NY Metro Hedgefund Law & News

Greenhouse Gas Emission Credits Funds - Caveat Emptor

Any alternative investment - which usually means taking a risk in a somewhat exotic asset class - deserves careful scrutiny sometimes on moral as well as economic grounds. One such class is an investment in a green house gas emission credit fund.

To understand these funds we need to back track to the Kyoto Protocol on global warming.

The Kyoto Protocol (“Kyoto”) proposed a commercial mechanism for regulating greenhouse gas emissions known as “cap and trade”. Kyoto establishes binding caps on emissions for developed nation parties and parties with economies in transition (“Annex I parties” or “Annex I nations”). These caps are limits on emissions of  green house gases ("GHGs") during the 2008-2012 period. The caps are set as reductions below each party’s 1990 emission level of six GHGs: CO2, methane (“CH4”), nitrous oxide (“N2O”), hydrofluorocarbons (“HFCs”), perfluorocarbons (“PFCs”), and sulfur hexafluoride (“SF6”). Emissions reduction commitments specified by Kyoto are typically 5-8% below the emissions baseline, although some parties successfully negotiated a commitment of no reduction below the baseline or even an increase above it. Additionally, different levels of economic growth or stagnation since 1990 mean that while some Annex 1 nations face steep cuts, others actually have excess allocations.

So far, only the European Union (“EU”) has established the Kyoto accord principles in the form of a mandated emissions trading program. In the EU program’s first phase, carbon emissions licenses called assigned allowance units (“AAU’s) were granted free of charge to established corporations. The people administering the EU plan were often forced to rely on emissions estimates prepared by the firms themselves. Not unexpectedly, these figures gave the corporations generous leeway.

The result was massive over-allocation of AAU’s, which in some areas of industry exceeded actual emissions by as much as 50%. In May 2006, after the scale of this over-allocation became a well known fact, the market in AAU’s collapsed.

Also included in Kyoto are provisions allowing Annex-1 parties to pay for emissions reductions additional to what otherwise would have occurred within other Annex I parties and then credit these reductions against their own assigned amount units. This is known as Joint Implementation (“JI”).

Another part of the Kyoto Protocol that needs to be understood by way of background is the Clean Development Mechanism (“CDM”). Annex I parties may pay for emissions reductions that are additional to those that otherwise would have occurred within a developing (“Non-Annex I”) nation that is a party to the protocol. The purchasing Annex I nation may then credit these emissions reductions against its AAU’s.

The CDM is an attempt at a market-based solution for addressing the problem of global warming. CDM is not a cap and trade system because the host nations of CDM projects are developing countries that have no binding cap limit to the mass of GHGs that they may emit under the Kyoto Protocol. An approved CDM project generates Certified Emission Reductions (“CERs”), the currency of the CDM system, which are in essence tradable emission credits generated by “offset” projects.

The CDM is a project-based system. This means that it accomplishes its objectives at the scale of individual projects that are validated by designated entities and registered with the CDM Executive Board the mechanism’s governing body, rather than at an industry or sector-wide scale. Each project wishing to participate in the CDM must prepare a Project Design Document that explains in detail how its future emissions reductions will be real, additional, and not induce leakage. It must also prepare a monitoring methodology that explains in detail how it will monitor emissions reductions made by the project.

Although the United States declined to join the Kyoto Protocol, market mechanisms to control carbon emissions are currently being developed by a coalition of 7 northeastern States (the Regional Greenhouse Gashouse Initiative – “RGGI”)) and by California. The RGGI does contain provisions for offset projects.

With that history out of the way, let us return to the greenhouse gas emission credit fund. The greenhouse gas emission credit funds generally have as their goal emissions reduction or avoidance projects in underdeveloped economies to generate saleable “credits” for the investors. The fund manager (the following language is from a manager of projects intended to produce EU CER’s) will claim to have needed expertise:

“It must be made clear, however, that an investor to a fund that captures [underdeveloped country] discounts in the generation of greenhouse gas emissions must be cognizant of important issues such as the risks involved in the creation of new credits: the lengthy and tedious administrative processes to establishing a carbon credit-worthy project, the verification and validation of real emission reductions, as well as the more obvious macro components affecting the supply and demand and ultimately the prices of credits. And also the investor must critically judge the fund manager (agent) to navigate the by-ways of the new credit approval process.

