ABC News Gets Feeder Funds Wrong
Not so interested in the ABC News parts, but here’s a good explanation of how most of these investment funds work to protect both income and provide tax shelters for investors.
ABC News and Brian Ross blows an “expose” on Mitt Romney’s investments and misrepresents US securities law.
Full disclosure: I used to do this. Hedge, Private Equity, and Managed Futures business analysis was my job for 5 years. Everything I say below is based on 5 years of experience building client registration databases, qualification systems, accounting systems, and trading systems exclusively intended to support private placement products. In other words I’ve built this stuff from the ground up.
I’m not only a proud American taxpayer, I’m a political liberal interested in advocating higher taxes for the rich including increases in Capital Gains rates. And ABC News completely botched this report.
Everything ABC News says in their report is some combination of wrong and falsely inflammatory. Ross’s report impugns the character of upstanding Americans that I worked with closely and hold the utmost respect for. I cannot in good conscience fail to rebut their false accusations even if it assists a political figure I dislike and breaks my vow to be silent in protest of SOPA.
ABC News’ report wrongly insinuates that Mitt Romney evades US taxes by investing in master limited partnerships. The individuals quoted in the report don’t understand what Romney’s invested in, falsely suggest that these investments are not taxed like any other investment vehicle, and ignore the point that capital gains are not tax evasion simply because they are at lower statutory rates.
First: let us explain what Romney’s invested in.
Private investment companies like Bain company are operated as 3(c)(1) investment companies exempt from most SEC registration requirements. They are capped at 99 investors, all of which must qualify under rigorous standards. Clients must be Accredited Investors, Qualified Clients (usually, for PE), and /or Qualified Purchasers. This requires, among other things, that the investors have 5MM in visible, verifiable investible assets that the investment partner pre-qualified prior to the investment in the vehicle. In other words: these small funds are intended to be niche boutiques for rare groups of very sophisticated investors.
3(c)(7) funds are typically then set up as “feeder” funds into the 3(c)(1) vehicles. Say I start a domestic 3c1 hedge fund called The Callus LLC - I can only put 99 investors in it. But one of those investors can be an entity - the 3(c)(7) - which also doesn’t have to register and caps at 499 investors. Add it all up and you can pack up to 49,401 folks into a single 3(c)(1). Maybe that’s a problem, but the government is well aware of this practice and saw fit to leave it be in Dodd-Frank; this practice complies with the 1940 Investment Company Act in full.
So those papers you see with “Bain Capital IX LLC?” Those are feeder funds. They’re legal, and you can only invest in the domestic versions in taxable accounts. The Transfer Agent for the fund must know the client, confirm the client is qualified, and provide the fund’s tax administrator with information about the client’s investment performance. The administrator then reports taxes to the investor via Schedule K1 like any other partnership to be taxed as capital gains or claimed as losses.
But how does Cayman fit in?
Cayman is a popular place to register “tax exempt” vehicles to pair up with the domestic 3(c)(1) and 3(c)(7) funds. Take The Callus LLC and sit The Callus LP next to it - they both would invest in the 3(c)(1) and thus track its performance, rendering them functionally equivalent. Since know-your-client (“KYC”) rules are more lax in Cayman and otherwise abroad, it’s possible to set up limited partnerships there to support an international client base without the expense and frustration of US KYC compliance. American investors must only invest in these in tax exempt accounts and still receive normal partnership tax reporting via Schedule K1. The funds also must limit their tax-exempt assets to 25% of AUM and investor counts - no more than 500 if there are 350 or more TE accounts.
We can feel your eyes glazing over. We once built a system that did this; it took three years. Most of those three years was spent explaining this to people. But it must be said:
Tax-exempt accounts are retirement accounts. Examples: IRA, RIRA, IRRA, SEP, KEOGH. These accounts are all subject to ERISA. ERISA says that if 25% of the feeder fund’s assets are in tax-exempt accounts the fund’s investment activities are reportable. Funds don’t want this, so they keep TE assets down by force-redeeming clients, using wait lists, and / or periodically closing the fund to new investors.
So what’s the big deal? Why does ABC News think Mitt Romney is a tax scofflaw?
Well, part of it’s the mystique of Private Equity. The other part is that a ton of tax lawyers don’t know what they’re doing when it comes to partnership accounting. Private investment vehicles are uncommon and occupy a unique space in securities law; experts area few. There’s also this bizarre perception that the Cayman Islands is a big hub of tax scofflaws hiding in plain sight.
It is possible to hide your money in Cayman. You can lie, first of all - if the TA can’t prove your KYC data false then it’s possible to hide taxable American investment returns in offshore private investment vehicles like Bain or its many feeder funds. You can use a proxy or otherwise launder money. But that’s a problem affecting virtually every investment company that operates overseas, problems that OFAC and its ilk work to solve. Outside America it’s even possible to have fully confidential accounts that don’t disclose the investor’s name or address. These are failures of international regulatory regimes.
But this is silly:
Wilkins agreed, saying the “primary advantage to setting those funds up in an offshore jurisdiction like the Cayman Islands or Bermuda is it helps the investors avoid tax.”
“It helps U.S. investors avoid U.S. tax,” said Wilkins, “it helps foreign investors avoid taxes in their home country, so it’s not illegal or improper to set those funds up in a foreign jurisdiction, but it makes it more attractive to investors because it helps them avoid paying taxes on that income.”
Bullshit. The primary advantage to setting up these funds in an offshore jurisdiction is that it’s drastically cheaper. Believe it or not, we care about investor expenses! The other reason is it helps funds simultaneously take tax-exempt money while avoiding disclosing their “secret sauce” in terms of investing strategies. If the likes of Renaissance or Bain or Partners Group had to report their investing activity like ERISA-registered domestic products the funds would decline to allow investments from those accounts structures.
These funds hire administrators and transfer agents responsible for reporting all tax information concerning their identifiably American customers. These administrators are good people who care about this country and about doing a good job and don’t need know-nothing ABC “exposes” insinuating that they are somehow aiding tax evaders. What helps US investors avoid US tax is lying to brokerage firms and transfer agents about their registration information; these faux-mysterious Cayman LP’s have fuck all to do with it.
This is also a lie that exposes the total lack of insight on the part of ABC News and its sources:
Tax experts agree that Romney remains subject to American taxes. But they say the offshore accounts have provided him — and Bain — with other potential financial benefits, such as higher management fees and greater foreign interest, all at the expense of the U.S. Treasury
First off, there is no law protecting US investors from 3(c)(1) or 3(c)(7) management fees (the infamous 2 and 20) as with mutual funds by very nature of their structure. LLC or LP, domestic or offshore, it doesn’t make a difference. And since Romney no longer manages Bain, such fees have absolutely no relevance to his personal finances or taxes. Regardless, Romney’s management fees and investment performance are all taxed at the capital gains rate of 15%.
Secondly, what the hell is wrong with “greater foreign interest?” Don’t they mean “any” foreign interest, considering you can’t put foreign investors in domestic vehicles because of the KYC and tax rules? Foreign investors don’t want to pay even our paltry tax rates, and shouldn’t have to because it would be double-taxed by their home regimes in most cases. Establishing a Cayman LP is the only way to service international clients if you operate a private placement entity, its feeders, or a brokerage firm selling those products via agreement. What’s inherently wrong with foreign investors?
TLDR: ABC News’ report is riddled with holes and represents a laughable analysis of the modern private placement regulatory environment and marketplace. It unduly tars Mitt Romney and everyone in an industry I worked in. Focus on the facts: the capital gains rate allows investors lower tax rates on investment income, and maybe it shouldn’t.