Dodd-Frank Act Title XVI (f) (2): Hedge Fund Tax

Dear hedge fund manager,

Please rate, on a scale of  1-10, your company’s importance as a source of credit for low-income, minority, or underserved communities and the impact the failure of such company would have on the availability of credit in such communities;

Here it is then. A punitive tax on large hedge funds in the US.

Fund managers with more than $10bn in AUM are to get hit by a new levy in the Dodd-Frank act (nee Volcker rule[s]) to help raise $19bn in compensation for the financial crisis.

Subject – of course – to an assessment of their systemic risk and value to society, calculated around the following parameters (click to enlarge):

In all likelihood, the tax will be something most managers with more than $10bn in AUM will absorb fairly comfortably.

Take the accounts of a fund manager like Brevan Howard, for example (domiciled in Guernsey, but instructive as an example of a big manager’s income mechanics).

Though the BH fund managers’ profit, as a company, is slim, that’s largely because the bulk of its income is paid out to its owners (in this case, Alan Howard). That payout can vary at the discretion of its board. Costs for Brevan Howard Fund Services were £282m in in the year ending 31 July 2008. Costs for the year ending March 2009 were lower, at £67m. The reduction reflects – almost wholly – a drop in the amount of money BHFS remitted to Brevan Howard Employment Services – a vehicle Mr Howard also controls. In the 2008 year BHES was paid £173m for the secondment of Mr Howard, in 2008, £729,134.

The point being that there is plenty of room in the cashflow of BHFS to accommodate a levy – be it ultimately borne by the fund manager, or else the funds’ investors.

All of which isn’t to say the tax isn’t wholly unwelcome, but rather that it ultimately depends on the amount. About which there are reasons to be sanguine.

The newly enfranchised Council for Financial Stability – the job of which it will be to set and oversee the collection of the levy – will be given discretion over the application of the tax-assessing “risk matrix”. Well-reasoned appeals from fund managers’ general counsel will likely help to avoid too much pain for the 20 or so hedge funds affected.

After all, while most hedge funds don’t profess to be extending credit to the needy, they can claim to have had very little to do with the financial crisis. And these days, they tend to be using their guile to make money for peoples’ pensions, rather than just enriching the already-wealthy.

Net, its perfectly feasible to argue that the Dodd-Frank act is a very good thing for the alternative asset industry. The restrictions on banks’ prop trading activities could well end up being one of the biggest gifts regulators have ever bequeathed  hedge funds.

Take a strategy like convertible arbitrage. In 2004, the average con arb fund returned 1.18 per cent, according to HFR. In 2005, it lost 1.86 per cent. In 2006, it made 12.17 per cent, in 2007, 5.33 and in 2008 it lost 33.73 per cent.

Pretty crummy. But then, those years were dominated by the rise of banks’ prop trading activities – a shift in the market that squeezed convertible arbitrageurs hard and narrowed their returns to the point where assets began shrinking well-before the financial crisis hit. The AUM of the convertible arbitrage sector rose every year from 1990 to 2004. Thereafter it shrunk, as returns flatlined and yield-hungry investors redeemed.

In 2009, though, the average convertible arbitrage fund returned 60 per cent. With prop desks knocked out of the market, the pricing inefficiencies and arbitrage opportunities were myriad.

The Dodd-Frank act is good for the industry in another sense too.

It will hit only the very largest managers. In comparison, something like the EU’s AIFM directive will hit smaller managers hardest. There is a competitive advantage in being big in the hedge fund industry because the costs of compliance are more easily absorbed. The Dodd-Frank provisions will have the opposite effect by lowering the competitiveness of the very biggest players, which can only be a good thing.

Related links:
Dodd-Frank, Titles I thru XVI – FT Alphaville
Washington’s hedge fund tax – FT Alphaville
Emotional finish to Wall St reform marathon – FT
War on banks unsettles hedge funds – FT