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Partnership NAV and Deferred Tax component


dual_bid
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To the fund managers members of this board:

 

How do you reconcile the deferred tax component in your NAV calculations?

 

e.g. say your fund holds large unrealized gains, a NAV is set for a potential investor, he buys in, and a day later you sell the holding, realize the gain and pay your (.e.g) 15-30% tax. Now the NAV is obviously reduced by the amount of tax paid. Had the investor waited a day he would have received a larger stake in the partnership (Lower NAV).

 

How do you reconcile this problem (new investors entering a fund with large unrealize gains)?

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Partnerships are flow-through vehicles.  Tax is not paid by the partnership, but flows through directly to the partners with their allocation of dividends, interest, long-term and short-term capital gains.  The partnership needs to recalculate the NAV after each new contribution or redemption.  The allocation of income (realized and unrealized) is also calculated for all partners at the same time.

 

We do our calculation each month.  So all of the income is distributed at the end of each month.  If a partner joins say April 1st, then they do not receive any portion of the gains realized or unrealized from the previous month.  They would only receive their proportional income from April 1st onwards during their holding period.  I haven't read the audited financials for many funds, in particular their full monthly accounting statements, so I can't say how others are doing it...I can only speak for our fund.  Cheers!

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Sorry Dual_bid, the other portion of your question applying to how to avoid such situations:  

 

Unfortunately, if your investment manager is at all successful, you are going to face some realized gains at some point.  Investment managers naturally need to try and offset some of their realized gains by losses in other investments if they can, to reduce the amount of realized income that passes through to partners.  You can reduce this as a manager, but you can't completely avoid it.  Some managers will sell stock between funds to realize losses in a fund that has realized gains.  This is common practice for many mutual funds, hedge funds, etc.  You can sell positions gradually over time, rather than in one lump-sum, so that the gains are distributed over a period of time.

 

From the investor's standpoint, averaging into the fund may be the better choice if the fund has a large amount of unrealized gains that is likely to be realized.  The problem is that the investor may not be able to figure this out easily, and there is no guarantee when those gains were to be realized.  Averaging in could actually end up working against you if you are wrong on the timing.  Cheers!

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So all of the income is distributed at the end of each month.  If a partner joins say April 1st, then they do not receive any portion of the gains realized or unrealized from the previous month.  They would only receive their proportional income from April 1st onwards during their holding period.

 

Sanj... I'm not sure I understand you. As far as I understand, NAV is calculated by taking the LP assets (say stock holding values at the given entering day) minus liabilities. However, those stock values may include large unrealized gains (with their inherent tax obligations), so a new investor's NAV will include those. No? On the other hand, had he entered AFTER the fund realized the large gain, his NAV would have been lower (because of the tax paid). No?

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Parsad,

 

A current co-worker and I always assume we will start a partnership one day in the future, so naturally I'm a bit curious in the process (capital raising, how they are set up, fees, etc). Do you guys outsource all your back-office stuff (redemptions, deposits, distributions, statement mailings, NAV calculations, keeping track of partnership interests, etc.) If so I'm curious what the ballpark fees would be for that back-office stuff would be, for say a $3 -10 million partnership fund. Do the folks you use charge a percentage of AUM for this service? Was your prime broker very helpful regarding the process of capital raising, suggestions for which firms to use for back-office support in your area, etc.)?

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To the fund managers members of this board:

 

How do you reconcile the deferred tax component in your NAV calculations?

 

e.g. say your fund holds large unrealized gains, a NAV is set for a potential investor, he buys in, and a day later you sell the holding, realize the gain and pay your (.e.g) 15-30% tax. Now the NAV is obviously reduced by the amount of tax paid. Had the investor waited a day he would have received a larger stake in the partnership (Lower NAV).

 

How do you reconcile this problem (new investors entering a fund with large unrealize gains)?

 

I just went through the process of setting one up over the last 6 months.  The documents we used for the limited partnership allow the general partner to make "special allocations" of realized gains/losses in situations where there is a large basis difference. In addition, the partnership may make a Section 754 election for a basis adjustment.

 

Basically, with all of the tax implications, corporate law implications, and security (the partnership interests are considered securities, and you are considered to be selling them) and investment adviser law implications, its near impossible to do this without seeking professional advice.

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Sanj... I'm not sure I understand you. As far as I understand, NAV is calculated by taking the LP assets (say stock holding values at the given entering day) minus liabilities. However, those stock values may include large unrealized gains (with their inherent tax obligations), so a new investor's NAV will include those. No? On the other hand, had he entered AFTER the fund realized the large gain, his NAV would have been lower (because of the tax paid). No?

