Fund Conflicts and Tax Napkins
If you run an investment firm that invests other people's money, should you also run a different investment firm that invests your own money? The problems are fairly obvious. There are conflicts of interest: If you find a good investment, how do you decide whether to put your money or your clients' money into it? And how do you deal with selling investments from one fund to another? There are attention issues: If you're spending your time on your personal fund, you're not spending it on your clients' fund. And there is a conceptual problem: Why should clients put their money in your fund when you are putting a lot of your own money in a different fund?
Here's a Wall Street Journal article about the family offices of big hedge-fund and private equity fund managers, full of conflict-y stories, like the time Blackstone Group LP President Tony James's family office bought some of a company from Blackstone and then later sold it back to a different Blackstone company. You'd think that this stuff could be mostly avoided, but only mostly:
Family offices, for their part, sometimes steer clear of an industry that is a focus of the owner’s fund for clients, or they stick to a different corner of the industry.
William Ackman’s Pershing Square Capital Management LP lets its employees invest in private companies, real estate and other assets because Pershing Square invests only in public companies.
But even there you can run into problems: What if one of your hedge fund's public portfolio companies wants to buy one of your personal private portfolio companies, as happened to Ackman?
Generally speaking the conflicts of interest seem to be, like, 80 percent solvable. You have conflicts committees, and recusals, and disclosure, and general rules about dividing up the investment universe. And you expect the fund's managers to mostly work for the fund, and work for themselves a little bit. "We want to make sure the fund is always the primary beneficiary of investment ideas and the primary beneficiary of the portfolio manager’s time," says an investment adviser.
"Primary," not "exclusive," but you live with the imperfection mostly because, in finance, conflicts of interest tend to be a good sign. You want to invest your money with someone who sees a lot of deal flow, who thinks about investing all the time, who has built up a network of information and favors with bankers and investors. And if some of the deals she sees, or some of the thoughts she has, or some of the favors she gets, aren't appropriate for her client's fund, why shouldn't she take advantage of them for herself? "Important people," runs John Whitehead's famous commandment, "like to deal with other important people. Are you one?" Fund investors like to deal with important fund managers, and conflicts are a pretty good measure of importance.
Beyond the conflicts issue, there is the conceptual issue:
Some clients of hedge and private-equity funds say they don’t understand why asset managers don’t have all of their own money in funds they charge hefty fees to manage.
This one, though, has a fairly straightforward answer. The clients aren't 100 percent in the managers' fund, so why should the managers be? The clients want the fund to do the thing it is supposed to do, to give them exposure to a particular asset class or strategy or risk factor. They want the fund manager to take certain risks -- the risks she told them she'd take -- because they have built a whole portfolio that balances out the risks that different managers will take. If you have money in a long fund, and money in a short fund, and you think that you're market neutral, then you want the short fund to actually be short. But if your short fund manager has 100 percent of her wealth in her own fund, and the market keeps going up, she is going to be tempted to get a bit less short.
Letting the fund manager diversify out of her fund lets her remain concentrated within the fund; letting her lower her personal risk lets her increase the risk in her funds. "Be regular and orderly in your personal account, so that you may be violent and original in your hedge fund," that sort of thing. You want her to manage her fund in the best interests of diversified investors, because all of the outside investors are diversified themselves. (Though, I mean, she could just index with her personal money.)
Elsewhere in family offices, family offices are buying art, which seems much worse than families buying art:
Many family offices are finding a large portion of their balance sheet taken up by a collection that may have once been the founder’s hobby. They have to “stop looking at the pretty pictures and start looking at the numbers,” says Von Sanborn, a partner at Day Pitney LLP, a law firm that works with family offices.
But ... what ... why? If you are rich enough to have a family office, you can afford to buy art because you like to look at it. You don't have to look at the numbers at all! That is the whole point of art, and of being rich! I don't understand people.
