Measuring the tax subsidy in private equity and hedge fund compensation

Hastings Law Journal

Volumn 60, Issue 1, 2008, Pages 27-59

  Brennan, Thomas J ^a   Okamoto, Karl S ^b  

^a NORTHWESTERN UNIVERSITY   (United States)

^b DREXEL UNIVERSITY   (United States)

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[No Author keywords available]

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EID: 58849102293     PISSN: 00178322     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (142)

1. See Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds, 83 N.Y.U. L. REV. I, I (2008).
2. See Andrew Ross Sorkin, A Professor's Word on a Buyout Tax Battle, N.Y. TIMES, Oct. 3, 2007, §Bus., at 8 (asking Professor Fleischer "about the whirlwind his paper had caused"), available at http://www.nytimes.com/2007/10/03/business/03tax.html.
3. See Michael J. de la Merced, Blackstone to Set a Stock Offering Price Sooner than Expected, N.Y. TIMES, June 20, 2007, at C2 (noting Congressional reaction to Blackstone IPO).
4. Alan S. Blinder, The Under-Taxed Kings of Private-Equity, N.Y. TIMES, July 29, 2007, § Bus., at 4 (arguing that preferential taxation of carried interest is not sound economic policy), available at http://www.nytimes.com/2007/10/03/business/03tax.html.
5. In addition to the capital gains treatment of carried interest and the deferral available for both carried interest and performance fees, commentators have questioned the ability of publiclytraded partnerships like the Blackstone Group to avoid the payment of corporate-level taxes. This was the primary focus of the legislation proposed by members of the Senate Finance Committee. See, e.g., Stephen Joyce, Baucus, Grassley Introduce Measure to Tax Traded Partnerships Similar to Corporations, BNA DAILY REPORT FOR EXECUTIVES, June 15, 2007, at G-5 (reporting on the introduction of S. 1624). The legislation proposed by three Democratic members of the House went further to specifically address the issue of the tax rate on carried interest payments.
6. See Brett Ferguson, House Democrats Target Fund Managers With Bill to Raise Taxes on Carried Interest, BNA DAILY REPORT FOR EXECUTIVES, June 25, 2007, at G-9 (reporting on the introduction of H.R. 2834). Blackstone's use of good will depreciation has also drawn criticism.
7. See David Cay Johnston, Tax Loopholes Sweeten a Deal for Blackstone, N.Y. TMES, July 13, 2007, at A1.
8. Jenny Anderson, Scrutiny on Tax Rates That Fund Managers Pay, N.Y. TIMES, June 13, 2007, atC3.
9. H.R. 2834, 110th Cong. (2007);
10. S. 1624, 110th Cong. (2007).
11. Commentators, including members of Congress, are often not very careful to distinguish between the "carried interest" earned by private equity managers and the "performance fee" earned by hedge fund managers. See, e.g.. Sen. Baucus Opening Remarks for Senate Finance Committee Hearing on Taxation of Carried Interest, 7 BNA TAXCORE, July 11, 2007, at 133-34 (July n. 2007). As we discuss below, there are important differences in the two types of compensation.
12. See discussion infra Part I and accompanying notes.
13. Carried Interest Part I: Hearing Before the Subcomm. on Finance, 110th Cong. (2007);
14. Carried Interest Part II: Hearing Before the Subcomm. on Finance, 110th Cong. (2007);
15. Carried Interest Part III: Pension Issues: Hearing Before the Subcomm. on Finance, 110th Cong. (2007);
16. Hearing on Fair and Equitable Tax Policy for America's Working Families Before H. Comm. on Ways and Means, 110th Cong. (2007).
17. For example, the two presidential candidates have taken opposing positions on the taxation of carried interest. See ROBERT WILLIAMS & HOWARD GLECKMAN, URBAN INSTITUTE, AN UPDATED ANALYSIS OF THE 2008 PRESIDENTIAL CANDIDATES' TAX PLANS: EXECUTIVE SUMMARY OF THE AUGUST 15, 2008 ANALYSIS I (2008), available at http://www.taxpolicycenter.org/ uploadedpdf/411750-updatedcandidates-summary.pdf. The opposing positions were typified by the testimony before Congress in connection with the aforementioned hearings.
