As if things weren’t bad enough already for private equity and hedge fund managers, it seems to be a pretty safe bet that their tax rate will be going up - though it may not make much difference to many of them until their returns go up too.
Deloitte provides a handy table of “Democratic revenue enhancement opportunities” in a useful summary and analysis of tax proposals. The report tabulates the proposals based on whether they are part of President-elect Barack Obama’s agenda, whether they are under active discussion by Congress and whether they are part of House Ways and Means Committee Chariman Rangel’s comprehensive tax reforms. Only one proposal has all three boxes checked; Taxing carried interest as ordinary income (as opposed to at the much lower capital gains rate). This proposal is targeted at managers of hedge funds, private equity and venture capital but would also affect general managers in a variety of business entities.
There are compelling arguments on both sides of the issue. Those supporting the new proposals argue that deferred compensation, even if risky, is still compensation. Or, as Paul Krugman has asked,
why does Henry Kravis pay a lower tax rate on his management fees than I pay on my book royalties?
Those who support the current system, including the current Bush Administration and the Private Equity Council, argue that treating carried interest as long-term capital gains are a way to reward entrepreneurial investment, likening investors in pooled assets to those who might launch a business.
Regardless of where you stand on the issue, the current economic and political climates suggest that a change is likely to come.
The free Deloitte report is worthwhile just for this one table of potential revenue opportunities, but includes analysis of many other aspects of tax policy, including this table of income tax rates:
Technorati Tags: carried-interest, Hedge-Funds, income taxes, private-equity, taxes
As in the previous quarter, the global credit crisis dominated Research Recap’s Top Ten Posts of the third quarter, with only one post not related in some way to the market meltdown. Many of the posts turned out to be prescient, led by Fitch Ratings’ July warning that US Mortgage Insurers’ Troubles May Worsen. This prediction was borne out this month when Moody’s put several of the insurers on watch for possible downgrade.
In the runner-up spot was NERA Economic Consulting’s July report Subprime-Related Litigation on the Rise, which was buttressed by a Stanford Law School analysis showing that subprime lawsuits were running at double last year’s pace.
The bronze medal goes to the lone non-financial post, Ernst & Young’s July report US Oil Production Flat Over Past 4 Years, published near the peak of the recent oil price spike.
The fourth place post based on the International Monetary Fund’s December 2007 report examining the Role of Hedge Funds in Subprime Crisis Examined is approaching Hall-of-Fame status, consistently featuring among our top posts nine months after it was first published. The IMF also featured in the fifth place post in which Oxford Analytica drew on IMF and OECD data in September to conclude that Speculation Does Not Explain Apparent Housing Overvaluation.
The sixth place post based on a June Moody’s report, Global Junk Bond Default Rate Doubled in First Five Months, now seems modest. Standard & Poors now expects the speculative default rate to triple in the next 12 months. Standard & Poor’s served up the seventh most popular post, in which the ratings agency accurately assessed that Lehman Failure’s Impact on European Banks would be significant.
In what now seems like understatement, the eighth place post based on a June report from Audit Integrity was also right on the money: Credit Default Swaps Adding Rather Than Mitigating Risk? Moody’s July Guide To Interpreting Mark-to-Market Losses of Monolines took the ninth spot.
In what may now seem like wishful thinking, rounding out the top ten on a more optimistic note was KPMG’s July report Greentech Expected to Lead Resurgence of IPOs in 2010.
Technorati Tags: (LEH), CDS, credit-default-swaps, european-banks, green-tech, Hedge-Funds, housing, IPO, junk-bonds, Lehman, litigation, monoline-insurers, oil-exploration, oil-refining, private-mortgage-insurers, structured-finance, subprime, Zeitgeist
What a difference six months makes. The Bank of England’s latest semi-annual Financial Stability Report might be better titled Financial Instability Report. In May Research Recap highlighted the Bank’s concern that subprime-related losses by financial institutions may be overstated. Seeing signs of an improvement in credit market sentiment, the Bank wrote then that “As uncertainty falls and market liquidity improves, it should become clearer that some assets appear cheap relative to credit fundamentals, which should in turn encourage a recovery in confidence and risk appetite by speculative and long-term investors… In that environment, firms may find that previous mark-to-market loss estimates have been overstated and some writebacks of reported losses may occur.”
Now, the Bank’s October report graphically illustrates the seismic changes that have taken place in the financial sector. One startling graphic shows the funding gap of UK banks:
Another illustrates the woes of hedge funds:
The report also summarizes and analyzes rescue efforts to date:
Taken together, perhaps as much as £5 trillion has implicitly or explicitly been made available by central banks and governments since April 2008 to support wholesale funding.