Yesterday the Trump administration pretended to release a tax plan, and while this obliges reporters, and poor Steven Mnuchin and Gary Cohn, to pretend that it was a tax plan, we are under no such obligation here. It doesn't even look like a tax plan! You can tell because there are almost no numbers in it, and the fonts are all wrong. Also, it would fit on a napkin, but it takes planning to print things on a napkin, and they clearly wrote this on the bus over to the press conference. Bloomberg reports:
If the one-page outline seemed hastily assembled, it was. Some Treasury officials found out that a plan would be made public Wednesday only after Trump announced his intentions last Friday, promising “massive” tax cuts. The Treasury staffers and counterparts from the White House then rushed to prepare a presentation with enough viable talking points to satisfy Trump’s expectations, while keeping it open-ended enough to leave room for further consideration.
It was designed to fool Donald Trump into thinking that it's a tax plan, but the rest of us don't need to be fooled.
Still there will be a lot of talk about winners and losers in the hypothetical universe where this plan becomes law. An obvious set of winners is corporations, whose top tax rate would drop from 35 to 15 percent. But through the magic of accounting, some of these winners would look like losers:
Banks like Citigroup and Bank of America would have to take some sour with the sweet: A lower tax rate would mean they will have to take billions of dollars in charges against earnings to write down the value of their giant piles of “deferred tax assets.”
Next time someone complains that companies that report non-GAAP earnings are using "fantasy numbers," let's all remember that GAAP would require Citigroup and Bank of America to report billions of dollars of losses solely because they will pay lower taxes in the future. Under this tax plan, Citi and BofA would have the same amount of money now, and more money in the future, but under U.S. generally accepted accounting principles they would have to report a huge loss anyway. Presumably shareholders would also be interested in the pro forma non-GAAP numbers excluding that loss.
Another set of hypothetical winners is owners of pass-through entities, like hedge-fund managers and law firm partners and Trump himself, whose taxes on their business income would top out at 15 percent. Here is one who is hypothetically excited:
One adviser to hedge funds, Michael Laveman of accounting firm EisnerAmper LLP, said the proposal would act as a tax cut for hedge-fund owners who share management fee income. Management fees, he said, are typically taxed at the current top 39.6% rate.
Mr. Laveman’s own firm, also a partnership, would be among the beneficiaries. “I’m trying not to tell my wife about the huge tax break we are about to get,” he said.
Cute! Wait, why not? Because he wants to keep her in the dark about the family's finances, or because, like me, he is not counting on this tax break being real? I assume that the way it would work is that any pass-through business income that is kept in the business would be subject to a 15 percent tax, while any income that is paid out in compensation -- and in particular, any income that is used to pay personal expenses -- would be subject to higher personal tax rates. In practice this would turn into sort of a consumption tax, at least on the rich: You'd pay personal income taxes on the money you need to live on, but 15 percent on money you can save. Those who need their money would be taxed more than those who don't. But here I am interpreting a lot, from the one-pager.
Hypothetical losers include people who live in New York, who would pay federal taxes on the money they pay in state taxes. I mean, also people in other high-tax states, but I live in New York, so that is of more hypothetical interest to me. Though I can avoid some of the problem by selling Money Stuff to Bloomberg via Money Stuff Business Thing LLC, my pass-through entity. (I have consulted the academic literature on naming and gravitas in coming up with its name.)
Elsewhere in executive theater, the Trump administration pretended to plan to pull out of Nafta for a few hours yesterday, but then backed away from that. Markets reacted sharply to the pretend withdrawal, and don't they feel silly now?
Poor Jesse Litvak.
Jesse Litvak is a former Jefferies LLC managing director who was convicted of lying about bond prices in 2014 and sentenced to two years in prison. His conviction was reversed on appeal in 2015, because the appeals court decided that he should have had the opportunity to explain to a jury that actually everyone lies about bond prices so it's no big deal: It can't be fraud if it doesn't deceive anyone, and if everyone lies then no one will be deceived. So he got a new trial, and he presented this defense, and it worked: This year a jury acquitted him on nine out of the 10 counts he faced. But it did convict him on one count, because he altered the transcript of a chat and sent it to a customer, and apparently the jury concluded that that's beyond the pale even in bond trading.
