Managers, Investors Should Prepare Now For ‘Deferred Compensation Doomsday’

By Gary Alexander 
Senior Vice President, Crown Global Insurance

Many U.S. managers of offshore investment vehicles have deferred compensation otherwise due to them as a way of maintaining their investments in these funds. In late 2008, Congress modified the relevant tax rules so that in 2017, such deferred compensation will be taxable to offshore fund managers. A fair estimate of the amount of unpaid deferred compensation is in the billions of dollars. Virtually every brand name hedge fund operates an offshore fund for institutional and foreign investors and much of the pre-2009 incentive compensation (and growth) has been deferred. While still in the future, it is not too early to think about the impact of this impending liquidity event for fund managers.

The argument for the deferral of compensation has always rested on the premise that deferral aligns the economic interests of managers and investors. If compensation is currently taxed, then managers will have the incentive to focus on their immediate term interests, which may conflict with the long-term interests of investors. Keeping managers “invested” along-side investors is a strong inducement to focus on long-term results. In our view, this alignment will be greatly undermined after 2017 when managers are forced to close-out their deferrals.

Not only will the termination of these deferred compensation arrangements decouple the interests of investors and managers, but the settlement of these liabilities will constitute a large, and perhaps untimely, redemption. Many funds have redemption gates to prevent just such events. Will the payment of these liabilities limit the ability of investors to exercise their redemption rights? Who will have the priority when funds must redeem these accounts? Which securities will be sold to satisfy deferred compensation liabilities? All of these questions must be considered. The point, of course, is that investors and their managers may not see these issues the same way.

Managers and investors could consider three approaches to resolving these issues, including:

1. Start payments earlier. Consideration should be given to winding down these accounts before 2017. This would spread-out the impact of a sudden liquidation of investments, avoiding gating issues arising from too many redemption requests.

2. Require reinvestment of after-tax payments. Some hedge funds are already thinking of ways to require managers to reinvest all or a portion of their after-tax receipts in their domestic fund. This will partially realign investors and managers and, to some extent, discourage good managers from moving on. This requirement could be tied to current bonus arrangements so that the receipt of current bonuses will be contingent on the reinvestment of deferred compensation.

3. Start new deferred compensation programs. Even though most of the deferred compensation programs of the past have been eliminated, there are still opportunities to create new programs, such as death-benefit plans, which will still permit the deferral of compensation. These new plans, often allowing for tax-free distributions through life insurance, will tie managers to the long-term interests of their funds.

There are no doubt other ways to deal with the deferred compensation doomsday which is slowly approaching. At the very least funds should focus on ways to continue the alignment of their managers and investors. These opportunities exist and should be quickly pursued.

Gary Alexander is Senior Vice President of Crown Global Insurance LLC, which partners with clients to enhance alternative investments. With more than 22 years as an investor in alternatives, Mr. Alexander specializes in servicing alternative investment managers and their clients with the company's suite of insurance products. He is currently a member of the bar of the State of New York.