Investors Seeking to Alter Hedge-Fund Fees Backed by IRS Ruling

Jun 11, 2014 7:43 am ET

June 11 (Bloomberg) -- The U.S. Internal Revenue Service issued a ruling yesterday clearing the way for institutional investors to seek changes to incentive fees assessed by hedge funds, which may make it cheaper for them to invest in such offerings.

The ruling, 2014-18, clarifies that hedge funds can charge incentive fees cumulatively rather than annually without running afoul of a tax law change adopted in 2008. These fees, typically equaling 15 percent to 20 percent of an investor’s profits, comprise a big portion of a hedge-fund manager’s annual revenue.

Institutions have been pushing managers to charge incentive fees on a cumulative basis, rather than locking in a share of profits annually, to ensure that both sides share the risk of having gains from good years being wiped out later on. Investors from California Public Employees’ Retirement System to the Utah Retirement System to Intel Corp. have urged hedge funds to make the change and have been spurned in the past, said Rick Ehrhart, chief executive officer of Optcapital LLC, a Charlotte, North Carolina, consulting firm specializing in incentive compensation payable to money managers.

“The holy grail for them is to divide profits on a cumulative basis,” Ehrhart said in an interview. “There is an inherent clawback” in using this sort of method, Ehrhart said, referring to a private-equity concept that allows investors to take back fees paid to managers if early gains in buyout funds are wiped out by subsequent losses.

Eric Smith, an IRS spokesman, confirmed that the agency had issued the revenue ruling, declining to comment further.

The ruling addresses an issue that arose after Congress passed the Emergency Economic Stabilization Act of 2008, which, among other things, curtailed the ability of hedge funds to defer taxes on billions of dollars in incentive fees. Hedge funds have said that its unclear whether cumulative incentive fees would comply with a provision added to the Internal Revenue Code under the 2008 law known as Section 457A.