Taxing Consequences for Private Funds
Private equity and hedge funds may soon find themselves taxed for incentive to continue privately
Blackstone Group (NYSE: BX) rushed its IPO five days ahead of schedule, but do you know why? The reason was likely to beat out the purposeful Democrats in Congress and their new legislation to tax the “carried interest” earned by partners, or the 20% incentive fee. The legislation seeks to treat the fee as ordinary income rather than capital gains, effectively raising the tax rate due on such income to the 35% ordinary corporate income rate from the 15% capital gains rate currently paid.
This incentive fee is key to the existence of private equity and hedge funds. It’s the lure that has drawn so many an MBA into the field. Now, if Congress were to pull the rug out from under the scheme, it would significantly alter the economics of the business, in our view, maybe even the liquidity of the total market. First and foremost, it might lead many more managers to cash out of the business now through IPO rather than engage in a later economically damaged ongoing effort.
The bill in Congress, known fondly to us as the “Blackstone Bill,” is presently focused on private equity, but could easily be tailored to impact hedge funds as well. Also, this Congress has certainly shown that it could prove threatening to offshore and domestic funds with yet to be imagined taxes or regulations. And if a Democrat is elected to the presidency, who’s to stop such legislation? The existence of the threatened incentive fee is probably the key reason why there have not been any follow-ups to the IPO of Fortress Investment Group (NYSE: FIG) yet to date. But, things could change quickly now.
And they already are…
A couple weeks ago, the partners of GLG Partners LP, a giant European hedge fund, announced plans to capitalize a portion of their interests in the business. GLG is doing it in a different way, but the result is similar, a transfer of ownership to the public. GLG is engineering a reverse takeover with Freedom Acquisition Holdings (AMEX: FRH), through which GLG will receive $1 billion in cash and 230 million shares of Freedom’s common stock. After it’s all said and done, GLG equity holders will still own a majority 72% of the combined company.
Spoiling the carrot…
If forced to pay the higher tax, an effective spoiling of the carrot of the private equity and potentially hedge fund industry, we think many a manager might move on to the next opportunity. This means a likely increase in the amount of public hedge fund companies in existence and a reduction in the amount of funds in aggregate. At the end of 2006, total assets managed by hedge funds were approximately $1.9 trillion, according to Institutional Investor News’ report, “Hedge Fund Industry Asset Flows and Trends,” authored by Peter H. Laurelli, CFA. Still, despite the 24% growth in assets managed by hedge funds in 2006, excluding fund of fund assets, we may be nearing a peak in the trend, thanks in part to Congress and its new bill.
The Funds that remain may not do as well…
With a reduced incentive to perform, we think you could see less productive performance from the public funds that come to market. If a fund comes public, its managers have to share the incentive income with shareholders, besides potentially paying a higher tax rate to Uncle Sam. With less of the money dribbling through to their pockets, they might not burn those same profit generating midnight oils that they have in recent years. Also, the best of the best may move on to greener pastures, leaving less qualified managers in their place.
Finally, if the incentive of the funds is impacted, the P/E ratios of the firms that trade on the public market should trend much closer to traditional money managers than they do now. Currently, Fortress Investment Group runs money while carrying a P/E of 20X the consensus $1.22 EPS estimate for 2007. This compares with P/Es of 10X fiscal 2007 (Nov) at Goldman Sachs Group Inc. (NYSE: GS) and 23X FY 07 (Dec) at T. Rowe Price Group (NASDAQ: TROW). After having followed money managers for a time as an analyst, amongst all other types of companies, I know that the Street applies the price to assets under management metric when comparing firms. New age managers like Fortress Investment Group are much more expensive in this respect. T. Rowe Price trades at 3.9% of assets under management, based on March ending assets and its market value on June 26, 2007. Fortress, on the other hand, is valued at 25% of assets under management based on its March ending assets and June 26 value.
We can argue that especially if the legislation is passed into law, the traditional managers like Goldman and T. Rowe may have a much more compelling offering relative to valuation, when taking into account their years in operation, portfolio managers’ experience and diversification of assets. Wall Street Greek thinks it might be time to follow private equity and hedge fund managers out of the business rather than to buy their stock.
