It’s a zoo out there in buy-out and hedge-fund land. First, private equity groups were labelled “locusts” in Germany. Then just recently, Japan’s financial services minister described hedge funds as “piranhas”.
At least some Japan-focused hedge funds might see some respite from a perceived regulatory crackdown by Tokyo following Wednesday’s resignation of Japan’s prime minister, Shinzo Abe and the impending reshuffle of his rather shell-shocked Cabinet.
Only last week, Yoshimi Watanabe, Japan’s newly appointed (and now possibly outgoing) financial services minister, used the “piranha” analogy and warned that the government would strengthen monitoring of hedge funds under a new law coming into force from the end of September.
Although he stressed that heightened monitoring would not amount to an offensive against hedge funds, the government’s decision to introduce the Financial Instruments and Exchange Law (FIEL) has spooked many foreign hedge funds operating in Japan. The new law extends to all financial organisations, requiring full compliance with all legal and licensing requirements for financial institutions in Japan.
It is not ostensibly a tax law, but foreign hedge funds fear that tax – and paying lots of it – is the bottom line. There has been a long-held view in foreign hedge fund circles in Japan that the perfect way to run a Japan-focused fund is to be registered in the Caymans; run your trading and administrative activities out of Singapore or Hong Kong; and keep your analysts and some middle-managers in Tokyo – and possibly your overall chiefs, if they happen to like sushi.
Thus, many foreign funds operate in what could kindly be called a “grey area” in Japan, saving themselves a lot of tax by calling themselves “investment advisers” – anything but “hedge fund” – and keeping their main operations (and their profits) off-shore. Having to regularise their operations and report their financial ins and outs to Japanese regulators could expose them to vastly increased tax obligations.
The hype about the law is just the latest problem for this shadowy but wealthy little community. As the FT’s Michiyo Nakamoto notes in a report earlier this week, Japan’s financial watchdog has been at pains to send the message that it welcomes foreign funds, “but hedge funds, in particular, have not received a warm reception in the country over the past year”.
A widespread campaign among Japanese corporations to adopt poison pills thwarted the attempts of many activist hedge funds to realise value from their Japanese investments, she says. “Companies are also increasing cross-shareholdings to discourage unsolicited takeovers by funds and business rivals.”
“And when managements have been criticised by foreign funds for poor performance, most domestic shareholders have rallied behind their countrymen to vote against proposals to raise dividends or otherwise improve returns.”
Meanwhile, the courts have taken an unsympathetic view of the most aggressive funds: Steel Partners, run by American activist fund manager Warren Lichtenstein, had sought to take over BullDog Sauce, a condiment maker, but was recently labelled an “abusive investor” by the Tokyo High Court.
Watanabe, who leads the FSA, sent similarly unsympathetic signals even though he vowed to bring down barriers around Japan’s domestic financial markets and transform them into “a pond where fish from overseas could swim”. Japan, he said, would “provide enough plankton and food to draw fish”, adding: “However, when piranhas happen to come, we have to take them out.”
In words that could hardly be described as “reassuring”, he said: “We cannot judge whether hedge funds are piranhas until we see their teeth,” indicating that Tokyo would be scrutinising their behaviour more closely.”Those who break compliance rules will be considered piranhas, and those who do not do so will not be considered as such,” he said.
That kind of sentiment is driving a slow trickle of middle to senior hedge fund managers out of Japan, say industry sources, leaving just a handful of analysts which, under the law, has so far enabled the funds to claim a mere advisory role.
Now, however, the FSA has taken an unexpected tack in favour of the hedge funds, asking the Ministry of Finance (which is responsible for tax policy) not to expose foreign-backed hedge funds to a punitive 40 per cent tax regime in any crackdown on the legal status of foreign funds that might result from the new FIEL regime.
The FSA, reports Nakomoto, wants to amend the much-feared FIEL legislation to ensure that overseas investors in funds investing in Japan are not subject to Japan’s high tax rates.
The logic behind the FSA’s move to champion foreign funds is its desire to boost Japan’s status as a financial centre. Foreign skills, the watchdog believes, are crucial to this push. It is therefore asking that overseas investors be exempt from the so-called “permanent establishment rule”, under which they could be subject to a 40 per cent income tax if the fund is considered to have a ‘permanent establishment’ in the country.
Under Japanese law, an offshore fund with a fund manager in Japan would be considered to have a “permanent establishment” in the country and its investors would be subject to Japanese taxes, notes Nakamoto.
But most funds get around the problem by declaring themselves “investment advisers” – who purportedly do not make investment decisions – in Japan.
Their core concern now is that the incoming FIEL will enable tax authorities to crack down on funds by claiming they have a permanent establishment in Japan.
“The nuclear bomb scenario for every hedge fund is to find themselves taxable in Japan,” Stan Howard, at Teneo Partners, a hedge fund marketing company, told Nakamoto.
More controversially, perhaps, the FSA is also requesting that foreigners investing in a fund established in Japan, be completely exempt from the 40 per cent income tax.
Under the existing law, which will be more strenuously policed under the new FIEL regime, foreign investors investing in a Japan-based fund are subject to a 20 per cent withholding tax and must file a tax return and pay taxes of up to a total of 40 per cent on the profits they make. That might sound draconian but actually, it’s another grey area – in which relatively few foreign investors ever find themselves having to pay. Even large, established Japanese funds which officially operate as hedge funds have a way around these requirements.
The FSA’s request to the MoF’s budget bureau “is quite radical”, Chris Wells, a partner at White and Case law firm in Tokyo told Nakamoto.
But if foreign fund managers can be encouraged to work in Japan, their presence will stimulate the financial sector and bring in additional tax revenue in the form of income tax and consumption taxes on their purchases in the country, Wells said.
Meanwhile, to top off the uninspiring outlook for Japan-focused hedge funds, the FT’s David Turner reports on Thursday that they suffered significant losses in August, falling 2.8 per cent and erasing virtually all their 2007 gains, according to data from Eurekahedge.
The August slide, based on data from Japan funds representing just above half the net asset value of those that report performance to Eurekahedge, is much worse than the overall 1.8 per cent drop recorded for hedge funds across the world. And although the Nikkei 225 average slid 3.5 per cent in August, hedge fund analysts say this is a poor excuse for an asset class that charges high fees in return for the promise of high absolute returns regardless of market conditions. Is it, however, such a poor excuse for a bunch of “piranhas” who fear the prospect of an evaporating pond?