Indeed, perhaps it is here that the investor might best value the fund since profitability mostly relies on the abilities of the manager to source discounted projects, manage the extraction process from the identification up to perhaps 5 years later when credits are issued: the fund manager must be a master of the carbon credit origination process.”

There are a number of market/regulatory factors that should be considered in such an EU project. First, the shorter the interval before the end of the initial Kyoto compliance period in 2012, the less money to be made from CERs, so the larger the transaction costs associated with registration and monitoring become. Second, without certainty about the shape of any future Kyoto based trading program or subsidy, financial incentives to invest with post-2012 in mind are absent. Finally, even for the 2008-2012 market, there is significant demand (and hence price) uncertainty because of the possible competition of CDM with both JI project based reductions and outright purchases of AAUs from Russia, Ukraine, and the remainder of Eastern Europe. Whether these other alternatives are sought out by Annex I parties in turn depends, on the costs of domestic compliance, the price of CERs, and other political considerations. 

CERs will eventually be transferable to a buyer who establishes an account with the International Transaction Log, a yet to be constructed database of Kyoto accounts. This requires that, for the time being, a fund which merely wants to acquire CER's from developers be designated as a “project participant” by the Kyoto project entity generating the CER’s. However, a fund which merely wants to purchase CER's to trade may not be able to be granted such status.

Moreover, not all methodologies that on their face would seem to be ways to reduce greenhouse gas and hence generate credits work out so well in practice. A prime example, is developing countries’ forests — both the old-growth forests now being eyed for carbon absorption as “carbon sinks”, and new tree plantations.

However, forests as carbon offsets are a questionable proposition for a long list of reasons. How much carbon dioxide a forest will absorb over a given period is at best an educated guess. Forests can burn, releasing their carbon. Old-growth forests absorb much less carbon dioxide than new plantations, which enhances the temptation to clear-fell the former in order to plant the latter.

The problems are multiplied wherever regulation is lax and officials corrupt. Tropical forests, it can be expected, will at times both be logged and claimed as carbon sinks. Where such forests are protected with any vigor, the “protection” is often likely to be aimed at indigenous people who practice a sustainable shifting agriculture. The increased incentives for plantation forestry threaten to cost tenant farmers their land. Perhaps on account of these issues, I know of no confirmed CDM project resulting in CER’s to be obtained from reducing CO₂ by planting trees.

The moral of course is to think very heavily about an investment in any greenhouse gas offset project or credit participation fund. As the European market experience shows even in a somewhat broad market situation the market price for carbon credits (albeit there in the AAU context) is hardly stable. The US experience, really limited so far on any major scale to sulphur emissions allowances (i.e. credits), has shown sizeable price volatility. In the developed countries future environmental legislative uncertainty adds another major risk to the mix. Advances in science also mean that the projected "credit" worth of an emission project today may not be realized tomorrow on account of a change in emission metric and analysis methodologies or the development of  scientifically "better" reduction programs. Thus, for  example, expected credits for carbon sinks like forest programs might not even exist or the status might be questionable as is seemingly the current case with such programs under the EU version of the Kyoto regimen. And when you start getting into emission reduction projects in underdeveloped countries, the financial (and moral) risks multiply enormously.

In short, caveat emptor.

Dubious Proposals for Tax "Reform" of Carried Interests

The debate continues to rage over the taxation at 15% capital gains rates of carried interests received by hedge fund, private equity, and venture capital managers.  At least two pieces of legislation are pending which would tax these carried interests as ordinary income at 35% rates - albeit one of them would do so in only the relatively limited context of publicly traded partnerships. A number of academic proposals to deal with the taxation of carried interests have been made as well.

In brief: under current law, the receipt of a carried interest, if structured as a partnership profits interest in future profits, is not a taxable event .  Moreover, unlike corporate executives who receive equity type interests as compensation, taxation on the carried interest is generally deferred until income is actually received  - often as a pass through of long term capital gains.

Arguments (often simplistic) are being made against this treatment. Arguments (often equally simplistic) are being made in favor of this treatment. This note is not meant to weigh in particularly on one side or the other of the debate.

However, what will be addressed is the effectiveness of the legislative and academic proposals at doing what they purport to do, i.e. raise revenues for the taxman. A review of comment made so far indicates that they are all sorely deficient in this regard. So let’s look at how this could come to pass, take a few potshots along the way, and try to have some fun in the process – if tax law can ever be “fun”.

