Attracting New Managers

Originally published in the June 2011 issue

More and more hedge funds are based in Texas, particularly in Dallas/Fort Worth. The proliferation of hedge funds in Texas has less to do with the historical wildcatting spirit of the State and more to do with other factors that have led many fund managers to realize that the establishment of a Texas office is a smart business decision. In particular, the very favourable tax environment in Texas includes comparatively low effective state taxes on the income of fund managers due to the complete absence of any state income tax on individuals.

The fund community has deep roots in Texas that go back to the late 1980s, when some large Texas-based family offices began to invest in hedge funds out of New York. This early investment experience coupled with willing high net worth investors fueled the early formation of several large hedge fund firms in the Dallas/Fort Worth area that now operate multi-billion dollar operations. These firms, in turn, have spawned dozens of start-up funds over the past 10 years, together with a strong selection of Texas-based professionals providing prime brokerage, fund administration, legal and accounting services to the hedge fund industry. In fact, many do not realize that the Dallas/Fort Worth area is now one of the largest metropolitan centers of hedge fund activity in the US.

Tax advantages
Unlike California, New York, Illinois, Connecticut, and other states with significant hedge fund activity, neither Texas nor any Texas counties or cities impose any state or local income tax on individuals. Although Texas imposes no income tax on individuals, Texas does assess a very low tax on any limited liability entity conducting an active business in the State (called the “margin” tax, which is effectively an income tax) at an effective maximum rate of only 0.7% of gross revenues attributable to Texas. Typically, fund general partners are formed as limited liability companies or limited partnerships, and so, are subject to this tax. However, with some upfront planning, it is possible to avoid paying this tax on a significant portion of the “2-and-20” management and performance fee typically earned by the general partner or investment manager of a fund.

Texas law provides an exemption from the margin tax for “passive entities,” which include partnerships or business trusts, with income at least 90% of which is “passive.” For purposes of this exemption, passive income includes a taxpayer’s distributive share of partnership income. Investment managers that form a special limited partner to receive the profit allocation in a hedge fund may qualify as passive and avoid paying Texas margin tax on those amounts. The management fee usually does not escape taxation. But, if the profit allocation, when combined with the management fee, makes up at least 90% of that aggregate amount, then the investment manager can collect both theprofit allocation and management fee in one entity, and none of it should be subject to Texas margin tax. In any event, even if the investment manager is subject to margin tax on either or both the management fee or profit allocation, the tax will be no greater than 1% of 70% of gross revenue (i.e., a 0.7% tax) attributable to Texas. (It should be mentioned that most funds themselves are exempt from the margin tax because of the passive entity exemption.)

For funds relocating from states such as New York and California, which impose high income taxes on corporations and individuals, the investment manager derives a significant direct benefit from the lower tax rates in Texas. In addition, and very importantly, the absence of an individual income tax in Texas typically allows an investment manager to relocate investment talent on a discounted basis. For example, if an employee is in New York or California, where the highest marginal state income tax rates are 8.97% and 10.3%, respectively, the after-tax income of that employee can be significantly reduced because the combined federal and state income tax rate in those states is about 41%, compared to only 35% in Texas.

So, the pre-tax amount needed to deliver $300,000 of after-tax dollars to an employee is clearly higher in New York and California as compared to Texas. And, those after-tax dollars buy significantly more in Texas due to its lower cost of living. Taking cost-of-living, particularly housing, into account, the amount that an employer needs to pay an employee to work in Texas is substantially lower than in almost any other place in the country that has a developed talent base and infrastructure to support this industry.These tax advantages are not new to Texas. Jerry Jones makes many of the same arguments when trying to attract high-dollar players to come play for the Dallas Cowboys. This also helps explain why so many Fortune 500 companies, including American Airlines and Exxon/Mobil, have moved their corporate headquarters to Texas over the past 20 years.

When combining the tax savings for hedge fund managers and their employees, it is obvious why Texas has continually been attracting investment funds that are flush with investment dollars. Simply stated, the management teams of more and more funds have relocated to Texas to keep more of the rewards from their investment expertise and earnings.

Other benefits
The low cost of living that benefits employees obviously also benefits the principals of a fund if they reside in Texas. Many of these individuals reside in Texas and then travel throughout the country and the world. Being in a moderate climate in the middle of the country with terrific access to international airports with extensive routes, those principals can typically visit investors on either coast and be back home the same day.

While never the intent, it is nice to know that Texas also is business (debtor) friendly when investments go the wrong way. The state has a generous homestead act that generally allows qualifying individuals to protect their home in bankruptcy up to an unlimited dollar amount. If the homestead is located in a city, town or village, the property cannot exceed one acre, and otherwise cannot be more than 200 acres. In addition, certain life insurance policies can be claimed under the personal exemption when filing for bankruptcy. And, this being Texas, farm animals, including two horses, mules or donkeys, plus a saddle, and up to 12 heads of cattle also may be claimed as exemptions.

From a regulatory standpoint, many Texas-based hedge fund advisers historically have shied away from the more onerous Texas laws requiring managers to register as investment advisers, while other states have followed the broader federal exemption under Section 203(b)(3) of the Investment Advisers Act. The adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act has effectively neutralized this issue, as the industry witnesses the demise of Section 203(b)(3). Infact, many smaller hedge fund managers who find themselves subject to registration with the Texas State Securities Board may be surprised by the depth of knowledge in this area by state regulators, together with their acceptance of hedge funds as a part of Main Street today.

Finally, it’s hard to talk about anything in Texas without mentioning the continuing significance of the energy industry in the region. Texas has the largest concentration of energy private equity funds nationally, with the largest firms based in Houston. In recent months, some of the larger hedge funds nationally have looked to deploy capital in the energy sector, and many have done so through managed accounts, sub-advisory agreements or other similar arrangements with Texas-based managers.

Others have opened Texas-based offices in an attempt to attract qualified portfolio managers in this sector. With oil around $100 per barrel and continued interest in this and other commodities investments, this trend should continue.

Taken together, the tax and other advantages have caused many hedge fund managers to saddle up and head to Texas.

Taylor H. Wilson and Vicki Martin-Odette lead the Investment Funds Practice Group at Haynes and Boone, LLP, in Dallas.