Taxation of Hedge Fund and Private Equity Managers Page: 3 of 6
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CRS-3
While there are no official or comprehensive statistics on the size of either industry,
the usual estimate is that there are now 8,000-9,000 hedge funds, with about $1.2 trillion
in investor funds under management. A decade ago, the comparable estimates were 2,500
funds and $200 billion in capital. In private equity, firms have raised over $1 trillion in
the past decade, with about $200-250 billion in 2006 alone. In 2006, LBOs accounted for
18% of the dollar value of all corporate mergers, up from about 2% in the late 1990s.2 In
short, private equity and hedge funds, once marginal players, now exert significant
influence in the markets where they operate.
Fund Structure and Compensation
While private equity firms and hedge funds may differ in their investment strategies,
their structures are similar. Nearly all are organized as partnerships, which means that
their earnings are not taxed at the firm level. Most partnerships are simply
straightforward conduits of taxable income or loss and tax attributes to the individual
partners. They can, however, also be used to manipulate the allocation of tax attributes
and the sheltering of income and assets from taxation.
There are two kinds of partners. The fund managers, who guide the investment
strategy, are general partners. Their background typically includes experience at a Wall
Street investment bank, although two former Secretaries of the Treasury and a former
Securities and Exchange Commission (SEC) chairman now run hedge funds.
Outside investors, who contribute capital but have no say in investment or
management decisions, are the limited partners. They are generally institutional investors
- public and corporate pension funds, insurance companies, foundations, and
endowments - or wealthy individuals. The general partners often invest their own
capital in the funds, but this is usually a small share of the total.3
Hedge funds typically establish multiple funds to accommodate the tax planning
preferences of different investors. While they generally share a common pool of
underlying assets, they are chartered in different jurisdictions to cater to different
clientele. Foreign investors and U.S. tax-exempt institutions may prefer to invest in
foreign-chartered funds, while other types of U.S. investors find it disadvantageous to
invest in foreign funds. By one estimate, about 7,000 hedge funds, or about 80% of the
total, are registered in the Cayman Islands as well as their home country.4
Excluded from the list of limited partners is the small public investor. Under U.S.
law, the sale of shares, or interests, in an investment partnership constitutes an offering
of securities, and must be registered with the SEC if the offering is public. In order to
2 "M&A Almanac," Mergers & Acquisitions, February 2007, p. 82.
3 General partners accounted for about 3% of funds raised by private equity firms in 2005.
"Here's Where the Capital Came From In 2005," Dow Jones Private Equity Analyst, April2006,
p. 16.
4 James Eedes, "Special Supplement: Cayman Islands - Funds Flourish," The Banker, July 1,
2006, p. 1.
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Jickling, Mark & Marples, Donald J. Taxation of Hedge Fund and Private Equity Managers, report, July 5, 2007; Washington D.C.. (https://digital.library.unt.edu/ark:/67531/metadc821648/m1/3/: accessed April 24, 2024), University of North Texas Libraries, UNT Digital Library, https://digital.library.unt.edu; crediting UNT Libraries Government Documents Department.