BACKGROUND

A hedge fund, at any point in time, may have realized and/or unrealized capital items. As an open-ended investment vehicle, partners may enter and exit the fund throughout the year. The question then becomes, how are these capital items fairly allocated among the partners? The allocation designed for hedge funds tackles these complex scenarios of partner turnover and capital item generation to smartly track and fairly allocate. The allocation method is called aggregate allocations, which allocates capital items based on each partner’s disparity.

Disparity is the difference between a partner’s book basis and tax basis. Typically, the book basis will not equal the tax basis due to unrealized gains and losses, although there are other items that could also cause a difference. When the book basis is higher than the tax basis, positive disparity exists, whereas a lower book basis creates negative disparity. The allocation method’s goal is to bring this disparity to zero, making book and tax basis equal. Allocating realized capital gains reduces positive disparity, whereas allocating realized capital losses reduces negative disparity. Generally, a partnership’s realized gains are first allocated to partners with positive disparity and realized losses to those with negative disparity.

AGGREGATE ALLOCATION EXAMPLE

Year 1 – Partnership generates a $5 long-term capital loss.
Year 2 – Partnership generates a $10 long-term capital gain.

In Year 1, the $5 loss will be 100% allocated to Partner A, bringing disparity to ($5) and closer to zero.
In Year 2, the $10 gain will be 100% allocated to Partner B, bringing disparity to $0.

Any tax loss allocated to Partner B and any tax gain allocated to Partner A would not bring their disparity closer to zero, which is counter to the goal. 

Closing the gap between book and tax basis is necessary because it deploys a fair and economical allocation of realized capital items. Disparity captures a partner’s historical accumulation of unrealized gains/losses by adding them to their book capital. The more unrealized gains accumulated the greater a partner’s positive disparity. It is a running total, like a bank account, of what the partnership owes a partner. As these unrealized gains become realized, they will be allocated to partners per their positive disparity. The same is true for unrealized losses that become realized for partners with negative disparity. There are several variations of allocating capital items within aggregate allocations discussed below.

DISPARITY – FULL V. PARTIAL NETTING

In the example above, assume the $5 realized loss and $10 realized gain were both generated in Year 1. Can these gross gains/losses be allocated to each partner, or must they first be netted and those net gains be allocated?

Full Netting

Full netting, as the name suggests, first nets capital gains and losses then allocates the netted amount to partners. Continuing with the example, Partnership had $10 of realized long-term capital gain and $5 of realized long-term capital loss, thus only $5 of realized long-term capital gain is available to reduce positive disparity. Under this method, the $5 realized long-term capital loss is unavailable to reduce negative disparity.

Partial Netting

Conversely, partial netting first allocates realized capital gains and losses separately. The $10 realized long-term capital gain and $5 realized long-term capital loss will not net to a $5 long-term capital gain but instead will be allocated independently to reduce disparity as needed. This approach will reduce disparity faster than full netting. However, it is important to note that this method would also eliminate the GP’s deferral more quickly and is generally not the approach chosen by fund managers.  

AVERAGE EQUITY

Non-capital items (interest, dividends, ordinary income, etc.) can be allocated based on a partner’s average equity. Simply put, if a partner’s average book basis is $50 and the total book capital in the partnership is $100, that partner will receive 50% of all ordinary items. Ordinary items typically are not unrealized, thus there is no running total of ordinary items a partnership owes a partner (Book equity and book basis are used interchangeably for purposes of this article.) If any capital gain or loss cannot be used to reduce a partner’s disparity, this unused gain/loss will be allocated among all partners per their average equity or ending capital.

FULL & PARTIAL REDEMPTION

 Generally, when a partner fully redeems, thereby exiting a partnership, a special allocation of realized capital gain/loss is made to reduce their book and tax basis to zero. It is common that the fully redeeming partner will receive capital gains/losses before other partners to ensure they exit the partnership with a zero disparity. In industry parlance, this special allocation is referred to as filling up/down a partner. The purpose of a fill up/down is to avoid double taxation.

For example, assume a fully redeeming partner (Partner A) has a $200 book and $100 tax basis. Now assume $200 of cash is distributed to reduce book basis to $0. In this situation, Partner A will recognize a $100 tax gain outside of the partnership ($200 cash - $100 tax basis = $100 received in excess of tax basis = $100 tax gain).

Instead, let’s say Partner A was allocated a $100 tax gain upon redemption. In this situation, Partner A’s tax basis increased $100, thus zero tax gain will be recognized outside of the partnership ($200 cash – [$100 tax basis + $100 tax gain] = $0 received in excess of tax basis).

Partner A will recognize a $100 tax gain regardless of the situation, whether inside or outside the partnership. If the gain is not allocated to Partner A inside the partnership, the remaining partners must pick up the $100 tax gain that Partner A was not allocated. Both Partner A and the remaining partners will recognize a $100 tax gain. It is economical and tax efficient for the partnership to allocate the redeeming partner a tax gain.

A partial redemption may use the same strategy of filling up/down, but applies it to the portion of the partner’s capital account that is being redeemed. This methodology results in stuffing for the GP on any partial redemption. Similar to partial netting, this approach is not preferred by fund managers as it more quickly eliminates the GP’s deferral.

 GROSS STUFFING

Realized capital gains and losses are not always available to reduce a redeeming partner’s book and tax basis to zero. In these situations, the gross gains and losses are used to accomplish the most tax advantageous outcome. In industry, this practice is known as gross stuffing.

For example, a hedge fund has $100 of long-term capital gain. This gain is a netted amount composed of $200 of long-term capital gain and $100 of long-term capital loss. Using gross stuffing, the hedge fund can break out the gross gains and losses and use these to reduce disparity accordingly.

Gross stuffing looks back and drills down into the capital gain/loss to pull out the gross gains/losses buried inside. There is typically an ample amount of gains/losses to stuff a partner’s disparity down to zero.

THE TAKEAWAY

The allocation method designed for hedge funds is nimble and responsive to the various book/tax scenarios. It takes a reasonable approach to track capital gains and losses owed to the partners all the while avoiding the burdensome task of assigning specific gains and losses. 

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