July 23, 2017    4 minute read

The Trouble with Hedge Funds and Marketplace Lending

More News for the 1%    July 23, 2017    4 minute read

The Trouble with Hedge Funds and Marketplace Lending

A recent article focused on a matter of partnership law. The case, for those whose appetite was whetted by this article, may be less than gripping reading for 99.9% of the business community, but the discussion of the law is well done.

Marketplace Lending

Another issue for partnerships has arisen in the area of marketplace lending. Market analysts have identified a $1trn addressable market for online marketplace lenders by 2020.  Marketplace lending started around ten years ago with companies such as Lending Club and Prosper. The ecosystem has grown considerably since then. Initially, these origination platforms were connecting lenders to borrowers in what was described as ‘peer-to-peer lending’.

Since then, the volume of growth has been driven by institutional investors searching for yield and the term ‘marketplace lending’ has emerged. Marketplace lending has become a very large part of the FinTech revolution as a mean of simplifying and streamlining the process for the emerging millennial borrowing universe to access the credit markets.

One of the key considerations for investors is to understand the level of risk and likeliness of default when lending in this space. Investors are largely agnostic to default rates provided the level of risk is properly priced. A 30% stated loan rate can be adequate compensation for a loan portfolio that suffers 20% rate of default provided that is known or predictable upfront and compares favourably to alternatives.

Why the Tax Is Tricky

The issue for investors in the US, however, is that the effective tax rate on a loan with a high default rate can be very high. The typical institutional investor in marketplace lending is a hedge fund. Hedge funds are usually structured as partnerships, and partnerships do not themselves pay tax as a corporation does: instead, they pass the taxable income through to their partners and evidence this on tax form K-1 that investors must file as part of their own Form 1040.

There is a material distinction in the US between capital gains and losses and ordinary income and losses. For individuals, long-term capital gains are taxed at a lower rate than ordinary income. Capital losses must be offset primarily against capital gains and only to a very limited extent – around $3,000 per annum – can they be offset against ordinary income.

In circumstances where investors in a hedge fund focused on marketplace loans are receiving a high rate of interest – 30%, for example – to compensate them for a 20% default rate, they will receive a K-1 reflecting the full 30% interest rate and will receive capital losses in respect of the defaults. Unfortunately, they will be largely unable to offset those capital losses against the high level of interest income they receive from the marketplace loans and the effective tax rate they will suffer on their investment could be almost double what they would expect to pay.

More Problems

This problem gets even worse if the hedge fund uses leverage on the investment portfolio because of another restrictive provision in the US tax code concerning the ability to offset so-called itemised deductions against ordinary income. The theory of using leverage against an investment portfolio is to enhance returns to the equity by borrowing money to fund an investment at rate lower than the rate of return on the underlying investments. The hedge fund will pass through to its own investors not only their share of the income on the underlying investments but also their share of the interest expense on the money borrowed by the hedge fund to enhance the investment returns.

Ordinarily, hedge fund investors would expect to be able to use any interest expense passed through to them by the hedge fund to offset the interest income they receive. Unfortunately, US tax law limits the amount of itemised expenses they may deduct. Exactly how much is limited depends on a complex formula relating the size of the deduction claimed to the overall amount of taxable income the investor has from all sources. For larger investors, they may lose – or rather be obliged to carry forward to use in later years – up to 80% of the deductions.

Clearly, if the marketplace is to experience the growth it is targeting, this structural inefficiency needs to be fixed. Solutions are being developed but are not currently widely used. Well-advised hedge funds will have a marked advantage in gaining market share.

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