After two op-eds in three days in the New York Times calling for an increase in the taxes that managers of investment funds pay on carried interest, and after a PBS program that dwelled on the issue, the Wall Street Journal gets into the act today with an op-ed piece by John Steele Gordon that also calls for increasing the tax.
Mr. Gordon writes: " Managers of these funds are compensated for their services in two ways. One is the annual management fee, usually 1% or 2% of a client's investment. The other is a share in the net profits of the fund's long-term investments. That share is often 30% or even more."
I don't think that's accurate. A Bloomberg article from earlier this year described hedge fund fees as "typically 2 percent of assets and 20 percent of returns." Those returns aren't just on "long-term investments" but of all investments, and in some cases the limited parters in the fund must pass a so-called "high-water mark" before the general partner earns carried interest on profits. The few funds that reportedly charge higher performance fees than 20 percent (Renaissance's Medallion Fund and Steven Cohen's SAC) are unusual enough to be newsworthy, and they also tend to be funds that trade so frequently, and on such a short term basis, that most or all of their carried interest is taxed at the higher short-term rates, not at the lower long term rates that Mr. Gordon finds so egregious.
Mr. Gordon goes on:
To defend the favored treatment of carried interest, private-equity and hedge-fund owners argue that their share of the customers' gains is analogous to "founders stock," which is granted to the founders of a company when it goes public, even though they may not have personally invested money in the venture.
This analogy is bogus when the companies in which a fund is invested are not actively managed. A founder has a bright idea. He works hard to convince others of its worth so that they will invest in it. He works hard to get the company off the ground, investing his time and his sweat equity in the business (not to mention the forgone income from the 9-to-5 job he could have had instead). He is risking a lot: a substantial portion of his working life, his reputation, his potential current income, etc.
What does a hedge-fund manager risk? His is an on-going business, not a start-up. His business is, in effect, giving investment advice to clients. If his advice nets to a profit he is rewarded with a portion of the gain. ...
Moreover, much of the investment advice actually comes from the staff of a hedge fund, not the partners. The staff does much of the hard work of investigating investment possibilities. They receive salaries for their advice and are liable to pay taxes at ordinary rates.
What's really "bogus" is Mr. Gordon's argument for a tax distinction between "actively managed" investments and those that are not. It sounds like he's arguing for long-term capital gains tax treatment of managers of private equity or venture capital funds (or, for that matter, oil and gas and real estate investment partnerships, which are taxed the same way), but not for hedge funds. But what about a hedge fund that takes a vocal minority or majority stake and gets a management change that creates value?
"What does a hedge fund manager risk?" Quite a lot, actually. He may have left a relatively secure job at Goldman Sachs to strike out on his own, taking a pay cut and paying organizational expenses like legal fees out of his own pocket with no guarantee that the fund will survive longer than a year or two. If the fund loses money in the first year or two, it might go out of business, and the fund manager would be unemployed. Mr. Gordon's claim that the hedge-fund manager's "is an on-going business, not a start-up," ignores that fact that every hedge fund was a start-up before it became an on-going business.
Now, one can argue that the risk taken by starting up a fund is reflected in the long-term tax treatment of the fund founder's interest in the fund management company itself, which could eventually be sold or go public. But the current tax treatment of carried interest encourages general partners (the fund managers) to create value for their limited partners, not just for themselves.
As for Mr. Gordon's claim that "much of the investment advice actually comes from the staff of a hedge fund, not the partners," it depends on the fund. Some funds are so driven by the partners' decisions on capital allocation that they have "key man" provisions that entitle limited partners to the return of their capital if the general partner dies or becomes disabled. What's next, different tax rates for funds depending on how many of the investment decisions are made by partners versus staff?
The larger picture here is that the federal government projects it will collect something on the order of $2.9 trillion in revenue this year, a record in both nominal and inflation-adjusted (if you believe the CPI adjustment, admittedly a big if) terms. Is it really a constructive thing for the Wall Street Journal op-ed page, or for Mr. Gordon, a center-right intellectual of considerable talents, to spend time and space searching for ways to wring yet more tax revenue out of America's capitalists?