MARHEDGE
EDITORIAL
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COMMENTARY
Self-DestrucMtivaen agers
Avoidinthge gamblinagd dict
By Fred Gehm
One of the fund-of-funds manager’s jobs is to
identify and avoid self-destructive hedge fund
managers. One of the worst of this species is
the gambling addict.
The first fund m:1nager I realized w.i.s .i,
gambling addict wos Ian S., and I didn’t realize
that he was .i.ddicted until after he was dead.
Ian was a talented trader with real insight
into the market. Unfortunately, he wasted
much of his potential by overtrading, trading
too often and trading too large.
Ian’s wife told me that while he was dying,
she kept saying to him, “Gold is rallying, Ian!
Gold is rallying!” She knew her husband. Ian
wasn’t particularly greedy .is fund managers
go. He wouldn’t have gotten off of his
deathbed just to mc1ke money. But I could
almost sec him getting up for the action.
Some authorities on gambling estimate
that 1-2% of the general population is
addicted. Considering the cost of gambling
addiction in terms of ruined marriages and
lost property, that estimate seems high to
me. But perhaps I don’t get out enough.
On the other hand, if that cstim.ite is correct,
or, at least, rcason.ible, then the percentage
of hedge fund managers who are
addicted to the action might be, say, I 0-20%.
And if these estimates are even vaguely correct,
the fund-of-funds manager who can
identify the gambling addict could have a real
and important advantage over those who
cannot.
Or perhaps not. Gambling addiction is almost
certainly a medical problem as opposed
to, say, a lack of understanding of probability
theory. (A recent article in the American
Journal of Psychiatry showed preliminary evidence
that the drug nalmefene can help control
pathological gambling. Nalmefene is an
impulse control drug used to treat alcoholism.)
Unfortunately, lacking a cerebr.:il dipstick
or, at least, a safe and polite way of getting a
hedge fund manager’s bodily fluids, there is no
PlanninAg head
obvious way to use this insight. Worse, the
difference between an addicted and a nonaddicted
hedge fund manager is almost certainly
only a matter of degree. Worse still, it is
not at all clear that a need for action, a need
to cake big risks, is a bad thing. After all, nearly
everyone in this industry is a risk-uker.
Consider. as a noninvcstment example,
Catholic priests.As I understand the issues (I
am not Catholic), there is nothing to prevent
a strongly sexed heterosexual man from
becoming a priest. He is expected, however,
to behave himself, to remain celibate. [ A mechanictraald ing
systemw on’st topa
gamblinagd dicftr om
losinygo urm oney. ]
A similar argument c.:in be m.1de for gambling
addicted hedge fund managers. The only
difference being that faith is a liability in our
line of work. This means that the fund-offunds
manager must determine the extent to
which the hedge fund manager needs action,
how aware the manager is of his needs and to
what extent he can control himself.
In vino veritas
In my experience, people who seek risk
rarely seek only one kind of risk. A gambling
addict might take sports, marriage and health
risks, for instance. Some of chis information is
available on the Internet, some of it is av.:iilable
only by employing a private detective,
but some of it is available for the asking.
Asking a hedge fund manager how he got
into this line of work, what he did before and
what he does with his time off is often
enough. On the other hand, the only time
some hedge fund m.:inagers tell the truth is at
two in the morning after the sixth or seventh
drink.
If a fund-of-funds manager’s interviews
and research indicate that the hedge fund
manager has a need for action, he needs to
look at the manager’s trading approach and
see where this need can compromise that
approach. For obvious reasons, nonsystematic
approaches are the most vulnerable.
But for many reasons, a mech.:inical trading
system won’t stop a gambling addict from
losing your money. Usually, this just means
that ovcrtrading is built into the system.
Managers who have il need for action, for
example, typically do not have the patience
necessary to do research right. Or they may
have money management systems th.it are far
too aggressive for their trading methods.
If the fund-of-funds manager’s research
indicates the hedge fund manager needs
action but he finds no weaknesses in the
manager’s technique, it may be that there are
no weaknesses in the manager’s technique.
Much more likely, the fund-of-funds manager
screwed u_p.
Ir a hedge fund manager has a destructive
need for action, there are only two things he
can do. He can try to manage his psychological
needs, and he can set up systems to manage
his work in a rational manner.
Unfortunately, unless the fund-of-funds
manager is willing to place a relatively large
amount of money, he will rarely be able to
enforce rules or delve deeply into the hedge
fund manager’s psychology. This is a serious
problem because it is part of rund-of-funds
manager’s job to ensure that the hedge fund
manager controls himself.
If the fund-of-funds manager thinks this is
necessary and does not think he can do it, he
must place his money with someone else.
Gambling addiction leads to overtrading and
overtrading turns a game that is at best difficult
to win into a game that is almost impossible
to win.
Fred Gehm is a hedge fund industry consultant.
