The concept of capitalism has always been associated with businesses and individuals taking risks. However, recent studies have shown that capitalism has become less about corporate risk-taking in recent decades. In fact, businesses have become more skilled at offloading risk, primarily by dumping it on those least able to bear it: ordinary households. This has led to a situation where policymakers must understand how risk is produced and distributed in modern economies to act appropriately and proportionately.
The business of alternative asset management is a prime example of this phenomenon. Alternative asset management is an umbrella term for hedge funds, private equity, and the like. Asset managers manage over $100tn of clients’ money globally and control everything from Center Parcs UK to your local Morrisons. However, what asset management companies in places like Britain and the US actually do raises some concerns.
Firstly, there is the matter of whose capital is put at risk when alternative asset managers invest. In large part, it’s not theirs. The proportion of equity invested by a typical hedge or private equity fund that is the asset manager’s own is usually between 1% and 3%. The rest is that of their external investor clients (the “limited partners”), which include pension schemes.
Secondly, consider how an asset manager’s investments are designed. Its own financial participation in, and management of, its investment funds is usually through a vehicle (the “general partnership”) that is constituted as a separate entity, precisely to insulate the firm and its professionals from liability risk. Furthermore, the fund and its manager are generally distanced from underlying investments by a chain of intermediary holding companies that protect it from the risk inherent in those investments.
Thirdly, fee structures also distance asset managers from risk. If a fund underperforms, they may earn no performance fee (based on fund profits), but they do have the considerable consolation of the guaranteed management fee, usually representing about 2% of limited partners’ committed capital, year after year. Essentially, management fees pay asset managers’ base salaries; performance fees pay bonuses.
In reality, the business of alternative asset management is less about taking on risk than, in Hacker’s terms, moving it elsewhere. So when things go wrong, others bear the brunt. This can be the employees on the shop floor of a retailer owned by private equity who find that they’ve shouldered the risk when they’re told they’re being laid off. It can be ordinary retirement savers, who find they have a meagre pension because the alternative funds in which their savings were invested by the asset manager have tanked.
The only meaningful risk alternative asset managers face is that of losing custom if fund returns prove underwhelming. Therefore, it would be far-fetched to suggest that what hedge funds and the like do amounts substantially to risk-taking.
This raises the question of how policymakers should respond to this issue. One very obvious policy recommendation for alternative asset management that flows from our understanding of what they actually do with “risk” is taxing them more. The main performance fee earned by alternative asset managers is “carried interest” – effectively, a profit share. In the UK and US, most asset management firms pay tax on this revenue at the capital gains rate, rather than the usually higher income tax rate. This is because the asset manager has typically been understood to be “taking on the entrepreneurial risk of the [investment]” – a standard justification for taxation as capital gain.
However, this justification is questionable, given that alternative asset managers are not taking on much risk. Therefore, policymakers should consider taxing them more, given that they are not bearing the risks that justify the current tax treatment.
The issue of risk distribution is a crucial one for policymakers to understand. Unless they understand how risk is produced and distributed in modern economies, they will not be in a position to act appropriately and proportionately. Thus, it is essential for policymakers to learn from economic realities as they actually are, as opposed to how economics textbooks say they could or should be.
In conclusion, the concept of capitalism has been associated with businesses and individuals taking risks. However, recent studies have shown that businesses have become more skilled at offloading risk, primarily by dumping it on those least able to bear it: ordinary households. Alternative asset management is a prime example of this phenomenon. Therefore, policymakers should consider taxing them more, given that they are not bearing the risks that justify the current tax treatment. The issue of risk distribution is a crucial one for policymakers to understand, and they should learn from economic realities as they actually are.
