A Tax-Efficient Hedge Fund For The Wealthy

by Carla Johnson, Investors Offshore.com

03 July 2001

The New York Times has reported that Bear Stearns, the sixth-largest brokerage in the United States, has created a new fund of hedge funds vehicle that has the potential to be very tax-efficient. The fund consists of six hedge funds run by their own managers. Investors can purchase a stake for $1 million and for those with over $5 million in assets a warrant is issued allowing investors to put up a piece of their stake in the fund and to borrow the remainder from Bear Stearns.

A warrant gives the owner the right to purchase an underlying asset at a pre-set price at a future date. Geraldine Fabrikant from the NYT explains: 'In this case, if an investor holds the warrant for seven and a quarter years and then exercises it, Bear Stearns appears to expect that investors will be able to declare a long-term capital gain, rather than pay annual taxes on the funds' short-term gains. Short-term gains are taxed at about 40 per cent for those in the highest income bracket, while long-term gains are taxed at 20 per cent.'

Bear Stearns believes that the risk that comes with the warrant will force the Internal Revenue Service (IRS) to treat it as a security subject to long-term gains if held long enough. However, according to offering documents obtained by the New York Times, it is uncertain whether or not the IRS will treat the warrants as "constructive ownership" in the funds. If it does then investors would be exposed to short-term gains in the underlying funds.

James R Hedges IV, head of LJH Global Investments, a hedge fund research and advisory firm, said: 'They seem to be offering leverage and tax avoidance, and we would not necessarily advise our clients to make an investment decision based on tax ramifications or leverage, but rather on the underlying funds. If they are compelling enough, why risk placing a leveraged bet on hedge funds, many of which are already leveraged, and why risk unknown tax ramifications?'

Each Bear Stearns fund charges a 1 per cent management fee and 20 per cent of the profits. The brokerage also levies a 1 per cent fee for constructing the fund of funds, and assumes 10 per cent of all profits for the funds once they reach 15 per cent.

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