Fee & Tax Deferral As Free Float

A Reader recently forwarded to me the marketing documents of an open-end investment fund based in London. The fund had an interesting incentive fee arrangement equal to 20% * (Value at Redemption - Value at Subscription), subject to an annual hurdle rate of XYZ Benchmark + 300 basis points. The incentive fee is deferred until the client decides to pull capital from the fund.

This led me to ponder: since the General Partner doesn’t get paid any incentive fees until redemption, are the taxes payable by the General Partner associated with the incentive fee also deferred until redemption?

If so, does this mean that the fee and tax deferral constitutes a form of “free float”? It would seem so since the manager is able to continue to compound the capital that otherwise would have gone to pay incentive fees and associated taxes at the GP level (a la 401Ks or IRAs).

Interestingly, as pointed out by the Reader, perhaps that’s the reason why Berkshire Hathaway has chosen to not sell some of its long-term public holdings. The cost at sale is not only the tax bill (deferred until now), but also the loss of a form of free float, made so much more valuable by the future compounding power of Berkshire.

PIMCO Wisdom

PIMCO's power brains often generate really interesting and unique analysis to common questions. The summary and thoughts below were derived from a recent presentation on asset allocation. Discount Rate

Post US downgrade, and recent sovereign debt crisis, what are the implications for the actual figure of the risk-free rate?

What about the equity risk premium? Academics prefer to examine historical spreads to determine this risk premium figure, think it’s around 2-6%. This “premium” increases when investors don’t want risky assets (e.g., 2008), and decreases when investors become risk loving (e.g., 2004-2006).

So what exactly is the appropriate equity risk premium? Is a historical figure appropriate? Does it differ depending on the security being analyzed?

Accordingly, if the risk free rate AND equity risk premium is constantly shifting, it would imply that the discount is constantly fluctuating as well. Any slight shift in the variable “k” in discount cash flow models creates huge ripples in the implied value of a security today. Perhaps we should all re-examine our casual use of “discount rates” when attempting to determine the value of a security.

Leverage

It’s a good time to be a borrower – especially on an after-tax basis. Ohio State had just sold $500MM 100-year “century” bonds at 4.849% coupon.

Risk

All risk within a portfolio can be explained by one of the four factors below, with Equity and Duration explaining about 95% of risk in most portfolios

• Equity
• Duration
• Liquidity
• Foreign Exchange

Lessons from Buffett's Tax Return

The investment management industry has a nasty habit of ignoring the effect of taxes upon returns – mainly because the biggest and most important clients don’t care about pre- vs. after-tax returns (pensions, endowments, foundations, etc.) PM Jar does not agree with this common practice. As a result, our Readers will continue to find posts related to effective and creative tax minimization strategies in a portfolio management context.

On the topic of taxes and leverage/margin in a portfolio context, my thoughts brought me back to an old WSJ article on Buffett’s tax return.

There’s lot of speculation in the article, but one particular section stood out:

“Another large element of the gap could be attributable to investment interest expense, which is deductible to the extent that Buffett had investment income—and he did. According to a person familiar with the matter, in the past he has taken out bank loans rather than liquidate shares from his Berkshire Hathaway holdings, which would be a taxable event. Obviously he qualifies for excellent interest rates. Interest expense could also flow through from investment partnerships such as hedge funds.”

Given today’s low interest rate environment (and since interest is tax deductible), could this be a lesson to all of us? Obviously Buffett is older and can use leverage/margin to defer sale of securities until his death. For the average investor, perhaps we should consider using margin or leverage (selectively and prudently) to manage around tax sensitive date thresholds (for example, short-term vs. long-term capital gain).

And it begins...with Michael F. Price

Michael F. Price is going to kick off our inagural post. Well, sort of. I'd like to share the summary (mainly the categorized juicy portfolio management bits) of an interview with MFP in Peter J. Tanous' book Investment Gurus.

Sourcing, Creativity: Price discusses how competitive the traditional bankruptcy and restructuring game has become (this was 1997 folks, think of how much more competitive it must be today). As a creative way to deploy capital into distressed situations, he would do “standby purchaser” deals, in which companies would do a rights offering to raise additional capital and reserve a certain % of the deal for Mutual Series, as well as whatever % existing shareholders didn’t want. These “standby purchaser” deals required him to keep an eye out for companies near liquidity crunches, and meet with them beforehand to offer his assistance, thereby requiring more work and proprietary sourcing, but involved far less competition than traditional bankruptcy/restructuring situations. Reminds of the recent Buffett deals (convertible preferred + warrants) with GE, Goldman Sachs, Bank of America.

Risk: “Risk is not the same as volatility. It’s very hard to measure risk. It’s very simple to measure return. You can’t model it.” He also discusses how earnings and asset value both help mitigate risk.

Cash / Special Situations / Volatility: Cash is ~5-25% of his portfolio “always.” Special situations (bankruptcy, arbitrage, tender offer, merger, buyback, liquidation, etc.) positions don’t move with general market but more with progress of individual situation. Cash + Special Situation is ~40% portfolio. The remaining ~60% consists of POCS (Plain Old Common Stock, value ideas trading below “intrinsic value”) which should theoretically go down less than the market. Therefore his portfolio beta is ~0.6.

Catalyst, Activism: “We perform well because some of our stocks have these catalysts. You asked why do we spend our time going around to shake some cages? It’s because a lot of times you can buy good values. But until there’s a catalyst, the value is not going to get realized.”

Turnover: Portfolio turnover is in mid-70s, skewed upwards by Special Situations basket.

Capital Preservation: “My mission isn’t to make money in bull markets. My mission is to preserve capital.”

Foreign Exchange: “Foreign positions are hedged perfectly every day so currency movements don’t affect our fund price.”

So there you have it: a little sample to whet your appetite! I'll be posting more summaries from other great investors in the weeks and months ahead, be sure to check back for updates.