 

Yes, that's correct.  But they will only inherit any unrealized and realized gains from the date of their ownership, as existing gains have already been allocated.  That was what I referred to in the second part of the answer in the following post.  The manager can try and offset gains by losses, realize gains gradually over time, or the investor can average in over time if they believe there will be large realized gains at some point.  But there is no certainty in the last choice, since the timing of the gains is completely dependent on the manager. 

 

That's part of the risk of investing an investment fund.  Investors by their very nature usually buy into funds when they have topped, rather than invest when the funds are near the bottom with few unrealized gains.  Cheers!

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Parsad,

 

A current co-worker and I always assume we will start a partnership one day in the future, so naturally I'm a bit curious in the process (capital raising, how they are set up, fees, etc). Do you guys outsource all your back-office stuff (redemptions, deposits, distributions, statement mailings, NAV calculations, keeping track of partnership interests, etc.) If so I'm curious what the ballpark fees would be for that back-office stuff would be, for say a $3 -10 million partnership fund. Do the folks you use charge a percentage of AUM for this service? Was your prime broker very helpful regarding the process of capital raising, suggestions for which firms to use for back-office support in your area, etc.)?

 

Ugh!  Capital raising is the hard part.  It's rare if you can get off the ground and have the capital at hand right away.  Be prepared to work on the side and live off your savings for at the very minimum of two years.  We had verbal commitments of $2.5M, but only $400K materialized once we had the LP set up.  And the money will come from the least expected places.  Forget about friends and family...they know you, so there is a natural bias that you are starting the damn thing.  They'll give you money, but very small amounts.

 

You have to keep costs low.  Alnesh is a CPA with a Masters in Science and Tax, so we save money by him doing the accounting.  Our costs for the fund are limited to prime broker, audit, legal and mailings.  You are talking to the back-end support.  I do all the statements, administrative work, mailings, discussion with legal counsel, contact with brokerage, and a good chunk of the contact with the auditors.  We are now finally getting of size where we feel comfortable to outsource some of the book-keeping work.  Probably in the next year at some point.  The one tip I can give is find a partner that complements your abilities...preferrably somebody with an accounting background, if you are handling the investment side. 

 

I've seen alot of funds start up and go cheap with the brokerage, but hire a high-end administrative company.  Even after they ask for my opinion on which broker to use (and I always tell them The Desai Group at Morgan Stanley Smith Barney), they still don't believe me and go with someone like Interactive Brokers and Michael J. Liccar for administrative stuff.  You can save alot of money for your partners by doing alot of this stuff yourself.  The Desai Group can do some of the back-end office stuff like cut checks, client contact, etc.  Alot of times, fund managers get so wrapped up in the glamor of the investment side, they aren't willing to do the dirty work and handle administrative chores.  It will be your fund, and you ultimately decide how efficiently you want to run it.       

 

I just went through the process of setting one up over the last 6 months.  The documents we used for the limited partnership allow the general partner to make "special allocations" of realized gains/losses in situations where there is a large basis difference. In addition, the partnership may make a Section 754 election for a basis adjustment.

 

Isn't section 754 election only for depreciable assets?  How can you use that to offset gains from equities or fixed income instruments?

 

Basically, with all of the tax implications, corporate law implications, and security (the partnership interests are considered securities, and you are considered to be selling them) and investment adviser law implications, its near impossible to do this without seeking professional advice.

 

Agree wholeheartedly!  You need to do it right...but as Prem told me...just start, whatever you have...just start and build a track record!  Cheers!

 

 

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I just went through the process of setting one up over the last 6 months.  The documents we used for the limited partnership allow the general partner to make "special allocations" of realized gains/losses in situations where there is a large basis difference. In addition, the partnership may make a Section 754 election for a basis adjustment.

 

Isn't section 754 election only for depreciable assets?  How can you use that to offset gains from equities or fixed income instruments?

 

Basically, with all of the tax implications, corporate law implications, and security (the partnership interests are considered securities, and you are considered to be selling them) and investment adviser law implications, its near impossible to do this without seeking professional advice.

 

Agree wholeheartedly!  You need to do it right...but as Prem told me...just start, whatever you have...just start and build a track record!  Cheers!

 

 

 

I am not a CPA, but the one who advised me said it (section 754) can be used for a basis difference related to stocks as well.

 

I just looked up actual internal revenue code, it reads "basis of partnership property shall be adjusted..." and refers to "partnership property."  I'm assuming marketable securities are included.

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Parsad and other managers,

 

What is the annual cost (as a % of your net asset size) of audit, legal, book-keeping and accounting for your fund? If you can share the approximate fund size also (for example, a range like $1-3M would be ok if you don't want to share the exact fund size), that would be very useful to me and perhaps others.

