The Tax Man Cometh

Congress has woken up to taxing hedge funds more heavily

Originally published in the September 2007 issue

The tax man’s heavy tread may soon be heard outside the doors of many US-based hedge fund firms, potentially the result of a failure by the US industry to engage effectively in the arcane art of political lobbying on Capitol Hill, as well as the high profile attached to the earnings of many successful hedge funds. The recent Baucus-Grassley bill, which is targeting financial services partnerships, has been described by one editor as “a bi-partisan mafia-style hit on the free market.” According to the Free Enterprise Education Institute, which aims to educate the US public about threats to the free enterprise system, “Its primary goal is to send a message to hedge fund and private equity partnerships that it’s time to pay your congressional bosses or face the consequences.”

The proposed legislation would increase the tax rate from 15% to 35% for publicly-traded partnerships that get most of their earnings from asset management and investment adviser services. The Baucus-Grassley bill would amend the IRS code to eliminate the exception for this subset of publicly-traded partnerships. The senators concerned have sought to justify the legislation by claiming that it is unfair for publicly traded partnerships to be taxed at a lower rate than corporations, and that the lower tax rate erodes the corporate tax base. The Free Enterprise Education Institute reckons that despite its supposed intent, it appears the bill is being aimed at Blackstone, the recently listed private equity powerhouse, as well as sending a message to other private equity and hedge fund firms. Contributing to the Institute’s concerns is the timing of the bill, which coincided with the Blackstone IPO, coupled with the lack of hearings to assess the long term consequences of the legislation. “The last time Congress rushed to judgement we ended up with Sarbanes-Oxley,” complains Steve Milloy, Executive Director of the Free Enterprise Education Institute. “This bill sends a chill through the financial markets, once again sending a clear message that IPOs are not welcome in the US. With US financial markets already under competitive pressure from globalisation, this bill will only harm the US markets’ ability to vie for business.”

Consequences for Blackstone and other investment partnerships could be all too real. Concerns about the possible change in tax rates for publicly-traded partnerships are believed to have impacted the IPO, potentially reducing the offer price by as much as 20%. Discussion of the bill caused the share price of Fortress Investment Group, the only publicly traded private equity partnership prior to the Blackstone listing, to drop by almost 7%.

Where did it all go wrong?

Unlike other industries, notably energy and real estate, private equity and hedge funds have not been big players in the political campaign scene (Blackstone only donated US$180,000 to candidates in the 2006 mid-term campaign), nor do they enjoy the close ties with Washington DC politicians that can help to head off this legislation at the pass. The SEC’s sudden decision to demand that hedge funds register as broker dealers was seen as a failure by hedge fund trade associations and the industry in general to grapple properly with the regulator and its political bosses. That measure’s defeat by Phillip Goldstein was a reprieve for many firms. But it is significant that it is the Free Enterprise Education Institute that is now complaining about Baucus-Grassley.

The Managed Funds Association, which represents the interests of the alternative investment management community on Capitol Hill, has responded with “an informational advertising campaign” designed to provide facts about hedge funds to policy-makers, which appeared in three inside the beltway publications. But is an advertising campaign enough? Surely this is shutting the door well after the horse has bolted? Many Washington DC pundits argue that lobbyists are needed.

As if Baucus-Grassley were not enough, the House of Representatives has joined the fray. On 22 June Stephanie Tubbs Jones, Sander Levin, Charles Rangel (Chairman of the Ways and Means Committee) and 10 other members of the Ways and Means Committee introduced legislation that would ensure that investment fund managers who take a share of the funds’ profits as compensation for investment management services, known as carried interest, would be taxed at an appropriate ordinary income rate. Currently, managers of private investment partnerships in the US are able to receive compensation for these services at the much lower capital gains tax rate than the ordinary income tax rate by virtue of their fund’s partnership structure.

Again, it seems to have been the Blackstone IPO rather than the bonuses of hedge fund managers that have provoked Congressional action. Tubbs Jones pointed to the sums that Blackstone co-founder and CEO Stephen Schwarzman and his business partner Pete G. Peterson stood to realise from the IPO. “I feel that it is important that we have a level playing field when dealing with our tax code,” she said. “The managers of private investment partnerships are currently taxed at the much lower 15% capital gains rate. Fund managers’ incomes should be taxed at the same rate as other hard working Americans, which can be as high as 35%. I understand the concern on Wall Street in some quarters that adjusting the tax scheme for these companies will somehow reduce their competitiveness and even encourage some of them to flee. This is undoubtedly a concern for the industry, but it is important to bear in mind that many of these investment management companies have been beneficiaries of the business and capital infrastructure of the United States for many years. Perhaps it would be imprudent to hint that they are going to ‘take their ball and go home.’”

Perhaps, but with the New York subway grinding to a halt in August due to flooding, many investment managers who relocated to Connecticut to benefit from the lower state taxes in Greenwich will be smiling ironically at Tubbs Jones’ remarks.

Viva Hammer, a tax partner with law firm Crowell & Moring, emphasises the bi-partisan nature of the legislation, and the expertise of those doing the drafting. “There is an awareness that Congress has to be careful here,” she adds. “It will be politically difficult for them to hit hedge funds and not energy or REITS. The alternative investments industry has now responded by hiring lobbyists for the first time. Hedge fund managers are getting educated about the political process. They need to have a strategy, and they need to have people in Washington to keep them informed.”

She thinks part of the problem has been the short-termist nature of hedge fund management, compared with the energy industry for example. There has been an assumption that the same business environment will prevail forever.

The question of taxing investment partnerships is now on the legislative agenda, and will never completely go away. Even if it is not adopted by the presidential candidates next year, the fact that pen has been put to paper on draft legislation in Congress means that it can be dusted off again in the future and pushed forwards. And there could be consequences for European investors too, like the fund of funds community. Higher taxes in the US could mean that managers will raise their fees. If this means losing investors, US managers could even be forced to abandon the US altogether, perhaps moving to London.

Hammer herself does not think there will be much progress on the legislation next year, as Congress becomes focused on the elections in November 2008. In addition, recent losses suffered by the hedge fund community may earn managers a respite, as they are seen to be taking a pasting in the turbulent market environment. But if there is one lesson to take away from all this, it is that the days of Congress leaving hedge funds alone to get on with making money seem to be ending. One US journalist summed the situation up well: “Those yearning for more Sopranos style entertainment can now program their DVDs to C-SPAN (the US public service broadcaster) instead of HBO to watch these congressional hits in action.”