18. H.R. 2834 (2007); S. 1624 (2007). An Internet search for "taxation carried interest" will bring hundreds of references to the discussion on both sides of the issue.
19. See, e.g., Fleischer, supra note 1, at 49-50 (concluding that the status quo treatment of a profits interest in a partnership is no longer a tenable position to take as a matter of sound tax policy);
20. see also Chris William Sanchirico, The Tax Advantage to Paying Private Equity Fund Managers with Profit Shares. What Is It? Why Is It Bad?, 75 U. CHI. L. REV. 1071 (2008);
21. David A. Weisbach, The Taxation of Carried Interests in Private Equity, 94 VA. L. REV. 715, 716-20 (2008);
22. Michael S. Knoll, The Taxation of Private Equity Carried Interests: Estimating the Revenue Effects of Taxing Profit Interests as Ordinary Income 1 (Univ. of Pa., Inst, for Law and Econ. Research, Working Paper No. 07-20), available at http://ssrn.com/abstract=1007774;
23. Note, Taxing Private Equity Carried Interest Using an Incentive Stock Option Analogy, 121 HARV. L. REV. 846, 846-47 (2008).
24. It may well be that a subsidy is good policy because, for example, an investment by society in alternative asset management leads to greater economic growth. Our goal is simply to provide a quantitative analysis to inform the discussion.
25. With the exception of one editorial by the economist, Robert Frank, taking a perspective similar to ours. Robert H. Frank, Editorial, A Career in Hedge Funds and the Price of Overcrowding, N.Y. TIMES, July 5, 2007, at C3 ("By making the after-tax rewards in the investment industry a little less spectacular, the proposed legislation would raise the attractiveness of other career paths, ones in which extra talent would yield substantial gains.").
26. See, e.g., Sanchirico, supra note 11, at 1078-79, 1134-35;
27. Weisbach, supra note 11, at 717-18 (discussing the alternative analogies used to argue over the appropriate tax treatment of carried interests);
28. Private Equity Council, Private Equity and the Treatment of Carried Interest: An Overview, http://www.privateequitycouncil.org/public-policy/ legislative/private-equity-funds-taxtreatment-of-carried-interests/ (last visited Nov. 13, 2008) ("The justification for a reduced tax rate for long-term capital gains is based on the concept of entrepreneurial investment."). The Private Equity Council is the principal trade association for the private equity industry. It sponsored the research that lead to Professor Weisbach's article.
29. Weisbach, supra note 11, at 715 n.*.
30. See, e.g., Nicholas Rummell, Private Equity and Hedge Funds Work Both Sides of the Aisle, FIN. WEEK, Sept. 1, 2008, at 3, 20, available at http://www.financialweek.com/apps/pbcs.dll/article? AID=/20080901/REG/309019978.
31. See, e.g., Robin Toner, A New Populism Spurs Democrats on the Economy, N.Y. TIMES, July 16, 2007, at Al.
32. Editorial, Too Timid for Tax Increases, N.Y. TIMES, Oct, 11, 2007, at A30 ("A spokesman for the Senate majority leader, Harry Reid, told The Post that time appeared to have run out to act this year and that, in any event, the issue needs more study.").
33. Id. ("That decision has all the signs of a delaying tactic to avoid raising taxes on an industry that is a heavy campaign contributor.");
34. Associated Press, Private Equity Warns Against Raising Taxes, N.Y. TIMES, Aug. 1, 2007, at C2 ("Though private equity groups and hedge funds could be tempting targets for lawmakers looking to pay for new federal programs, the industry has been lobbying aggressively against the tax increase and crucial senators appear to be listening.").
35. Professor Knoll has calculated the potential tax revenues that would come from changing the tax treatment of private equity carried interests at an estimated two to three billion dollars per year. See Knoll, supra note 11, at 12-13. He also predicts that much of that gain will be eliminated as private equity funds restructure in order to ameliorate the effect of any change.
