TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Thursday, November 22, 2018

Hedge Fund Investors Lose Key Tax Break For Management Expenses: '1.5 And 17' Is The New '2 And 20'

Bloomberg, Hedge Fund Investors Lose Key Tax Break for Management Expenses:

For some hedge fund investors, President Donald Trump’s tax overhaul adds insult to the injury from poor investment performance.

The Republican law eliminates deductions for certain expenses that wealthy taxpayers previously could itemize on their returns, including the management fees paid to hedge fund managers, which are usually mandatory. Now, rich investors will have to eat every penny of those expenses — even if the fund investments lose money. ...

Beleaguered hedge fund managers have lost money this year after suffering their worst month since 2011 in October. The $3.2 trillion industry has been hit by years of mediocre performance and fund closures, with investors pulling $68.8 billion since the start of 2016. Several managers have announced plans to shutter in anticipation of year-end withdrawals.

Hedge fund managers have long justified their fees by selling their funds as better at making money and protecting investors during downturns. But in the three decades since alternative investments took off, the industry has hardly done much better than the Standard & Poor’s 500 Index, according to Hedge Fund Research.

The tax hit could put even more pressure on poor performing hedge funds to lower some of their fees. Funds historically charged “2 and 20,” with an annual management fee of 2 percent of assets under management plus a 20 percent performance fee on profits. Funds using that model are in the minority, with the averages now at 1.45 percent and about 17 percent, according to an August report from Credit Suisse Group.

Donald Steinbrugge, founder and chief executive of Agecroft Partners, a consulting and marketing firm for hedge funds, said he knows of a hedge fund, which he declined to name, that started offering a 0 percent management fee because of the deduction change. “They’re not going to be alone,” Steinbrugge said.

Even with the “significant windfall” of deductibility gone, smaller funds will have a harder time cutting their management fees in a down market, according to Brandon Colon, a senior vice president at fund consulting and advisory firm Meketa Investment Group. Those fees along with separate annual expenses for a fund’s operations go toward anything from printing costs to “a manager’s lobster Thermidor dinner,” Colon said.

In addition to fund management fees, taxpayers could previously take other so-called miscellaneous itemized deductions on expenses such as work-related travel costs that weren’t reimbursed under the old tax code. The expenses had to exceed 2 percent of adjusted gross income, a hurdle hit fairly easily by many investors. ...

One option for fund managers reassessing their fees is to convert the management fee to a performance fee. But that puts more pressure on those managers to beat the market and doesn’t leave much of a buffer to keep the lights on.

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Tax Reform: Is there anything it can't do?

Posted by: brad | Nov 22, 2018 11:01:05 AM