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8 Jun 2010

House Bill on Carried Interests may Affect Hedge Funds

HedgeCo News - The House of Representatives recently passed legislation pushing back the effective date of a proposed tax increase on hedge fund managers which would prevent a portion of their income realized from carried interests in investment partnerships from being characterized as capital gain.

This provision would increase the effective tax rate for fund managers with respect to the portion of their compensation they receive as a "carried interest". An earlier version of the bill had a Jan. 1, 2010 effective date which has now been moved to Jan. 1, 2011.

"As one of the revenue offsets for these extensions, the bill would generally prevent a portion of any income with respect to carried interests in investment partnerships held by service providers to such partnerships (“investment service partnership interests”) from being characterized as capital gains." Federal income taxation specialist at RK&O Kenneth E. Werner, said, "Instead, such portion (50% for tax years beginning before January 1, 2013 and 75% thereafter) would be treated as ordinary income."

The term ‘investment services partnership interest’ means any interest in a partnership which is held by any person if it was reasonably expected that such person (or any person related to such person) would provide a substantial quantity of any services in the nature of advising as to investing in, purchasing, or selling any specified asset, managing, acquiring, or disposing of any specified asset, arranging financing with respect to acquiring specified assets, or any activities in support of the foregoing.

The term “specified asset” means securities, real estate held for rental or investment, partnership interests, commodities, or options or derivative contracts with respect to any of the foregoing.

Hedge Funds Down -2.99% In May

The Hennessee Hedge Fund Index declined -2.99% in May (+1.57% YTD), while the S&P 500 decreased -8.20% (-2.30% YTD), the Dow Jones Industrial Average declined -7.92% (-2.79%), and the NASDAQ Composite Index fell -8.29% (-0.53% YTD). Bonds advanced, as the Barclays Aggregate Bond Index increased +0.84% (+3.74% YTD), due to increases in U.S. Treasuries as both Investment Grade and High Yield bonds declined.

“May was the worst month of the year for hedge funds and the worst monthly drawdown since October 2008. However, hedge fund managers avoided significant losses and outperformed traditional benchmarks on a relative basis due to conservative exposures, hedging and short positions,” commented Charles Gradante , Co-Founder of Hennessee Group . “In May, we saw investors significantly de-risk portfolios as volatility increased. Given the negative headwinds that exist and potential global crises, hedge funds continue to operate with low gross exposure levels as they navigate an increasingly challenging investment environment.”

“Hedge funds’ defensive positioning prior to May helped limit losses and provided downside protection,” said Lee Hennessee, Managing Principal of Hennessee Group . “Downside protection is the primary benefit of the hedge fund asset class. In the current environment, where investors seem to be very skittish due to higher volatility and dramatic drawdowns, downside protection and hedges are extremely beneficial. We are seeing hedge funds garner continued interest by the investment community desiring lower drawdowns.”