Beware of Hedge Fund Managers
Bearing Gifts
"Do not trust the horse, Trojans. Whatever it is, I fear the Greeks even when they bring gifts."
According to Greek mythology, the Greeks had struggled for nearly a decade to penetrate and conquer the city of Troy. In an act of trickery, they constructed a huge wooden horse, hid men inside it and pretended to sail away from the city.
Ignoring wise counsel, the Trojans opened the gates and unknowingly opened the door for the Greek army to enter their city. Shortly after the Trojans brought the horse into the formerly impenetrable area, the Greek army sailed back under the cover of night and stationed their men to attack. Once the Greek army was in place, the men crept out of the horse and opened the gates for the rest of the army to enter and destroy the city of Troy.
The term "Trojan Horse" has metaphorically come to mean any trick or strategy that causes a target to invite a foe into a securely protected area.
We correlate this story to the appeal of hedge funds and private equity to a high net worth investor and the economic reality that is likely to follow.
Diverging from our normal lines of discussion, we are going to explore the implications of the Tax Cuts and Jobs Act (the new tax code) on alternative investment income.
The tax implications on alternative investment income are staggering. The new US tax code raises the bar so high that most alternative investments will fail to pass the test for the average high-net-worth investor.
The term “high-net-worth investor” is a relative term. After all, nobody wants to be the one millionaire on an island of billionaires!
Rather than defining high-net-worth by the size of someone’s balance sheet, we are going to define it as anyone with an annual income above $400,000, the beginning of the 35% tax bracket for married couples filing a joint tax return here in the United States ($200,000 is the beginning of the 35% bracket for a single filer).
For today’s discussion we are going to use the 37% tax bracket to define high net worth, so technically this would be a married couple with a taxable income above $600,000 or an individual with a taxable income above $300,000.
A brief history lesson on our tax code and investment management fees:
The “two and twenty” fee structure (2% management fee and 20% performance or carried interest fee) charged by hedge fund and private equity managers has always been a challenging hurdle for alternative investment managers to overcome. Prior to 2018, however, the US tax code took some of that sting out of the bite by allowing investors to deduct their investment management fees once they surpassed 2% of adjusted gross income. In other words, a tax payer with $1 million dollars in adjusted gross income could deduct the investment management fees that surpassed the $20,000 mark (the 2% hurdle).
The new tax code however, has removed investment management fees from the list of itemizable deductions.
The colossal impact of this change comes down to the fact that 100% of your investment income flows through to your personal tax return and your investment management fees no longer offset that income.
It’s like the opposite of a tax-free municipal bond. Instead of receiving income on which the government will not tax you, you are required to pay tax on income you will never receive.
Let’s take the example of a married couple making $700,000 per year from their employer plus another $150,000 of income from their alternative investments. To keep things simple, we will make the following assumptions:
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The couple earns $700,000 in wage income from their employer
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The alternative investment is custodied in a traditional taxable account (ie. non-retirement account)
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The alternative investment generates $150,000 of investment income on $1,000,000 of invested capital
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Half of the investment income is taxed at the investor's ordinary income tax rate and half is taxed at the long-term capital gains rate
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The investment manager is paid $20,000 from the 2% management fee and $26,000 from the 20% performance fee
Description
$150,000 Of Investment Income
($20,000) 2% Management Fee
($26,000) 20% Performance fee
$104,000 Net to Investor Before Tax
Tax Liability
+$42,750 (Federal Income Tax)
+$3,885 (Net Investment Income Tax)
Cannot be deducted on Schedule A
Cannot be deducted on Schedule A
$46,635 Additional Tax Liability
The investor receives $57,365 after investment management fees and federal income tax, and still has a state income tax bill to pay. This 5.7% return is a long way from the 15% gross return generated by the hedge fund manager.
Keep in mind, we are just looking at the tax implications of alternative investment fee structures. Considering the fact that the HFRI Equity Hedge Index only returned 3.38% over the last five years (according to Hedge Fund Research, Inc. – 2/28/19), we haven’t even begun to address the impact of performance fees on net returns to investors.
Potential Solution: Asset Location
One potential way to address this problem is to put investments with high management fees into tax-deferred retirement accounts instead of traditional taxable accounts. The challenge with this option is that it puts the investor at risk of being subject to UBIT issues (unrelated business income tax). Because of the potential UBIT and ERISA issues, some managers and many custodians will not accept retirement assets in alternative funds.
This asset location issue is a critical piece of the wealth preservation and accumulation puzzle. Unfortunately, this mission-critical issue is often missed by the wealth management community due to a lack of knowledge about our tax code.
Conclusion
The Tax Cuts and Jobs Act creates a very challenging hurdle for many alternative investments to overcome. Investors should be careful to analyze the net after-tax return on their investments and make sure they are being fairly compensated for putting their capital at risk.