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May 15, 2016


So what is carried interest? It is the 20 per cent over threshold I mentioned but did not identify as such in Part I as that portion of the investment profits (if any) payable to the hedge fund manager. I don’t know what carried interest as a phrase means other than one lobbyists for hedge fund managers had congress write into the internal revenue code with a view toward trying to differentiate between ordinary income and capital gains for tax treatment. Parenthetically, it is noteworthy that hedge fund managers only share in the profits of their investors, not the losses, which are the burden only of the investors, and the hedge fund managers get their 2 per cent of the assets under management in any event, so they make money however their clients’ investments perform.

The phrase “carried interest” is, in other words, a maneuver that allows hedge fund managers to take their 20 percent share of profits above benchmark as capital gains instead of earned income, saving billions of dollars in taxes to such managers, and though there has been bipartisan support to end this costly anomaly for ten years, the loophole remains intact thanks to the millions spent to keep it that way by various trade organizations and individual hedge funds (with their “campaign contributions”).

Our treasury is losing billions of dollars annually as a result of keeping this law on the books and you and I are having to make up what these hedge fund operators are not paying into our treasury. This law should be repealed, and the sooner the better. I suspect that politicians keep this law on the books so that they can threaten to repeal it every year unless the lobbyists for the hedge fund industry pony up “campaign contributions” (known in my day as “bribes”).

We saw in Part I that hedge fund managers pay a low capital gains tax on capital gins that are not theirs. I  understand how a 20% take on profits could be considered fair compensation for hedge fund managers; I do not understand how we can manufacture the phrase “carried interest” to cover an obvious tax dodge and I fail to see how such legislation is in the public interest.

All hedge funds, unlike Lake Woebegon, are not above average. While it is difficult to know precisely what their performance is because they are free from substantial regulatory reporting, there were $2.7 trillion invested in hedge funds in 2015, but most of that was with a relatively few hedge fund managers, those with a reputation for high returns. However, 2 per cent of $2.7 trillion for the year amounts to $54 billion for the industry exclusive of the 20 per cent above threshold those who were profitable collected, so that is an excellent return for those in the business who don’t have a penny at investment risk. Author Leo Leopold reports that top managers routinely make a million dollars an hour!

In 1996 Bill Clinton signed the so-called National Securities Markets Improvement Act (NSMIA) which was designed to overhaul state and federal responsibility for securities market oversight. There had been no resistance in congress; indeed the congress passed the measure by voice vote! Section 209 of the Act (which nobody apparently noticed at the time when it was slipped into the bill) expanded the number of clients hedge funds could handle while continuing to escape the 1940 Act’s rules (weak as they were and are) from 99 to an unlimited number of “qualified purchasers.” This not only included individuals with $5 million in investments (presumably “sophisticated investors”), but more importantly, institutional investors with assets of $25 million or more. The SEC wanted to raise this threshold but the congress refused, noting “that investor protections could be maintained” at $25 million. Hedge funds salivated at the prospect of a wholly new funding force, including tens of billions in retirement savings from ordinary workers who otherwise certainly did not as individuals have $5 million to invest. University endowment funds also found their way into the clutches of these hedge funds, and with mixed results, as will be seen in Part III. As it turns out, this industry desperately in need of stronger regulation in order to protect investors and the larger economy got weaker regulation and far more and greater investor targets, a far call from A. W. Jones’s original hedge fund idea of neutral investing with longs and shorts in the stock market. The fact is that hedge funds don’t hedge anymore; they are just another investment vessel running on exemption and amendment of the Investment Act of 1940.

There is another problem associated with projection of outsize returns from hedge fund investments, and it is a doozy. A cash-strapped state, for instance, can project big returns for hedge fund investments which allows it to provide fewer resources for pensions (and also keep tax increases in check). Thus Rhode Island can plan to put less into its pension fund if its legislature and governor assume a return of 10 per cent rather than five. If they miss the target, that’s the next governor’s problem; what matters is making a projection in the short term that allows them to potentially shortchange public employees – so that teachers and other workers stand to lose pension money they’re owed to make billionaires richer. I think this practice is appalling – and dangerous to the contractural rights of pensioners past and present.

In Part III I will discuss the mythology that has sprung up concerning the big profits hedge funds can earn for their investing clients, how the industry needs more regulation to protect investors and the larger economy, and what we can do to bring the industry into compliance with the rules and regulations that their mutual fund competitors must follow. Stay tuned.   GERALD     E










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