Tax-exempt Investors Research Articles

Tax Implications of Hedge Fund Investments

Different investment vehicles have different implications for individual, corporate, and tax-exempt investors. Hedge funds in particular pose significant tax considerations. In order to achieve the benefits of tax planning for U.S.-based investors, a thorough understanding of the major differences in tax treatment of three common hedge fund structures (U.S. master-feeder, offshore master-feeder, and side-by-side) and private foreign investment companies is necessary.

THE ENERGY MLP GOES INSTITUTIONAL: IMPLICATIONS FOR STRATEGY AND GOVERNANCE

Master limited partnerships (MLPs) were popular in the 1980s because of the favorable tax treatment of their cash distributions. But since the Revenue Act of 1987, which imited the lines of business and income sources for which this tax treatment was available, virtually all remaining public MLPs have been in natural resource businesses.Institutional investors have traditionally avoided investing in master limited partnerships because any cash distributions must be treated as unrelated business income, creating an immediate tax liability. But in an innovative underwriting in May 001, Goldman Sachs offered shares in a limited liability company that would pay stock dividends equivalent to the cash distributions on its proportional ownership interest in Kinder Morgan Energy Partners, a pipeline operator. In effect, this structure allows tax‐exempt investors (institutions) to own an interest in Kinder Morgan Energy Partners without triggering unrelated business taxable income.An interesting aspect of this recent development is that while the MLP was originally viewed as a vehicle for slow‐growth firms to distribute cash and wind down operations, the “institutional” MLP could be used to facilitate growth by attracting needed investment to businesses currently housed in MLP form—typically energy transportation and storage infrastructure businesses (so‐called “mid‐stream” energy assets). The new structure raises some potential corporate governance challenges in that it is highly complex and offers investors only limited control rights. But the authors' conclusion is that the institutional MLP is likely to be a successful financing innovation whose tax‐favored status and extensive public disclosure will outweigh any governance concerns.

What a Portfolio Manager Needs to Implement a Tax–Efficient Strategy

Successful tax-efficient investing requires discipline. It tends to appeal to sophisticated investors who have waded through the tax-blind marketing clutter and concluded that it is either not applicable or is a low probability bet. The key to success for taxable investors is having both a stable and rational investment policy and a sound investment process that the stakeholders support. The evidence continues to build that the traditional approach of not differentiating between taxable and tax-exempt investors does not serve taxable investors well. Few managers are sufficiently talented to overcome the burden of taxes. This article addresses some of the issues taxable investors will face from the perspective of a portfolio manager. It pursues the question of what does a portfolio manager need to do his job well. The discussion includes some common pitfalls and suggestions regarding learning from the mistakes of others as well as what are reasonable expectations. Taxable investors will inevitably face some challenges with which tax-exempt ones will not be familiar.

Tax-exempt investors and the asset allocation puzzle

Investors frequently hold equity in pensions and other tax-exempt savings plans, despite the prediction of the standard model that they hold only bonds. We provide a new explanation for this empirical puzzle based on differences between tax-exempt and taxable assets in the tax treatment of capital losses. We show how limits on refundability of losses on taxable equities leads to diversity of investors’ preferences for corporate leverage on the basis of tax rates. In the simplest equilibrium of the model, tax-exempt savers hold risky, highly levered equities, while low-bracket taxable savers hold bonds and high-bracket taxpayers hold relatively safe, unlevered equities. We discuss the implications of tax-exempts for risk taking and agency costs within the firm.

The Role of Alternative Assets in Tax-Efficient Portfolio Construction

The author considers the role alternative assets play in a taxable portfolio and suggests that investors who pay taxes ought to have a greater portion of their wealth, ceteris paribus, invested in alternative asses relative to tax-exempt investors. The analysis starts with the intuition that fix-income assets are relatively tax-inefficient, and the diversification power of alternative assets should lead them to play a greater portfolio role. The author compares the results of pre- and after-tax portfolio optimization. He suggest that, in line with the original intuition, investors who optimize their asset allocation on an after-tax basis will seek a greater exposure to equity and alternative assets than those who ignore the impact of taxes at the asset allocation stage. Furthermore, an analysis that biases the decision process toward minimizing taxes rather than risks shows that the optimizer shifts even more dramatically out of fixed-income investments toward alternative assets.