He can be contacted at (redgehm@dls.net.
Whens ettingu p a fundp, rincipaslsh oulda ddreses statep lanninogp portunities
By Michael Ben-Jacob and Peter Bilfield
In the early stages of fund formation, hedge fund
and private equity fund principals must focus on
a host of issues, among them the type of entity
to be used M each level of the structure, the
jurisdictions of formation, tax and allocation provisions,
deferred compensation arrangements
and myriad other details.
One important aspect of fund formation
often overlooked, however, is the significant
estate pl.lnning opportunities .:ittendant on forming
hedge funds or private equity funds and
which, if not addressed at the early stages of fund
formation, are generally lost to the principal.
Some estate planning background
Typically, when considering estate planning
options for high-net-worth clients, estate planners
will seek to isolate a client’s assets that are
currently of comparatively low value and suggest
strategies for tr”ansferring those assets to trusts
or other estate planning vehicles on a transfer
tax. advantaged basis. thereby removing the
asset-and its future appreciation–from the
individual’s taxable estate.
From a transfer tax valuation perspective, a
carried interest derived from a hedge fund or
private equity fund is che ideal asset candidate
for this type of rax planning. Prior to the initi.:il
closing of the fund, and even for a short time
thereafter, the carried interest would generally
be valued at only a small fraction or it.s actual
future value.
The reason for such a low valuation, in most
circumstances, is that the carried interest is paid
only if certain profit hurdles are met by the fund
(i.e., the high-water mark), and at the earliest
stilges of the fund, it would be mere speculation
to assume that the fund would be successful
enough to result in carried interest payments.
Thus, the c.:irried interest with its IO ►
MARCH 27, 2006 • MARHEDGE 9
,GUEST COMMENTARY
◄ 9 Planning Ahead low current value and that provides that if one makes a tr.msfer of an principal’s carried interest and the value of any Despite this and other possible arguments
that favor the nonapplication of Section 270 I,
given the overwhelming gift tax burden on the
principal if Section 270 I is found co apply.,nd the
lack of authority on point, prudent practitioners
will advise their clients to formulate any estate
planning strategy involving gifting of a carried
interest to fall within a clear exception to
Section 2701.
expected significant appreciation serves .i.s an
excellent asset for estate planning purposes, If a
fund principal could simply transfer a portion of
his or- her carried interest to a trust, the valua•
tion problems would be solved-but nothing is
ever quite that simple.
Estate freezes, IRC Section 270 I
Prior to I 996, estate planners often employed
the following strategy to move significant value
from the estate of the senior generation to the
junior generation at a reduced transfer tax case
The senior generation would fund a family corporation
or partnership with an asset expected
to appreciate significantly in the future. In
exchcmge for his or her capital contribution, the
senior family member would retain preferred
return shares with future appreciation allocated
to the common shares.
Since at the time of formation the value of
the preferred return shares encompassed most,
and possibly >II, of the value of the entity, the
common shares could be given away to junior
family members or trusts for their benefit at little
or no transfer tax cost. This technique
became known as an “estate freeze,” as it froze
the value of the assets in the estate of the senior
t.imily member.
Enter section 270 I of the Internal Revenue
Code, which was enacted in 1996 to address this
perceived abusive tax planning strategy.
At its core, Section 270 I is a valuation rule
interest in a corporation, partnership or limited
liability company and the transferor or related
family member keeps an “applicable recained
interest,” the value of the rights retained is treated
as being zero.
An interest is an “applicable retained interest”
if the transferor retains an equity interest
that is either a distribution right (except forcertain
qualified payments), or a liquidation, put, cil11
or conversion right. Thus. if in assessing a a-ansfor
what the transferor has retained is valued at
zero, all of his or her interest in the entity is
deemed to have been given away and gift tax,
currently at a maximum federal rate of 46%, will
be Imposed accordingly.
ln the context of hedge funds and priv.i.tc
equity funds, carried interest distributable to a
fund principal would be deemed a “distribution”
right that seems to full squarely within the definition
of an “applicable retained interest,”
Accordingly,a transfer ofa portion ofa principal’s
carried interest would implicate this section and
result in gift tax being imposed. Unfortunately for
the fund principal, the resultant gift tax will be significant
and will not be limited solely to the portion
of the carried interest transferred.
Because of the manner in which the value of
the gift is alculated in this context, once Section
270 I is found co apply, gift tax will be imposed on
the value of the princip.1l’s entire interest in the
fund enterprise, i.e., the entire value of the capital
contl’ibutcd to the general partner, all of the
10 MARHU)GF • MARCH 27, 2006
investment made directly by such principal in the
underlying fund.
Needless to say, if Section 270 I is found to
apply to the transfer of a carried interest. the gift
tax burden on the principal would be untenable.
But whether Section 270 I applies to transfers
of a carried interest in a hedge fund or private
equiry fund is technically still an open question,
and there arc reasonable arguments in favor
of the position that it should not apply.