“While temporarily helping lengthen funding maturities, this cannot be a source of funding for banks in the medium term. It will need to be replaced from private sector sources. Given the scale of this intervention, reducing reliance on the official sector as a source of funds is likely to be a significant constraint on banks’ activities over the medium term.”
Looking further ahead, the Bank says “the events of the past year or so clearly highlight the need for a fundamental overhaul of the regulatory safeguards used to mitigate systemic risk within the financial system.”
The report also compares mark-to-market and credit losses, and analyses counterparty credit risks in OTC derivatives markets.
Technorati Tags: Bank-of-England, banking-system, credit-crisis, derivatives, Hedge-Funds, subprime
A google search for “subprime” carried out 10 years ago would have yielded 14,500 results. Today that same search offers up 14.5 million results. A search for “credit default swaps” in October 1998 yielded 33,900 results, compared with over 1 million today, while results for “hedge funds” ballooned from 162,000 to over 8.5 million. By contrast, a search for “conventional mortgage” has risen only from 111,000 to 579,000.
Even allowing for extraneous factors, these are startling numbers. They help explain the continuing popularity of a Research Recap post from last December that combines “hedge funds” and “subprime.” Of course, interest in the massive liquidations by hedge funds no doubt played a part in making Role of Hedge Funds in Subprime Crisis Examined the top post of the week. Still, it just goes to show that good research has a long shelf life. So it’s worth taking a look back at that article by the International Monetary Fund’s Randall Dodd.
The article examines the role of hedge funds in the unfolding crisis, noting that Fitch Ratings warned of the risks in 2005.
“Hedge funds have quickly become important sources of capital to the credit market,” but “there are legitimate concerns that these funds may end up inadvertently exacerbating risks.”
That is because hedge funds, which invest in largely high-risk ventures, are not transparent entities—their assets, liabilities, and trading activities are not disclosed publicly—and they are sometimes highly leveraged, using derivatives or borrowing large amounts to invest, Dodd wrote. So other investors and regulators knew little of hedge funds’ activities, while, as Fitch Ratings put it, because of their leverage, their “impact in the global credit markets is greater than their assets under management would indicate.”
Among the potential remedies suggested by Dodd in December 2007: “applying industry standards and any existing regulations pertaining to the use of collateral (margin) to OTC derivatives and hedge fund borrowing.”
Likewise, the current meltdown had recent visitors looking back to our January 2008 Research Primer on Credit Default Swaps, based on a Fitch Ratings report.
More recently, our Ratings Roundups of recent ratings actions affecting financial institutions in the news continue to be popular, as is the Standard & Poor’s report detailing the sharp rise in delinquencies among not-quite-prime “Alt-A” mortgages.
Research Recap Headline of the Week:
Bonuses May Fall in London (The Wall Street Journal)
Technorati Tags: Alt-A, CDS, credit-crisis, credit-default-swaps, credit-ratings, Hedge-Funds, RMBS, structured-finance, subprime, Zeitgeist
While it may turn out that this is not something to be bragged about, most financial markets grew more rapidly in Europe than in the US, both in 2007 and over the last several years, according to International Financial Services London.
Key findings from IFSL’s annual report Financial Market Trends Europe vs.US 2008 show that in over half indicators - 10 out of 16 - financial markets in Europe grew more rapidly than the US in 2007. Over the longer period since 2001 activity in Europe rose relative to the US in 13 out of 18 markets.
Most of the gains over the past six years have been in 8 out of 9 sectors where activity in Europe is smaller than the US: these include hedge funds, securitisation and equity market turnover, IFSL said. Europe has also made some large relative gains since 2001 in sectors where it has the larger market, including IPOs, cross border bank lending, issuance of international bonds, and insurance premiums.
The US has made up ground in a few areas in recent years, particularly foreign equity trading, where the gap with Europe has been largely closed, as well as OTC derivatives where Europe’s lead has been curtailed.
The report is based on 2007 data when the credit crunch was in its early phase so does not take account of the deterioration in credit markets in 2008. Some indicators such as investment banking revenue, securitisation and IPOs are likely to fall in 2008, but it is not yet clear how this will influence the relative positions of the US and Europe in financial markets, IFSL said.
Technorati Tags: banking, derivatives, equities, financial-markets, financial-products, forex, Hedge-Funds, Insurance, private-equity
Companies hoping to stave off activist hedge fund managers such as Carl Icahn would do well to be more proactive by keeping close tabs on who is accumulating their shares and initiating contact early on to gauge the hedge fund’s intentions.
That’s just one of dozens of recommendations for corporate directors and institutional investors in a Conference Board report aimed at creating strong guidelines for dealing with the growing number of activist hedge funds.
