Currently there is a debate in Congress about how to tax the compensation earned by private equity and hedge fund managers who are compensated using a "2 and 20" formula: 2 percent of the funds under management (taxed as ordinary income, i.e., at a 35% rate); and 20 percent of the profit (taxed at a 15% capital gains rate), referred to as "carried interest."
Testimony by Peter Orszag at CBO lays out the basic alternatives and tells the recent history of the industry. Reading between the lines, Dr. Orszag seems to favor the following alternative:
...one can think of carried interest as an interest-free nonrecourse loan from the limited partners to the general partner equal to 20 percent of the partnership assets, with the requirement that the loan proceeds be reinvested in the fund. ... To see how this example works, imagine a fund worth $100 million. With no direct capital investment, the carried interest entitles the general partner to the profits on $20 million (20 percent of the profits on $100 million is equivalent to the full profits on $20 million). It is therefore as if the limited partners have contributed $80 million to the fund and then lent the general partner $20 million to invest in the fund too, but without charging the general partner interest on that loan.
This implicit loan perspective would result in treating carried interest somewhere between purely capital income and purely ordinary income... this perspective would suggest that the component of carried interest attributable to implicit interest on the implied loan would be ordinary income and that the returns in excess of that implicit interest would be capital income
What interests me is whether this compensation scheme aligns the incentives of fund managers (general partners) with the goals of the fund purchasers (limited partners). And why has the industry standardized on this compensation scheme? A friend of mine raised $15 million for a "fund of funds," which he invests in other funds, and is charging "1 and 10" instead of "2 and 20."
I would like to hear some stories about how well (or poorly) this compensation scheme works to align the incentives of fund managers with the profitability goals of fund owners.
Regarding the guy's description, I think it is pretty good, although many funds carried interest look a little more like convertible preferred shares (meaning the manager doesn't earn his carry unless a minimum IRR is met).ReplyDelete
There are two big incentive problems that have emerged with this scheme
and both have to do with risk.
1. Winner's bias. The competition for capital among funds is significant. The best way for a firm to attract capital is to show (way) above average returns. If a hedge fund or private equity fund isn't very successful the principals typically shut it down, find a new partner, name the firm something else and raise a new fund. This reinforces the notion, among LPs that these funds can and will crush the expected returns of ordinary investments. It also encourages managers to shoot for the moon, otherwise they won't get capital; if they screw up, close the fund and open a new one.
2. From a GP's perspective getting a 10% return is equivalent to getting (25%). Because compensation is driven so much by the 20%, risk controls are typically incredible weak. There are tons of examples of this. Amaranth Advisors fell victim to this problem; essentially, they took the "hedge" out of hedge fund and bet HUDGE that natural gas prices would move in a particular direction. They didn't, and Amaranth lost $3B+. What is interesting is, the guy on the other side of the trade, John Arnold (an old Enron trader) is hailed as a genius and probably doubled his capital raise because of the one trade. It could have easily moved in the opposite direction.
One particular advantage of the 20% carry is the fact that carried interest is typically earned at exit, not some arbitrary date like stock options or restricted stock. Managers are free to implement long-term oriented strategies that may negatively impact short-term profits without risk of a shareholder revolt (think migrating newspaper revenue models from pay-per-paper/advertising to online adwords).
Despite is drawbacks, the carried interest compensation scheme is better than most because everyone in the game views these investments as risk capital. And risk capital is expected to take on greater risk and earn a greater reward.
I always prefer to manage things on my own, I don’t like these and as Forex trader, I prefer to take minimum stress since that is how I am able to perform better. I am lucky enough to be working with OctaFX broker and they are high class company to work with due to wide range of benefits which includes low spreads starting from just 0.1 pips to high leverage up to 1.500 plus much more, it all connects very well with me and I am able to make profits easily.ReplyDelete