Taxes, Hedge Funds and an Incident
The board (the “Board”) of directors (the “Directors”) of the Company wishes to inform the shareholders of the Company (the “Shareholders”) that on 4 December 2015, a truck of the Group (the “Truck”) loaded with, among other things, all original financial documents of the Group for the four financial years ended 31 December 2014 and for the current year (the “Lost Documents”) were stolen in the Qingyuan District of Baoding City, Hubei Province, China while the truck driver was taking a lunch break on his journey to transport the Lost Documents back to the Group's head office in Beijing (the “Incident”).
If you read a better sentence than that this week, you are very lucky. The defined terms alone -- "(the 'Truck')," "(the 'Lost Documents')," "(the 'Incident')" -- are pure poetry, but the narrative flow of the sentence -- starting with a banal corporate setup, foreshadowing with the ominous "among other things," slipping the ungrammatical climax ("were stolen") in between irrelevancies (the fiscal years of the documents, the precise neighborhood of the theft), and finally lightening the mood with the quotidian comedy of the driver's lunch break and the crowning absurdity of "the Incident" -- is so compelling that I recommend that you not read the rest of the press release. I guess they are still looking for the documents? Why? They have created a perfect document; the Lost Documents could add nothing to it. If I were a shareholder of China Animal Healthcare Ltd., and all of its financial reports from now until the end of time were just this sentence on a postcard, I would be content.
The New York Times published a big article yesterday about how hedge-fund managers "have financed a sophisticated and astonishingly effective apparatus for shielding their fortunes" from taxes. The Times article focuses particularly on the use of Bermuda reinsurance to shield hedge funds from taxation, which Zachary Mider wrote about at Bloomberg in 2013, and which, sure, probably is a loophole; go ahead and be angry about it if you want.
But here let's move up a few levels of abstraction. You have a machine that generates a lot of money. You would prefer not to pay taxes on that money. If you point the machine at yourself, and it shoots the money at you, then that is taxable income to you. But -- and this is really the main trick -- you don't need all that money now. You can, like, buy food and stuff with a tiny fraction of the money. So you point the machine somewhere else, somewhere you don't pay taxes until you actually take the money out. You have transformed an income-tax system into a consumption-tax system (for you), which, if you don't consume most of your income, is cheaper (for you).
That's the basic idea of the "income defense industry," just finding places to point money-generating machines that won't generate present taxation. That's how the Bermuda-reinsurance thing works; it transforms a money-generating machine (a hedge fund) from immediate income into capital appreciation. But it's also how Warren Buffett's taxes are so low: The large majority of his economic income comes from the appreciation in value of his Berkshire Hathaway shares, and he doesn't pay taxes on those gains until he sells the shares. Then he doesn't sell the shares. "The 800-pound gorilla is unrealized appreciation," and much of the income-defense game is about transforming income from present cash into unrealized appreciation. In general, putting your money-generating machine inside a corporation in a place with zero corporate income tax, and then giving yourself shares of that corporation, is a good starting point. (The advanced move is to then borrow against the unrealized appreciation to fund your consumption.)
The point here is not that these tricks are good or bad or "opaque" or "dizzying"; the point is that they are hard to stop in an income-tax-based system. Generally speaking the U.S. does have a lot of laws aimed at stopping the more obvious of these tricks -- that's why the Bermuda thing is relatively complicated, and why tax lawyers get paid the big bucks -- but as long as the system distinguishes taxable income from unrealized appreciation, people will find ways to characterize their economic income as untaxed appreciation. There are partial solutions -- taxing unrealized appreciation, taxing wealth, or giving up and just explicitly taxing consumption -- but they all have their own flaws.
Seneca, te neca.
Here's how Doug Hirsch told investors that he's shutting down his hedge fund, Seneca Capital Investments:
“I am no longer able to continue making the commitment and sacrifices required to run outside capital,” Hirsch said in the Dec. 21 letter. “Despite negligible redemption requests and increasing market opportunities that are the result of a challenging year in event-driven investing, I cannot in good faith start next year with the dedication required to manage your capital.”
The implication here -- you all love me, but I have decided that I am too good for you -- is perhaps undermined just a bit by the fact that Seneca was down 6 percent this year, but still, great letter.
Elsewhere in asset-manager performance, Pimco's Total Return Fund "outperformed 89 percent of peers in the first calendar year since the ouster of its former manager Bill Gross, returning almost 1 percent through Dec. 28," though I always wonder a bit about the significance of a year of outperformance in which the absolute returns didn't quite reach 1 percent. And: "Warren Buffett is headed for his worst year relative to the rest of the US stock market since 2009, with shares in his conglomerate Berkshire Hathaway down 11 per cent with two more trading days to go."
People are worried about unicorns.
