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HEDGE FUNDS, CARRIED INTEREST ETC. (PART I)

May 13, 2016

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HEDGE FUNDS, CARRIED INTEREST ETC. (PART I)

I saw the movie “The Big Short” last evening and thought it dramatized the housing mortgage crunch we had not that long ago quite well. The movie emphasized that you can bet for or against “the market” and make money either way if you guess right, whether stocks or bonds or currency or whatever is subject to securitization by some Wharton or Harvard whiz on Wall Street.

One criticism of the point the movie was trying to make was that it glorified the lead banker’s conscience (I didn’t know they had any) in making $200 million based on shorting housing mortgage bonds (which was done because of wholesale fraud in putting the underlying mortgage portfolios together by unscrupulous sales people and the big banks’ subsequent issue of bonds based upon the value of such underlying assets). Rating agencies (hired by the big banks) gave Triple A ratings to junk bonds (issued by the same big banks), which was highly misleading, for instance, to the manager of the San Diego Teachers’ Retirement System and others who depend upon rating agencies’ ratings of investment assets. If you can’t trust the rating agencies’ assessments, then just who can you trust?

One of the required courses when I was in law school was Trade Regulation, in which we learned of the Investment Company Act of 1940 (more properly known as The Investment Company and Investment Advisers Acts of 1940). We learned that the purpose of this New Deal Act was to stop companies that trade on behalf of investors from engaging in risky practices like short sales (bets that a stock will go down instead of up), leverage (investing with borrowed funds that amplify returns and heighten risk) and corporate takeovers. (David Dayen has an interesting hedge fund article in the current edition of The American Prospect which, along with seeing the movie on shorting, inspired me to write this blog.)

The Great Depression (which I personally endured) was caused by Wall Street speculation and Republican laissez faire policy response. New Deal statutes were put in place by FDR to correct the mistakes and Wall Street influence that brought us to such a meltdown with a view toward seeing that we never would have another such economic catastrophe. The Investment Company Act was one such statute. Among other things, the Act required that investment companies had to register with the SEC, disclosing their portfolios and their corporate structures. The Act also restricted certain types of fund manager compensation. The purpose of the Act was to eliminate the kind of speculative risks with pools of capital that caused the Great Depression, a noble idea.

Unfortunately, rich families secured a loophole in the 1940 Act for their own private investment managers. The law exempted advisers with fewer than 100 clients who did not offer services to the general public from complying with the regulations. Lawmakers justified the loophole by concluding that “sophisticated investors” can handle the risks, while retail investors (the widows and orphans and other unsophisticated investors) needed to be protected more carefully).

Bingo! Hedge funds are given birth by such loopholes. Less than ten years after the Act became law the first hedge fund was formed by Alfred Winslow Jones, who formed a limited partnership, A.W. Jones & Co., which employed two strategies (both plainly banned by the 1940 Acts): leveraged purchases of certain stocks with borrowed money, and short sales of other stocks. Jones was of the view that this tandem of investments created a “hedged” portfolio which didn’t go up or down with market changes because the stock investments are balanced by both long and short positions so that there is no net exposure to loss.

Jones also came up with a compensation structure managers of hedge funds use almost universally today: an annual fee of 2% of all assets under management and a 20 percent take of all profits above a certain threshold. This, of course, amounts to a tax dodge. Instead of defining such take of the profits as ordinary income subject to a higher tax rate, Jones and subsequent hedge fund managers have successfully conned the IRS into considering their take of the profits as capital gains and thus subject to a lower rate of taxation. This dodge is still in operation and is a pet peeve of mine. The investments managed by hedge funds are not their capital; it’s that of their clients, so how could the mere managers call this obvious compensation for services (and therefore ordinary income subject to a higher tax rate) capital gain?

It isn’t, but the law as written has been interpreted to say that it is. That, among many other provisions of the internal revenue code, is in dire need of amendment, because what the hedge fund managers aren’t paying into the treasury, you and I are. When do these people pay their fair share of the load?

In Part II I will discuss how the Act(s) of 1940 have been amended to make the hedge fund business even more lucrative than before, including the greater number of people who can now participate, the advent of large university endowment investments, access to working peoples’ pension money etc., all without the regulatory regimen enforced by the SEC on, for instance, the $30-trillion mutual fund industry, which also invests mightily on behalf of investors. Stay tuned.    GERALD     E

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