Live fee, or die?

Private equity and hedge fund professionals are masters at structuring and restructuring cash flows, and these skills have been put to great use in maximizing the utility of their most beloved cash flows, partnership fees.

In particular, management fees figure prominently in the limited partnership agreement as mechanisms for solving complex problems. For example, these fees can be offset as a means for ?sharing? deal fees with investors; management fees can be ?contributed? to a capital account as an efficient way of bolstering the GP's commitment to the fund; and performance and management fees from hedge funds can be deferred and rolled into a manager's capital account tax free, creating a tax efficient way for these managers to sink their paychecks back into their own funds.

Not all members of the US Congress appreciate the nuanced explanations for these structures, particularly the structures that can be roughly characterized as deferred compensation. Now Congress is considering changes to the tax code that could affect all three of the structures mentioned above.

With regard to management fee offset arrangements, Congress is not currently considering changes to this scheme. Now the bad news ? Congress is considering changes that would negate private equity management fee fund-contribution schemes, as well as dramatically hike the tax on hedge fund compensation deferral techniques.

Management fee offsets
According to Mary Kuusisto, a Boston-based tax partner at law firm Proskauer Rose, Congress is unlikely to take a negative view of current LP management fee offset arrangements because, from a tax revenue perspective, ?The government wouldn't get much out of? a rule change.

Management fee offset arrangements will be familiar to any firm that ?shares? transaction fees with limited partners. This partnership term is very common in the buyout market, but not widely used in the venture market, where charging fees to portfolio companies is rare.

According to Kuusisto, the structure was originally devised as a way to benefit limited partners without exposing tax-exempt LPs to unrelated business tax income (UBTI) or, for foreign LPs, to effectively connected income (ECI).

How much of the transaction fees generated by the GP get shared with the LP is a point of negotiation between these parties to the partnership. Kuusisto says market terms for buyout funds tend to be 80 percent of these deal fees going to the LPs and 20 percent remaining with the GPs. From an administrative standpoint, the way this structure works is that when transaction fees are taken, the amount ?owed? to the limited partners is simply deducted from the amount of management fees owed by the limited partner.

In some cases, the fees generated from the portfolio companies in a given year exceed in value the management fees for the year, a scenario that can produce ?carryover? that is used to offset management fees the next year. However, some tax-sensitive LPs actually request that GPs keep any carryover, out of a fear that the carryover might be deemed evidence of fee-sharing, and therefore trigger UBTI or ECI.

Any fees earned by any member of the general partnership, including directorship fees, must be reported and remitted to the management company, according to most limited partnership agreements.

Hedge fund tax deferrals
A policy issue being followed with high anxiety by hedge fund tax experts is that of deferred compensation, which was among the subjects of a hearing before the US House Ways and Means Committee on September 6. As explained in the testimony of Daniel Shapiro, a London-based partner at law firm Schulte, Roth & Zabel, many hedge fund managers will elect to defer they payment of management fees and incentive fees, in so doing putting these proceeds, pre-tax, back into their own funds.

According to Shapiro, ?the deferrals buttress the continuing alignment of interest between the manager and the investors.?

When these deferred amounts are finally received at the end of the deferral period, they are taxed at the full rate of 35 percent. Along the way, noted Shapiro, ?the deferred amounts? are subject to the risk of loss in the event of future adverse investment performance??

However, a proposal from Rahm Emanuel, a member of the House of Representatives, would place exceptionally low caps on the amount that hedge fund managers of offshore vehicles may defer tax free each year. The proposed amount is $19,500, equal to what most US citizens may defer into individual retirement accounts.

Emanuel's proposed tax legislation follows an earlier Senate Finance Committee proposal to amend Section 409A of the US tax code such that the amount of income a taxpayer may defer each year is equal to the lesser of $1 million or the average annual compensation paid to the individual during the preceding five years. That proposal, which was dropped, was aimed squarely at hedge fund compensation deferral schemes.

?Deemed contributions?
One mechanism used by many private equity GPs, which is also of interest to Congress, is so complicated that it very nearly has no name.

According to an attorney who has worked on the issue, ?Nobody knows what to call it.?

?It? is the process by which GPs turn management fees into their capital commitments to the fund. Many in the industry view it as a tax-efficient means by which a general partner without a significant amount of capital to commit to his or her own fund may build such a commitment.

The technique has been called a ?cashless contribution,? ?management fee waiver? and a ?deemed contribution mechanism,? or DCM.

Put simply, a DCM agreement allows the GP to take a lower management fee in exchange for receiving a proportionately larger share of the carried interest. In practice, the LPs, instead of paying, say $4 million in management fees, agree to ?give? the GPs $4 million in excess profit, which may or may not materialize. Because payment of this ?fee? is not guaranteed, as is a management fee, advocates of the DCM argue that it should be viewed in the same light as carried interest. Some in Congress see it as a way of converting ordinary income into capital gains.

?You could say that instead of getting two and twenty, I get 1.95 and 20.05,? says a tax source. ?If you said it that way nobody would care. But you can't say it that way.?

Another legal source said the issue of DCM is ?very, very sensitive,? and that a number of his private equity clients use it.

At last month's congressional hearings, an observer says there were some questions from lawmakers about DCM, but no indications that any further movement on the topic is pending.

Charles Rangel, the head of the House Ways and Means Committee, which controls tax legislation, has reportedly said that he expects his committee to ?soon? pass a major tax bill.