Private markets might be the new public markets, but they don't replicate the public markets perfectly, as a lot of unicorn employees are finding out. We talked last week about Good Technology, and today the Wall Street Journal has a story about Palantir, the Spy Unicorn, which is valued at $20 billion and has no particular plans to go public. This is annoying for its employee-shareholders, and even for some of its venture-capital shareholders, who after all have to return money to their own investors eventually. These people can sell their Palantir shares in the private secondary market, but it's not especially robust. "One stockbroker estimated that the market totaled about $100 million in 2014," for a $20 billion company; by comparison, HP Inc., a public company with a $21 billion market capitalization, traded more than $100 million yesterday, and yesterday was December 29. And in a market that illiquid, the employees and VCs can't get a great price:
Palantir issued shares in its latest funding round for $11.38 apiece. In the secondary market, Palantir shares trade in a range of $7 to $10, brokers say. Palantir employees who have banded together to sell stock sought $8.75 a share, people familiar with the group say.
There is talk of solutions -- a special-purpose vehicle or employee share blocks to make sales a bit easier -- but this is to some extent an inescapable feature of staying private. By staying private, companies get a lot more control of who buys their stock, eliminating public-market worries like activists and short sellers and high-frequency traders, as well as the annoyance of public financial reporting. Those are real benefits to the companies, with corresponding costs to their shareholders, which you'd expect the shareholders to bear in the form of reduced liquidity and prices for their shares. The question is really whether the shareholders pass those costs back to the companies by paying less for the shares in the first place. Historically the answer was of course yes, which is why public valuations tended to be above private ones, but in the unicorn era it looks like private companies can get those benefits for free. So they do.
Elsewhere, Felix Salmon points out that the $30 billion raised in U.S. initial public offerings in 2015 is half the amount raised from venture capitalists in the first nine months of the year. "Meet The Benedictine Monk Of Silicon Valley." And "Mark Zuckerberg is giving away a magical unicorn if you post this picture."
Yesterday the Securities and Exchange Commission released a surprisingly boring 88-page report on the chaos in the equity market on August 24, when "from 9:30 to 9:45, more than 20% of S&P 500 companies and more than 40% of NASDAQ-100 companies reached daily lows that were 10% or more below their previous day’s closing price." The report describes the chaos in dry detail, but is strangely short on explanations or suggestions for improvements:
The foregoing data points are based on publicly available information. They, along with all of the empirical analyses and information provided in this Research Note, are not intended to reach or suggest any legal conclusions or factual findings regarding the causes of the volatility on August 24 or potential steps to address volatility. Rather, publication of this paper should be regarded as a preliminary step to help inform a public assessment of the operation of U.S. equity markets under stressed conditions.
Umm cool okay carry on then. Elsewhere in market structure, "Market Police Deploy New Weapons Against Spoofers." And: "Chinese securities regulators are preparing some of the world's strictest regulations" about order cancellations, which would forbid "frequently placing and withdrawing orders where the ratio of trades concluded is abnormally low."
One of my enduring obsessions is the interaction between rules against insider trading and selective disclosure, on the one hand, and the fact that companies meet with their investors all the time, on the other. So I enjoyed this article about "corporate access":
Firms like Business Intelligence Advisors provide training to investment professionals to analyze and interpret the physical responses of a management executive to questions. The buy side continues to get great value from meeting face to face with a management team.
New technologies such as better and cheaper video communication platforms have not changed the demand for face to face meetings. Increasingly high resolution video can allow beads of sweat to be visible on a management’s face during a video conference call but getting a live office meeting with a management team is still much more valuable.
Are the beads of sweat material nonpublic information?
People are worried about stock buybacks.
I see less about this worry these days, but I assume it's still out there. Apple has by far the biggest program of returning cash to its shareholders, and Goldman Sachs points out that it "has returned $104 bn to shareholders through its buyback and $143.5 bn through dividends over the last 3 years, and the company has more cash now on its balance sheet than it did at the start of the program." Also it invented a watch and stuff. If Apple's buyback is bad, what should it have been doing with all that money?
People are worried about bond market liquidity.
It says here that "Wall Street is searching for new ways to protect corporate bond investments amid concern that traditional hedging tools aren’t working properly as default rates rise," and it's December 30 so I'm going to count that as a bond-market-liquidity concern. The story is largely about the decline of credit-default swaps, and the concomitant rise of exchange-traded funds, as tools for hedging corporate bond risk.
Shkreli’s Former Biotech Company KaloBios Files for Bankruptcy. On Pep Boys, Carl Icahn Doesn’t Have to Win to Be a Winner. Puerto Rico Debt Crisis Closes In on Jan. 1 Deadline. Fannie and Freddie Give Birth to New Mortgage Bond. Lehman Sues Japanese Investment Bank Over Derivatives. Barclays to Pay $13.75 Million to Settle Case Over Mutual Funds. Fed's Asset-Bubble Focus Tries to Clear Path for Gradual Hikes. Divergence Between Fed, Other Central Banks to Test Global Economy. 25% of Donald Trump’s political spending goes to his own companies. "Carbone—the sophisticate’s Olive Garden." "Daniel Humm would serve a chili dog on a skateboard if he had thought of it first." Goats Love To Eat Christmas Trees. The internet can't decide how dogs should wear pants. Diocese Suspends Priest Who Used Hoverboard During Mass. Wall punchers.
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