Managers Face Tough Choice Over IRS Edict

There are early indications that at least some fund operators plan to take advantage of a recent IRS decree on deferred compensation, though it’s unclear to what extent managers will embrace the opportunity.

In a June 10 “revenue ruling,” the IRS gave hedge fund executives the green light to use stock options to structure their performance compensation, thereby enabling them to defer their tax obligations until the options are exercised. The expectation is that pension operators and other long-term investors will favor such an approach because it rewards fund managers for being profitable over the long run.

“This is a great way for [hedge funds] to really show that you care about alignment” of interests with investors, said Jonathan Koerner, a lawyer for the $25 billion Utah Retirement pension system who specializes in innovative fund structures.

Optcapital, a Charlotte firm that helps companies administer stock-option plans, already has received inquiries from a number of fund operators — including one “top-tier” firm with some $30 billion of assets. When it comes to raising capital from institutional investors, managers that adopt options-based compensation plans will have “a huge competitive advantage to say that we are producing this alignment of alpha,” said Optcapital president Rick Ehrhart.

The firm led the way in pressing the IRS to issue last week’s ruling, which clarified tax provisions in the Emergency Economic Stabilization Act of 2008. One section of that law banned a long-standing practice among hedge fund managers of deferring taxes on performance bonuses by keeping the money invested in their offshore vehicles. Left unclear were the tax obligations of managers who receive compensation in the form of options to purchase shares in their funds.

The IRS said fund managers have no obligation to pay taxes on unexercised options. “A stock option might not be the best compensation arrangement in every situation, but in many cases [it] may provide a tax-efficient mechanism to compensate managers for their services in a manner that is designed to better align the compensation realized with the time horizon of those services,” law firm K&L Gates wrote in client note about the ruling.

The question is whether managers will want to give up collecting performance-fee revenue annually for the potential tax benefits of stock options. Take a hypothetical scenario in which a hedge fund with $100 million of investor capital generates a one-year gain of 40%, then loses 30% the following year. Under a traditional performance-fee arrangement, the manager would earn $8 million over two years — that is, 20% of the $40 million profit the first year and nothing the second year. Meanwhile, investors would have realized a loss over two years.

But if the manager’s incentive compensation were structured as a stock option, with a strike price equal to the net asset value of the fund shares at the beginning of the first year, then the option would be worthless at the end of the second year.

One hedge fund marketer expressed doubt that managers would be willing to accept options in lieu of annual performance fees. “The managers don’t want it — they want the cash,” she said. “I sort of feel this discussion will go on for 2-3 years and then maybe someone finally moves. But it won’t be when the equity markets are ripping and producing big profits.”

Optcapital acknowledged that options-based compensation plans only make sense for managers with tax-exempt clients. That’s because taxable investors would be liable for paying taxes on any gains in fund shares that managers have options to purchase. Another potential obstacle: Managers that agree to options-based compensation would likely demand longer-term lockups, which might be resisted by investors.

“A manager would have a strong incentive to adopt this stock-option compensation if it enabled a manager to get mandates that they wouldn’t otherwise get,” said K&L Gates attorney Nicholas Hodge.

Utah Retirement, which has some $4.6 billion invested with 31 hedge fund operators, has asked 15 managers since 2009 to structure their performance compensation in the form of stock options. But prior to last week’s IRS ruling, only one manager consented. The $1 billion-plus firm agreed to accept options that wouldn’t vest for three years, while Utah Retirement agreed to a three-year lockup on its capital. In fact, the lockup recently expired, at which point the pension withdrew its money due to disappointing returns.

Utah Retirement is recognized as an innovator when it comes to structuring hedge fund investments. In a number of cases, it has negotiated terms under which managers have agreed to leave portions of their performance-fee revenue in their funds for 3-4 years. In those instances, the managers are permitted to withdraw at least enough to meet their tax liabilities.

Other than Utah Retirement, it appears few if any investors have convinced managers to adopt options-based compensation structures. That’s partly because until last week, most hedge fund law firms took the position that stock options didn’t absolve managers of their tax obligations. One exception was K&L Gates, which said the IRS ruling “is consistent with the position our firm has taken since 2009.”

Optcapital, with help from K&L Gates and lobbying firm Capitol Tax Partners, spent three years lobbying the IRS to issue the ruling. As part of that effort, they organized a 2012 conference call between IRS officials and institutional investors including APG Asset Management, North Carolina Retirement and Utah Retirement.

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