This article was initially published at Motley Fool. Wall Street Greek has the exclusive right to republish this article. We thank you for your support of our advertisers. It and our passion for the markets are the sustaining force fueling our effort. (disclosure)
Blackstone Group (NYSE: BX) rushed its IPO five days ahead of schedule, but do you know why? The reason was likely to beat out the purposeful Democrats in Congress and their new legislation to tax the “carried interest” earned by partners, or the 20% incentive fee. The legislation seeks to treat the fee as ordinary income rather than capital gains, effectively raising the tax rate due on such income to the 35% ordinary corporate income rate from the 15% capital gains rate currently paid.
This incentive fee is key to the existence of private equity and hedge funds. It’s the lure that has drawn so many an MBA into the field. Now, if Congress were to pull the rug out from under the scheme, it would significantly alter the economics of the business, in our view, maybe even the liquidity of the total market. First and foremost, it might lead many more managers to cash out of the business now through IPO rather than engage in a later economically damaged ongoing effort.
The bill in Congress, known fondly to us as the “Blackstone Bill,” is presently focused on private equity, but could easily be tailored to impact hedge funds as well. Also, this Congress has certainly shown that it could prove threatening to offshore and domestic funds with yet to be imagined taxes or regulations. And if a Democrat is elected to the presidency, who’s to stop such legislation? The existence of the threatened incentive fee is probably the key reason why there have not been any follow-ups to the IPO of Fortress Investment Group (NYSE: FIG) yet to date. But, things could change quickly now.
And they already are…
A couple weeks ago, the partners of GLG Partners LP, a giant European hedge fund, announced plans to capitalize a portion of their interests in the business. GLG is doing it in a different way, but the result is similar, a transfer of ownership to the public. GLG is engineering a reverse takeover with Freedom Acquisition Holdings (AMEX: FRH), through which GLG will receive $1 billion in cash and 230 million shares of Freedom’s common stock. After it’s all said and done, GLG equity holders will still own a majority 72% of the combined company.
Spoiling the carrot…
If forced to pay the higher tax, an effective spoiling of the carrot of the private equity and potentially hedge fund industry, we think many a manager might move on to the next opportunity. This means a likely increase in the amount of public hedge fund companies in existence and a reduction in the amount of funds in aggregate. At the end of 2006, total assets managed by hedge funds were approximately $1.9 trillion, according to Institutional Investor News’ report, “Hedge Fund Industry Asset Flows and Trends,” authored by Peter H. Laurelli, CFA. Still, despite the 24% growth in assets managed by hedge funds in 2006, excluding fund of fund assets, we may be nearing a peak in the trend, thanks in part to Congress and its new bill.
The Funds that remain may not do as well…
With a reduced incentive to perform, we think you could see less productive performance from the public funds that come to market. If a fund comes public, its managers have to share the incentive income with shareholders, besides potentially paying a higher tax rate to Uncle Sam. With less of the money dribbling through to their pockets, they might not burn those same profit generating midnight oils that they have in recent years. Also, the best of the best may move on to greener pastures, leaving less qualified managers in their place.
Finally, if the incentive of the funds is impacted, the P/E ratios of the firms that trade on the public market should trend much closer to traditional money managers than they do now. Currently, Fortress Investment Group runs money while carrying a P/E of 20X the consensus $1.22 EPS estimate for 2007. This compares with P/Es of 10X fiscal 2007 (Nov) at Goldman Sachs Group Inc. (NYSE: GS) and 23X FY 07 (Dec) at T. Rowe Price Group (NASDAQ: TROW). After having followed money managers for a time as an analyst, amongst all other types of companies, I know that the Street applies the price to assets under management metric when comparing firms. New age managers like Fortress Investment Group are much more expensive in this respect. T. Rowe Price trades at 3.9% of assets under management, based on March ending assets and its market value on June 26, 2007. Fortress, on the other hand, is valued at 25% of assets under management based on its March ending assets and June 26 value.
We can argue that especially if the legislation is passed into law, the traditional managers like Goldman and T. Rowe may have a much more compelling offering relative to valuation, when taking into account their years in operation, portfolio managers’ experience and diversification of assets. Wall Street Greek thinks it might be time to follow private equity and hedge fund managers out of the business rather than to buy their stock.
This article was initially published at Motley Fool. Wall Street Greek has the exclusive right to republish this article. We thank you for your support of our advertisers. It and our passion for the markets are the sustaining force fueling our effort. (disclosure)
posted by The Greek | 7:28 PM
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