The report is based on a study by a working group of high-level corporate and investor representatives convened by the Conference Board Governance Center in May, 2007. That was about the time that Icahn, whose hedge fund had accumulated a 6-percent stake in Motorola Inc. (MOT), launched a proxy fight for a seat on the company’s board of directors while also calling for the ouster of then-CEO Ed Zander.
The Conference Board report also urges institutional investors to do a better job of controlling the shares of companies they own, especially during proxy fights.
Institutional investors’ trustees should explicitly prohibit the practice of lending shares to those borrowers whose intention is to influence meetings of shareholders by voting.
The Conference Board report follows a set of hedge fund recommendations earlier this year by the President’s Working Group on Financial Regulation and featured in an April, 2008 Research Recap post.
For details, see “The Conference Board Working Group on Hedge Fund Activism’s Final Recommendations.”
Technorati Tags: (MOT), activist shareholders, Carl Icahn, corporate directors, corporate-governance, Hedge-Funds, institutional investors, Motorola, proxy fight, The Conference Board
One of the aims of Research Recap is to provide educational background on financial and economic topics, so it is gratifying when our “Research Primers” attract attention. The latest of these, based on an article in the International Monetary Fund’s Finance & Development magazine, provides a useful history and explanation of Securitization. Indeed, the IMF publication is earning a reputation for this kind of thing. Its December explainer of the Role of Hedge Funds in the Subprime Crisis features among the top posts on a regular basis and this week was no exception.
The top post of the week by a considerable margin was Fitch Says Worst of Credit Storm is Over for US Banks, in which Fitch Ratings threw every meteorological metaphor in the book at the issue. Fitch also featured in another top post, noting that the decline in house prices was likely to accelerate resetting of payment rates on option adjustable rate mortgages to higher levels. In the same post, CreditSights wondered why delinquencies are running at a higher rate than they should be based on the pace of rate resets.
There’s no doubt that Sarah Palin captured the zeitgeist this week, and the inaugural edition of the WSJ glossy wealthy lifestyle magazine includes an interview with the Alaska Governor about her running (marathons, that is). Carried out before she joined the McCain ticket, the interview reveals that her biggest pitfall is breakfast. “I hate to admit it, but a skinny white-chocolate mocha is my staple in the morning.” Guess that takes the “latte factor” off the table as an attack weapon against Barack Obama.
Now that the euphoria of the Democratic and Republican conventions has been punctured by Palin and unemployment respectively, the focus should return to policy issues and what the respective tickets plan to do about a weak economy and fragile markets. First up, the much anticipated takeover of Fannie Mae and Freddie Mac.
Research Recap Quote of the Week:
Dependence on oil imports continues to be highest, reaching 95% in 2030. - International Energy Agency analysis of European Community energy policies.
Technorati Tags: banking, energy, Hedge-Funds, mccain, obama, palin, renewable-energy, securitization, subprime-mortgage, Zeitgeist
Looks like Richard Syron has a lot of work to do to. On top of reporting a dismal quarter and being downgraded, Freddie Mac’s (NYSE: FRE) chief was pilloried on the front page of The New York Times for allegedly ignoring internal warnings that the GSE was taking on too much risk. He acknowledged hearing the warnings but said his options were limited. The article concluded with the quote: “I’ve had four other jobs as C.E.O., and I came out of them all pretty well,” Mr. Syron said. “What I’m working for right now is to save my reputation.” He’s certainly not alone in having taken on too much risk, but as they say … good luck with that.
Worries about credit card debt being the next credit sector to come under pressure were evident in the popularity of Research Recap’s top post of the week, Fitch Ratings’ Prime Credit Card Chargoff Rate to Exceed 7% by Year-end. However, both this report and the also-popular S&P Upbeat on Outlook for Credit Card-backed Securities found that the sector is in relatively good shape.
Given the confusion over the state and prospects for the struggling monoline insurers, it comes as no surprise that Moody’s Q&A on Financial Guarantors was also well read. This in turn led to renewed interest in Moody’s month-old Guide to Interpreting Mark-to-market Losses of Monolines.
The International Monetary Fund’s Euro-Area Subprime Bank Losses to Hit GDP by 0.2-0.3 points drew strong interest, as did its Loan Technology Causes “Bad Banks” To Take on More Risk, which may have led visitors back to its now classic December report Role of Hedge Funds in Subprime Crisis Examined.
For a change of pace, also polular was Forrester’s report on how Sustainability and Profits go Hand-in-hand, at least for Herman Miller, maker of the iconic Aeron chair.
