Financial Services Insights July 2009

Independent third party fund accounting and administration has been pushed to the forefront of investor thinking in light of the Madoff and other recently publicized investment scandals. The current push is being driven primarily by demand, both by institutional and individual investors, and also by fund managers attempting to be proactive in implementing what many would consider “best practices” in the operational area of their fund(s) and trying to be ahead of the curve as increased regulation appears certain.

This drive to outsource the accounting and administration functions brings with it many challenges and responsibilities. In addition to satisfying investor demand for independent third party accounting, there are many reasons why a firm would outsource. Benefi ts may include reducing the costs of an internal accounting team, avoiding large investments in technology and IT infrastructure, keeping focused on management’s core competencies (investment selection, portfolio management, raising capital), reduction of errors, timely and qualitative reporting, and obtaining a marketing advantage, to name a few. A higher level of comfort is achieved when fund activity, portfolio holdings, subscriptions/redemptions, and account balances are being reconciled to prime brokers and custodians on a daily basis by an independent third party. Common procedures now being performed by administrators include pricing the portfolios daily, using independent third party pricing vendors, and reconciling the value of each security and the portfolio in aggregate to the prime broker/custodian (or to alternative pricing sources), and computing and communicating daily performance and attribution data.

Investors are also demanding greater transparency and access to fund information as well as timely reporting of investor balances. Access to information is one of the main drivers behind the growth of secure investor portals being offered by many administrators, whereby investors log on to secure websites and, with a user name and password, obtain access to their capital statements, performance data and, in some cases, fund holdings.

Once the decision to outsource has been made, the next logical question is: How do you choose an administrator? While references and reputation carry some weight, your due diligence should include visiting the offices of the administrator, meeting and interviewing the team, understanding their service model and technological capabilities, and getting a feel for the qualifi cations and experience of the team members who will actually be performing the work on a daily basis. Make sure they have the requisite skills to understand the instruments traded by the fund, the technology in place to efficiently process and store the transactions, and the ability to provide scalability as the fund grows, other strategies are implemented, and additional prime brokers or custodians are used. There should also be a process in place for continued education or training programs so the team is up-to-date on recent accounting and regulatory changes affecting the industry. Of utmost importance to many fund managers is the timely delivery of reports, including performance reports, monthly NAVs and investor capital statements. A full-service administrator should also have the skills, in-house, to prepare the draft financial statements for the auditors and liaise with the audit firm so that the audit is conducted efficiently and timely. Other value-added services may include the ability to prepare the tax allocations and, in the most efficient environment, the tax returns and K-1s as well.

A thorough understanding of onshore and offshore fund structures, fee calculations, hurdles, redemption policies, gates, accounting rules, side pockets, and valuation policies, as well as the ability to interpret and adhere to the funds’ legal documents, are additional examples of what to look for in an administrator. The administrator can also be a valuable source of input when structuring or updating the fund’s private placement memorandum and limited partnership agreement, since they often see many variations of these documents written by various law firms.

Increased regulation will surely bring with it the need for better organization, document retention and storage, and more transparency of investment strategy, positions, fees and compensation--requiring state of the art, flexible, customizable, and robust technology capable of efficiently aggregating and accounting for fund and investor data. A recent example of this is the surge in the trend toward a multi-prime/multi-custodian environment, post the Bear Stearns and Lehman situations. Changes in accounting rules, such as the recently implemented FAS 157, are another example of where technology is going to be valuable in achieving an efficient process and highlights the need of being up to speed on recent accounting developments. The administrator should be proactive on the accounting front and in agreement with the auditors and fund management on policies, presentation, footnotes, etc., in advance of year end.

Matching a service provider to fit the needs of your fund can be challenging. Expectations and abilities need to be managed by both parties. While you may be delegating accounting and administration tasks to an outside third party, you cannot delegate the responsibility for these tasks. Management of the process typically requires having dedicated personnel in-house who understand the fundamentals of fund accounting and reporting and have the ability to review and approve the work of the administrator. Since at least some of the reporting (i.e., investor capital balances) may come directly from the administrator to the fund’s investors, how the administrator performs will be a reflection on the fund’s management.

An increase in investor requests to conduct their own due diligence on the fund’s service providers, including the administrator, is another consideration in the selection process.

Increased demand for independence, transparency, better reporting and more frequent communication will influence more and more funds to eventually turn to third party administrators to efficiently address these trends and concerns and ultimately should bring more qualitative aspects to the hedge fund industry.

Anthony Deliso is the director of operations of Eisner Fund Services LLC.

For more information, you can contact Anthony at 212.891.6874  


Carried Interest Update  


On May 11, 2009, the Treasury Department issued the “Green Book,” General Explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (Administration’s FY 2010 Proposals) which details the Administration’s tax change proposals. Among the tax proposals is tax treatment and character of carried interests.

The President’s proposal to tax carried interests as ordinary income subject to self-employment taxes rather than capital gain is similar to H.R. 1935 which was introduced by Rep. Sander Levin (D-Mich.) on April 3, 2009. However, there are differences to note.