First, the legislation dealing only with publicly traded partnerships is so limited in scope and application as to be unworthy of any great analysis or criticism. It was clearly a knee jerk high profile reaction to the recent Blackstone  deal and would apply only to a handful of publicly traded private equity and hedge funds. Any tax revenues raised will be inconsequential to the point of meaninglessness.

Second, the other pending bill (the “Levin bill”)  would be more broadly applicable. Essentially it would create a new section in the Internal Revenue Code which will characterize income from a profit share interest attributable to investment management services furnished by a partner to a partnership as ordinary income. The bill would generally affect carried interests in which the partner has made no contribution of investment capital. If the partner has contributed capital, however, the allocation of profits to the partnership interest represented by capital must not be unreasonable, otherwise the bill would apply. There are other provisions dealing with losses, distributions of property, and dispositions of partnership interests. The Levin bill has been roundly criticized on a variety of technical grounds.

Third, besides the legislative proposals a couple of academic proposals have tackled the taxation of carried interest. One such proposal (“Fleischer/Schmolka”) would treat a carried interest as a loan of capital to the general partner (GP) from the limited partners. If the GP has a 20 percent profits interest, he would be treated as if he borrowed 20 percent of the partnership capital for the life of the partnership. The GP would either be required to pay interest on the use of capital or be taxed on the forgiveness of such a payment much like imputed interest on loans. In effect, under this proposal, the GP is treated as receiving a payment for services equal to the interest-free use of capital. A second proposal (“Gergen”) would treat any payment on a profits interest as ordinary income (and grant the partnership a deduction for the same amount, which would then potentially be capitalized.) The approach taken in the Levin bill discussed above is similar to the Gergen approach.

The problem with all the proposals is that, like the horcruxes of Lord Valdemort which Harry Potter of the fictional Harry Potter series has to deal with before he can extinguish that evil villain, every imaginable manner of escape for the perceived “evil”  of the current tax treatment of the carried interest has to be closed.  If not - a lot of legislative wheels will have been spun in vain.

This, sans the Harry Potter allusion, is precisely the view taken in a recent article entitled “The Taxation of Carried Interests in Private Equity Partnerships” at Tax Notes, July 31, 2007, p. 32 by Prof. David A. Weisbach of the University of Chicago who lays out - at least some of – the “horcruxes” left untouched by the proposals:

“The Gergen proposal would treat some distributions to partners as payments for services… The Gergen approach would … be easy to avoid. Using debt rather than limited partnership interests would make any such rules entirely inapplicable because there would be no partnership. If a partnership must be used, the transaction could be documented as the Fleischer/Schmolka structure. That is, if the profits interest were documented as a loan from the limited partners to the general partner (and a contribution of the loaned money), the general partner would unquestionably be receiving a return on contributed capital. The two-percent management fee would be their compensation for services. Thus, the significant complexity that the Gergen approach would introduce would be for naught, or at least very little.

The Levin approach is similar to the Gergen approach but rather than adopting a straight-up allocation rule, it would merely require a reasonable allocation between labor and capital. Similar avoidance mechanisms, such as the use of debt, would be similarly easy to use. Moreover, simply rearranging the labels on the current partnership structure would get around the Levin bill. For example, if the various returns paid to private equity sponsors are combined into a single return, the sponsors could allocate two-thirds of their returns as service income without changing their tax results at all. Auditors would have little basis to challenge such an allocation. More complex restructurings, such as loans from the limited partners to the sponsor who would then contribute the capital to the partnership would make a challenge to the allocations even more difficult. The result would be less efficient and transparent capital structures, an increase in tax controversies, and little or no additional revenue. More subtle rules that attempt to distinguish more accurately would be complex and yet remain inaccurate. This was the very problem faced by Congress when enacting section 707(a)(2)(A). Twenty-three years after passage of this rule, the Treasury has yet to issue regulations because there is no easy way to make the distinction between labor income and capital income. The Levin bill simply glosses over this central problem, hiding its complexities behind a rule that allocations must be reasonable.

The Fleischer/Schmolka approach suffers from similar problems. The underlying rationale is that uneven sharing of returns to capital represents implicit loans that should be recognized. This is a more accurate measure of the return to services than the Gergen approach, but would likely be impossible to implement. It would be necessary to identify when one partner has implicitly loaned funds to another partner and then impute an appropriate cost of capital. If allocations are not straight-up, it would be impossible to identify implicit loans. At a deeper level, the capital accounts system required by the 704(b) regulations does not incorporate time value concepts (except to a limited extent in the substantiality test). Without time value concepts incorporated into capital accounts, there can be all kinds of internal loans among the partners. Attempting to revise the capital accounts rules to incorporate time value concepts, however, is a daunting prospect and would likely make the partnership tax rules entirely unworkable.