Research Recap Quote of the Week:
“If I had better foresight, maybe I could have improved things a little bit, but frankly, if I had perfect foresight, I would never have taken this job in the first place.” - Richard F. Syron, CEO Freddie Mac
Technorati Tags: asset-backed-securities, banking-system, credit-cards, Hedge-Funds, monoline-insurers, subprime-mortgage, sustainability, Zeitgeist
Companies that want to avoid being targetted by short-sellers may want to make sure their corporate governance is in order.
The Financial Times quotes a leading hedge fund investor as saying that companies that do not comply with high standards of good governance are ripe for short-selling. Bill Hwang, chief executive and founder of Tiger Asia Asset Management, which has about $12bn invested in short-selling positions in Korean, Japanese and Chinese equities, said a bet that these companies’ stocks would fall was a good one.
Hwang, one of the “Tiger Seeds” whose business was seeded by legendary hedge fund investor Julian Robertson in 2001, said: “Companies with serious corporate governance problems are [like] a big red flag for short-selling for us.” He was speaking at an audience of more than 400 investors at the annual meeting of the International Corporate Governance Network on Friday.
Audit Integrity recently published a list of companies that performed poorly in its rankings of corporate governance.
Audit Integrity identified University of Phoenix owner Apollo Group, Inc. (NASDAQ: APOL), footwear manufacturer Crocs, Inc., (NASDAQ: CROX), digital theater company DTS Inc. (NASDAQ: DTSI), physician services provider Pediatrix Medical Group, Inc. (NYSE: PDX), and digital media company Sigma Designs, Inc., (NASDAQ: SIGM), as firms with “serious questions regarding management’s integrity vis-a-vis their shareholders.”
All five companies are tagged as “Very Aggressive” under Audit Integrity’s Accounting and Governance Risk rating. “These ratings are cause for concern that the companies may be intentionally deceiving their shareholders to mask serious problems,” according to Audit Integrity Chairman Jim Kaplan. The ratings take into account such factors as share repurchases, insider sales and a high ratio of incentive compensation.
Technorati Tags: corporate-governance, Hedge-Funds, short-selling
Further signs of the challenges facing the hedge fund industry emerge in a new survey of their dealings with their prime brokers. Fully one third of them are unhappy with the relationship with their prime broker, including in the crucial area of helping raise capital.
More than one-third of hedge fund and CTA managers are considering changing their prime brokers or have recently done so, according to the survey conducted by FINalternatives and Advent Software. Funds report that the main reason they are considering changing prime brokers is because they are dissatisfied with the level of personal service they are receiving, with poor competency also playing a major role.
One key finding is that, while 63% of fund managers say their prime brokers are either “good” or “excellent” when it comes to personal service, satisfaction in that area has declined markedly. Last year, 80% of funds gave their prime brokers high marks for personal service. The drop in satisfaction may be due to last year’s turbulence in the industry, as 16% of fund managers report that the liquidity crisis has worsened their relationships with their primes, the survey finds.
When it comes to capital introduction, survey respondents report that their prime brokers’ services fall far short, with 38% of respondents rating their primes as “poor” performers in the capital introduction space.
As hedge funds grow in size, so do their capital-raising needs. Over 80% of the hedge funds in the early stages of capitalization are already planning moderate to aggressive growth, and the percentage of funds planning to grow at a moderate rate expands as funds grow in size, while the percentage of funds planning to conservative growth declines to nil as funds grow in size.
While at least 50% of the funds with under $100 million in assets under management find their prime broker’s capital introduction services satisfactory, funds with $100 million to $500 million report a dire need to improve servicing of this particular segment. Those funds in the $500 million to $1 billion category that are pursuing aggressive expansion are equally disappointed in the capital introduction offerings of their prime brokers, as are large funds (over $500 million) desiring to grow more conservatively.
The major reasons reported are prime brokers’ insufficient activity in the capital introduction space, inferiority of investors the funds are being introduced to, and the tough financial environment makes it difficult to conduct fundraising.
As one anonymous survey respondent with over $1 billion in assets puts it, “cap intro has gotten worse and worse. [The prime broker] used to have events for us to present our products to investors, but these are getting fewer and fewer, and investors are less impressive.”
The observed dissatisfaction with capital introduction services comes at a time when 28% of hedge fund managers report that their prime broker has tightened margin requirements in response to the crisis. Since capital introduction is a natural substitute for margin lending in that it increases the overall pool of assets available to a hedge fund manager to invest, one might expect the funds to be more dissatisfied with the capital introduction of prime brokers who tighten margin lending requirements. An in-depth analysis reveals that this is not the case: Instead, it appears that the prime brokers that have succeeded at arranging meaningful capital introductions for their clients have subsequently tightened their margin requirements, the survey says.
Technorati Tags: Hedge-Funds, prime-brokers