Thread by @SahilBloom

Jim Simons, Robert Mercer, and other partners of famed hedge fund Renaissance Technologies recently agreed to settle a long-running tax dispute with the IRS.

The settlement? Up to $7 billion—the largest in history.

Here's a breakdown of the financial magic behind the dispute:

Jim Simons launched Renaissance Technologies in 1982.

It became the most successful hedge fund of all time.

The Medallion Fund posted an eye-popping 66% annual return (39% after fees) from 1988 to 2018.

(Here’s a great thread on its history from @TrungTPhan!)

https://twitter.com/TrungTPhan/status/1424399014204637186

Along the way, its founders and employees amassed correspondingly eye-popping fortunes.

But beginning in 2014, they came under scrutiny from regulators for potentially massive tax avoidance.

It's an fascinating financial story, so let's walk through the mechanics:

The whole saga centers around the tax treatment of short vs. long-term investment gains.

Short-term investments (held for <1 year) have gains taxed at ordinary income rates.

Long-term investments (held for >1 year) have gains taxed at significantly lower rates.

Hedge funds are typically structured as limited partnerships, so any profits/gains flow through to the partners, who are responsible for tax payments at prevailing rates.

Unsurprisingly, these partners prefer to pay as little as possible in taxes.

But it can be tricky...

RenTech had developed a strategy revolving around fast-paced trading—their portfolio would shift on a second-by-second basis.

This means a lot of short-term investment gains.

Checking the scoreboard here:
• The Tax Man:😁
• Renaissance Partners:😫

So they got creative!

The RenTech partners—along with a coterie of bankers, lawyers, and accountants—devised a plan.

More of a magic trick, really.

They just had to convert short-term gains into long-term gains...and voila...lower taxes!

Here's a very, very simple model of how it worked:

RenTech wants to do some of its proprietary, fast-paced trading and make some profits.

But that generates a lot of short-term gains and its partners don't want to pay those taxes.

So they call up their bank partner (or "prime broker") and try out something new.

The prime broker puts a bunch of its own money in an account.

It writes a call option that gives RenTech the right to purchase that account.

RenTech contributes an upfront premium to buy the call option.

The prime broker gives RenTech control over managing the account.

RenTech manages the account—generating insane profits.

At the end of the year, RenTech executes its call option on the account.

Its profits are (roughly):
• the ending $ in the account
• less the amount from the prime broker
• less fees & interest
• less upfront premium

Most importantly, those profits *appear to be* long-term capital gains.

In a way, Renaissance simply bought an option, executed the option a year later, and took the profits.

Clearly, they did more than that (managing the account's trading!), but that's for the IRS to realize.

Well, eventually, they did.

Last week, after several years of back and forth with regulators, RenTech's partners agreed to a settlement, rumored to be worth up to $7 billion in back taxes, interest, and penalties.

In a letter about to its investors, RenTech's chief executive wrote:

"[Our] board eventually concluded that the interests of our investors from the relevant period would be best served by agreeing to this resolution with the IRS, rather than risking a worse outcome.”

It's a fascinating story of financial creativity (and how the chickens eventually come home to roost).

For more on the story, I recommend these breakdowns:

wsj.com/articles/james…

bloomberg.com/opinion/articl…

I hope you enjoyed this quick breakdown and feel more well-informed about financial happenings.

Follow me @SahilBloom for more threads on business, finance, and decision-making.