What Every Tax Advisor Needs to Know About Hedge Funds Paul S. Lee, J. D. , LL. M. National Managing Director This presentation booklet has been provided to you for use in a private and confidential meeting to discuss a potential or existing investment advisory relationship. This presentation is not an advertisement and is not intended for public use or distribution beyond our private meeting. Bernstein does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with professionals in those areas before making any decisions.
Hedge Funds: Staggering Popularity and Growth < Over 9, 000 Funds Presentation Code < Over $1. 4 Trillion Source: HFR Industry Report , Fourth Quarter, 2006 2
What Do You Need to Know as an Advisor? Fund Strategies & Categories Financial Instruments Fund Structure Non-U. S. Funds U. S. Trade or Business pgs. 39 -44 FDAP Tax Classification Subchapter K Valuation Issues UBTI Presentation Code PFIC Taxation of Investments CRTs Investor Level Issues Choosing a Fund 3
Hedge Fund: No Standard Legal Definition < Lightly regulated investment vehicle = Not registered under the Investment Company Act of 1940 = Securities not registered with SEC = Limited to high net worth individuals and institutions < Limited liquidity < Flexible investment mandate = Not just “long, ” but also “short” = Employ “leverage” < Two layers of fees Presentation Code = Investment management fee (1% to 3%) = Incentive fee based on profits (10% to 30%) <With a “watermark” <Above “benchmark” 4
“Categories” of Hedge Fund Strategies “Market Neutral” (~1/3) < Event Driven = Merger Arbitrage = Distressed Securities < Equity Market Neutral < Arbitrage Strategies Directional Strategies (~2/3) < Long-Short Equity Strategies < Global Asset Allocators (Macro) < Emerging Markets = Fixed Income Arbitrage Presentation Code = Convertible Arbitrage Source: HFR Industry Report 2006. 5
Going “Long” and “Short” < Financial tools and strategies = Short sales = Futures and forwards = Options Presentation Code = Notional principal contracts (pg. 5, fn. 4) 6
Mechanics of a Short Sale Loan 100 shares XYZ “Short Sale” 100 shares XYZ @ $10 per share Short Seller (Borrower) (Hedge Fund) Owner (Lender) Borrow Fee + In Lieu Dividends Market Proceeds ($1, 000) + Interest @$15 per share ($500) Loss Short Seller Closing Transaction Short Seller (Borrower) (Hedge Fund) Presentation Code Owner (Lender) Return 100 shares of XYZ Market “Closing” Purchase 100 shares XYZ @$5 per share $500 Profit Short Seller 7
Mechanics of a Futures/Forward Contract to Buy/Sell (No Premium or Up-Front Payment) Obligation: Buy Purchaser (Long Position) Seller (Short Position) Obligation: Sell + Deliver Future Date + Futures Price Gain to Long Position Presentation Code “Cash-Settled” Futures Contracts and Mark to Market System Loss to Short Position Market vs. Futures Price Loss to Long Position Commodities Currencies Securities Profit to Short Position 8
Options CALL Holder (Buyer) Right or Obligation Right (Buy) Writer (Seller) Obligation (Sell) PUT Holder (Buyer) Right (Sell) Writer (Seller) Obligation (Buy) Outlook on Security Presentation Code Maximum Gain Unlimited Premium Strike price minus premium Premium Maximum Loss Premium Unlimited unless “covered” Premium Strike price minus premium 9
Structure of “Onshore” Hedge Funds Investment Manager General Partner Limited Partners (Investors) Levels of Inquiry 1) Tax classification of fund Hedge Fund L. P. or LLC 2) Subchapter K implications Presentation Code 3) Valuation Issues 4) Taxation of investments Hedge Fund Investments 5) Investor-level issues 10
Tax Classification of Fund < Onshore hedge funds are partnerships = “Publicly traded partnership” exceptions (pg. 7) < Hedge fund status Limited Partner (Investor) Trader or Investor Hedge Fund L. P. vs. Presentation Code Dealer Hedge Fund Investments 11
Subchapter K: Allocation of Profit and Loss General Partner Limited Partners (Investors) General Allocations Special Allocation Incentive Fee Hedge Fund L. P. Based on benchmark? Presentation Code Index: -9 Return: -1 Incentive Fee: 20% of +8% Hedge Fund Investments Net capital appreciation (depreciation) to capital accounts Tax items allocated under § 704(b) and § 704(c) based on net capital All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 12
Subchapter K: Contribution of Assets In-Kind Limited Partner (Investor) Assets-in-kind Non-taxable event Unless hedge fund is “Investment Company” §§ 721(b) and 351(e) Special Allocations Hedge Fund L. P. Exception for Differences in book value & tax basis “Diversified portfolio” Presentation Code “Insignificant amount” Hedge Fund Investments All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 13
Subchapter K: Disguised Sale Rules Limited Partner (Investor) Presumed Disguised Sale Triggering Events § 707(a)(2)(B) Contribution of appreciated property Partial redemption or withdrawal Hedge Fund L. P. Distribution of other property or cash to contributing partner Distributions with corresponding allocation? Within 2 years Presentation Code Tax Distributions? Hedge Fund Investments All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 14