36. Id. at 14.
37. Professor Weisbach concludes that any attempt to change the partnership tax rules, which give rise to the preferential treatment of carried interest, "will be complex and easily avoidable rules that raise little revenue while imposing excessive compliance costs." Weisbach, supra note 11, at 719.
38. Sanchirico, supra note 11, at 1076 ("[T]he Article's main point is that the tax advantage... is... a form of 'joint tax arbitrage.'").
39. Id. at 1077-78.
40. Id. at 1076.
41. "Lost" tax revenues from deferred compensation are matched by the "lost" tax deduction that would have otherwise been available to the investors in the funds, and vice versa. Id.
42. Id. at 1082.
43. Knoll, supra note 11, at 5-7.
44. Knoll, supra note 11, at 14;
45. Sanchirico, supra note 11, at 1076.
46. Offshore investors play a similar role in hedge funds. They do not pay U.S. taxes and therefore do not value the lost deduction for compensation expense. See 26 U.S.C. S 864(b) (2006). Under section 864(b) of the Internal Revenue Code, trade in stocks, securities, and commodities through a resident agent does not amount to the conduct of a trade or business within the United States by a foreign principal. Thus, if a foreign individual invests in a hedge fund structured as a U.S. partnership but has no other connections with the United States, and if the hedge fund engages exclusively in transactions qualifying under section 864(b), then the foreign individual will not be subject to U.S. income taxation.
47. Sanchirico, supra note 11, at 1152.
48. Knoll, supra note 11, at 14.
49. Professor Sanchirico has not ignored this possibility, but asserts that any disequilibrium is not best addressed as a tax issue. Sanchirico, supra note 11, at 1151. We tend to agree, but nevertheless see value in developing our model as an analytical tool.
50. Two observations may be of interest. First, in the Authors' experience, hedge fund managers limit their use of "deferral" to their off-shore funds. This suggests that they hesitate to impose the "cost" of deferral on those of their investors who may value the current deduction of management fee expenses, and take advantage of the tax planning opportunity only where it is costless to their investors. Any suggestion that this implies that the tax opportunity provides "excess" returns begs the question of why offshore and tax-exempt investors do not bargain for their share in providing this opportunity. One theory that is consistent with our experience is that individual investors simply donot think this way, at least not yet, about the terms of their investee funds. They focus on the net returns offered at the fund level. In order to effectively bargain for their "share" of the value of the deferral opportunity, hedge fund investors would first need to understand the potential value from a total portfolio perspective (and in their case insert structures that allow them to capture some of the value) and then overcome the collective action problems inherent in seeking to change industry terms necessary to capture a share. This same "fund level, net returns" focus is also common among the much more developed and mature investor community in private equity. Here lies our second observation. Because private equity funds are essentially liquidating partnerships, cash flows tend to be fairly well matched. So, investors receive cash at roughly the same time as they "book" taxable gains. We would suggest that the appetite of investors to revisit the "sharing" of tax benefits would be voracious if this were not true. If investors had to fund cash taxes before they received cash returns because of the taxation of carried interests, this would change. But because there is this match of cash flows, investors simply focus on their net after-tax returns. The "cost" of deferring the deduction for the management fees and the carried interest paid to the fund manager is never made evident, leading fund investors to view the "tax benefit" paid to the managers as "costless" to them and outside the economics of the fund. As Professors Knoll and Sanchirico demonstrate, they are wrong. Knoll, supra note 11, at 11-15;
51. Sanchirico, supra note 11, at 1076-77. But it is instructive to see how the negotiations over the carried interest and its structure changes when one compares a "captive fund," such as the private equity arm of a large financial institution or family office and a stand-alone private equity limited partnership. In the captive context, the tax benefits of carry are very much on the table. Not so in the traditional partnership structure. We see this as anecdotal evidence of disequilibrium, at least for the time being.
