Politicians of both parties have long criticized the lack of regulation of hedge funds, vast pools of capital that operate secretively, without having to make the disclosures that other investment firms such as mutual funds do. Adding to their explosive growth and unbridled operations, the jaw-dropping compensation of their executives has made hedge funds even more tempting targets to federal lawmakers.
That helps explain a recent surge in the hiring of lobbyists and stepped-up contributions to political action committees by managers in the trillion-dollar hedge fund industry and top officials of private-equity groups that have piled up billions in profits in recent years.
Hedge fund executives gave at least $2.3 million in campaign donations during the 2004 election, compared with $576,000 four years earlier, according to federal election data compiled by the nonpartisan Center for Responsive Politics. In 2006, that jumped to around $6 million.
"Particular industries reach a point where they get big enough that they realize that Congress can, intentionally or unintentionally, harm them through taxation or regulation," said Frank Fahrenkopf, a prominent Washington figure and lobbyist who headed the Republican National Committee in the 1980s.
Ever since a Fortune magazine writer and four pals scraped together $100,000 in 1949 to start what became the first hedge fund, the industry has flown under the public-policy radar. But the "absolutely obscene" profits, as one fund's managing partner called them recently, and the massive loss to a California public pension fund from a hedge fund investment blowup last fall have drawn new and unwanted attention.
Sen. Charles Grassley, R-Iowa, the senior Republican on the tax-writing Senate Finance Committee, and Sen. Max Baucus, the Montana Democrat who heads the panel, are looking closely at how the profits of managers of hedge funds, as well as private-equity funds, are taxed, and whether that should be changed.
One question on the table at a closed-door meeting committee aides held this week with tax practitioners and academic experts: Is it fair for the managers' portion of the funds' anticipated future profits to be taxed at 15 percent, the rate for capital gains, rather than at income-tax rates of up to 35 percent?
Depending on the answer, that could mean tens of millions of dollars in higher tax bills for executives like James Simons, a math whiz and former professor and Pentagon code breaker who founded hedge fund Renaissance Technologies Corp.
Simons pulled in $1.7 billion last year, topping the hedge fund executive pay list compiled by Alpha magazine, published by Institutional Investor. He was followed by Kenneth Griffin of Citadel Investment Group, $1.4 billion, and Sears Holding Corp. Chairman Edward Lampert, whose returns from his ESL Investments was $1.3 billion. Also high on the list were liberal activist George Soros, Quantum Fund, $950 million; and Steven Cohen, SAC Capital Advisors, $900 million.
It's far too early to say how politically difficult it might be to change the tax regime in a way that would withstand legal challenge. But hedge fund managers aren't taking any chances, especially in light of criticism that the U.S. tax code has become far too sympathetic to the wealthy in recent years.
"We're making a very, very big drive to grow our" political action committee, said John Gaine, president of the Managed Funds Association, which he called the largest and "loudest" of several hedge fund industry lobby groups. "There's a broader awakening of our membership to the need to pay attention to Washington."
Hedge fund executives individually made 63 contributions exceeding $200 to the Managed Funds Association's political action committee in the 2005-06 congressional election cycle, according to the Center for Responsive Politics. The association doubled its donations through the PAC to $200,000 last year and is aiming to give $400,000 in 2007-08.
Individual hedge funds, meanwhile, are starting to establish PACs for the first time. Tudor Investment Corp., one of the largest, registered one recently with the Federal Election Commission.
Hedge funds swoop in and out of markets like day traders, investing millions in complex derivative securities and assets ranging far beyond stocks and bonds. Traditionally the domain of wealthy individuals, they increasingly have gained access to money from pension funds, mutual funds and university endowments - meaning that millions of people unwittingly now invest in hedge funds. They are believed to account for around 20 percent of all U.S. stock trading. With some policymakers voicing concern about a potential risk to workers' retirement security, a proposal still in the early talking stages on Capitol Hill would restrict the amount of money that pension funds can plow into hedge funds. Critics see a financial house of cards and point to two spectacular blowups: The 1998 collapse of hedge fund Long-Term Capital Management, amid the Asian financial crisis, rocked Wall Street and prompted the Federal Reserve to help arrange a $3.6 billion private bailout. And last September, fund Amaranth Advisors lost $6 billion because of wrong bets on natural gas prices, socking the employee pension fund of California's San Diego County by an estimated $85 million. Hedge funds "pose a risk to the stability of the markets," said Barbara Roper, director of investor protection at Consumer Federation of America. "It's something Congress should be looking into." Indeed, Senator Grassley recently attempted to impose through legislation a mandate for hedge fund managers to register with the SEC, thereby opening the funds' books to agency examiners. The unsuccessful move, which Grassley may try again, came after a federal appeals court last year slapped down the SEC's effort to bring hedge funds under its supervision. In February, the Bush administration and federal regulators said that heightened vigilance - not new rules - was the best way to handle potential risks. -- On the Net: Securities and Exchange Commission: http://www.sec.gov Managed Funds Association: http://www.mfainfo.org Senate Finance Committee: http://finance.senate.gov AP-CS-05-11-07 1348EDT