Unprecedented turmoil, uncertainty and change in financial markets has caused many hedge funds to take significant write downs on their investment portfolios and face highly illiquid markets for their remaining investments. Many funds, even profitable ones, are also experiencing significant investor redemption requests, as investors search for liquidity. Funds are also struggling to meet margin calls from lenders and prime brokers. Some hedge funds have already been forced into a fire sale of their portfolios, while others have introduced gates or even suspended redemptions as they attempt to sell illiquid assets in an orderly manner over an extended period of time. This has led to concerns from investors that there is a lack of transparency in the liquidation and valuation processes, and has also impacted on the investor’s ability to gain access to their money in a timely manner.
It’s, therefore, important, now more than ever, to ensure that hedge funds and their managers are focused on the proper management of their operations to ensure that business is being conducted as effectively and efficiently as possible in order to give their business the best chance of survival and recovery. Cash, P&L and Balance Sheet forecasting should be stressed tested not only for the Manager but also for the Fund. Manager’s are likely to be in a better position if they are able to demonstrate that the commercial decisions made (i.e. to allow redemptions for some investors) were based on reasonable commercial assumptions and that all investors were treated fairly.
One of the key areas for management to focus on is the realm of taxation. The full scale of tax flows from income tax to corporate tax needs to be reassessed to ensure cash management is optimal. First there are the simple, yet easily forgotten, messages for hedge fund managers to consider:
• Take for example the repayment of corporate tax payments which are made on account. Where a company believes that it will be in a reduced or non-tax paying position for the period in which quarterly instalments have been paid, then the company is able to make immediate reclaims for excess taxes paid.
• Similarly, correct management of losses is a key issue. Ensuring that necessary expense payments and provisions are booked into the 2008 tax year to allow for the carry back of losses to the profitable year of 2007 is good practice.
These are simple ideas which people can forget but which result in giving cash flow benefits which are vital in the downturn.
Taking advantage of tax
Hedge fund managers should be considering whether they have taken advantage of all aspects of deductions and claims. Areas such as capital allowances and research and development expenditure (particularly in the area of computer software) are common items which may have gone unnoticed in the ’good times‘, but this now means there may be potential claims against expenditure available for a business to tap into. Again the management of these issues may result in positive cash flows for the business.In most cases, management’s focus right now is on cost management. Once the simple steps are taken, planning techniques will then become critical. Many hedge fund managers are reducing headcount, and questions should be asked as to whether specific reliefs and planning opportunities are available in relation to redundancy payments and payments in lieu of notice. Additionally, for the future, managers/businesses may want to retain the staff seen as key assets and should, therefore, be structuring employment packages for staff in tax efficient methods to ensure both the manager and its staff are maximising their positions.
Partners and principals of the management houses need to consider their remuneration arrangements too. In particular, for those hedge fund managers who are set up as LLP’s the LLP agreement should be reviewed to confirm the arrangements for departing LLP members in terms of their capital accounts, cash drawings and taxable profit allocations. Now is not a time to have a lack of clarity about such things.
Pricing is another cash focused question mark. The “arm’s length” principle is the bedrock of transfer pricing. In a downturn it is, therefore, particularly necessary to consider your transfer pricing policies. It is not inconceivable that a third party may be negotiating better deals for the same services and, as such, this should be reflected in connected party transactions, with clients specifically questioning whether their profit splits, cost plus margins or even interest rates on inter-company debt are still valid as arm’s length in today’s market.
In addition, changes to the commercial operations of the group, for example the loss of a key investment executive from one location, may fundamentally change the previously acceptable inter-group pricing within the hedge fund manager’s own corporate group. Again, the key driver behind all these considerations and planning techniques is to drive cash flows into a positive position for the hedge fund manager.
To liquidate or not?
Inevitably, for some managers the turmoil has taken its toll to the extreme and they will be looking at potential liquidation either from a solvent or insolvent perspective. However, from a holistic view, managers should be asking themselves whether they have considered all their bases before they go down the liquidation path. Have they fully considered the restructuring opportunities available as an alternative to winding down the funds? Have they considered how to manage a restructure in an orderly process which is equitable to all investors, both exiting and remaining? The key fact is that liquidation is not the sole answer. We are working closely with hedge fund managers and their sponsored funds to consider run off options which exist and can work to recover a business, and, therefore, this is an area where relevant managers may need to focus rather than just closing the books and walking away.
Where liquidation is in sight, managers should continue to consider their tax position, for example if a potential acquisition arises, tax due diligence is relevant whether it be on sale of business or assets pre liquidation.
Hedge fund managers should be considering income tax matters for individuals on winding up of the business, for example, CGT treatment on disposal of shares or partnership interest. Where there may be a partial disposal or spin off there is a need to revalue the tax basis of capital investment as this can impact on personal tax reporting. A final consideration is going to be the proper management of the sale of portfolio assets which may be transferred or sold pre or post liquidation as the attached tax impact can have a significant impact on the final returns.
Inaction is out of the question
The key message for all hedge fund managers and their sponsored funds, whether they are profitable or not, is that inaction is no longer a viable option. Tax advisers should be talking with their clients and visa versa on all these topics to ensure that managers
i. are in the best possible position to survive the downturn;
ii. get positive cash flows as soon as they are available;
iii. can grow into the new hedge fund model which evolves; and
iv. are able to manage themselves through to the eventual upturn.