Aircraft owners at Hanscom Field divide up into doctors, techies, and “money guys”. One of the money guys mentioned that Kohlberg Kravis Roberts, one of the largest private equity (buyout) firms, has performed about the same as the S&P 500 over the years, if you account properly for leverage. In other words, if KKR had borrowed money to the same extent that they have and, instead of carefully selecting and managing businesses to buy, had simply put the cash into the Vanguard S&P 500 index fund, they would have returned just as much to investors.
If their selections don’t outperform the S&P 500, where is the genius of KKR? In the fee! Their investors could have borrowed some money and leveraged up the S&P for fees that would have been a fraction of 1%. Instead, they gave up 20 and 30% of their gains to the managers at KKR. So the real genius of the private equity firms was, we thought, to deliver similar results to those of public companies, if you’d bought additional stock on margin, but to collect fees that are 100X larger than the fees charged by indexers such as Vanguard.
[KKR also offered a full partnership to Ken Lay, the Chairman of Enron, shortly before Enron’s meltdown and after more savvy Wall Street analysts and funds were predicting a collapse and shorting the stock.]
Now the news stories are all about the favorable tax treatments received by employees at hedge funds and private equity firms. Ronald Reagan cut the capital gains tax in order to encourage folks to invest in risky young companies in hopes of keeping more of the rewards if a company succeeded. It was one of the most spectacular economic growth policies in U.S. history. It is tough to see why it should apply to hedge and private equity employees. These folks put no money at risk. If the fund goes up, they take 20-30% of the upside. If the fund goes down, they lose nothing. They certainly don’t need any incentive from the government to continue to go to work under these conditions. What they take home as a management fee looks like ordinary income and yet it is taxed as though they had made an investment in a stock and waited patiently for 5-10 years before cashing out.
After all of their talk about class warefare and inequality, you’d expect the Democrats who control Congress to eliminate tax preferences for guys who take no risk and yet receive a salary of $50 million/year. The newspapers seem to be predicting otherwise, however. It may be that this falls under the general principle that there is no point in trying to tax rich people more than 20%. If you try to hit a rich person with a tax of more than 20%, he or she will come up with an exotic, possibly offshore, way to avoid paying the tax.
Phil,
There are times when many hedge funds and private equity groups do indeed risk their own money on their investments. And if they cannot generate a good return (even if they don’t have their own money invested) they will go out of business, as evidenced by the many hedge funds shutting down now.
And although I do agree that the fees they charge are ridiculous, many folks don’t seem to mind paying them…
In my opinion one move that you can indeed bet on is the Dems upping the long term capital gains tax by 2009.
PS
I think that KKR would challenge your associate’s quote of their after-tax returns. I believe it’s actually a bit higher over the last fifteen years.
Regards,
Mark
Bob Merton (the Nobel prize winner) had some interesting things to say about this phenomenon. He offered the following example: If you leverage the S&P 500 by 50% or so (I forget the exact amount), it will show 50% more volatility than the S&P 500. But if you then only look at the value of your 150% S&P index investment every week or every month (instead of every day) it will appear as though it’s only as volatile as a 100% S&P 500 index fund. So you observe spurious lower risk, and therefore spuriously high alpha. But by construction you know that you haven’t added any real value: your “alpha” is actually beta masquerading as alpha.
Now leverage up your S&P 500 index fund by 200% or 300%, and only mark your investment to market every quarter or so, mimicking a private equity fund. You will show artificially low volatility, and therefore artificially high alpha, in an environment when the S&P index rises. The good part, from the manager’s point of view, is that even the most sophisticated clients and consultants cannot detect the (often inadvertent) legerdemain of transferring beta to alpha.
I believe there are private equity managers who do offer truly positive alpha, but it’s really hard to separate alpha from beta in a benign financial environment. The tools that financial analysts use are just not robust enough, when faced with funds that feature leverage and asynchronous pricing.
Regards,
Tom
There’s another factor at work here: up until this guy’s antics: http://www.slate.com/id/2168650/
Most people have rarely even thought about the compensation of private-equity fund managers. While they may be getting rich, they actually are a sort of tax on the wealthy in and of themselves. As you point out, these guys aren’t skimming high fees off of average Joes’ company-sponsored 401k accounts. (Vanguard is something of an exemplar, with it’s
I haven’t seen Democrats stand up to Big Money in any significant way lately.
39 Democrats just voted for the most anti-working-class piece of legislation ever, S 1639.
And many Democrats supported estate tax repeal. Perhaps no tax is ever truly “soak the rich” without dampening innovation / risk taking / jobs (i.e., a yacht tax results in unemployed yacht builders), but a tax on Paris Hilton-type inherited millions would seem to come as close as possible.
In the past, it seemed that each party represented different segments of Americans or drew differing conclusions about how best to benefit Americans. Today both parties seem to view American citizens as cannon fodder and taxpayers who are to be used in service of Corporations, Iraq, and Mexico.
“What they take home as a management fee looks like ordinary income and yet it is taxed as though they had made an investment in a stock and waited patiently for 5-10 years before cashing out.”
The 20% carried interest PE firms “skim” only comes after acquired companies are (at least partially) divested. Thus, managers have in fact waited for (on average) 3-7 years – this in addition to putting extensive effort into revamping the original failing business. To me, this seems more tax-break worthy than sitting back with an index fund.
Granted, I wish I had their salaries, but to bash them, you have to at least grant that PE serves an important purpose in the economy: driving world market and corporate efficiency. Legislators have to avoid any shortsighted tax reform that stints PE investment.
So a limited number of guys get rich through a loophole, on a policy that literally creates billions upon billions in GDP growth. Doesn’t sound like a bad tradeoff. You mentioning 20% taxes on the rich reminds me of the Laffer curve, which states that a tax rate of about 17% results in the most amount of taxes actually being paid.
After expense and taxes, over the long run, I doubt that any investment will beat stock market returns provided by a diversified basket of low cost index mutual funds.
You may be interested in this recent New Yorker article on Hedge Funds. It’s the same old story when it comes to managing equities – while these guys are better than your average investor, but they end up costing more than they’re worth.
http://www.newyorker.com/reporting/2007/07/02/070702fa_fact_cassidy
This was in the Wall Street Journal earlier this week, but I was able to find another reference on the web. Here is the reason that the newspapers are predicting such tax increases will fail to pass: “two-thirds of voters in the last election were investors”.
http://www.americansforprosperity.org/index.php?id=3651
“The choice could not be clearer. One is higher taxes on capital, first on partnerships and then likely on everyone else, with profoundly negative implications for the stock market, U.S. economy and federal tax revenues. The other is encouraging growth and prosperity for American workers and investors. Members of Congress should choose wisely, keeping in mind that two-thirds of voters in the last election were investors.”