 

Thank you.

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I am not a CPA, but the one who advised me said it (section 754) can be used for a basis difference related to stocks as well.

 

I just looked up actual internal revenue code, it reads "basis of partnership property shall be adjusted..." and refers to "partnership property."  I'm assuming marketable securities are included.

 

Be careful Watsa.  I don't think that is correct.  Also, just because the partnership has the clause in the agreement, doesn't mean the IRS will view the nature of the income in that way.  You could be creating a future tax problem for your partners if you exercise the clause and the application is incorrect.  Simplest way is usually the best way to go.  Cheers!

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Parsad and other managers,

 

What is the annual cost (as a % of your net asset size) of audit, legal, book-keeping and accounting for your fund? If you can share the approximate fund size also (for example, a range like $1-3M would be ok if you don't want to share the exact fund size), that would be very useful to me and perhaps others.

 

We will be under 0.8% with $3M in assets (this year) and under 0.5% with $5M in assets for audit, legal, book-keeping, accounting, mailings, and tax preparation.  I think we can get it down to about 0.3-0.35% with $7.5M under management.  Of course, there are certain shareholder initiatives we will be involved with from time to time, and the expenses will elevate slightly when we are involved in those activities.  Cheers!

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Parsad and other managers,

 

We do our calculation each month.  So all of the income is distributed at the end of each month.  If a partner joins say April 1st, then they do not receive any portion of the gains realized or unrealized from the previous month.  They would only receive their proportional income from April 1st onwards during their holding period.

 

Does this monthly calculation not drive up your audit costs for under $10M Funds? Why not do it like a Mutual Fund and if you buy on April 1st or December 1st, you get the same amount of distributable income, short-term, long-terms gains on or around December 15th. The GP usually advises the investor coming in of the tax issues and the GP can always provide a fair deal for the LP, and all partners, by adjusting the NAV when a new LP comes in.

 

This view is from a small fund perspective as costs are key.

 

 

Cheers

JEast

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I am not a CPA, but the one who advised me said it (section 754) can be used for a basis difference related to stocks as well.

 

I just looked up actual internal revenue code, it reads "basis of partnership property shall be adjusted..." and refers to "partnership property."  I'm assuming marketable securities are included.

 

Be careful Watsa.  I don't think that is correct.  Also, just because the partnership has the clause in the agreement, doesn't mean the IRS will view the nature of the income in that way.  You could be creating a future tax problem for your partners if you exercise the clause and the application is incorrect.  Simplest way is usually the best way to go.  Cheers!

 

yeah - not my area of expertise.  However, I am still pretty sure what I said is correct.  just some quick googling - refer to page 355 & 356 of US Regulation of Hedge Funds

 

http://books.google.com/books?id=_Mz09XY9B0AC&pg=PA356&lpg=PA356&dq=Section+754+irs+hedge+fund&source=bl&ots=xWaD7JUnTl&sig=Bqc0mPxfjyQiGkvfBNB9lvCeA8U&hl=en&ei=EA-pS4mEFI2MNu7siK4B&sa=X&oi=book_result&ct=result&resnum=1&ved=0CAYQ6AEwAA#v=onepage&q=Section%20754%20irs%20hedge%20fund&f=false

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Does this monthly calculation not drive up your audit costs for under $10M Funds? Why not do it like a Mutual Fund and if you buy on April 1st or December 1st, you get the same amount of distributable income, short-term, long-terms gains on or around December 15th. The GP usually advises the investor coming in of the tax issues and the GP can always provide a fair deal for the LP, and all partners, by adjusting the NAV when a new LP comes in.

 

This view is from a small fund perspective as costs are key.

 

Hi James,

 

The increased cost for the audit is minimal, as we receive statements from the broker monthly and the auditor still has to go through each statement and journal entry.  Also, we are at the point now where we get money into the fund almost monthly...you never say no because when you do need the capital, it usually stops coming in at that point...so we incur the small increased cost of the audit if it means capital flows into the fund a bit more regularly.  It's also more convenient for existing partners and new partners when depositing, and we have no lock-up so if there are redemptions, partners can receive their funds easier also.  Cheers!

 

 

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Parsad where did you raise most of your assets from? Who are your clients?

 

For the U.S. fund which is domiciled in the U.S., they are all U.S. citizens and accredited investors.  For the Canadian fund which is domiciled in Canada, they are all Canadian citizens and qualify for exemptions under our offering.  Cheers!

