Hedge fund managers to increasingly defer performance fee pay-outs
The decision by California Public Employees’ Retirement System (CALPERS) to exit hedge fund investing coupled with the Internal Revenue Service’s (IRS) ruling that now permits managers to charge performance fees cumulatively without falling foul of a 2008 tax law change, could lead to more firms deferring performance fee pay-outs.
The IRS Ruling 2014-18 published in June 2014 clarifies certain types of cumulative incentive fees are compliant with Section 457A, a 2008 law that curtailed the ability of offshore entities such as hedge funds from using deferred compensation arrangements, a measure that had been introduced when Congress passed the Emergency Economic Stabilisation Act. As a result, many managers paid themselves a performance fee in the form of annually determined compensation package.
This looks set to change. “The IRS provided a ruling that allows long term investors and their hedge fund managers to be aligned by structuring an incentive fee that gives the investors what they want - a hold back of the full pre tax incentive fee to net against their actual return, and gives the managers what they want - a way to keep their fees invested in their fund tax deferred until they are paid out," said Thom Young, managing director at OptCapital in North Carolina.
The annual payment of performance fees had irked some investors, who complained that annually determined incentive fee payments resulted in misaligned compensation opportunities with high-pay outs when returns were high, and little opportunity to claw back those high payments during choppy bouts of performance. A number of pension plans including CALPERS and the Utah Retirement System had urged fund managers to charge performance fees on a cumulative basis.
“A handful of powerful investors have been pushing for managers to change their compensation tools, and I suspect the IRS ruling will significantly assist managers and their clients in efforts to align their interests. Charging a cumulative performance fee in the form of appreciation rights now makes sense from a tax point of view although it remains to be seen whether investors are actively going to raise their hands demanding cumulative performance fees,” said Andrew Oringer, partner at Dechert.
The decision by CALPERS to withdraw from hedge funds has spurred much debate too about fees, with the US public pension fund having been an early adopter of the asset class. CALPERS, which pulled $4 billion worth of investments out of 24 hedge funds and six funds of hedge funds, criticised the industry for being too complex and costly. Other plans including the Los Angeles Fire and Police Pensions System, San Diego County Employees’ Retirement Association and Louisiana Firefighters Retirement System are mulling whether to scale back or cease investing in hedge funds. The London Pensions Fund Authority, which recently withdrew capital from Brevan Howard citing transparency concerns, was reported to have described hedge fund fees as being unjustifiable.
This has led to speculation whether the traditional 2% management fee and 20% performance fee will be lowered further, particularly given that performance has been disappointing.