On hedge funds and the taxpayer
Hedge funds are in the news. Some of them are starting to go bust. Carlyle Capital, linked to some of the most formidable names in global politics and based in the tax haven of Guernsey, is a recent casualty. Worse, this sector seems to be just the latest domino to falling across the global financial system. Anecdotal evidence is building up that this global crisis is rather more frightening than other ones in living memory. Try this recent headline, for example: “World trade decelerates almost to standstill.” It all seems to be going in waves: if you want to be really frightened, try this analysis by one of the world’s most respected economists. Hedge funds will be an important part of this evolving tale.
The Tax Justice Network has a couple of problems with hedge funds. As a general principle, we're not opposed to people getting rich (although income and wealth inequality are political problems which worry us too). But we do worry when the tax system subsidises wealth. How does this happen? In a couple of ways. First, hedge funds, like private equity funds, use leverage (borrowing) to generate artificial costs that can be offset against tax. (There are other loopholes that they exploit too.) We have blogged about this kind of thing before.
But there is another way that these companies are subsidised by our tax systems: through the way they take risks with other people's money. Bear with us.
Let's start with another penetrating article by the FT's Martin Wolf (whom we wrote about recently.) It's entitled "Why today's hedge fund industry may not survive." In it, he exposes the hedge fund industry's model for making money. Here is the key section:
Imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.
There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.
The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.
The first part of the above scenario, or at least parallel versions of it, are what these funds have been doing for the last few years. The last part, "the bad event" that we have highlighted in bold, is what seems to be happening now. Wolf finishes:
If these unfavourable events – stock market crashes, mortgage failures, liquidity freezes – come in stampeding herds (because so many managers copy one another), they will say: “Nobody could have expected this, but, now that it has happened to all of us the government must come to the rescue.” The more one believes this is how an unregulated financial system operates, the more worried one has to become.
In the above case, the funds are taking risks through the sale of insurance in the good times - and when things turn sour they default on that insurance. Elsewhere, they take risks through borrowing - leverage - which magnifies the effects of market movements. Not only does this enable them to earn the unjustified tax subsidies, but it rewards them handsomely when markets are rising. But when markets turn, calamity strikes, and they clamour for - and because of the scale of the systemic risks in the financial system they unfortunately might get - bailouts. In other words, the hedge funds have been playing with risks, which reward them with the upside when times are good - and when the game ends, it is the taxpayer who rescues them. It is our concern for the taxpayer that makes it an issue for TJN to address. This helps illustrate why the Tax Justice Network, while ostensibly focused on tax, needs to consider regulation as an inherent part of its approach.
As a long aside - this is not quite so close to TJN's core concerns but is worth remarking on because it is so fascinating - here is an excerpt from another FT article, comparing the hedge fund model (they take from investors a 2 percent management fee plus 20 percent of any gains over a benchmark) with the model used by Warren Buffett, the world's richest investor, worth an estimated $62 billion:
During Mr Buffett’s tenure at Berkshire Hathaway, the S&P 500 index has produced an average total return of 10 per cent. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that – as Mr Buffett’s have done – your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr Buffett the richest man in the world. The calculation illustrates a more subtle point. Mr Buffett’s fortune has come not through growing an investment management business, but from his own share in the value of the funds he manages. Suppose he had adopted a more conventional investment management structure, charging the 2 per cent management fee and 20 per cent of performance common in private equity and hedge funds. How much of that $62bn wealth would have been the property of Buffett the manager – Buffett Investment Management – and Buffett the investor – the Buffett Foundation?
The answer is astonishing. At “2 and 20”, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent.
That really is quite remarkable (and, as another aside, if you want more insight into how Buffett got so rich, read this article which concludes that "Mr Buffett’s success demonstrates the weakness of one economic theory, the efficient market hypothesis, and the strength of another – the central role that the pursuit and defence of economic rents plays in modern corporate life.")
The above arithmetic on the "2 and 20" formula is equally skewed whether the hedge funds outperform, match, or underperform the markets. Not only are they fleecing the taxpayer, they seem to be gouging their investors too.
This blog is not going to provide a set of recommendations for how to reform the hedge funds industry. Plenty of people have been aware of the problem for years - and now that there is an economic crisis to sharpen people's minds, at least some appropriate action is likely to be taken. This blog is going to make one simple recommendation, only: that civil society in rich countries and poor ones pays more attention to high finance. This will affect us all, in the real world. And bear in mind that while on the surface it may seem that the hedge funds industry is all about the private sector only - it is not. Approach these kinds of issues from the perspective of tax, and the interests of the taxpayer, and you will find that this is usually one of the best ways to get to the heart of the matter.
