Replicating the Big Idea
Investors who are unaffiliated with investment managers like Structural Alpha vehicles because they usually outperform the investment manager’s funds or separate managed accounts. In an ideal world, asset managers would launch or acquire an insurer, reinsurer, and/or bank as Buffett did, and manage its assets solely due to his or her passion for improving performance for his or her investors without incurring a proportionate increase in risk.
Sadly, even though hedge fund managers are often the biggest investors in their funds and personally benefit from this outperformance, they are usually more interested in the Big Idea because Structural Alpha vehicles are permanent capital, asset gathering, and fee generating machines.
Greenlight Re and Third Point Re had nearly $4 billion of investable assets at their peak, all of which were permanent capital. Furthermore, we estimate that roughly $3 billion of these assets would not have been available to Einhorn and Loeb if they only offered funds or managed accounts.
First of all, they would not have had nearly $2 billion in float, which is not only permanent capital, but also generates full fees. Float is a function of equity capital. Increasing equity capital from investors who would not otherwise be fund investors proportionately increases the float and all equity capital (whether from new investors or regular investors who have given up redemption rights) is also permanent capital.
In the case of Third Point Re, $390 million of its startup capital came from four private equity funds, none of which would have invested in Dan Loeb’s hedge funds. But they invested in a reinsurer where he ran the assets in a separate managed account pari passu with his funds (due to the new U.S. tax law in 2018, the assets are invested in Loeb’s offshore fund).
Once GLRE and TPRE went public, their shareholders also included mutual funds, pensions, endowments, trusts, other insurers and individuals. Mutual funds would never invest in Einhorn’s and Loeb’s hedge funds, but GLRE and TPRE became attractive stocks and a number of mutual funds became investors in them.
Pensions, endowments, trusts, insurers, and reinsurers have legal list requirements. Many of their investment policies prohibit them from investing in hedge funds, but since GLRE and TPRE were stocks, not hedge funds, so they were OK. Some legal lists specifically name the types of permitted investments and unless hedge funds are specifically mentioned, they are verboten. Again, GLRE and TPRE were stocks, not hedge funds, which were usually OK.
Pensions and endowments also lose their tax exemptions in the U.S. if they invest in domestic hedge funds, but investments in GLRE and TPRE do not cause the loss of a tax exemption, because they are stocks. Lastly, since domestic funds have limits on the numbers of investors, access to Greenlight’s and Third Point’s magic requires a minimum investment in the millions, if not tens of millions, so many individuals could not access Einhorn’s and Loeb’s magic. For $1,900 or $1,250, an individual could buy 100 shares of GLRE or TPRE on their IPOs and gain access to Einhorn or Loeb respectively.
The combination of shareholders who would not or could not otherwise invest in the Greenlight or Third Point funds and the magnitude of float (much of which is generated by the new segments of investors) accounts for the asset gathering power of Structural alpha vehicles. Through the end of 2018, seeding GLRE with $50 million has allowed David Einhorn to earn $368 million in fees from the reinsurer. Dan Loeb’s $75 million seed investment in TPRE has resulted in $465 million in fees. Management and performance fees for services to Structural Alpha vehicles can be tax deferred, compound tax deferred, and repatriated as capital gains.
In addition to the benefits outlined above, there are two other benefits for asset manager sponsors. The first is that they can defer taxes on their fees, where they can compound tax deferred, and repatriate them as capital gains.
Lastly, any business that has the growth history and profit margins enjoyed by the hedge fund industry could easily monetize some or all of its value through an IPO or a private sale. Unfortunately, neither of these have worked well for hedge fund managers and most hedge fund managers will never receive a penny for the value of their business. If an asset manager successfully launches a Structural Alpha vehicle, it can acquire some or all of the asset manager for shares allowing it to monetize some or all of its business on a tax free basis with a liquid stock, which can then be margined, allowing the asset manager to take 50% off the table tax free.
Four provisions of the U.S. tax law that went into effect in 2018 can impact these startups. This tax law has made some launches more difficult and helped others. The first provision concerns controlled foreign corporation (“CFC”) taxation. Prior to this provision, hedge fund managers could put up all or the vast majority of capital, but keep the voting rights under 25% for insurers and reinsurers or 50% for banks and not have look through taxation as long as the vehicle was primarily in the business of insurance, reinsurance, or banking and was exempt from PFIC taxation.
Senator Wyden publicly upbraided John Paulson’s PAC Re for this and the new tax law bases CFC taxation on value as well as voting, so sponsors of insurers and reinsurers will need to find 3 x unaffiliated investors and sponsors of banks 1 x unaffiliated investors (none of whom own more than 10%) in order to maximize tax efficiency. This almost requires future vehicles to go public, whereas most previous sponsors of Structural Alpha vehicles have not wanted the scrutiny of being a publicly traded company. That said, there are some ways to avoid a public offering for some managers and still maximize tax efficiency.
The second provision will affect those vehicles with both non-U.S. and U.S. subsidiaries. Writing primary insurance in the U.S. greatly reduces the risk of bad underwriting results while reinsuring large portions of the business to the non-U.S. sister permits underwriting profits and investments to compound tax free. The new provision limits the amount of business that can be reinsured and could affect many reinsurers, such as D.E. Shaw’s James River and Third Point Re.
The third provision will help launches. One of the impediments to a launch was the uncertainty of whether or not an insurer or reinsurer was primarily in the insurance or reinsurance business and entitled to the exemption from PFC taxation. This tax uncertainty was not a risk that some managers were willing to accept. There is no definition of insurance or reinsurance in the U.S. tax code and heretofore no bright line ratio test. The new law gives a safe harbor if reserves are more than 25% of assets, which is not a difficult standard to meet and should mitigate a lot of bad underwriting in the future that has plagued some of these vehicles in the past.
The fourth provision lowers the corporate tax rate to 21%. While not as tax efficient as a non-CFC, it means that a CFC will be taxed far more favorably than the majority of fund investments. While once a PFIC, always a PFIC, CFC status is not permanent. This means that sponsors can start an insurer, reinsurer, or bank as a 100% owner and be somewhat tax efficient until they can bring in enough unaffiliated other investors and become even more tax efficient (not to mention the additional permanent capital, AuM, and fees that the other investors generate).