Hedge funds, private equity and venture capital firms have failed both in performance and in their claims of creating jobs.
As a result, the huge lobbying effort to gain preferential tax treatment through something called “carried interest,” should be revoked.
Carried interest let these hybrid financials firms pay ordinary income tax rates on their compensation at the lower rate of 20%. Closing this and other tax loopholes is being proposed as part of a tax reform package by President Obama with the goal of raising $1 trillion over the next 10 years. This is long overdue.
But the carried interest abuse is especially noteworthy since it is the result of a huge lobbying effort by a special class of new financiers, who consider themselves above-the norm in terms of their importance to society and their delivered benefits to the investment world. Maybe the fact that the 25 highest-earning hedge fund managers and traders made a combined $24.3 billion in 2013, according to Nathan Vardi in Forbes, can help explain where the lobbying money came from. But given the gross distortions in the nation’s wealth distribution, this loophole should be seriously re-examined.
First, it must be noted that this hedge fund tax loophole was never voted on as a law. It was part of a revenue action issued by the Internal Revenue Service in 1993, and originally applied to real estate transactions. According to the Slate the IRS tried to address when a piece of property was sold or traded in the future and determine how it would be taxed. The IRS called this a “realization event,” and if the transaction occurred over a year after the real estate was acquired, the tax would be considered on a long-term capital gain. When carried interest was developed, hedge funds were not popular.
But as the hedge industry developed, it also earned a special place in the hear of Robert Rubin of Goldman Sachs and Citibank. Rubin also plays a very dubious role in the 2008 market meltdown due to subprime market originations and securitization.
When Rubin, who spent 26 years as a top executive of Goldman Sachs, became Secretary of the Treasury in the Clinton administration from 1995 to 1999, he opposed the regulation of over-the-counter derivatives. He also served as chairman of the executive committee of the board at Citibank from 2007 to 2009 and his role in covering up abuses in the sub-prime mortgage department deserves re-telling. (For his work, Rubin received more than $126 million in cash and stock during his tenure at Citigroup.)
At Citi, as early as 2006, Richard Bowen, then head of Citi’s chief underwriter, testified before Congress that he “witnessed business practices that made a mockery of Citi credit policy,” as cited in the book, The Rise of the American Corporate Security State, by Beatrice Edwards. He specifically said: “I believe that these practices exposed Citi to substantial risk of loss. And I warned my business unit management, repeatedly during 2006 and 2007 about the risk—risk issues I identified.”
Bowen testified that he sent an e-mail to Rubin and the banks FCO about the bad business practices and the unrecognized losses he saw within his business unit. This later proved to be a $60 billion loss. He also requested that the bank conduct an investigation into what was happening. Rubin ignored the request. The timing of Bowen’s e-mail is important since he sent it to Rubin since Rubin was expected to be named Citi chairman by year-end 2007. Bowen also wanted to alert Rubin that he should conduct the investigation and not sign off on the Sarbanes-Oxley requirement that the bank’s internal financial controls were working properly and that all was OK at Citi.
Instead, Rubin ignored Bowen’s message and no one spoke with him in January before the approved sign-off was given for the Sarbanes-Oxley requirement. By avoiding any contact with Bowen in January 2008, Citi executives could swear that they never heard anything about the pending crisis from Bowen; a white lie, but it would work in their Congressional testimony. Not surprisingly, Bowen was dismissed around January 2008.
In his Senate testimony, no one from the SEC, Federal Crisis Inquiry Commission or any Congressmen asked Bowen or Rubin any follow-up questions about this critical sequence of events. If they did, they would have discovered that Rubin knowingly ignored off on a report he knew was false and that thousands of Citi shareholders suffered direct financial losses as a result of his negligence. The American public would also have been alerted that toxic debt instruments were circulating inside the banking system. This information did come out years later.
In an April 18, 2010, interview on ABC’s This Week program, President Clinton said Rubin gave him the wrong advice when he advised him not to regulate derivatives. Rubin, along with his successor the Treasury Department Larry Summers, both advocated the 1999 repeal of the Glass–Steagall Act (passed in 1933), which separated investment from retail banking. Allowing banks to engage in these two types of very different businesses enabled banks to develop and sell mortgage-backed instruments that became a principal contributor in the 2008 financial collapse. Later, in September 2011, the UK Independent Commission on Banking released a report which recommended a separation of investment and retail banking to prevent a repeat of the 2008 crisis.
