the AIFMD implementing Regulations.
This paper suggests that the essence of these funds and their regulation lies not just in the nature of their investments, as is widely supposed, but also—and more importantly—in the nature of their organization.
Specifically, every enterprise that we commonly think of as an investment fund adopts a pattern of organization that I am calling the “separation of investments and management.” These enterprises place their securities, currency and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. Investment enterprises also radically limit fund investors’ control. A typical hedge fund, for example, cannot fire and replace its management company or its employees—not even by unanimous vote of the fund’s board and equity holders.
I explain this pattern of organization and explore its costs and benefits. I argue, paradoxically, that the separation of investments and management benefits fund investors by limiting their control over managers and their exposure to managers’ profits and liabilities.
Concerns about the internal governance of hedge funds have dramatically increased in recent years. During the financial crisis of 2008, investors became frustrated when numerous hedge fund managers suddenly prevented them from withdrawing their capital yet nonetheless continued to charge them fees. Since the financial crisis, concerns about hedge fund governance have focused on transparency, operational practices, and the growing view that fund directors do not effectively monitor fund managers.
In my paper, Hedge Fund Governance, which was recently made publicly available on SSRN, I provide the first comprehensive scholarly analysis of hedge fund governance. In doing so, my paper makes several contributions. First, it contributes to the literature on corporate governance by conceptualizing the unique way in which hedge funds are governed and situating their style of governance within established paradigms. I argue that hedge fund governance is a type of responsive managerialism.
I plan to speak about the Enforcement Division’s and in particular the Asset Management Unit’s priorities in the hedge fund space. I’ll discuss the importance of specialization and expertise to this effort; the risks for investors; how these risks are informed by the hedge fund operating model; and how a hedge fund manager’s business may be at odds with the manager’s fiduciary duty to the fund. I’ll also discuss the types of misconduct we’ve seen crossing our desks in the Asset Management Unit, and I’ll conclude with certain best practices to avoid the specter of an enforcement referral or inquiry.
The UK Financial Services Authority Publishes Consultation Paper on Implementation of AIFMD
On November 14, 2012, the UK Financial Services Authority (“FSA“) published the first part of its long-awaited consultation paper “CP 12/32 Implementation of the Alternative Investment Fund Managers Directive (“AIFMD“) Part 1″ (“CP 32“). 
This post summarises key points from CP 32 and includes a brief reminder of other key issues arising under AIFMD  (which we have written about in the past  and we assume that you are familiar with these issues). Please note that not all the requirements discussed below apply to all AIFMs and/or AIFs.
In our recent NBER working paper, Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance, we use a large, proprietary database of private equity funds to study the links between the terms of private equity management contracts and the subsequent cash flow behavior and performance of the funds. The database is the largest and most recent source of private equity compensation terms available to date, and is the first to provide information on manager ownership and to include cash flow information along with the terms of management contract.
We use these data to contrast two views of the state of managerial compensation practices in private equity. The first is that highly compensated GPs, or those with little skin in the game, extract excessive rents and have inadequate incentives, which ultimately spells poor returns for limited partners. The second view is that the management contracts we observe reflect (potentially constrained) efficient bargaining outcomes between sophisticated parties, and that management contracts reflect the productivity of GP skills and the agency problems that LP’s face.