At the time, I said that this was a "totally sensible distinction": Lying about your cost for a bond seems like the sort of used-car-salesman-y tactic that (a jury could reasonably conclude) a customer would treat skeptically, while altering documents seems like ... you know ... fraud. But I also said that it was sad for Litvak: "In the federal white-collar sentencing system, one conviction is not all that much better than 10." That was correct: Yesterday he was sentenced to the same two years in prison, and a larger fine than the first time. Litvak's lawyers did their best:
They said the circumstances surrounding his conviction have changed "dramatically," given he is only facing punishment for one count instead of 15.
They also argued that the government has handled similar bond-trading infractions via regulatory sanctions and fines, rather than criminal prosecutions.
That is true. Litvak's case is part of a broader crackdown on lying by bond traders, which both Litvak and the government seem to agree is (or was) pervasive. But the crackdown has been pretty uneven: One of Litvak's ex-colleagues, who was accused of very similar conduct, got a $30,000 fine and a three-month suspension from the industry, while Litvak will spend two years in prison. I suppose the point is to make a few examples out of people to scare the rest straight, but it's a bit rough if you are the example.
Bitcoins and banks.
U.S. bank regulation is so weird:
Many bitcoin exchanges have accounts with local banks that rely on larger “correspondent banks” to facilitate wire transfers and process transactions that involve foreign currencies. But global banks have long been wary of even indirect interactions with bitcoin exchanges, for fear of being held liable if bitcoin users—who are difficult to identify—are involved in illegal or shady activities, said Ross Delston, a former U.S. banking regulator and anti-money-laundering consultant.
J.P. Morgan Chase & Co. prohibits banks it transacts with from dealing with virtual-currency exchanges, according to an internal document seen by The Wall Street Journal.
The concern here is that JPMorgan might transfer money for another bank, and that other bank might transfer money for a bitcoin exchange, and that bitcoin exchange might transfer money for a drug dealer. Which, in the eyes of the law, means that JPMorgan might as well be dealing drugs itself. I sometimes think about the analogy between banks and airlines: If a drug dealer uses a bank to move money, that bank is held responsible, but if he just gets on a plane with a bag of money, no one thinks to hold the airline responsible. But this is much further removed. This is like, a taxi driver flies on United Airlines from New York to Miami, and in Miami he picks up a guy who owns a boat and drives him to the marina, and then the guy with with boat transports bags of cash for a drug dealer, and you hold United responsible. Vast swathes of legitimate financial transactions will be cut off if you punish banks for dealing with people who deal with people who deal with people who commit crimes.
Alternatively banks are just protecting their financial hegemony by trying to shut down bitcoin exchanges. That's also possible. But bitcoin's claim to be able to supplant the banking system is a little undermined by its reliance on big U.S. banks to actually be useful.
People are worried about unicorns.
"All of Uber's problems can be boiled down to a single policy," says a guy, and it's not one of the 20 policies you're thinking of! (It's the no-tipping policy.) Meanwhile Didi Chuxing, Uber Technologies Inc.'s Chinese rival, "is raising between $5 and $6 billion in a funding round that would value the company at around $50 billion." I remember once declaring that a $50 billion valuation makes a private company an "ubercorn," and now there will apparently be two of them, both in the same industry.
Elsewhere, Robinhood, the free stock-trading app, is now a unicorn, raising $110 million at a $1.3 billion valuation. So the Enchanted Forest is now also Sherwood Forest.
People are worried about stock buybacks.
When people in the U.S. worry about stock buybacks, it's usually because they think that buybacks encourage short-termism and reduce investment and innovation. There's occasionally an element of worry that the buybacks could be market manipulation, but you rarely see anything quite like this, about China Evergrande Group in Hong Kong:
Evergrande has bought back 4.9 per cent of its shares in the past four weeks while the price has rallied 40 per cent, sparking concerns about potential market manipulation.
Shares bought by the company have accounted for at least one-third of all trading on more than half the days it has stepped into the market. On Tuesday, its buying represented 69 per cent of all the shares traded as it spent HK$2bn (US$257m) when the price reached a record high of HK$9.25.
"Analysts believe that the buybacks are related to the need for a higher valuation in order to inject Evergrande’s property assets into a Shenzhen-listed vehicle," and I am always happy to see companies buying back stock in order to make it easier to sell stock. It's an equity-financed share repurchase, but in reverse.
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