The Blackstone IPO has focused attention on the fact that hedge funds and private equity funds have their fees taxed at the 15 percent capital gains rate rather than the 35 percent ordinary income rate. The ensuing debate has asked if these funds should receive favorable tax treatment. Wherever you come out in this debate – and I am too removed from the world of tax legislation to venture a yea or nay view – a starting point for answering this question in the affirmative is to establish that these funds are somehow different from other businesses. If they aren’t any different, then it is hard to argue they should be taxed differently.
Hedge funds are businesses in which managers are responsible for assessing a set of possible investments and allocating the firm’s capital to the best investments within that set. They are then rewarded according to the results of their decisions. That does not sound a whole lot different than what manager do in any other business. Granted fund managers are compensated for their results in a more formulaic manner than are those in most other businesses, but ultimately they are being compensated based on how well they manage the assets under their control, just as any other business manager is – or at least should be – compensated.
So if there really is a difference, it comes not from what they do, but how they do it. In particular, it must be based on the nature of the capital they use or the types of investments they make.
The typical hedge fund gets its capital from private investors. But then, so do a lot of other businesses – namely all those that are private. And for the larger hedge funds and private equity firms – the ones like Blackstone and KKR that are at the center of the tax controversy – the capital sources look a lot like any other public companies. They are tapping into the public equity market for capital, just like all the other public companies. And almost all of these funds have substantial leverage, so the majority of their investments are done using short-term debt. Some large hedge funds also issue longer-term debt, just as a host of other businesses.
So there is not much distinction between these and other businesses in terms of the sources of their funds. How about how they use those funds?
Well, there are a lot of different types of hedge funds, so it is hard to come up with a one-size-fits-all answer. As I argue in my book, A Demon of Our Own Design, hedge funds – and I would include private equity firms within the “hedge fund” moniker – are so varied in their strategies and the markets they follow that it is hard to consider them as a well-defined entity. But for present purposes, let’s look at two types of funds, those that do short-term trading, and those that do longer-term investments and private equity.
The funds that do short-term trading – those that do statistical arbitrage or high frequency trading – are providing a market making role. They are providing liquidity to the marketplace. In this function, they are not really different from the main business of the broker-dealer community. The managers at private equity firms and any number of the “deep value” hedge funds that do longer-term investing apply the same sort of analysis and premise for returns as the managers making acquisitions at Google, deciding to go through with a merger at Alcan, or growing a division at GE. They think a business is undervalued, or can be improved with better management or with a refocus of strategic direction, or can be combined with other assets to generate synergistic value.
There are many other aspects to this debate about the correct tax treatment for these funds. But it seems to me that a good starting point for allowing differential tax treatment is to demonstrate that these funds are different from other types of businesses. After that, of course, comes an argument about whether the difference is one that justifies a difference in taxation. But putting first things first, I would like to hear the opposing case to what I have presented here, that the hedge funds and private equity funds are spending their time and capital doing the same sort of thing that any number of other business are doing, and getting compensated in a similar way.