A Flaw in John Carney’s Hedge Fund Tax Hike Analysis

John Carney argues that hedge funds can avoid tax hikes by re-characterizing the transaction as a loan transaction. Here is how he explains this:

“Here’s how it works. I invest that $1 million but this time only $800,000 goes directly into the fund and $200,000 becomes a loan to Cadie. Cadie uses the $200,000 to buy a 20 percent stake in the fund. So now we both have purchased interests in the fund and our long-term gains can be characterized as capital gains.

Now there are complications. If I charge Cadie interest on the loan, she’ll likely increase the management fee to make up for that. She’ll have to pay ordinary income taxes on that increase but far less than she would if the entire 20 percent were taxed as ordinary income. (If I don’t charge Cadie interest, she’ll have to pay taxes on the imputed income.)”

The best thing about being a hedge fund manager is getting %20 of the upside and none of the downside. It’s like a free option. Many hedge funds shut down after they lose a significant percent of their clients’ assets because they don’t want to work for “free” for years to make up all the losses. Their talented employees won’t stay with them anyway- they would rather switch to another fund where they can get a cut of any upside.

If hedge funds re-characterize their transactions as loan transactions, then they expose themselves to the losses in their funds. John Carney forgets the fact that most long-short equity hedge funds have around 50% beta exposures. That’s why hedge funds lost nearly 20% on average in 2008. The losses at some hedge funds exceeded 50% in 2008. Most hedge fund managers won’t be willing to accept this additional risk or demand additional fees to make up for it.

It’s ridiculous that hedge fund managers pay such a small percent of their overall income in taxes. There are some hedge fund managers, i.e. Jim Chanos, who have publicly acknowledged this. What’s clear is hedge fund managers will be hurt significantly if Obama manages to get the hedge fund tax hike he wants. Otherwise, he wouldn’t have got this much of a push-back from hedge fund managers.