To illustrate, a typical private equity partnership uses a hurdle rate. The limited partners get the first 8 or 9 percent of the return. Once that return is achieved, the general partners get an allocation so that the overall return is split 80/20. This could be restated as a nonrecourse loan with a fixed return of eight percent and a contingent return of 80 percent of all profits above 10 percent. With a fixed return of eight percent, it would easily exceed any requirement of paying minimal interest as required by the Fleischer/Schmolka approach. Indeed, if we view the limited partnership interests as financial instruments issued to sophisticated third-party investors, there is no question that they are compensated for the use of capital. Tax rules that treat this return as inadequate would be ignoring the economic realities.”

In short, per the critics, none of the proposals in their current forms seems likely to raise any significant tax revenues. There are just too many places in the partnership tax law to “hide” in that the proposals do not cover.

Enthusiasts who wish to have a further go at this are invited to try to work out solutions to the thicket of issues presented in finding and dealing with more of the tax law “horcruxes”.  For myself, I think I am going to wait until the next Harry Potter movie comes out  or at least for the school season to start again before further agonizing over this issue.

I hope you all enjoyed your summers.
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How the Blackstone Goodwill Write off Really Works

Recently there have been a number of articles about a $1B goodwill write off generated for the Blackstone insiders (i.e. its founders and senior managing directors) in its recent initial public offering (IPO).

Apart from the often either alarmist or apologist nature of the articles, they are, in my opinion, if not inaccurate, so thin on details  (OK I will say it - "dumbed down") as to make it virtually impossible to understand what actually transpired. I saw a blog that  said that some poor fellow read one of these articles 100 times and still could not understand what had happened. It is for those malnourished, intellectually curious souls that I am writing this blog entry.

In my opinion you can't make heads or tails of what happened without an organizational chart of the post IPO Blackstone structure. I have embedded such a chart above. Just click on it to blow it up to legible size and print it out (hopefully you can) to follow this discussion. (For better quality you can also get the chart from the S-1 filings with the SEC on the IPO which are publicly available.)

To start at the top of the chart: pre IPO the insiders (represented by the left oval at the top of the chart) privately owned management companies that managed several investment partnerships - all essentially operating under the "Blackstone" name.  In the IPO the insiders contributed noncontrolling interests in some of these management companies to what is now a public company named Blackstone Group LP (Blackstone Group - the biggest triangle in the middle of the chart) and the insiders (middle oval at the top of the chart) continue to control Blackstone Group through an intermediary LLC (the rectangle above the biggest triangle - there may be two rectangles at this level in a later chart as some type of limited voting LLC was I think also established but that is not relevant to this discussion) which is the general partner which has no economic rights in Blackstone Group or anything anywhere else on the chart.

Still at the top of the chart: limited partnership interests in Blackstone Group were sold in the IPO to outside investors (the oval at the top right of the chart) of which the Chinese government (through I believe the not very imaginatively named "State Investment Company") purchased 40%. The amount raised on the IPO has been reported as $4.75 Billion.

Moving down the chart: Blackstone Group via purchase from the insiders (the left top oval on chart) using IPO proceeds has become the sole general partner of two partnerships (the smaller triangles one tier below Blackstone Group on the chart) and the sole owner of three entities treated as corporations (the 2 rectangles also one tier below Blackstone Group - one of the rectangles contains 2 corporations) through which management fee and carried interest income from the group's investment funds will flow. Think of these two partnerships and three corporations as the middle tier entities.

Moving to the bottom of the chart: the middle tier entities serve as general partners of five fund limited partnerships (the 5 triangles on the lowest tier of the organizational chart) and the middle tier entities have a 22 percent share of each lowest tier fund limited partnership. The insiders (left top oval - sorry you have to jump back up to the top of the chart) retained a 78 percent economic interest in the management and carry fees generated from the lowest tier limited partnerships.

