Hedge Fund Investors Lose Key Tax Break for Management Expenses

(Bloomberg) -- 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.

The tax change “makes hedge funds, which are already struggling, even less appealing,” said billionaire Mike Novogratz, founder of crypto-focused merchant bank Galaxy Digital LP. Novogratz used to run a hedge fund at Fortress Investment Group LLC that was liquidated in 2015 following poor performance.

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 Inc.

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 AG.

Donald Steinbrugge, founder and chief executive of Agecroft Partners LLC, 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.

Hedge Fund Hypothetical

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.

Wealthy taxpayers most affected by killing off the management fee deduction are those who have money in activist funds or those that tend to buy and hold securities, Colon said. Investors in funds that use swap payments, a type of derivative involving exchanged financial instruments, are also at risk, said Robert Gordon, the president and founder of Twenty-First Securities Corp., a brokerage and financial services firm.

Investors who pay their performance fees in cash get a double whammy -- they can no longer deduct those fees as miscellaneous itemized deductions either.

Trader funds, which rapidly and frequently trade high volumes of securities as their core businesses, aren’t affected since investors in those funds were never able to take the management fees as itemized deductions. Those funds are allowed to write off management fees as business expenses, and pass those savings to investors, which they can still do under the tax law.

For investors in hedge funds with poor performance, the deduction change can make the loss even more painful. For example, U.S. investors in David Einhorn’s Greenlight Capital LP fund would have suffered a net 25.2 percent loss this year through October without the 1.5 percent management fee write-off, compared to the fund’s gross 23.7 percent decline. A Greenlight spokesman declined to comment.

Converting Fees

Even a fund with stronger returns can deliver a blow to taxpayers who can no longer write off the management fee. Say a fund delivered a 7.3 percent return -- after deducting management and performance fees of 2 and 20, the investor would be left with a 4.24 percent return. But since investors are no longer allowed to deduct the management fee, that 2 percent gets added back in -- leaving a tax bill on a 6.24 percent return, even though the investor only got a 4.24 percent net return.

Still, the loss of the deduction could be softened by the long-term capital gains rate investors in hedge funds are often eligible for -- assets that are held for at least three years can qualify for a rate of 23.8 percent while shorter-term assets are taxed at ordinary income rates. Meanwhile, investors in trader funds are on the hook for ordinary income tax rates. “You have to do the math and see where you’re better off,” said Jeffrey Chazen, a tax partner at accounting firm EisnerAmper.

Also, there are benefits for top earners in Trump’s law that may offset the management fee pain, such as the cut in the top rate to 37 percent from 39.6 percent. The law also increased the thresholds for the alternative minimum tax -- those who pay the so-called AMT aren’t able to take miscellaneous itemized deductions. But wealthy taxpayers face new limits on deductions for mortgage interest and for state and local taxes.

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.

“You’re at risk and you might not have money to live on,” Chazen said.

©2018 Bloomberg L.P.