If any common ground exists between Hillary Clinton and Donald Trump, it is on the subject of carried interest taxation. Both regard the favorable tax treatment received by private and hedge fund general partners on carried interest to be grossly unfair.

The politicians and many mainstream media pseudo-journalists make an uncomplicated argument—carried interest is taxed at the capital gains rate of around twenty percent, whereas it should be taxed as ordinary income, which is subject to a maximum rate of about thirty-nine percent. The politicians say, “It’s just unfair, that truck drivers, secretaries and nurses pay higher taxes than hedge fund billionaires!”

The Argument Is Straightforward but the Facts Are Complex

Of course, the political argument is fundamentally misleading. While hedge fund and private equity partners may pay a lower effective tax rate, they will almost certainly write a bigger check to Uncle Sam than a boatload of truck drivers, secretaries and nurses will pay collectively in federal income tax.

That said, Trump’s tax plan, as originally drafted, would hand hedge fund and private equity general partners a net windfall by reducing their overall tax rate to 15 percent, well below the current capital gains rate paid on carried interest. Trump has recently made revisions that deny pass-through entities (like hedge funds and private equity firms) the ability to qualify for the proposed 15 percent business rate. Moreover, Trump remains committed to taxing carried interest as ordinary income.

Clinton’s approach to the so-called carried interest loophole is radically different from Trump’s proposal in that she believes the Treasury Secretary has the authority to unilaterally define carried interest as ordinary income and tax it accordingly—no congressional action required. And, unlike Trump, Clinton plans across the board tax increases for the wealthiest Americans.

Monetary Impact

The Congressional Budget Office (CBO) estimates the elimination of the carried interest loophole would generate around $18 billion in revenue over ten years. This means $1.8 billion of additional revenue for the federal government, annually. When one considers the total value of assets under management in the industries primarily affected (hedge funds and private equity firms) is just over $7 trillion, a $1.8 billion annual impact seems quite small, relative to the high profile dust-up this tax question has engendered.

Hedge Fund Jobs

Hedge fund jobs will not suffer if the carried interest tax rate is calculated on the basis of the ordinary income tax rate. Aggregate hedge fund performance has been less than robust over the past three years, meaning far fewer dollars are eligible for the loophole tax rate. This may explain why the impact of the increase in the tax rate is insignificant, as cited in the CBO’s report.

According to the 2016 Hedge Fund Compensation Report, 75 percent of hedge fund professionals do not participate in upside sharing (hedge fund speak for carried interest) and, of the remaining 25 percent, 13 percent receive a share amounting to less than 2 percent of the available pool of funds. The report offers considerably more detail for anyone interested. The important take-away is that the impact on the vast majority of hedge fund professionals will be zero and almost zero for the remainder.

While hedge funds remain the industry that everyone loves to hate, the changes proposed by both candidates with regard to carried interest will have an impact that falls very much short of voter expectations. There will be no wailing, no gnashing of teeth and no leaps from the ledges of iconic Wall Street buildings.

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When Paul Tudor Jones says adieu to roughly 60 employees, Pershing Square Capital Management shaves its staff by 10 percent and Citadel trims its headcount by more than a dozen souls, this is a fair question to ask. After all, these are some of the largest and, most successful, names in the industry.

What’s Driving This?

While the obvious reasons for headcount reductions are lackluster performance and shrinking assets under management (AUM)—the root causes are deeper still.

Pension funds, institutional investors and endowments have been vocal regarding exorbitant hedge fund fee structures for years. Until recently, investors have been content to complain loudly, while quietly pocketing the gains these hedge funds generated.

However, the game has changed. Hedge fund performance has plummeted as have investor gains. What was formerly little more than good-natured grumbling became a rallying cry for hedge fund investors of all stripes. Hedge fund gains, which had previously justified the two-and-twenty fee structure, evaporated. As a result, CalPERS, AIG, MetLife, NYCERS and a host of other investors have either reduced or eliminated hedge fund exposure.

The Future of Fee Structures

Steve Eisman of Neuberger Berman, a private, independent, employee-owned investment management firm, has embarked on a new approach. For an investment of $1 million, he exacts a fee of 1.25 percent. This fee cannot be described as cheap. Most long-only mutual funds have fees that are far lower, but compared to hedge fund fees, it is a bargain basement rate.

In case you’ve forgotten, Eisman was the guy who foresaw the subprime mortgage securities collapse. You may recall him from Michael Lewis’ book The Big Short or from the 2015 movie of the same name in which he appeared as the fictional character Mark Baum, portrayed by Steve Carell.

Although his product is not a hedge fund, Eisman believes this 1.25 percent flat fee will become standard in the hedge fund industry within 10 years.

Whether that will come to pass is uncertain, but it is certain that something needs to change. Either performance must improve to justify the current fee structures or, alternatively, the fee structures must be altered to fairly reflect actual results.

Change Is Afoot

One example is Caspian Capital. They have offered discounted fees to long-term investors. Other hedge fund firms have implemented hard hurdle rates, usually between 4 and 10 percent, while others have opted to use soft hurdle benchmarks such as Libor.

How rapidly these changes occur and how long they will stand is entirely dependent on hedge fund performance. Underperformance will accelerate these changes and outperformance may kill them entirely. The needle is likely to settle somewhere in between these extremes.

What Does it Mean for Hedge Fund Jobs?

For obvious reasons, small hedge fund firms and hedge fund startups are in the most favorable position to experiment with fee structures. For this reason, they may be the preferred target of opportunity for anyone seeking first-time hedge fund employment. That is not to suggest that employment opportunities in larger firms have dried up—they have not. It is only to suggest that startups and smaller firms may be the softest target in the present set of circumstances.

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June 13, 2016

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