Investors who have their money with hedge funds like Point72 could be blindsided by a surprise tax liability, according to a new report from Bloomberg. LPs across the hedge fund universe could be affected by deductions that most businesses used to be able to take for the interest they pay on loans.
When the IRS released hundreds of pages of proposed regulation last month, it became clear that these deductions would be limited to hedge funds who were performing well - and that since most hedge funds have had a poor year, their tax bills might increase as a result. Those are costs that are likely to be passed on to each fund's limited partners.
David Miller, a tax lawyer at Proskauer Rose LLP stated: "The rules create the worst possible situation".
This impact is just one of the many unexpected changes that both corporate and private taxpayers are learning about as the IRS issues "thousands of pages" of new regulations to implement new tax law.
However, the private equity industry was able to hang onto tax breaks for carried interest. The new law extended the period required for managers to qualify for a lower rate on their investment profits, instead of simply killing the break.
Hedge fund investors will likely be surprised when they get their tax forms early next year. There will be new lines for calculating interest expense that weren’t previously there. Funds that rely on borrowing money to make their bets will see the biggest impact. Funds now can only deduct these costs if they have had strong performance and have generated enough income against which to take the deductions.
And the timing for these changes is awful. Hedge funds have been widely underperforming, overall down 3.62% this year through November. Because they won’t meet the income and performance thresholds necessary, the underperformance will result in a "double whammy" where performance lags at the same time that expenses rise. Hedge funds more focused on buy and hold strategies are not affected by the deduction cap. Also exempt from the deduction cap are businesses with gross receipts of less than $25 million.
For certain, those who invest in Point72 are potentially at risk. It had $13 billion in client assets and $71 billion in regulatory assets under management as of last month. The fund was down about 5% last month, which offset its 2018 gains.
Trader funds that use leverage could balance interest income and expenses so that their investors won’t see too much of an effect, but because many hedge fund managers have lost money this year, the shockwaves could still be profound. The $3.2 trillion hedge fund industry has seen investors pull out $68.8 billion since the beginning of 2016. We recently noted that these outflows were accelerating over the last few months.
And the continued effect of these new tax laws could get worse moving forward. For now, companies can deduct interest cost up to 30% of EBITDA until 2022. After that, it changes to 30% of EBIT, excluding depreciation and amortization.
Like many things involving the IRS, there wasn’t a lot of clarity on the law until it was actually released.
Simcha David, a tax partner at accounting and advisory firm EisnerAmper stated:
“It’s really the limited partners that seem to get screwed here. I was completely shocked.”