In general, a non-public investment fund, structured as a limited partnership or LLC, has a general partner or managing member of the LLC that serves as an investment manager to the fund.

The investment manager provides advisory and other services to the partnership for an interest in partnership’s future profits. Under current law, once the partnership is profitable and meets certain hurdles per the partnership agreement, a share of partnership profit is allocated to the investment manager. The partnership profit, or “carried interest,” retains the character (including long-term capital gain) of the partnership income in the hands of the investment manager.

H.R. 1935 and the Administration’s
FY 2010 Proposals

H.R. 1935 proposes to introduce new Section 710 to Subchapter K of the Internal Revenue Code. The Bill proposes to tax income from investment services partnership interests (“ISPI”) as ordinary income subject to self-employment taxes. In addition, any gain recognized on the sale of ISPI generally would also be taxed as ordinary income.

ISPI are interests received, if at the point the partner acquires the partnership interests, the partner or a related party is expected to provide advisory,management, or financing arrangement services with respect to “specified assets” held by the partnership.

Specified assets include securities, rental and investment real estate, partnership interests, commodities, and options or derivative contracts related to the aforementioned assets. As we can see from the Administration’s FY 2010 Proposals discussed below, H.R. 1935 provides narrower language to define the type of income which would be subject to re-characterization as ordinary income.

Under H.R. 1935 income from “qualified capital interest” would not be recharacterized as ordinary income. H.R. 1935 identifies qualified capital interest as the fair market value of money or property contributed to the partnership, amounts included in gross income under IRC Sec. 83, and the cumulative net income or gain taken into account for years to which the new law would apply. Qualified capital interest would not include capital contributions that are attributed to loans from or guaranteed by any partner or the partnership.

In addition, the Bill provides that if a person would perform investment management services for any entity and held either directly or indirectly “disqualified interests” with respect to that entity, income or gain with respect to the interest would be treated as ordinary income. In general, disqualified interests include convertible or contingent debt of such entity and any derivative instruments entered into with such entity, where the value of such interest would be related to the amount of income or gain from the assets to which the management services are provided.

Finally, income received by publicly traded partnership (PTP) from ISPI would be treated as ordinary income and would not be treated as qualifying income under the PTP rules. Some transition rules would apply.

In contrast to H.R. 1935, the provision on carried interest in the Administration’s FY 2010 Proposals states that income from a services partnership interest (“SPI”) would be taxed as ordinary income subject to self-employment taxes.

SPI is defined as “a carried interest held by a person who provides services to the partnership.” The language is much broader than H.R. 1935 in that it does not target investment type services nor distinguish the types of assets required to be held by the partnership. In addition, gain on the sale of an SPI would generally be taxed as ordinary income.

The Administration’s proposal does provide an exception for income attributed to “invested capital.” Invested capital is defined as money or property contributed to the partnership. Income which is reasonably allocated to invested capital would not be re-characterized as ordinary income. It is important to note that invested capital would not include capital contributions that are attributed to loans or advances by any partner or the partnership.

Finally, as an anti-avoidance measure which targets other compensatory arrangements other than through partnership interests, any person who would perform services for an entity and hold a “disqualified interest,” such as convertible or contingent debt, options or any derivative instruments, with respect to that entity, would be subject to tax on ordinary income.

The Administration’s FY 2010 Proposals would take effect in 2011.

New York State  

Last year, New York Governor David Paterson put out a proposed budget to tax non-New York resident partners on the carried interest they receive for performing investment management services to a partnership doing business in New York. On April 7, 2009, Governor Patterson signed into law the New York State Budget Bill and the carried interest legislation was removed in its entirety. Under current law, if a partner is not a resident of New York State, the income from carried interest is not subject to New York tax. A non-resident partner’s share of carried interest allocations made by a fund to the general partner and allocated to the non-resident partner of the general partnership entity does not constitute New York source income, except if the general partner is engaged in a New York trade or business.

New York City  

In June of 2008, New York City introduced legislation that would impose the Unincorporated Business Tax (UBT) on the carried interest received for investment management services.

Under current law, the UBT is generally not imposed on the income for carried interest. Carried interest received by fund managers is exempt from the UBT.

On January 15, 2009, New York State Assemblyman Micah Kellner reintroduced legislation to amend the New York City Administrative Code and impose the UBT on carried interest from investment management services.

Under New York State Assembly Bill A2415, income and gain realized in connection with an “investment management services interest” would not be subtracted from the gross income of an unincorporated business with assets in excess of $10 million for purposes of the UBT. This provision would not apply to the portion of an interest received as a result of capital contributions. We will continue to monitor carried interest legislation at the federal, state and local levels.

Fran Vallone is a director in Eisner tax advisory services group.  

Questions? You can contact her at 212.891.6086  


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©2009 Eisner LLP. You are welcome to reprint short quotations from the material with credit given to Eisner LLP. Written requests for permission to reprint articles should be made prior to use.

This publication is intended to provide general information for readers. It does not constitute accounting, tax, or legal advice, nor is it intended to convey a comprehensive treatment of the subject matter. 

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