Renewed confidence in financial markets generally, and hedge funds in particular, seems to have launched the industry forward in early 2013. According to the Boston Business Journal, however, fees have continued their downward trend despite the renewed interest. With dwindling revenues despite climbing assets under management, how the industry copes with this changing dynamic will have a significant impact on hedge fund job seekers. Higher expenses from regulatory costs and taxation also are pressuring the bottom line for hedge fund managers.
New Hedge Fund Launches Up Significantly in First Quarter
The first quarter of 2013 saw a significant increase in new hedge funds being launched. The Chicago-based Hedge Fund Research Inc. reported that 297 funds were launched in the first three months of the year, which is the third highest quarterly total since the beginning of 2008. The first quarter of the year is traditionally a strong quarter however, with the only two stronger quarters coming at the start of 2011 and 2012.
The new hedge funds that are being launched are far more conservative than in the past, however. Industry executives have told the Boston Business Journal that most new launches are small and are taking much longer to come to market. “No one is doing anything overly funky,” Michael Silvia, Director at Marcum LLP told the Journal.
Strong Track Records Behind Successful New Launches
Many of the new hedge funds that are being launched are led by established and experienced managers. In uncertain economic times, the strong track record behind these managers provides some confidence to weary investors. Those with less experience are finding themselves seeing small allocations as investors test the waters carefully, or in some cases, they are unable to access the market altogether.
Fee Revenues Declining Despite Renewed Interest
Importantly for hedge fund bottom lines, and accordingly, the ability for firms to bring on new talent, fee revenues have not experienced similar strength in light of this renewed hedge fund interest. In general, investors are feeling fees are too high. Daivd Simoes of Deloitte’s hedge fund practice told the Journal that “the days of ‘two and 20’ are behind us,” reminiscing over the days when fund managers could comfortably earn two percent of assets under management as a flat fee and a 20 percent bonus fee for outperformance. In fact, in the first quarter, hedge funds earned 1.55 percent in management fees on average, and only 17.4 percent in average incentive fees.
What are the Implications for Hedge Fund Job Seekers?
The ongoing pressure on hedge fund fees is weighing heavily on their ability to hire more individuals, despite the growing funds they are managing. Overall, the industry has seen a substantial increase in costs as well, as regulation and taxation issues weigh heavily. This double impact of lower revenue and higher overhead expenses makes it hard to offer higher compensation to core investment staff or to make the investment in bringing on new members to the team. Unless the industry can see some stabilization on the fee front, hedge fund job opportunities likely face continued pressure.
In most jurisdictions around the world, and particularly in Europe, governments and regulators are examining a number of options to rein in compensation for financial industry professionals. In the UK, the government there imposed substantial taxes on high income earners, and, not surprisingly, hedge funds have worked to develop structures in order to pay their professionals in a manner which minimized the tax burden.
Complex Structure Seems to be Designed to Avoid Taxes
A considerable number of hedge funds in the UK utilize a complex structure that seems designed to pay staffers their compensation at lower tax rates. As most hedge fund managed firms are structured as partnerships, tax authorities are beginning to see an increasing number of partners in many firms. In some cases, these partners are corporations, which pay substantially less tax (approximately 20 percent versus 45 percent for individual taxpayers). This practice in and of itself would be acceptable, however tax authorities are concerned that many of these “partners” are likely just employees, not having contributed any capital and not exposed to much risk due to fixed salaries.
In addition the partnership structure allows for some manipulation of profit and loss allocations for tax purposes, again adding to the amount of tax avoided. Finally, a third source of avoidance is using corporate partners in order to pay dividends out to spouses and children, reducing the amount of income taxed at the highest tax brackets. All of these measures help shield the industry and employees from $20 billion in taxes each year.
And the use of these structures is very widespread. “It affects virtually everybody. Out of 400 odd firms in London, more than 80 percent of them have these [corporate member] structures,” Joe Seet, a senior partner at London based hedge fund consultancy Sigma Partnership told the Financial Times. Seet also suggested that performance bonuses were a particular form of compensation channeled through these structures, with many of the corporations being based in much lower taxed Ireland.
Clearly, British tax authorities, HM Revenue and Customs, are not a big fan of the arrangement and are looking to recover lost revenues. With $20 billion potentially at play, one can be assured no effort will be spared in going after these structures.
Taxation Approach is Inconsistent with Objectives to Grow Financial Industry
Unfortunately for British policy makers, these attacks on the industry are counterproductive to the goal of establishing a stronger financial industry and associated high income jobs. On one hand they want wealthy financial professionals to establish themselves in London but on the other, they want an increasingly large piece of their income. The overall approach of the government may encourage firms to look elsewhere in terms of where they want to locate their business; however, London will likely be a major player regardless of any tax crackdown.
In the end, hedge funds will develop new and innovative ways to create as much tax efficiency as possible for themselves and their employees, as they have done for decades. Many funds are considering corporate structures rather than partnerships to avoid tax issues, though this may also limit their flexibility in avoiding European Union caps on bonus payments. In the end, when a number of highly talented financial minds are put in one place, innovative solutions will be developed in terms of tax efficiency, which should ensure hedge funds remain a big part of London finance for some time.