Subchapter K: “Mixing Bowl” Transactions Contributing Partner Other Partner Recognition of Gain/Loss Capital accounts unaffected Contributed property Distributed to any other partner Hedge Fund L. P. or Receive other property Outside basis of contributing partner and inside basis of property automatically adjusted (no § 754 election) Presentation Code Within 7 years Hedge Fund Investments Character of gain/loss determined at fund level All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 15
Valuation Issues Donor/Decedent (Investor) Valuation for Wealth Transfer Tax Purposes Withdraw • Date of Transfer • Value Received (Future) • Previous Valuation Hedge Fund L. P. Restrictions Cure Book/Tax Lose “Watermark” § 754 • Transferability • Withdrawal • No Chapter 14 Presentation Code Hedge Fund Investments Valuation of the Investments Book/Tax Disparity • Accounting/Valuation Periods • Actively traded • Hard to value assets 16
Taxation of Investments: The Rules. . . And Exceptions CAPITAL GAIN/LOSS X Limited Partner Contracts under § 1256 Currency Transactions (§ 988) [pgs. 15 -16] Conversion Transactions (§ 1258) [pgs. 25 -26] Hedge Fund L. P. Constructive Ownership (§ 1260) [pg. 35 -37] CLOSE OF TRANSACTION X Presentation Code Hedge Fund Investments Contracts under § 1256 Constructive Sales (§ 1259) Straddle Rules (§ 1092) All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 17
Taxation of Short Sales (Borrower’s Standpoint) < Gain or loss is on the closing transaction = Short-sale proceeds less basis in replacement stock < Short-term = Unless replacement stock has a long-term holding period = Special rule for converting short- to long-term gain = Special rule for converting long- to short-term loss < Section 1259 Constructive Sale = Appreciated financial position (contributed or acquired) Presentation Code = Deemed to have been sold upon the short sale All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 18
Taxation of Futures and Forward Contracts < Realization events = Sale or exchange of the contract = Physical settlement at maturity = Offsetting contract = Cash settlement at maturity < Capital gain or loss < Short term Presentation Code < Options are essentially the same (pgs. 21 - 25) 19
Section 1256 Contracts: Mark to Market Taxation < Includes: = Regulated Futures Contracts <Traded on an established exchange = Foreign Currency Contracts <Forward contracts traded in interbank market = Nonequity Options <Traded on an exchange <Broad-based equity index options (not narrow) <Options on commodities, currencies and financial instruments < Annual mark to market realization Presentation Code < Tax treatment = 60% long-term capital gain/loss = 40% short-term capital gain/loss All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 20
Straddle Rules (Section 1092) < Defer loss realized from disposition of a straddle position < Straddle = Positions that are valued on an established market, = That can be sold, exchanged or otherwise liquidated, and = The value change in one position will result in an inverse change in value in the offsetting position. < Included = Short sales while holding a long position in the stock Presentation Code = Any short position in “substantially similar” property All section (§) references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted. 21
Summary of Investor Level issues < Straddle rules apply to investors’ outside holdings (pg. 28) < Deductibility of Interest and Short Sale Expenses (pgs. 30 - 31) < Deductibility of Hedge Fund Investment Expenses (pgs. 31 - 32) < Passive Activity Rules (pg. 33) < At-Risk Limitations (pgs. 33 - 34) Presentation Code < Tax Shelter Reporting Requirements (pgs. 37 - 38) 22
The Hedge Fund Claim < Produce equity-like returns < Maintain lower volatility Presentation Code < Exploit low correlation to rest of portfolio 23
Hedging Market Exposures Tends to Lower Volatility Market-Neutral* < Fully hedge market exposure < Examples: Arbitrage; Event-Driven Directional Strategies* < Retain some market exposure < Examples: Long/Short Equity; Global Macro Presentation Code Annualized Volatility: 1996– 2005 *We group Convertible Arbitrage, Event-Driven, Equity Market-Neutral, and Fixed-Income Arbitrage hedge funds (as defined by the TASS database) into our index of Market-Neutral Hedge Funds. We group Long/Short Equity, Emerging Markets, CTAs, and Global Macro hedge funds (as defined by the TASS Database) into our index of Directional Hedge Funds. See “TASS Database” in the Appendix for a description of these indexes. Bonds are represented by the Lehman Brothers U. S. Aggregate Index, stocks by the S&P 500. Source: Lehman Brothers, Standard & Poor’s, TASS, and Bernstein 24