52. Professor Sanchirico does make passing reference to the issue of risk in comparing types of activities. He argues that risk is not a basis for distinguishing labor from capital returns. See Sanchirico, supra note 11, at 1152-53. We agree. However, as asset pricing theory informs us, differing risk is a basis for modeling, and ultimately comparing, differing financial "streams," whether they stem from "sweat" or money.
53. See generally ZVI BODIE ET AL., INVESTMENTS (8th ed. 2009) (outlining the importance of risk in comparing asset returns and forming portfolios).
54. Professor Sanchirico makes the point that horizontal equity "analysis is plagued with many serious problems." Sanchirico, supra note 11, at 1146. We agree, and do not want to suggest we are doing anything more than adding some analytical tools for the larger, more complex normative discussion.
55. As will become clear in our choice of modeling inputs, we define entrepreneur to include only that very narrow subset of self-employed persons who are able to attract venture capital financing for their businesses. The concept of "entrepreneur" is often seen to include a much larger universe of activities. See generally SHANE A. SCOTT, THE ILLUSIONS OF ENTREPRENEURSHIP 2-3 (2008) (defining entrepreneur in several different ways).
56. See sources cited supra note 14.
57. Sanchirico, supra note 11, at 1148-49 (noting that limiting a horizontal equity discussion to the differing tax treatments of labor returns ignores the issue of how returns on endowments, such as gifts and inheritance, may also benefit from preferences).
58. Professor Sanchirico expresses some skepticism. Sanchirico, supra note 11, at 1137 (noting that the "sweat equity" analogy is inapt). Our analysis agrees with his conclusion as it regards the taxation of carried interests. We also agree more generally that the "sweat equity" concept needs unpacking for proper analysis. The kind of " entrepreneur" Professor Sanchirico seems to have in mind in his discussion sounds more like the self-employed small business person than the venture capitalbacked high-technology executive. Our initial suspicion is that the latter may be the one case where the usual rhetoric around "sweat equity" may make sense.
59. See Ronald J. Gilson & David M. Schizer, Understanding Venture Capital Structure: A Tax Explanation for Convertible Preferred Stock, 116 HARV. L. REV. 874, 889-96 (2003) (discussing the "tax subsidy" available in structuring management incentives in venture capital companies). Our current project is a taxonomy (excuse the pun) of various compensation structures that live behind the "entrepreneur" label.
60. For a discussion of how we make these calculations, see infra notes 97-102 and accompanying text.
61. See 26 U.S.C. § 1(1)(2) (2006) (specifying that 35% is the current maximum rate generally applicable to ordinary income).
62. See 26 U.S.C § 1(h)(1)(C) (2006) (specifying that 15% is the current maximum rate generally applicable to long term capital gains).
63. See Gilson & Schizer, supra note 38, at 880-81.
64. See, e.g., Julie B. Cullen & Roger H. Gordon, Taxes and Entrepreneurial Activity: Theory and Evidence for the U.S. i (Nat'l Bureau of Econ. Research, Working Paper No. 9015, 2002) ("Given [the] positive spillovers generated by entrepreneurial activity, there are clear reasons to try to subsidize such activity through the tax system.").
65. We are ignoring the risk of being assessed for any amount of original issue discount. See generally JACK S. LEVIN, STRUCTURING VENTURE CAPITAL, PRIVATE EQUITY, AND ENTREPRENEURIAL TRANSACTIONS ¶ 202, at 2-9 to 2-26 (2008) (discussing tax structuring options for equity investment by the entrepreneur).
66. Id. ¶ 202.3.7, at 2-22.
67. See id. ¶ 408, at 4-46 to 4-56.
68. See generally FRANCOIS-SERGE LHABITANT, THE HANDBOOK OF HEDGE FUNDS 1-50 (2006) (providing background on the nature of hedge funds and their compensation structures).
69. See Fleischer, supra note 1, at 3 (describing the industry standard of "2 and 20").
70. See 28 U.S.C. § 162 (2006) (allowing for a deduction from gross income for all ordinary and necessary business expenses).