When Blackstone Group (biggest triangle) bought interests in the management companies (middle tier entities) from the insiders (top left oval), the basis in the tangible and intangible assets of those middle tier entities was immediately increased (using something like Section 732 of the Internal Revenue Code or Section 1012 of the Internal Revenue Code, or Sections 743(b) and 754 of the Internal Revenue Code) by the purchase. This, without more, would have entitled Blackstone Group (biggest triangle) to larger deductions for depreciation of tangible assets and amortization of intangible assets, notably goodwill (about $3.7 billion to be written off over 15 years). [Basis can also be increased in the future by the insiders exchange of their 78% economic interests in the fee and carried interest stream from the lowest tier entities (with an Internal Revenue Code 754 election in effect) for interests in Blackstone Group, the public company]. However, for reasons I will next explain, the lion's share of these larger deductions did not flow through to Blackstone Group (again, at risk of hammering the reader, the biggest triangle).

Go back to the middle tier companies: two of these (the left rectangle) are US corporations. This means that they are technically liable for annual income tax (since a corporation's tax income, losses, deduction, and credits do not flow through to its owners, corporations can be thought of as "blocker" entities) which they can reduce by the annual amortization of their share of the goodwill. This future tax reduction benefit is referred to as a "tax receivable".

A corporation's tax receivable can be sold and that is precisely what happened here. The US corporations (the left mid tier rectangle) entered into a tax receivable agreement with the insiders (the upper left hand oval) to pay the insiders 85 percent of the cash savings that the corporations will realize as the result of amortization (the 15 year write off) of increases in tax basis of assets and other tax benefits, including any associated with the tax receivable agreement itself. Some sources have indicated that this savings is expected to be about $1.1 Billion.

Here is the magic: the value of the tax receivable will seemingly be taxed to the insiders as part of the compensation received from the sale but at the infamous (as favoring the wealthy) 15% rates applicable to capital gains. However the tax benefit from the goodwill amortization will save the blocker corporations future taxes at 35% rates, 85% of which savings will get paid to the insiders under the tax receivable agreement. This has been referred to as a "tax low, deduct high" strategy. Moreover, on account of their retained control the insiders may be able to accelerate some of the tax benefits through disposition of blocker corporation assets bearing the goodwill.

A recent New York Times article (July 13, 2007) indicated that the present value of the insiders' share of tax benefit from the tax receivable would outstrip the taxes paid by the insiders on the IPO sale cum tax receivable agreement by $198 Million. That has set off a maelstrom with the pols, the pundits, the businessmen (e.g. Blackstone saying the Times article was "filled with inaccuracies, myths and misrepresentations that give a false impression of Blackstone's tax situation and that of its partners" such as failing to note that the tax benefit of the tax receivable would be taxable to the insiders as paid to them and allegedly lowballing the discount rate in valuing the tax benefit and hence allegedly overstating it) , and John Q. Public all getting in on the fray. Hopefully, this article will, while not resolving the fray, at least have given those who took the time to work their way through it a much more solid understanding of the facts behind it.

SEC Delays Action on Increase in Accredited Investor Minimum Net Worth Standards

An SEC proposal to provide tougher qualification standards (having at least $2.5 M in investments exclusive of equity in a home) for individuals investing in private hedge funds and other private alternative investments has proved to be so controversial that the SEC may have to alter the plan or abandon it altogether. Or at least that is the assessment of industry observers about the proposal, which was first introduced in December, 2006 by the SEC.

The SEC last week approved another part of the proposal asserting its anti-fraud authority over all pooled-investment funds, including hedge funds, private-equity funds and mutual funds. However, the SEC indefinitely delayed action on the part of that original proposal that would raise wealth qualifications for individual investors in private-investment pools.

Past that, at least so far, the SEC is being close mouthed about its intentions.

One possibility is an adoption of a middle ground standard higher than the current standard [>$1m net worth inclusive of home or past 2 yrs income >$200K/yr ($300K with spouse) with expectation of reaching that level in current year] but lower than the proposed $2.5M or more in investments standard. For example, some have speculated that the SEC might use $1.5M net worth prong of the "qualified client" standard currently used to determine when an SEC registered investment adviser can charge performance fees.

Personally, I would not declare the increase in individual "accredited investor" standards dead yet  - not by any means.   Abandonment seems far less likely than, perhaps, some toning down of the proposed standards.

New Tax Salvo Fired at Hedge Fund Managers

Montana Democrat Max Baucus, and Iowa Republican Charles Grassley,  senior Senators and members of the Senate Finance Committee are at it again.  This time their guns are trained at publicly traded hedge funds.  The catalyst for pulling the trigger is the proposed IPO (initial public offering) of hedge fund operator Blackstone Group.