The Tax Justice Network has a couple of problems with hedge funds. As a general principle, we're not opposed to people getting rich (although income and wealth inequality are political problems which worry us too). But we do worry when the tax system subsidises wealth. How does this happen? In a couple of ways. First, hedge funds, like private equity funds, use leverage (borrowing) to generate artificial costs that can be offset against tax. (There are other loopholes that they exploit too.) We have blogged about this kind of thing before.
But there is another way that these companies are subsidised by our tax systems: through the way they take risks with other people's money. Bear with us.
Let's start with another penetrating article by the FT's Martin Wolf (whom we wrote about recently.) It's entitled "Why today's hedge fund industry may not survive." In it, he exposes the hedge fund industry's model for making money. Here is the key section:
Imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.
There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.
The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.
The first part of the above scenario, or at least parallel versions of it, are what these funds have been doing for the last few years. The last part, "the bad event" that we have highlighted in bold, is what seems to be happening now. Wolf finishes:
If these unfavourable events – stock market crashes, mortgage failures, liquidity freezes – come in stampeding herds (because so many managers copy one another), they will say: “Nobody could have expected this, but, now that it has happened to all of us the government must come to the rescue.” The more one believes this is how an unregulated financial system operates, the more worried one has to become.
In the above case, the funds are taking risks through the sale of insurance in the good times - and when things turn sour they default on that insurance. Elsewhere, they take risks through borrowing - leverage - which magnifies the effects of market movements. Not only does this enable them to earn the unjustified tax subsidies, but it rewards them handsomely when markets are rising. But when markets turn, calamity strikes, and they clamour for - and because of the scale of the systemic risks in the financial system they unfortunately might get - bailouts. In other words, the hedge funds have been playing with risks, which reward them with the upside when times are good - and when the game ends, it is the taxpayer who rescues them. It is our concern for the taxpayer that makes it an issue for TJN to address. This helps illustrate why the Tax Justice Network, while ostensibly focused on tax, needs to consider regulation as an inherent part of its approach.
As a long aside - this is not quite so close to TJN's core concerns but is worth remarking on because it is so fascinating - here is an excerpt from another FT article, comparing the hedge fund model (they take from investors a 2 percent management fee plus 20 percent of any gains over a benchmark) with the model used by Warren Buffett, the world's richest investor, worth an estimated $62 billion:
During Mr Buffett’s tenure at Berkshire Hathaway, the S&P 500 index has produced an average total return of 10 per cent. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that – as Mr Buffett’s have done – your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr Buffett the richest man in the world. The calculation illustrates a more subtle point. Mr Buffett’s fortune has come not through growing an investment management business, but from his own share in the value of the funds he manages. Suppose he had adopted a more conventional investment management structure, charging the 2 per cent management fee and 20 per cent of performance common in private equity and hedge funds. How much of that $62bn wealth would have been the property of Buffett the manager – Buffett Investment Management – and Buffett the investor – the Buffett Foundation?
The answer is astonishing. At “2 and 20”, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Foundation. The effect of compounding at 14 per cent, rather than at 20 per cent, is to reduce the accumulated pot by over 90 per cent.
That really is quite remarkable (and, as another aside, if you want more insight into how Buffett got so rich, read this article which concludes that "Mr Buffett’s success demonstrates the weakness of one economic theory, the efficient market hypothesis, and the strength of another – the central role that the pursuit and defence of economic rents plays in modern corporate life.")
The above arithmetic on the "2 and 20" formula is equally skewed whether the hedge funds outperform, match, or underperform the markets. Not only are they fleecing the taxpayer, they seem to be gouging their investors too.
This blog is not going to provide a set of recommendations for how to reform the hedge funds industry. Plenty of people have been aware of the problem for years - and now that there is an economic crisis to sharpen people's minds, at least some appropriate action is likely to be taken. This blog is going to make one simple recommendation, only: that civil society in rich countries and poor ones pays more attention to high finance. This will affect us all, in the real world. And bear in mind that while on the surface it may seem that the hedge funds industry is all about the private sector only - it is not. Approach these kinds of issues from the perspective of tax, and the interests of the taxpayer, and you will find that this is usually one of the best ways to get to the heart of the matter.
posted by TJN at 6:37 am
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