71. See, e.g., Jenny Anderson, Managers Use Hedge Funds as Big I.R.A.'s, N.Y. TIMES, Apr. 17, 2007, at A1.
72. See infra notes 69-71 and accompanying text.
73. See generally GUY FRASER-SAMPSON, PRIVATE EQUITY AS AN ASSET CLASS 15-42 (2007) (discussing the background on the nature of private equity firms and their compensation structures);
74. JOSH LERNER ET AL., VENTURE CAPITAL AND PRIVATE EQUITY: A CASEBOOK 1-35 (4th ed. 2009) (same);
75. Andrew Metrick & Ayako Yasuda, The Economics of Private Equity Fund 19-20 (Univ. of Pa., Wharton Sch., Dept. of Fin., Preliminary Draft, Feb. 22, 2007) (on file with author) (same).
76. For a complete discussion of the current tax law treatment of private equity fund compensation, see Weisbach, supra note 11, at 727-33.
77. Ironically, one response to the SEC's attempt to compel hedge fund managers to register as investment advisers was a shift from quarterly to two-year lock-ups which would have allowed hedge funds to escape the registration requirement. See Gregory Zuckerman & Ian McDonald, Hedge Funds Avoid SEC Registration Rule; Some Big Firms Change Lockups, Stop Accepting New Investments to Take Advantage of Loopholes, WALL ST. J., Nov. 10, 2005, at Ci. More recently, higher performing firms have been able to impose longer lock-up periods as a cost of entry for new investors.
78. See, e.g., All Hedge Funds: Locked-Up, THE ECONOMIST, Aug. 4, 2007, § Finance & Economics.
79. See, e.g., Andrew Ross Sorkin, Hard Lesson on Running Hedge Fund, N.Y. TIMES, Aug. 19, 2008, at C1, C5 ("Wall Street is going to be littered with such flameouts.").
80. Some managers have attempted various techniques to both defer and convert to capital gains a portion of these management fees by essentially taking additional carried interest in lieu of management fees. See Fleischer, supra note 1, at 17.
81. See supra notes 7-11 and accompanying text.
82. See LEVIN, supra note 44, ¶ 1001.1, at 10-3 to 10-9.
83. Id. ¶ 602, at 6-37 to 6-74.
84. See Eric D. Chanson, Deferred Compensation Reform: Taxing the Fruit of the Tree in Its Proper Season, 67 OHIO. ST. L.J. 2, 2-4 (2006);
85. Ethan Yale & Gregg D. Polsky, Reforming the Taxation of Deferred Compensation, 85 N.C L. REV. 571, 571-74 (2007).
86. Beyond the limited financial benefit of deferring cash compensation, deferral of cash also imposes additional risk on the manager. See Sanchirico, supra note 11, at 1152;
87. see also Yale & Polsky, supra note 59, at 572-74. The deferral rules generally require the person deferring to have only a general creditor's claim against her employer for the amount deferred. In other words, the deferred amount needs to be at risk of bankruptcy. So given the limited benefit of deferring cash payments and the risk of loss, it would seem unlikely that deferral is a meaningful benefit outside of the equity-basedcompensation situation. The risk of bankruptcy, while important with respect to cash compensation, does not impose a greater risk in the case of deferred equity compensation. Any compensation whose value is tied to the firm's equity value is by definition already subject to bankruptcy risk.
88. See LEVIN, supra note 44, ¶ 408.1, at 4-46 to 4-47.
89. As Black-Scholes tells us, the option itself even if not "in the money" today is valuable as long as it remains unexpired. The chance that it will sometime before expiration become "in the money" is worth something. See, e.g., RONALD J. GILSON & BERNARD S. BLACK, (SOME OF) THE ESSENTIALS OF FINANCE AND INVESTMENT 231-51 (1993) (discussing the Black-Scholes model).
90. This was the problem with option backdating. By setting a date were the market value was lower than the date of grant, thus setting the exercise price so that the option was "in the money," issuers were giving income (nothing inherently wrong with that since they could have given cash bonuses) but were failing to book this expense because they treated them as "no money" options.