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yeah - not my area of expertise.  However, I am still pretty sure what I said is correct.  just some quick googling - refer to page 355 & 356 of US Regulation of Hedge Funds

 

Yeah Watsa, if you read the 3rd paragraph from the bottom of the page, it talks about what I was saying.  It can create serious problems in how you track the income for your other partners.  Also, once elected, you cannot opt out...thus your tax basis is changed forever as long as the partnership operates.  Cheers!

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yeah - not my area of expertise.  However, I am still pretty sure what I said is correct.  just some quick googling - refer to page 355 & 356 of US Regulation of Hedge Funds

 

Yeah Watsa, if you read the 3rd paragraph from the bottom of the page, it talks about what I was saying.  It can create serious problems in how you track the income for your other partners.  Also, once elected, you cannot opt out...thus your tax basis is changed forever as long as the partnership operates.  Cheers!

 

Yes, I think what they are saying "As a practical matter, hedge funds rarely make elections under Tax Code section 754" sums up the point you are make.  

 

The point I was making is, however administratively difficult,  that it is still there as an option for a basis adjustment.  What they talk about on page 356 (they refer to as "fill-up" or "stuffing" provisions) is what I was talking about with special elections.  The special allocations are a more preferable way to do it.  

 

The PPM & partnership agreement we used allows for both.

 

 

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So all of the income is distributed at the end of each month.  If a partner joins say April 1st, then they do not receive any portion of the gains realized or unrealized from the previous month.  They would only receive their proportional income from April 1st onwards during their holding period.

 

could you give an example in NAV terms?

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Parsad's 0.8% figure is definitely on the low end of what you should expect.  Third Party administrators are typically a $1,000 a month minimum, and many want to charge a % of AUM in addition.  An audit is $10,000 to $25,000 per year.  If AUM is only $1 million it is possible to have a 3 to 4% annual expense ratio and that is not including management fees and the costs to start the fund (legal for documents and state and SEC filngs).  What makes sense form a cost perspective (e.g. doing administration yourself) may not be allowable per your stae regulators.  

 

As for the deferred tax component question.  New investors in mutual funds get hit with any realized gains.  In a private partnership they typically do not due to the allocation being done monthly.      

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I pay 0.2% administration (and that includes everything) on the first $10m, going down to 0.15% on the next and down to 0.1% after $20m. Other fees include $100 per investor annual maintenance and $50 per investor transaction.

 

My fund's audit is only $4,000 per annum. 

 

On a fund of $10m+, I pay less than 30bps and do nothing.

 

 

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could you give an example in NAV terms?

 

For example, income from March 1st to March 31st:

 

10 Partners each have $100K invested:

 

Dividends $10K

Interest $10K

ST Gains $20K

LT Gains $50K

Unrealized Gains $100K

 

Simply divide the income totals by 10 and allocate.

 

April 1st...new partner puts in $100K...distributable income is now divided by 11 partners.  Does not partake in any of the previous income except for the unrealized gains when realized.  Yes, NAV is inflated by unrealized gains, but it does not impact investor unless realized or fund liquidated.  Over a long-period of time, the effect is relatively negligible.  Cheers!

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I pay 0.2% administration (and that includes everything) on the first $10m, going down to 0.15% on the next and down to 0.1% after $20m. Other fees include $100 per investor annual maintenance and $50 per investor transaction.

 

My fund's audit is only $4,000 per annum.  

 

On a fund of $10m+, I pay less than 30bps and do nothing.

 

Hi Returnonmycapital,

 

You use Commonwealth correct?  A few questions:

 

- The 0.2% is just for administration...doesn't include brokerage, legal, audit, tax preparation and mailings right?  

- How do you find their services?

- Do they mail out your annual reports as well?

- What about filing and reporting of new subscriptions to provincial securities regulators?  

- How do your partners find their services?  

- Are you happy with them?  

- Any problems with them doing the books?  

 

Thanks!  Cheers!

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Parsad,

 

I do use Commonwealth and I am happy with their service. Alex Chapman is my main contact and is a straight-up guy and I trust him. He has a good team and I like them. Commonwealth is fairly new, when I started my fund it was when Alex was with Mintz. So, there have been some kinks as new people are brought on board and systems are built, but I have had no material issues to report. It just took a little longer to do the NAV than I would have thought on a couple of occasions.

 

The 0.2% includes admin, tax prep, mailings, provincial reporting (I have only helped fill in 1 provincial reporting document).

I email them my annual letter, they then mail out the annual report.

I have yet to hear a complaint from any of the fund's owners with regard to their services.

When doing the books, they are conservative - I use GAAP accounting (only bid prices), rather than transactional - for example.

 

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