Hedge Funds Don’t Move in Tandem with the Markets Correlations to S&P 500* 1996– 2005 High Correlation US Growth Stocks US Value Stocks International Stocks Directional Hedge Funds Presentation Code Market-Neutral Hedge Funds Real Estate Low Correlation Bonds *Correlation between the S&P 500 and other investment alternatives, which are represented by the following—US Growth Stocks: Russell 1000 Growth Index; US Value Stocks: Russell 1000 Value Index; International Stocks: Morgan Stanley Capital International (MSCI) All Country World Index–Ex-USA; REITs: National Association of Real Estate Investment Trusts (NAREIT) Index; Hedge Funds: TASS and Bernstein; Bonds: Lehman Brothers U. S. Aggregate Index. Past correlations are not necessarily indicative of future results. 25
Analysis of Hedge Fund Database Directional Funds Market-Neutral Funds < Full history of funds currently reporting 16. 6% 12. 4% < Remove returns that were “backfilled” (Backfill Bias)* (2. 2) (1. 2) < Include returns of funds no longer reporting (Survivorship Bias)* (5. 0) (3. 1) Presentation Code < Adjusted Hedge Fund Returns 9. 4% 8. 1% *“Backfill bias” is the tendency of reported database returns to be higher as a result of hedge funds beginning to report returns after they have achieved strong performance and then retroactively filling in their history. To adjust for this, fund returns were included only if they appeared after the date that the fund first reported to the database. “Survivorship bias” is the tendency of reported database returns to be higher as a result of capturing only the returns of funds that continue to report to the database. To adjust for this, returns of funds that dropped out of the database were added back. All funds with less than $10 million in assets under management were removed from the sample. Given the data in the TASS database, the impact of “look-ahead bias” (unreported returns of funds leaving the database) cannot be determined. See “TASS Database” in the Appendix. Source: TASS and Bernstein 26
Hedge Funds: Superior Trade-Offs 1996– 2005 Annualized* Return (%) Market-Neutral Hedge Funds Directional Hedge Funds Stocks Bonds Presentation Code T-Bills *Past performance does not guarantee future results. Stocks are represented by the S&P 500, bonds by the Lehman Brothers U. S. Aggregate Index; maturity of Treasury bills is three months. See “TASS Database” in the Appendix for details on our hedge fund indexes. Hedge fund performance is given after fees (1% on asset management and 20% of profits, with a highwater mark). Source: Federal Reserve, Lehman Brothers, Standard & Poor’s, TASS, and Bernstein 27
Traditional Allocation Models: A New Paradigm? Percentage of Total Assets Traditional Assets Only 60% Stocks 100% Hedge Funds? Presentation Code 40% Bonds With Hedge Funds 28
Market vs. Manager: The Traditional Approach Sources of Returns: 1996– 2005* 17% Manager Decisions (Alpha) Objectives ■ Capture market return Presentation Code ■ Add a premium (alpha) through Market long-only security selection Movements *We measured the variation in monthly returns attributable to the Russell 3000 Index for each fund in our sample universes. We then took the average result to represent the market return driver. Though funds may have had exposures to other market factors, we attributed all returns not explained by the Russell 3000 movements to active manager decisions. See “Mercer Database” in the Appendix for details. Source: Mercer, Russell Investment Group, and Bernstein 29
Hedge Funds Focus on Alpha, Not the Market Sources of Returns: 1996– 2005* Sources of Alpha ● Long security selection ● Short-selling Manager Decisions (Alpha) Presentation Code Market Movements ● Various markets and instruments ● Leverage ● Specialized strategies (arbitrage, etc. ) *We measured the variation in monthly returns attributable to the Russell 3000 Index for each fund in our sample universes and took the average result to represent the market return driver. Though funds may have had exposures to other market factors, we attributed all returns not explained by the Russell 3000 movements to active manager decisions. See “TASS Database” in the Appendix for details on how we analyzed hedge fund returns and “Mercer Database” for a description of how we analyzed traditionally managed stock returns. Source: Mercer, Russell Investment Group, TASS, and Bernstein 30
Alpha Dispersion Among Hedge Funds Is Wide… Alpha +/- Median Manager: 1996– 2005 Annualized* Directional Hedge Funds Market-Neutral Hedge Funds Top-Decile Manager Presentation Code Median Bottom- Decile Manager *“Alpha” is defined as a fund’s total return, minus the cash return and minus the fund’s estimated sensitivity to Russell 3000 Index returns (in excess of the rate on cash). See the Appendix for details on how we used and adjusted the TASS database of hedge funds and the Mercer database of traditionally managed portfolios. Source: Federal Reserve, Mercer, Russell Investment Group, TASS, and Bernstein 31
…But Much Narrower for Traditional Managers Alpha +/- Median Manager: 1996– 2005 Annualized* Directional Hedge Funds Market-Neutral Hedge Funds Long-Only Stocks Long-Only Bonds Top-Decile Manager 1. 3% 0. 4% (1. 2)% (0. 4)% Presentation Code Median Bottom- Decile Manager *“Alpha” is defined as a fund’s total return, minus the cash return and minus the fund’s estimated sensitivity to Russell 3000 Index returns (in excess of the rate on cash). See the Appendix for details on how we used and adjusted the TASS database of hedge funds and the Mercer database of traditionally managed portfolios. Source: Federal Reserve, Mercer, Russell Investment Group, TASS, and Bernstein 32