91. See LEVIN, supra note 44, ¶ 408.1 at 4-46 to 4-47.
92. Id.
93. This may explain why so many CEOs want to turn their companies into private equity investments. Although not the same as the fund manager's carried interest, managers of private equity portfolio companies have an opportunity to have their equity-based compensation be taxed as capital gains rather than ordinary income. See Sanchirico, supra note 11, at 1075.
94. See, e.g., Carolyn Said, Companies Reassess Stock Option Grants, S.F. CHRON., Aug. 27, 2006, at F1.
95. Of course the Enron debacle is the poster child for how this dynamic can play out. There is a lively academic debate over the use of stock options as compensation. See, e.g., Lucian Arye Bebchuk, et al., Managerial Power and Rent Extraction in the Design of Executive Compensation, 69 U. CHI. L. REV. 751 (2002) (arguing that stock options are not optimal arrangement for maximizing shareholder wealth but result rather from the exercise of managerial power);
96. Kevin J. Murphy, Explaining Executive Compensation: Managerial Power Versus the Perceived Cost of Stock Options, 69 U. CHI. L. REV. 847, 851-55 (2002) (disputing managerial power thesis and arguing that stock options are over used because they are mispriced by both employers and managers).
97. Although, if you truly believe in the potential return on the stock, it actually is a good deal since you would be entitled to capital gains treatment on any appreciation.
98. See LEVIN, supra note 44, 1602 at 6-37 to 6-74.
99. Much of both Professor Sanchirico and Professor Weisbach's discussion is an analysis of the validity of the analogy between private equity managers and entrepreneurs. See Sanchirico, supra note 11, at 1135-39;
100. Weisbach, supra note 11, at 717. Professor Sanchirico makes the point that the analogy fails because the real source of tax advantage in the private equity context lies in the tax-exempt status of the majority of private equity limited partners, whereas the "sweat equity" story is "a single actor tax play," which does not rely on the differing tax rates that give rise to the tax rate arbitrage opportunity that private equity managers are exploiting.
101. Sanchirico, supra note 11, at 1079-80. Professor Weisbach concludes that the analogy of a private equity investor to an entrepreneur is as compelling as the analogy to a wage earner and that therefore "the problem is which one to choose."
102. Weisbach, supra note 11, at 717.
103. Professor Sanchirico has catalogued a long list of various commentators' use of the "sweat equity" analogy at Sanchirico, supra note 11, at 1078.
104. In essence, this is equivalent to simply making an investment in an index fund that mimics the performance of the entire market. We set this up as a call option so that we have similar components in the model across the four types we are comparing.
105. The effect of inserting a "knock-out" feature is to cause the option to expire before its stated maturity date in the event that the value of the underlying asset falls below the stated "knock-out" level. This is a convenient way of adding the risk of bankruptcy or firm failure to the analysis. If the value of the firm or portfolio falls below a certain level, the ability of the option holder to "wait and see" if the value will recover may, in some cases, be "knocked out" even though the possibility remains.
106. The investment of an executive in the equity of her employer, like that of an entrepreneur, is an investment in a single, undiversified asset (again, all her eggs are in one basket), and therefore she faces idiosyncratic risk. See generally Murphy, supra note 68, at 847-60.
107. See generally Sanchirico, supra note 11.
108. Since beta is the measure of portfolio risk correlated with the market, a market neutral strategy which seeks to avoid correlation with the market, has a beta of zero. In real life, few "market neutral" hedge funds succeed in fully eliminating beta. For our purposes, we simply incorporate any such volatility into the idiosyncratic risk variables we use in the model.
