Reading Warren Buffett on the importance of earning power over tangible common equity when valuing a bank got me thinking about, of all things, how hedge fund managers think about taxes, something I've touched on in the past.
American family offices that invest in hedge funds care about taxes in a way that other institutional hedge fund investors--pensions, endowments, offshore money--do not. In the course of their due diligence, these family offices will typically ask a prospective manager how he thinks about taxes, that is, how does he go about trying to maximize his limited partners' after-tax returns rather than pre-tax-returns.
The typical answer from the manager is something like this: "Of course I think about post-tax returns a great deal, because my entire net worth is invested in the fund and I'm a taxable investor, so I invest the fund with my own tax situation in mind. Our interests are closely aligned."
This answer makes sense, but it's also an example of Nabokov's doughnut truth: it's the truth, the whole truth, but with a hole in the truth (thank you Seth Roberts). Here's why:
A hedge fund manager actually has two net worths. The first is the "tangible net worth" represented by his interests in the fund of which he's a general partner. On a look-through basis, these interests correspond to actual stocks, bonds, derivatives, etc. that can be traded and valued presently.
The second net worth, sort of a shadow net worth, is the manager's earning power, the capitalized present value of the income to be earned from managing other people's money. This depends on the future returns of the fund AND on the amount of capital to be raised in the future. The latter matters more because it's much easier to double the size of a hedge fund by taking on outside money than by earning 100% returns on existing capital. Most of the outside money invested in hedge funds is non-taxable, so a hedge fund manager can maximize his second net worth more easily by behaving in such a way as to increase the amount of non-taxable money managed, which makes minimizing taxes a lesser priority.
An ambitious hedge fund manager, confident in his ability to generate future returns and desiring to make a lot of money personally, keeps a close eye on his shadow net worth, although he seldom discusses it in public. So should you, and in particular you should look for managers ethical enough to constrain their ambition in the interests of serving their investors. The ideal money manager is someone who is very rich, the result of a successful track record over time, but much less rich than he could be.
An unambitious hedge fund manager may behave differently but to my knowledge there is no such thing. If I ever meet one I'll report back to you.
Comments