Hedge fund taxes Featured

8:00pm EDT June 25, 2007

Hedge funds are designed to have positive returns in all markets, bull or bear. However, they come at a price in terms of tax liability, fees, and the time and attention required to conduct proper due diligence.

In regard to taxes, the point is not necessarily to minimize them, but to maximize the after-tax return from the investment, says John T. Alfonsi, CPA/ABV, CVA, CFE, partner, Cendrowski Selecky PC, Bloomfield Hills. “Taxes are just like any other transaction cost that the investor needs to quantify and consider. Certain hedge fund investments might generate a higher return, such that even after considering taxes, the investment still makes sense.”

Smart Business asked Alfonsi for guidance on maximizing hedge fund investments returns.

How do the taxes and fees on a hedge fund differ from those of a mutual fund?

Most hedge funds are treated as partnerships for income tax purposes. As part of the partnership, you will be allocated a share of the income, whether or not that income is actually distributed. Therefore, you need a liquidity plan for covering taxes attributable to the income. Partnership allocation rules are complex such that an after-tax return could be significantly different than a pretax return. When considering an investment in a hedge fund, ask if the fund is reporting after-tax returns. If not, ask to see the components of the return. The character of each item of income and deduction could have a significant impact on the after-tax return. Unlike mutual funds, hedge funds are subject to little or no regulation, so close scrutiny is extremely important.

The fees involved with hedge funds are clearly greater than those for mutual funds. Hedge funds typically charge a 2 percent management fee, plus a 20 percent incentive fee or allocation.

How should the investor perform due diligence?

Every investor or his or her representative should meet with the fund team in person on a regular basis. Both quantitative and qualitative due diligence is required.

Quantitative due diligence involves an analysis of numbers, strategy and perspective. The goal is to get a comfort level with the fund’s reported performance and how it was derived. Investors should focus on the fund’s volatility. The goal of a hedge fund is absolute return with little correlation to the market, so there should be little, if any, down periods. Look at the breadth of gains. Look for across-the-board wins, not just a home run here and there. The investor needs to understand the fund’s risk management. How do they handle interest rate risk? Do they employ leverage? The quantitative due diligence should also focus on taxability. Investors need to understand the relationship of taxable income to economic income. The fund’s investment strategy also plays a part in analyzing after-tax returns. By analyzing their strategy, investors may be able to devise a predictable estimate of their tax liability.

Qualitative due diligence requires an analysis of the organization and its approach. Conduct background checks on the fund manager and team. If managed by one person, consider the risk should that person no longer be in that position. The investor also needs to be familiar with the fund’s service providers. Does generating audits result in any delays? Have they switched audit firms or attorneys? If so, why?

What are the advantages and disadvantages of a fund of funds?

A fund of funds is a good way to get your feet wet with hedge fund investing, giving you exposure to many managers that you may not otherwise have access to. They may also diversify risk. However, there is often a second layer of fees. The underlying funds each charge their 2/20 fees, while the fund of funds may also charge a 2/20 fee. From a reporting perspective, another disadvantage could be the complexity and timeliness of obtaining information.

Provide some advice for ongoing monitoring of the fund.

Typically, hedge funds hold quarterly phone conferences. Participate even if you don’t have any questions. Read any and all information sent to you, including the audit report. Have your CPA analyze the information as well.

Always watch for warning flags. Have they changed their risk philosophy? Examine their portfolio/holdings on a regular basis. A consistent change in the fund’s relationship of taxable income to economic income may be a signal of other changes at the fund.

Nothing is better than quarterly in-person meetings. The hedge fund manager should be someone you are in frequent contact with on a regular basis. Remember, all the reasons that induced you into investing in the fund in the first place should still be there.

JOHN T. ALFONSI, CPA/ABV, CVA, CFE, is a partner with Cendrowski Selecky PC, Bloomfield Hills. Reach him at (248) 540-5760 or jta@cendsel.com.