109. As already noted, an important difference between hedge funds and private equity funds is the differing degree of liquidity each type of fund offers its investors. Traditionally, most private equity funds require their investors to commit capital for a period of ten to twelve years. The capitalweighted average life is shorter since capital is drawn down (as investments are made) and returned (as investments are harvested) over time. Nevertheless, the legal commitment made at the outset calls for a long-term, relatively illiquid investment in the fund. As a consequence, private equity fund managers can be said to operate a relatively low-risk business since they do not face the risk of a sudden demise of their business by reason of a "run on the bank." To use the industry vernacular, they have relatively "permanent capital." In contrast, hedge fund managers face a substantially higher risk of "losing their seat." Until relatively recently, the majority of hedge funds offered their investors annual and often quarterly redemption rights. See Jasmina Hasanhodzic & Andrew W. Lo, Can Hedge-Fund Returns Be Replicated?: The Linear Case 1-7 (unpublished draft of Aug. 16, 2006), available at http://ssrn.com/abstract=924565.
110. This changed, at least among the more successful funds, to bi-annual redemption because of the recent attempt by the SEC to regulate hedge fund managers. See SEC STAFF REPORT, IMPLICATIONS OF THE GROWTH OF HEDGE FUNDS 7-8 (2003), available at http:www.sec.gov/news/studies/hedgefunds0903.pdf. The SEC exempted funds with "lock-up terms of two years or more in order to leave private equity managers unregulated."
111. Id. Ironically, this attempt to increase regulation simply caused the hedge fund industry to curtail the liquidity rights it afforded its investors to avoid regulation.
112. See Said, supra note 67. Nevertheless, hedge fund managers continue to face a far greater risk of "going out of business" when their performance disappoints their investor base. In addition, because of so-called "high water mark" provisions, it is actually in a manager's interest to consider shutting a fund with negative returns and returning capital even when investors themselves have not forced a liquidation of the fund through redemption calls. To reflect this risk faced by hedge fund manager, we have inserted a "knock-out" feature into the call option we model. We set the "knock-out" level to be equal to the level of fund losses at which a typical fund would shut down and return capital, either voluntarily or through investor redemptions. This is admittedly a very arbitrary variable for which we have no empirical foundation. We do test the sensitivity of our conclusions to changes in our assumed "knock-out" levels below.
113. See infra Table A.
114. See generally JOHN C HULL, OPTIONS, FUTURES, AND OTHER DERIVATIVES (7th ed. 2008) (discussing Monte Carlo simulation in the context of financial instruments);
115. GEORGE S. FISHMAN, MONTE CARLO: CONCEPTS, ALGORITHMS, AND APPLICATIONS (1996) (discussing the Monte Carlo technique in more general circumstances).
116. In addition to the 1,000 basic random iterations of investment simulation, we also use an additional second set of 1,000 random iterations, for a total of 2,000 iterations. The second set is constructed by using underlying normal random variables which are antithetic to the first set. This technique allows us to obtain more precise results by reducing the sampling error associated with a Monte Carlo simulation.
117. A normal standard distribution is completely characterized by its mean and standard deviation. See generally KAI LAI CHUNG & FARID AITSAHLIA, ELEMENTARY PROBABILITY THEORY (4th ed. 2006) (discussing probability and the normal distribution).
118. See infra Table A.
119. The Wage Earner is assumed to receive a salary payment each year and, after paying ordinary income taxes on the payment, invest the proceeds in the market for the remainder of the five year term of the analysis. Thus, the term of each of his investments expires at the end of the five year window, but there will be a new investment made in each year of the analysis.
120. John H. Cochrane, The Risk and Return of Venture Capital, 75 J. FIN. ECON. 3, 19 (2005).
121. Id. at 18.
122. Turan G. Bali & Nusret Cakici, Idiosyncratic Volatility and the Cross Section of Expected Returns, 43 J. FIN. & QUANT. ANALYSIS 29, 41-42 (reporting that the range of idiosyncratic volatility and betas for all stocks traded over a twenty-year period on the major exchanges range from a volatility of 15.87% per annum and a beta of 0.60 for the highest quintile to a volatility of 95.69% and a beta of 1.14 for the lowest). In picking our inputs, we used values that were not set at the two extremes, but approximated the second and fourth quintiles.
