Fear and Greed Blog

Okay, maybe too much Star Wars as a child.

Anyway, I suggest that (if you haven't already) you read the comments to my last post. I think they provide some interesting elaboration.

As a follow up, I want to point out something that I think is often forgotten.

When we study economics or finance, each theory either assumes that everything else is held constant, or that a specific set of assumptions are agreed.

In reality, it doesn't work that way.

We can speculate all we want, but there is no way to know for sure how one policy will, in the future (or would have, in the past) effect(ed) the markets.

Markets are dynamic. They react (and often overreact) to stimuli, often in unexpected ways.

It's part of what makes the market fun.

Please keep that in mind when you engage in "Monday morning quarterbacking."

After reviewing my analysis, I clearly made a mistake in my calculations in my initial post. My only excuse is that I'm out of practice in pricing derivatives.

That said, the value of a 20% carried interest (assuming a 10 year life and between 10 and 100 percent volatility) would range from 7.99% to 18.24% of the initial value of the fund, assuming no liquidity discount (implied tax, at 35%, of 2.80% to 6.38%).

If the term were for 1 year (the minimum for long term capital gains treatment) the initial value would range from 1.36% to 7.97%, assuming no liquidity discount (implied tax, at 35%, of 0.48% to 2.79%).

The appropriate analysis is to take 20% (or whatever the carried interest percentage is) of the value of an at the money call (the option value of the appreciation of the fund). The exercise price is borrowed and returned almost immediately, and should not be reflected in the calculations.

Given the limitations of Black-Scholes (among other things, it assumes efficient markets, the ability to engage in hedging and the liquidity of the positions) and the fact that the carried interest is not liquid, a discount of at least 50% would be appropriate.

In other words, if tax policy were changed so that the initial option value of the carried interest were taxable, taxes could be less than 0.25% of the size of the fund ($2.5 million on a $1 billion fund).

I am now reading some coherent arguments AGAINST any change in tax policy as it relates to carried interest.

I am no longer certain what I think is the appropriate tax treatment for this issue.

I met with several people yesterday, one of whom pointed out an error in the way that I presented the value of carried interest at the inception of a fund (which would have the effect of completely changing my stance on the issue).

I am reviewing the arguments and I expect to post again on this subject.

Part of the reason that I started this blog was to initiate conversations on topics that, while often complex, are interesting to me and relate to financial markets and economics (generally). Unfortunately, thus far, the only comments that I have received (while helpful) were received off-line.

Please feel free to comment, whether you agree with me or not. I am always interested in learning of alternative approaches that may (or may not) teach me something new (or remind me of something I forgot).

As in the hedge/private equity taxation issue, if I'm wrong I want to be able to recognize that. In this case, since the comments were from people who did not want to comment directly, I felt compelled to remove the posts until I become more comfortable with my position.

I didn't intend this blog to be strictly a monologue on my part (although it is nice to be able to throw ideas out into the blogosphere in the hope that it makes some degree of difference).

I hope that people will feel free to comment (even anonymously). Of course, I would be more comfortable knowing who is posting (even if my knowledge is received off-line), but what I really hope for are well thought out arguments for why I am right or wrong.

I have removed this post.

It referred to another post that I am currently reviewing.

I have removed this post.

A respected friend, yesterday, pointed out that I may have made some errors in my analysis of how to measure carried interest at fund inception (unfortunately, not through the blog's comment section and not for attribution).

I may post a new commentary on this item in the future.