The Senators wrote a letter yesterday to Henry Paulson, the Secretary of the Treasury, critical of the tax treatment of incentive compensation received by hedge fund managers.  This income is currently often received as a dividend or capital gain and taxed at favorable 15% rates, as opposed to the 35% rates, or so, paid on ordinary income.  Moreover, the entities in which the business are conducted are almost invariably treated as private partnerships for tax purposes for which, unlike in a corporation, there is no entity level taxation.

The essence of the letter is that IPOs of hedge fund operators come under the rules for publicly traded partnerships (PTP) under section 7704  of the Internal Revenue Code.  Under this section, a PTP is taxed as a corporation unless 90% of its income is  "passive".

Grassley and Bacchus argue that since these funds are primarily engaged in the business of providing asset management and financial advisory services that their income is "active".  Hence, their incentive fees should be taxed as corporate income at corporate income tax rates of up to 38%.  Of course, if these fees were paid out currently as salary the corporation would receive a deduction but the income would be taxed as salary at the 35%  ordinary income rates to the individual recipient - not the favorable 15% rate for capital gains or dividends.

There is broader concern that this principle may be extended to try to convert incentive fees of all hedge fund and private equity managers to ordinary income.  However, since very few hedge funds or private equity funds (in fact only about 2 or 3 so far) are publicly traded partnerships some means other than that cited in the Grassley Baucus letter will need to be found.

Morphable Shares (Hiding Voting)

Yesterday I wrote about empty voting - being able to vote shares without having an economic interest in the issuer of the shares or with having only a relatively miniscule interest in the issuer.

Today I will discuss pretty much the opposite: morphable shares which involves having an economic interest in the share issuer while not have a voting interest but pretty much having a "right" to get a voting interest.

This functions again largely through the swaps markets. A person who is long a swap is in the economic position of a shareholder but does not have voting rights. However, the counterparty who is short the swap pretty much invariably hedges the short position by holding an equivalent amount of the underlying security with the tantamont voting rights. (In fact, if the counterparty votes the shares it pretty much is an instance of "empty" voting as we discussed yesterday as the counterparty really has no economic interest in the issuer.)

However, what can often happen is that the party in the long position, at a given point in time (e.g. the date for being a shareholder of record for a critical vote)  "morphs" the long swap position into a voting position by terminating the swap and acquiring the shares of the underlying security held as a hedge by the counterparty. Then, surprise, surprise the hithertofore unknown voter surfaces as a major player in, for example, a proxy fight.

This technique was employed by Perry Corporation which at one point had been a major disclosed shareholder (under New Zealand law) of Rubicon Ltd., a public New Zealand company. Perry offloaded 31 million Rubicon shares to 2 derivatives dealers and simultaneously took a long position in the shares in an equity swap with the dealers. This arguably put Perry's voting position in Rubicon below the 12.5% of Rubicon at which it would have been required to be disclosed under New Zealand.

Low and behold, to the surprise of all (well almost all), Perry reacquired the Rubicon shares by unwinding the equity swap just in time to vote (with a 16% position) at a key annual meeting to be held by Rubicon. In ensuing litigation, Perry lost the battle (at trial) but won the war (on appeal).

The reason this "works" in practice is that as an economic matter in thinly traded issues, which virtually all of these situations involve, the equity swap counterparty in the short position virtually always has to cover by being long the underlying security. In turn, when the party in the equity swap long position wants the vote it makes market sense for the counterparty to agree to unwind the swap and "sell" the underlying security back.

Does it work legally? Yes, general opinion is that in most countries (likely including the US) it does.

Empty Voting - Activist Funds

Things are not always as they seem to be. It used to be that a vote in a company meant the person entitled to the vote had a certain quanta (pro rata to his vote) economic interest in the company. However, activist funds (and others) may use "empty voting" to acquire voting interest in a target company without having any actual economic ownership or with very limited economic ownership far less than their voting position.

There are a  number  of  ways  to  unlink votes  from economic ownership. One method relies on the share lending market, which lets one  investor  “borrow” shares   from  another.  Under  standard lending arrangements, the borrower has voting rights but no economic ownership, while the lender has economic ownership without voting rights. Think short sale without the sale - just with the borrowing. A second approach employs an equity swap, in which the person with the long equity side (the “equity leg”) of the swap acquires economic ownership of shares (but not voting rights) from the short side  (the “interest leg”). The short side often hedges its economic risk by holding shares, thus ending up with votes but no net economic ownership.