123. The Cochrane study found a failure rate of 9% among its sample. Id.
124. See supra Table A;
125. see also supra notes 86-88.
126. Metrick & Yasuda, supra note 52, at 19-20;
127. see also, Knoll, supra note 11, at 13-18 (using the same attributes to calculate likely tax revenues from a change in the taxation of carried interests).
128. See Hasanhodzic & Lo, supra note 77, at 24.
129. These return multiples represent the full, final after tax return to the investor per dollar invested, including any return of the amount originally invested.
130. The column "Tax on Gains Above Initial Amount Received" represents a tax on gain amounts only, with no tax deduction for losses.
131. In fact, the actual rate paid by hedge fund managers on "deferral" brought into income is probably lower. First, there may be planning opportunities within the hedge fund structure to allocate gains and losses among various investors so as to allocate long-term capital gains to the manager and ordinary income or short-term capital gains to offshore or tax-exempt investors. Second, hedge fund managers can defer income for much longer than five years. The longer term would increase the value of their option. Thus, it may be that our calculation understates the level of tax subsidy enjoyed by the hedge fund manager.
132. The column "Tax on Gains above Initial Amount Received" represents a tax on gain amounts only with no tax deduction for losses.
133. The vertical axis on the graph measures full final after tax return to the investor per dollar invested, including any return of the amount originally invested. The horizontal axis measures the standard deviation of this return amount.
134. The vertical axis on the graph measures the annualized compounded percentage return realized by each investment. The horizontal axis measures the standard deviation of this return percentage.
135. We calculate that the compound average annual return to a private equity manager is 10.7% per year, with a risk of 45.2%. An individual who spends approximately 59% of his time engaged in entrepreneurial activities and the remaining 41 % of his time as an ordinary wage earner has the same level of risk but an expected return of only 2.5%, or 8.2 percentage points less than that of the private equity manager. All averages and risks are computed for geometric returns that compound over a period of five years.
136. We calculate that the compound average annual return to a hedge fund manager is 26.3% per year, with a risk of 37.5%. An individual who spends approximately 49% of his time engaged in entrepreneurial activities and the remaining 51% of his time as an ordinary wage earner has the same level of risk but an expected return of only 2.2 %, or 24.1 percentage points less than that of the private equity manager. All averages and risks are computed for geometric returns that compound over a period of five years.
137. This calculation assumes that the entire impact of the tax change would be borne by the fund managers and that no correlative change in salary paid by the limited partner investors would occur. For the calculations under the revised tax, the compound average annual return to the private equity manager is 2.7%, with a risk of 41.5%, and the average annual return to the hedge fund manager is 21.3%, with a risk of 35.5%.The corresponding return levels for a combination of entrepreneurial and wage-earner activities with the matching risk levels are 2.3% and 2.1%, respectively. AU averages and risks are computed for geometric returns that compound over a period of five years.
138. For private equity managers, the percentage is computed as the percentage reduction from an excess return of 8.2 percentage points to an excess return of 0.4 percentage points. For hedge fund managers, the percentage is computed as the percentage reduction from an excess return of 24.1 percentage points to an excess return of 19.2 percentage points. Both of these results require the assumption that the hypothetical tax change is borne entirely by the fund managers and not their clients.
139. Assuming a constant beta of 1.9 and idiosyncratic volatility of 60%.
140. Estimates of failure rates among entrepreneurial companies vary greatly. See, e.g., Cochrane, supra note 84, at 8 (finding that 8.9% of companies in a large sample of venture-backed companies go out of business);
141. Mark Henricks, Think Your Startup's Destined to Fail?, ENTREPRENEUR MAG., Feb. 2007, at 22 (reporting that the popularly believed statistic of a 90% failure rate among new businesses is unsubstantiated and that the best evidence available shows that a majority of new businesses are still in business four years after their founding).
142. Readers are invited to visit the website, http://www.tbrenn.net/rtm, where they can find a copy of the model used in this Article's analysis, color versions of the graphs, and the ability to change the various inputs in order to explore the robustness of our results.