Taxable Investors Need Different Strategies

T ax-efficient investing is both a challenge and an opportunity for the investment management industry. Few firms seem to recognize the importance of taxes; the same is true for many taxable investors. Although taxes impose material constraints and costs in the investment process, taxable investing has not received much attention from academics, practitioners, and investors. The investment world largely assumes tax-exempt investors. Portfolio management and perfbrmance measurement are generally inaerent to the effect of taxes on the investors who pay them. These facts are not surprising, as the tax-exempt segment is not only larger but also easier to reach than the taxable one. For taxable investors, the name of the game is to stay in the game. Taxable investors face several issues that those who are taxexempt do not need to address. Beyond the pleasures of maintaining meticulous records and completing forms for various taxing authorities, taxable entities should use hfferent strategies from those that operate in an environment without the negative cash flow of taxes. Jeffrey and Arnott [1993] demonstrate the importance of reducing turnover to a very low percentage. The power of compoundmg is one of the most significant aspects of taxable investing. Exhibit 1 displays pretax and after-tax returns of several investment styles using 1 actual returns and dstribution data from Morningstar over tenand twenty-year spans. An important aspect of this information is that it reflects how managers act within their respective styles. Among the equity styles, growth stocks have the highest pretax and after-tax returns. The growth style has the highest tax efficiency (after-tax returns as a percentage of pretax returns), but also the most volathty. A value approach (represented by the equity income style) has lower returns and tax efficiency but less volatility. These findings are noteworthy, given several studies that conclude that a value approach is superior. Whde it is beyond the scope of t h s article to address this issue, several factors could explain t h s Ifference. For diversification and other reasons, value managers may not exclusively own the lowest price-tobook or price-to-earnings companies. Alternatively, growth or “glamour” managers may invest in not only the most expensive stocks, but also those with more modest valuations. Growth managers, with their lower yields relative to other equity styles, have tax arbitrage working in their favor, as capital gains are taxed at a lower rate than ordmary income for most investors. The difference in the pretax and after-tax numbers for the equity styles is staggering. Consistent with Jeffrey and Arnott, we find that there is real money in increased tax efficiency. For example, if a

What Drives Venture Capital Fundraising?

We examine the determinants of venture capital fundraising in the U.S. over the past twenty-five years. We study industry aggregate, state-level, and firm-specific fundraising to determine if macroeconomic, regulatory, or performance factors affect venture capital activity. We find that shifts in demand for venture capital appear to have a positive and important impact on commitments to new venture capital funds. Commitments by taxable and tax-exempt investors seem equally sensitive to changes in capital gains tax rates, consistent with the notion that decreases in capital gains tax rates increase the demand for venture capital as more workers are incented to become entrepreneurs. Aggregate and state level venture fundraising are positively affected by easing of pension investment restrictions as well as industrial and academic R&D expenditures. Fund performance and reputation also lead to greater fundraising by venture organizations.

What Drives Venture Capital Fundraising?

We examine the determinants of venture capital fundraising in the U.S. over the past twenty-five years. We study industry aggregate, state-level, and firm-specific fundraising to determine if macroeconomic, regulatory, or performance factors affect venture capital activity. We find that shifts in demand for venture capital appear to have a positive and important impact on commitments to new venture capital funds. Commitments by taxable and tax-exempt investors seem equally sensitive to changes in capital gains tax rates that decreases in capital gains tax rates increase the demand for venture capital as more workers are incented to become entrepreneurs. Aggregate and state level venture fundraising are positively affected by easing of pension investment restrictions as well as industrial and academic R&D expenditures. Fund performance and reputation also lead to greater fundraising by venture organizations.

The Effect of Forward Markets on the Debt-Equity Mix of Investor Portfolios and the Optimal Capital Structure of Firms

This paper demonstrates that the various market imperfections that have been suggested to explain observed portfolio choices and capital structures can be circumvented if securities (e.g., options) can be traded that simulate forward contracts on stock. It is shown that if the risk-adjusted returns to bondholders exceed the returns to stockholders (to reflect personal tax differences) tax-exempt investors will prefer a combination of these synthetic forward purchases and corporate bonds to purchasing stock directly. They will not, as has been suggested, include stock in their portfolios for diversification purposes when they can alternatively purchase securities that simulate forward contracts. It is also shown that firms that can sell synthetic forward positions on their own stock can essentially guarantee that sufficient funds will be available to meet their bond obligations. This gives firms the opportunity to increase their debt levels without increasing the possibility of bankruptcy and the corresponding administrative and agency costs.

Arbitrage pricing, transaction costs and taxation of capital gains

Abstract This paper examines one of the few cases of seemingly redundant securities: sets of three government bonds with the same maturity date. Within the bounds on relative bond prices established by tax-exempt investors in a market with proportional transaction costs, the taxation of capital gains on the basis of realization has a significant impact on relative prices. The empirical evidence supports the tax option effect discussed by Constantinides and Ingersoll, but does not generally support the segmented tax-clientele equilibrium discussed by Schaefer.