Empty voting can also be used to multiply the  voting power of  an existing long ownership position. For example, a shareholder can borrow shares just before the record date for a shareholder vote, and then reverse the  transaction afterward. Other tactics used are so-called zero cost collars and variable pre-paid forwards.

The zero cost collar essentially involves holding an underlying security long, shorting (selling) a call with a strike above the market value of the underlying security for $x premium and being long (buying) a put with a strike below the market value of the underlying security for $x premium. It essentially reduces the economic risk of holding the position to the range between the two strike prices.  For example, assume the a person's basis in the stock is 10 and the stock has a current fair market value of 100. The person could buy a put at 90 (which limits his/her downside risk to 10) and sell a call at 110 (which limits his/her upside to 10).

Under a variable forward arrangement, a person with a substantially appreciated equity position, enters into a contract (typically with a bank) that economically resembles the collar, i.e. a combination of a sold call and purchased put. The difference is that the settlement is permitted to be made in shares. Specifically, using the example above, if the share price at maturity was below 90, the person would deliver one share, between 90 and 110, the client would deliver shares with a value of 100 and if the share price was greater than 100,the client would deliver a number of shares to the bank that allowed the client to recognize the value of 10% appreciation. Often, the bank writing these contracts will then make an upfront payment on the contract (usually no greater than 85 on the numbers used in the example). When there is an upfront payment, the transaction is known as a “variable prepaid forward contract.”

The essence of these collar and variable forward transactions is that those employing them, typically managers and controlling shareholders, retain formal ownership of shares while getting rid of some or most of their economic ownership. Although typically used in the US as tax deferral techniques these can be readily adapted for empty voting.

A 2004 public instance of empty voting illustrates the potential risks from empty voting. Perry Corp., a hedge fund, owned 7 million shares of  King Pharmaceuticals.   In late  2004, Mylan Laboratories  agreed to  buy King in a stock-for-stock merger at a  substantial premium, but Mylan’s  shares  dropped  sharply when  the deal was announced.  To help  Mylan obtain shareholder approval for the merger, Perry bought 10% of Mylan, becoming Mylan’s largest shareholder. But Perry fully hedged the market   risk associated  with its  Mylan shares. Perry thus had 10% voting ownership and zero economic ownership.  Including its position in King, Perry’s overall economic interest in Mylan was negative. The more Mylan (over) paid for King, the more Perry stood to profit.

When Perry filed its 13D it disclosed the 10% ownership of Mylan but not the offsetting hedge. A company named Hugh River which was controlled by Carl Icahn opposed the merger. He bought suit on an alleged 13D violation and eventually the case was settled.

That being said it is far from clear that empty voting techniques are illegal. Classic corporate legal theory prohibits vote selling by transferring voting rights to a vote buyer. However, many of the techniques discussed above don't involve vote selling. Moreover, on the disclosure front, 13D (and 13G) were written in the 1970's  before swaps and OTC derivatives existed and other disclosure rules (e.g. Section 16, 13F and mutual fund rules) don't quite cover the "empty voting" waterfront either. In short the consensus is that there are plenty of holes in the disclosure system.

Next, the flip side of "empty voting" - morphable (hidden) ownership.

Beware the Small Business and Work Opportunity Act of 2007

OK - this one isn't law yet. It's a bill pending in the Senate introduced on 1/22/07.

One (of a host of items)  basic effect, if passed, will be to cap annual non-qualified income tax deferral to the lesser of (i) average of last 5 years compensation or (ii) $1 Million. Yes, there is a provision adjusting in the case where there is not 5 years of compensation.

This will set the hedge fund manager world on its ear if passed. Successful hedge fund managers who are generally sufficiently well advised to navigate the infamous Sec. 409A of the Internal Revenue Code - another nightmare of tax complexity - are accustomed to deferring way, way over $1 M per year. So this bill is not going to make them happy campers - if it becomes law.

The slated effective date is now (i.e. for tax years beginning in 2007). Folks who've overcooked their 2007 deferral election will apparently be allowed to remedy it down to the mere $1 M.

So us legal types will be keeping our eye on it. Currently the bill (S. 349) is on the Senate legislative calendar. The rumor mill says that this one has "legs". We shall see.

GAIM Day 3

Last day of GAIM today.