Today, Rubin remains a welcome guest at Clinton functions and has served as a moderator for Clinton’s Global Initiatives programs, despite his dubious role in covering up major abuses at Citi and remaining silent about why he chose to ignore reports about bad business practices in a major business unit.
Just as Rubin looked the other way when it came time to oversee poor business practices at an internal Citi unit, he also looked the other way when it came time to re-visit the carried interest benefit for his friends in the hedge fund industry.
As a result of the 2008 recession, hedge funds worldwide saw $1 trillion in redemptions as a result of underperformance. This drop came after many funds claimed they could be “all-weather” investments. Instead they suffered the results of the hundred-year flood, just as Long-Term Capital Management became the victim of non-correlation and a Black Swan event in 1998 involving the default of Russian bonds and over-leverage.
Not Much Hiring
Hedge funds have also failed to deliver jobs. The latest employment statistics from the U.S. fund industry are difficult to find. One KPMG study mentioned the number of employees based on assets under management, but total figures were not available. But what is clear is that hedge funds failed to deliver after the 2008 recession and investors jumped ship. In the first half of 2014, 461 funds closed, according to Hedge Fund Research Inc. said.
The company said that if that pace continues, it will be the worst year for closures since 2009, when 1,023 funds shut their doors.
What’s more, this shock caused investors to flee the market entirely or move into the most successful funds. According to the same Bloomberg report cited above, hedge funds, on average, have returned only 2% in 2014, their worst performance since 2011. In the first half of 2014, 10 firms, including Citadel LLC and Millennium Management LLC, accounted for about a third of the $57 billion that came into the hedge fund industry. In short, fewer funds are handling more assets and I bet they are doing so without a major hiring binge.
Automation, the closing of many funds since 2008 and declining investor interest has culled the number of these alpha-seeking managers. Now, instead of hiring, many of these former bosses are looking for work themselves.
As for the VC and private equity firms, they have done about as good a job as creating new jobs as any commercial bank could if they had been better managed and had open or more liberal lines of credit.
Plus, commercial banks already have an established, recognized local footprint and are better suited and ready to provide loans to local small businesses without all the fanfare and shark-tank presentations that are required in the high-tech arena. While the VC and private equity firms consider themselves above the fray, too many of them cannot pass the transparency test with the American public. I suspect this is why Mitt Romney and Jeb Bush, both private equity executives, had a hard time connecting with Main Street when it came time to describing details about their investment activities, including off-shoring, automation and how many jobs they actually created inside the US that paid above the minimum wage.
Exaggerated Employment Claims
So despite all the exalted claims, it is not clear at all how many jobs are created in the hedge fund industry or even how many people are employed in them nationwide. One reason is that hedge funds are not supervised by regulators. If a fund has over 100 employees, it has to register with the SEC. If a fund has under 100 workers, it files with their state financial regulatory body. But no where is there any single place to find out how many people work in this industry, despite the hedge fund lobbyists’ claims that they create jobs. If they did, they certainly don’t do it in their own industry. Ironically, hedge funds which did report a hiring binge did so to meet new regulatory and transparency requirements requested by customers, according to a KPMG survey.
What is clear is that these highly-paid executives do have the lobbying cash and cache to push their own personal compensation agendas through Congress, regardless of the validity of their respective cover stories. The “carried interest” preferential treatment, based on dubious numbers, demonstrates that these firms consider themselves superior. And in the case of hedge funds, they cannot prove they are smarter than the larger, unwashed investing crowd or more importantly, have delivered better returns than most index funds.
Democrats Should Take Note
While revoking carried interest is an esoteric topic, it is a great example for the upcoming 2016 presidential election. This issue is about the abuse of moneyed privilege and the supposed benefits that one very limited class of financiers supposedly delivers for the rest of society. The only problem is that these claims cannot withstand a critical test. Even the hedge fund industry’s own trade association, the Hedge Fund Association, does not know how many people are employed in the U.S. hedge fund industry, let alone how many new jobs they create annually.
When Republican presidential candidates speak about how entitlements erode the American work ethic, stifle creativity, create generations of lazy citizens, and the abuses of regulation, carried interest embodies all of those detrimental characteristics. The only difference is that entitlements, such as carried interest, have made the tax responsibilities of the most wealthy a little lighter. As for the vast middle class which has suffered wage stagnation since the Reagan presidency, let them eat cake.
The bottom line: drop the “carried interest.” Bring the high-flying hedge fund managers back to earth and let them pay taxes like average investors.