The Internal Revenue Service issued a ruling clearing the way for institutional investors to seek changes to incentive fees assessed by hedge funds, which might make it cheaper for them to invest in such offerings.
The ruling issued Tuesday, 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% to 20% of an investor's profits, make up 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 the $295.5 billion California Public Employees' Retirement System, Sacramento, to the $24 billion Utah Retirement System, Salt Lake City, to Intel Corp. have urged hedge funds to make the change and have been spurned in the past, said Rick Ehrhart, CEO of Optcapital, a consulting firm specializing in incentive compensation payable to money managers.
“The holy grail for them is to divide profits on a cumulative basis,” Mr. Ehrhart said in an interview. “There is an inherent clawback” in using this sort of method, Mr. 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.