Lots of activity in the AM but late afternoon sessions were cancelled. Not so nice for the tail end speakers. Of course, the rule of thumb is that you don't want to be speaking toward the tail end of any conference. Still cancellation before the scheduled time? Plus the workmen for the venue were tearing the joint down when conferences were still scheduled. So....all kinda weird.

So anyhow from today's notes:

Big funds - trouble with returns (too low).

Asia Pacific - why go there:

• values from inefficient markets
• far less sell side analytical coverage - takes pressure off interim short term earnings
• no Reg FD
• not correlated to US
• even easing up on shorting restrictions

Wilbur Ross - Sort of the King of Distressed

• heavy due diligence process before they go in
• lots of foolish $$ in the distressed biz
• low defaults are masking overbought conditions
• sees default doubling or tripling in 2007 and again in 2008
• sees all time hi in Chapt XI in 2009

Predictions/comments re Hedge Fund Regulation:

• general sense the regulators don't know really how to do the job
• admiration expressed for UK approach to regulation
• expects that some type of risk reporting will emerge, e.g. a leverage metric, a liquidity metric
• more calls for regulation seen as forthcoming in 2007

There was a whole session devoted to increased correlations of hedge fund returns with broader market returns. Some of the factors giving rise to this were deemed as structural (long term) and others as cyclical (short term). For now this is a bit of an issue for the industry.

There was a session on some of the big brokerages making hedge funds available for their customers. Sounds like very early days for all of them - and it really sounds like quasi-mutual funds.

One theme that does arise - the big hedge funds are not interested in "small" retail investors - read that as a $5M order or less.

There were a few legal type topics discussed in the afternoon sessions. I am going to defer discussion of some of them.

There was however a very interesting discussion of fees. The bottom line is that the standard 2/20 is probably pretty negotiable.

A few fee pricing drivers are worth noting:

• quant/black box stuff which sort of runs itself get lower fees
• active alpha producing strategies call for higher fees
• side letters - a big investor can cut a deal for a lower fee than other investors through a side letter - however, this scares the lawyers (like me!!)
• lock ins call for lower fees than more liquid situations

Creative fee structures:

• lower fee (or no fee) for beta - this is a little controversial since beta is often arrived at synthetically through derivatives - which require some skill/capacity to set up
• higher fee for alpha - issues here will focus around metrics - i.e. how do you know its alpha (Sharpe ratios? Information return? etc.)

All in all an interesting day and a good (if not without flaws) conference.

GAIM Day 2

Here's todays report (from my notes). Heard today:

Bonds don't have tail events (c.f. Enron)

Go for brick (brazil, russia, india, china) - cynics say brick is finished.

Hedge fund replication is a crock.

Need to know how to pay for alpha/exotic beta. Don't pay for garden variety beta.

US stocks and bonds vastly overvalued.

A few niches FOFs (funds of funds) are looking at: reinsurance, "bricks" (see above), commodities, private equity, direct lending, the activists.

Alpha, alpha, alpha - catch it if you can.

Pensions and endowments - looking to hedge funds for alpha.

Risk budgeting is replacing asset allocation.

Decompse your risk.

Spain is dipping its toes into hedge funds - seems not really ready yet - unions are big market drivers.

The new Fair Value measurement rules - hedge fund folks you need to learn what Level 1, 2 and 3 assets are. Avoid Level 3 if you can. Effective for fiscal years beginning after 11/15/2007.

Structured credit - incomprehensible.

New fund looking for seed capital? If you can't miss and will let us run you we might be able to do business.

The rouble is going through the roof vs. don't trust anything in Russia.

And now a few editorial comments:

Not to knock it - lots of smart people - but invariably the best money managers go to the big big money investors.

Thus, your average Joe millionaire (soon to be Joe $2.5M sans house) probably will in fact do best being extremely cautious in dealing with hedge funds.

The big investors ($1B and up) are maybe putting up to 15% of their portfolios into this and they are getting the cream of the managers. There are niches for small investors of course  (outside of FOFs) but it's going to be in very risky stuff with unproven managers.

However, if you start small - 5% of your portfolio (this is $125K if you are worth $2.5M liquid) in, for example, a good FOF you just might get some alpha or at least exotic beta for your management fee.

Caveat: I am not an investment adviser. This is a free non-professional (as to investment advice) blog. I hope to entertain my readers and pass along some of what I heard today. Any enlightenment given is purely coincidental. My opinions in today's blog are purely those of a private investor.