Low Volatility Masks Full Downside Risk Presentation Code Worst Peak-to-Trough Loss* 1996– 2005 *Bonds are represented by the Lehman Brothers U. S. Aggregate Index. See “TASS Database” in the Appendix for details on our Market-Neutral Hedge Fund Index. Source: Lehman Brothers, TASS, and Bernstein 33
More Like Stocks at Just the Wrong Times Correlations to S&P 500* 1996– 2005 Up S&P Months Down S&P Months Bonds Presentation Code Market-Neutral Hedge Funds Bonds Market-Neutral Hedge Funds *See “TASS Database” in the Appendix for details on our Market-Neutral Hedge Fund Index. Bonds are represented by the Lehman Brothers U. S. Aggregate Index. Past correlations are not necessarily indicative of future results. Source: Lehman Brothers, Standard & Poor’s, TASS, and Bernstein 34
Choosing the Right Hedge Fund Manager Competitive Advantage Risk Management Presentation Code Infrastructure and Oversight < Core competence < History of positive alpha < Experienced management team < Diversified sources of return < Market/economic exposure quantified < Prudent use of leverage < Efficient trading and operations < Legal compliance/independent accounting < Detailed reporting Superior Performance After Fees and Taxes 35
Appendix TASS Database The TASS database includes the net-of-fee performance of individual hedge funds whose managers have elected to report to the database. As of December 2005, there were a total of more than 6, 000 funds included in the database. In constructing our Market-Neutral Hedge Fund, Directional Hedge Fund, and Fund of Fund indexes, we included the performance of funds only after their managers decided to report to the database, and only for those funds that had at least $10 million in AUM. We also included the performance of all funds in the database that are no longer currently reporting. The indexes are equal-weighted. We calculated after-tax returns using ordinary-income and capital-gains tax rates at the highest marginal brackets in effect each month over the 1995 -2005 period. In the case of directional hedge funds, we assumed that 75% of the return was characterized as ordinary income and 25% as long-term capital gain; for market-neutral funds, we assumed 90% ordinary income and 10% capital gain. In the calculations for funds of funds, we assumed a weighted average of the two fund categories. Mercer Database of Equity and Fixed Income Managers In analyzing traditional active long-only equity manager and fixed income manager returns, we used the Mercer database of large-cap equity and fixed income managers. The database includes the net-of-fee performance of individual managers. As of December 2005, more than 1, 400 funds were included in the large-cap equity manager database and more than 500 funds in the fixed income database. In both cases, we included the performance of all funds in the database that were no longer currently reporting. Presentation Code Hedge Fund Allocation Recommendations The recommendations regarding the allocations to hedge funds are based on an analysis and consideration of the financial circumstances and risk profile of one specific client. The allocations to hedge funds in total recognize that there is unusual uncertainty regarding the ability of any hedge fund to achieve its premium goals, and therefore long-term risk is higher than it might appear. This leads us to limit the client’s overall hedge fund exposure in a way that varies with the risk profile of the client. These recommendations are intended to provide general guidance only and may not be suitable for all clients with that type of stock and bond allocation. The characteristics of hedge funds vary widely and may contain aggressive investment strategies designed for investors who understand are willing to accept the risks associated with investing in funds that may utilize various investment strategies to enhance returns, including the use of leverage, investment in futures and options, and the technique of short-selling securities. There are substantial risks associated with investment in hedge funds, including the loss of all capital invested. Sales of hedge funds are restricted to investors who meet certain qualification standards. This presentation is neither an offer to sell nor a solicitation of an offer to buy shares or interests in any Alliance. Bernstein hedge fund. The offering of any Alliance. Bernstein hedge fund is made only pursuant to the fund’s Confidential Memorandum, Subscription Agreement, and if available, current financial statements, all of which must be read in their entirety. No offer to purchase shares or interests will be accepted prior to receipt by the offeree of these documents and the completion of all appropriate documentation. 37
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