It probably has something to do with taxes. Democrats in Congress proposed new legislation to tax the "carried interest" partners earn through their 20% incentive fee. The legislation seeks to treat the fee as ordinary income rather than capital gains, effectively raising the tax rate due on such income to the 35% ordinary corporate income rate from the 15% capital-gains rate currently paid.
This incentive fee is key to the existence of private-equity and hedge funds. It's the lure that has drawn so many MBAs into the field. Now, if Congress were to pull the rug out from under the current setup, it would significantly alter the economics of the business and perhaps even the liquidity of the total market. First and foremost, it might lead many more managers to cash out of the business now through IPOs, rather than continue to operate without the benefit of lower tax rates.
The bill in Congress, also known as the "Blackstone Bill," is currently focused on private equity, but it could easily be tailored to affect hedge funds as well. The threat of this legislation is one primary reason why there haven't been any follow-ups to the IPO of Fortress Investment Group (NYSE: FIG) to date.
But things could change quickly now.
The beginning of the end?If private hedge-fund managers are forced to pay the higher tax, it could cause many managers to move on to the next opportunity. That would means a likely increase in the amount of public hedge-fund companies in existence and a reduction in the amount of funds in aggregate. At the end of 2006, total assets managed by hedge funds were approximately $1.9 trillion, according to a report from Institutional Investor. Still, despite the 24% growth in assets that hedge funds managed in 2006 (excluding fund-of-fund assets), we may be nearing a peak in the trend, thanks in part to Congress and its new bill.
Indeed, some funds are already moving in that direction. Earlier this week, the partners of GLG Partners LP, a giant European hedge fund, announced plans to capitalize a portion of their interests in the business. GLG is doing it in a different way, but the result is similar: a transfer of ownership to the public. It's engineering a reverse takeover with Freedom Acquisition Holdings (AMEX: FRH) by which GLG will receive $1 billion in cash and 230 million shares of Freedom's common stock. After it's all said and done, GLG equity holders will still own a 72% majority of the combined company.
The surviving hedge funds may struggleWith a reduced incentive to perform, the public funds that come to market could generate less productive performance. That's because when a fund comes public, its managers have to share the incentive income with shareholders, in addition to paying potentially paying higher taxes to Uncle Sam. With less money landing in their pockets, managers might not burn those same profit-generating midnight oils that they have in recent years. The best of the best may simply move on to greener pastures and leave less qualified managers in their place.
Finally, if the incentive of the funds is affected, the P/E ratios of the firms that trade on the public market should trend much closer to those of traditional money managers than they do now. Currently, Fortress trades at a P/E of about 20 times the 2007 consensus estimate of $1.13. That compares with P/Es of 9.8 times the fiscal 2007 estimate for Goldman Sachs (NYSE: GS) and 22 times earnings at T. Rowe Price (Nasdaq: TROW). Wall Street analysts typically measure the ratio of price to assets under management when comparing firms. By this metric, Fortress is much more expensive than its established counterparts. Based on recent figures, T. Rowe Price trades at less than 4% of assets under management, compared with 25% for Fortress.
One might argue that especially if the legislation is passed into law, the traditional managers such as Goldman and T. Rowe may have a much more compelling offering relative to valuation, when taking into account their years in operation, portfolio managers' experience, and diversification of assets. This Fool thinks it might be time to follow private-equity and hedge-fund managers out of the business rather than to buy their stock.