For example, in the case of a distribution
right (such as the right to receive carried interest
payments), Section 270 I applies only if the
transferor, immediately before the transfer, con~
·olled the entity. In the classic two-tiered fund
structure (i.e.,a limited liability company acting as
general partner of a fund that is formed as a limited
p.1.rtnership) where the entities are treated
as limited partnerships for federal income tax
purposes, the principals who hold il portion of
the carried interest will generally hold the carried
interest by virtue of their investtnent ln the
general partner.
The regulations under Section 270 I, however,
state that control of a limited partnership
means “holding any interest as a general partner.”
One might distinguish the circumstance where
fund principals hold their interests in the general
partner, but where no p1incipal functions as
the general partner.Thus, if the principal docs not
hold a liquidation, put, call or conversion right,
Section 270 I may not opply.
Exceptions
Several exceptions to Section 270 I exist, but the
one most often employed in the context of
hedge and private equity fund planning is the
“proportionate tromsfcr” exception. This exception
states that Section 2701 does not apply to
the extent that the transfer results in a proportionate
reduction of each class of equity interest
held by the individual and all of his or her applicable
family members in the aggregate immediately
before the transfer.
Thus, if the principal transfers, say, 20% of his
carried interest and capital interest in the gcncr•
I partner of the fund, and 20% of his direct
investment in the underlying fund (keeping in
mind that Section 270 I .1pplies to the entire fund
enterprise), and these proportions are kept constant
throughout the lifetime of the fund, the
proportionate transfer exception to Section
270 I should be met and the value of die carried
interest should be determined in accordance
with standard valuation praccices, resulting in significant
estate planning benefits.
Hedge.\Vorks rec.e.ntlvi ncreaseidts ‘-‘ .
client base by over 30%>.
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San Diego ■ Cayman ■ Boston
Section 270 I is extremely complex,
.ind the foregoing should not be construed
as a full ilnd complete overview
of this often overlooked valuation rule.
Timing is everything
As mentioned, .\nd setting aside the
possible application of Section 270 I.
the value of the carried interest is most
likely lowest before the fund’s initial
closing, since at that point in time the
possibility of payment is most speculative.
Therefore. for maximum benefit
such estate planning should be implemented
prior to the fund’s launch or as
early in the fund’s life as possible.
COMPANY INDEX
ABNAmro … . . . . . I
AIS Futures Management . . . . . . . . 3
ALTIN ..
Amaranth ….
Bmini Playfalr Wright LLC ……. 12
Brfdgewatl?r Capital .. I
Campbell & Co 14
Ced.1r Partners . . . I
Cllffwater . . . . . . . . 16
CSFB . . . . . .. 12
Custom House Group . . . . I
DE Shaw . . . …….. I
Dexion Capital . . . . . . . . . . . . . . . I
DUNN Capital Management ….. 1-4
Eton Rock Capital Management … 13
Freeman Associates
GAIM Advisors ….
.. I
… I
Glopar…… . …………. 13
Grupo Elektra .. 13
HSBC……… . .. I
JohnW Henry & Co ……….. 14
Kenmar ………….. 16
Laurus Capital Management LLC … ~
Lotsoff Capiul Management ……. I
Mount Lucas Management …. , . . 16
Net Services de Comunicacao SA . 13
Numeric …………………. I
Penthouse International . . . . . . 13
RMF Investment M::inagement ….. I
Roc::iton Investment Advisors . . . 16
Rockefeller Treasury Services …… 3
Salus Capital ….
Strategic lnvestrrients .. 14
WGTradlng .. . . . . . . . I
But addressing estate planning concerns
prior to the fund’s initial closing is
important for other reasons as well.
When est.ice planning is not considered
during the prcpariltion of the
fund’s opcr::itive documents, it is later
difficult-if not Impossible-to incorporate
the necessi’.lry estate planning
provisions.
For example, while it is becoming
more commonplace to see fund document.
acion that permits the transfer of
a principal’s interest to an est.ate planning
vehicle, it is still rare to see default
langu.igc that deals with the implications
of Section 2701 described above.
Specifically, the operative documents
should include language that
keeps the proportionality of interest
between fund principal and the estate
pl.1.nning vehicle constant, and ensures
that capit.al contributions and all distributions
are made in accordance with
the proportionality rules.
In addition, it is important that
these provisions be incorporated into
each entity in the fund enterprise in
which the principal has an equity interest.
Finally, it often occurs that some
technical point of the fund structure or
the business deal makes it impossible
to comply with Section 270 I, but only
because the issue w.is not considered
from inception.
More often than not, if addressed
early enough the overall fund structure
and business deal can be achieved while
at the same time pcrmltting highly tax
efficient and beneficial estate pl::inning
to be implemented,
Michael Ben-Jacob is a partner at
Withers Bergman LLPi n New Yori