How to get paid more for managing money and still give investors what they want

01 Sep, 2014

In the heroic age of hedge fund investing, managers based in the United States enjoyed a more than useful tax break. They could leave their crystallised annual performance fees in the offshore funds they managed. This had the twin advantage of ensuring the money accrued and compounded pre-tax, and enabled managers to claim to investors that their interests were aligned since they (as the phrase has it) “ate their own cooking.”

In 2008 the United States Congress passed Internal Revenue Code Section 457A, which obliged managers to recognise for tax purposes all of their management fees - including performance fees – in the year that they are earned. The requisite tax was payable even if the manager did not even take the money out of the fund. Indeed, if the tax is not paid on time, a manager is liable not only to pay the tax retrospectively, but also interest plus a penalty of 20 per cent of its value.

However, Section 457A now includes an escape clause, thanks to a ruling by the Internal Revenue Service (IRS) on 23 June 2014, after four years of active lobbying by a number of interested parties, that stock options do not constitute deferred compensation under Section 457A. This allows investors to agree to issue to managers equity options exercisable into shares in the funds they manage, at the prevailing market price (as determined by the Net Asset Value) on the date the options are granted.

The escape clause works because, under laws now long established, options are not taxed until they are exercised. Now, managers can use options confidently to remain invested in their funds while deferring the tax on the investment until they exercise the option.

“For managers, it means their wealth compounds at a spectacular rate, so long as their performance is good,” explains Thom Young of OptCapital, a third party administrator of stock option and other deferred compensation programmes. Options have the further advantage of mitigating the risk of falling below a high water market, since a fall in the shares of the fund means the manager remain invested, and is not dependent on annual performance fees to make and maintain the investment. The (taxable) management fee income needed to manage and maintain the firm, and retain staff, is also less important, since a pool of pre-tax earnings is at hand to cover difficult periods. Options can of course also be shared more widely among staff of the firm.

Importantly, options also restore the alignment of interests between investors and managers which Section 457A threatened to undermine. “If the performance of the fund swoons, managers now share in the downside with investors,” says Young. “It is what long term investors have always wanted – happy to share in the ups but a way to claw back fees during the downs.” This obviously works only for those investors which are tax-exempt (such as pension funds and endowments and foundations) or based offshore (and therefore outside the US tax system) since taxable investors based in the United States prefer to offset management and performance fees they pay against the profits they make from the fund.

But, for tax-exempt investors, options actually align their interests with those of the managers even more closely than traditional performance fees. Under the ancien regime, the value of a fund was impacted negatively every time managers withdrew their accumulated performance fees, leaving investors to bear the investment risk going forward. It effectively gave managers a preferred return on the same investment, and an asymmetric balance of risk, with managers collecting rewards even in bad years for the fund.

With options, investors can insist that managers do not realise their investment until five or six years have passed or even until they redeem their own, ensuring a perfect alignment of interests. Apart from anything else, that guarantees the key people stay involved through the life of their investment.

In fact, Thom Young says his firm is receiving an enthusiastic welcome from tax-exempt funds allocating to hedge fund managers in the United States. “Pension funds and endowments I have spoken to in the United States are eager to get this done, now the ruling of 23 June has eliminated the tax risk to the manager,” he says. “Managers, too, I might add, are happy to know there is a tax-efficient way to attain alignment as well.”

Its real appeal to investors is the automatic clawback of incentive payments when performance dips. Thom Young says the State of Utah Retirement System has calculated that sharing the dramatic 2007-08 downside with its hedge fund managers through options rather than accumulated performance fees would have seen their managers report a decline not of 20 per cent, but 16 per cent.

The same phenomenon makes options a useful marketing tool for managers eager to demonstrate that their interests are aligned with those of their investors.  Better still, options can equip managers with an effective riposte to investors which insist on a managed account. Managed accounts offer investors transparency and asset safety, but no alignment of interest with managers.

Managers are also reluctant to take on managed accounts, since they represent a constant risk of redemption. Furthermore, managed accounts offer no means of remuneration other than an annual management and performance fee, both taxed as ordinary income. Managers that are incentivised by options on a managed account, by contrast, enjoy twin benefits. First, their incentive fees remain in the fund, alongside the investor, compounding on a pre-tax basis because the tax is deferred until the options are exercised. Secondly, by providing the investor with an automatic clawback, redemption becomes a costlier decision.

It follows that prudent managed account platform providers might be well-advised to add stock option programmes to their product offerings, since options would work for managers as well as investors. There is one final advantage to the managers. If a manager wishes to make an acquisition or other large investment, there is a tax-effective alternative to asking the partners to provide capital: the cost of the acquisition can be offset against the profit on the realised value of the stock options.

So there is more than one reason why OptCapital is marketing its options services to managers as well as their investors. It is well-qualified to do the work, since stock options administration has long been its core business. The firm was set up in 1998 in conjunction with Wachovia to administer executive compensation packages - other forms of deferred compensation as well as stock options- for Fortune 1000 companies, most of which rely on a third party administrator to do the work in order to eliminate the obvious conflict of interest. OptCapital took on its first hedge fund clients in 2006, but it is only in the post-Section 457A environment that their services have expanded to include the administration of stock options for hedge fund managers.

Young says it is relatively straightforward to adjust an investment management agreement to pay managers in FARs rather than performance fees. “We have standard documents pre-prepared, and software in place to administer the options,” he says. Indeed, the firm has already branded (and trade-marked) its service to fund managers as Fund Alignment Rights (FARs) for hedge funds.

Young even senses there may be an opportunity in the deferred compensation requirements of the Alternative Investment Fund Managers Directive (AIFMD), which insists managers defer 40-60 per cent of performance-related income for three to five years, with the exact proportion and term varying by investment strategy. “If that is true, a US manager cannot do that without being in violation of Section 457A, because under 457A the manager has to pay the tax every year, and so will have a tough time marketing in Europe” says Young. “Unless, of course, the manager uses options. If I am right, US managers and their European Union clients know there is a ready-made solution available.”

One group that will definitely not benefit from the options opportunity is private equity managers – or at least not yet. The general partners of private equity firms in the United States currently enjoy such favourable tax treatment of their carried interests in the funds they manage that they have no incentive to pursue the tax advantages of being incentivised by options instead.

In fact, general partners of private equity firms enjoy annual tax distributions to meet their tax obligations, even though their capital gains have yet to be realised, because the capital gains tax rate is well below income tax rates. “If and when the government does away with the capital gains tax advantage, private equity firms will want to do FARs as well,” predicts Thom Young.

You can read the IRS ruling here: http://www.irs.gov/pub/irs-drop/rr-14-18.pdf