Hedge-Fund Strategy by Harvard Gets Senate Scrutiny

Date: Tuesday, May 8, 2007
Author: Ryan J. Donmoyer, Bloomberg

May 8 (Bloomberg) -- Offshore hedge-fund investments by Harvard, Yale and Stanford are prompting scrutiny by Senate Finance Committee aides looking for new sources of tax revenue.

Finance Committee staff discussed the matter yesterday with experts on taxes and hedge funds at a closed-door meeting on Capitol Hill, according to four congressional aides who were present.

The discussion was part of a broader review of the tax treatment of hedge funds and private-equity firms that the committee staff is conducting as lawmakers search for revenue to offset the costs of tax and budget priorities, according to Mark Heesen, president of the National Venture Capital Association, who met with congressional aides last month.

``They have been told to look for potential revenue-raisers and just be very aware of what's going on in the private-equity and hedge-fund arena,'' Heesen said.

Universities, pension funds, and foundations don't owe tax on most investment proceeds, though they are required to pay ``unrelated business income tax'' when they receive profits from debt-financed investing. Hedge funds set up ``blocker'' companies in tax havens such as the Cayman Islands that convert such profit into dividends, which aren't taxed.

Congressional aides who attended the meeting said the inquiry has established that the endowments of many universities, including Harvard, Yale and Stanford, use this technique.

`Properly and Legally'

``If you're a tax-exempt entity and you're investing in a hedge fund, you're very properly and legally in a much better position by investing in one of these corporations,'' said John Gaine, president of the Managed Funds Association, the main Washington-based lobbying group for hedge funds. He said his organization has been meeting with congressional aides for months to educate them about how hedge funds operate.

John Longbrake, a spokesman for Cambridge, Massachusetts- based Harvard, said the university does ``not discuss investment structuring.'' Chris Yates, director of planned giving at Stanford, near Palo Alto, California, said the university ``probably'' uses intermediary companies in some cases. Karen Peart, a spokeswoman for New Haven, Connecticut-based Yale, said she couldn't immediately comment.

Broader Review

The Senate Finance Committee's broader review includes scrutiny of fund managers' ability to pay the 15 percent capital-gains rate on a large portion of their pay. The staff is also reviewing the use of offshore tax havens by fund managers to defer large amounts of pay and the intention of Blackstone Group LP, the private-equity firm seeking to raise $4 billion in an initial public offering, to avoid the 35 percent corporate tax on most of its income by organizing as a limited partnership.

Senate Finance Committee Chairman Max Baucus his panel is ``looking at the general question'' of how hedge funds and private-equity firms are taxed, and Congress is ``nowhere close'' to drafting a bill.

``I'm not close to having legislation, not yet, but I may,'' Baucus, a Montana Democrat, said yesterday at the National Press Club in Washington. ``My view is, first I want the facts. I want to know what's going on here.''

Senator Charles Grassley of Iowa, the ranking Republican on the committee, said the inquiry should determine how hedge-fund managers' income should be defined for tax purposes.

``If it's earned income, it ought to be taxed at 35 percent instead of 15 percent, if it's capital gains, then we'll just leave it the way it is right now,'' Grassley said in an interview.

1950 Rule

Congressional aides said they had become more interested recently in how tax-exempt organizations are sidestepping rules taxing debt-financed investing that were created in 1950 to stop charities from acquiring for-profit businesses with borrowed money.

The ``blocker'' company technique has been approved in individual cases by

Internal Revenue Service rulings.

It makes it easier for tax-exempt organizations to take bigger risks, and reap bigger returns, without incurring tax penalties.

On average, about 18 percent of university endowment money was invested in hedge funds as of June 30, 2006, according to separate surveys by the Commonfund Institute in Wilton, Connecticut, and the National Association of College and University Business Officers, based in Washington. Schools with more than $1 billion in assets are more likely to have money invested in hedge funds than smaller colleges.

According to IRS data, 1,012 U.S. tax exempt organizations reported earning a total of $110.1 million from debt-financed investing and 646 of them paid tax of $13.3 million on those proceeds. That's slightly less than the 1,217 organizations that paid $14.8 million on debt-financed investments a decade earlier.

Percentage Targets

Harvard has a target of 17 percent of its endowment invested in hedge funds, according to its annual report. For Stanford, the target is 15 percent. Yale had 23 percent of its assets invested in hedge funds as of June 30, 2006, according to its annual report.

If the ``blocker'' strategy were banned, the portion of endowment earnings allocable to hedge fund returns would face taxes as high as 35 percent.

``It would cut into the returns,'' said Bill Wilkins, a partner at Wilmer, Cutler & Pickering in Washington, who was a former staff director and chief counsel for the Senate Finance Committee. ``It would just be another drag in addition to the large fees.''

To contact the reporter on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net