Hedge Funds
Frank Martin
Berkeley Law Spring 2016
Overview of Hedge Funds
Hedge Funds:
Entity that holds a pool of securities or other assets that does not register its offerings under the Securities Act and is not registered as an investment company under the Investment Company Act
It is an actively managed, pooled investment vehicle open to only a limited group of investors.
Performance is measured in absolute return units.
Absolute return = portfolio return without subtracting any market benchmark return
The hedge fund is expected to do well regardless of the market.
Domestic Funds v. Foreign
Domestic fund advisers usually operate an offshore fund, with a master-feeder structure that allows management to deal with different pools of assets for investors in different taxable categories
The Advisor/Manager selects the portfolio
There is also an administrator who does the back-office work
Who invests?
Only caters to accredited investors (institutional investors, pension funds and very high net worth individuals)
Structure
Usually has a US Delaware component paired with a Cayman Islands component
Usually structured as an LPs or LLCs for pass-through taxation reasons.
This means the fund is not taxed on profits, only the individual investor is
Time Horizon of Investment (How Quickly do Investors Realize Returns)
Typically 6 months to a year
Sometimes contingent on certain events, could be a few hours
Payment Modus (How do investors pay?)
Investors commit by paying up-front
Liquidity (How do investors enter and exit?)
New investors can come into the fund periodically and exit the fund (redeem their investment) periodically
One year lockup of your money, because the fund needs a stable investment base. If you want out earlier, there is a fee.
You can get money back on a quarterly basis after the year is up.
Much more liquid for the investor than VCs
Deviation: Some lock-up schemes last from 2-5 years.
Fee Structure
Hedge fund managers are motivated to maximize absolute returns under any market condition.
Most receive asymmetric incentive fees based on positive absolute returns and are not measured against the performance of passive benchmarks that represent the overall market.
Asymmetric refers to the fact that they will earn for producing a positive absolute return, but they won’t have money taken away for producing negative results (they just won’t get any incentive fee).
2% management fee plus 20% incentive fee (receipt of which depends on profits)
Sometimes there is a hurdle rate/water mark before incentive fees are paid.
Leverage
Highly levered
Sometimes you can get leverage without going to a bank and asking for a loan. Instead, you can sell assets short and using the proceeds from short sale to buy other assets. This is what hedge funds do.
Ex. Someone loans me a share of Facebook that I sell to someone else. I think Facebook is going down, so I make money because I sell it for $20, it goes down to $10 after I sell, and then I buy it back for $10, giving it back to the original owner and pocketing the $10 extra dollars.
But leverage goes both ways. What if the cost of Facebook shares goes up? Then you have to go buy back the Facebook share for more than you sold it for!
Key Areas of Focus: Hedge funds are structured in a way so as to take advantage of the exemptions provided by the following Acts
Securities Act of 1933
Securities Exchange Act of 1934
Investment Company Act of 1940
Investment Advisors Act of 1940
Internal Revenue Code
Fund Formation and Regulatory Exemption frameworks
Intro via Demystifying Hedge Funds by Ordower
Hedge funds are defined by their exemptions from regulation under securities, investment company, investment advisory and tax laws.
The exemptions permit hedge funds to do the following:
Pay their investment advisers fees that materially exceed those a mutual fund can pay its advisers
Prevent the US from imposing taxes on foreign investors
Prevent the US from collecting corporate level tax from the fund
Generally, neither funds nor their managers had to register under the statutes that give the SEC regulatory oversight over mutual funds and mutual fund advisors.
Except for large funds with 2000 investors or more, the SEC could not demand information reporting for hedge fund holdings and investment strategies.
The SEC has tried unsuccessfully to extend mandatory registration under the Investment Advisers Act of 1940 to hedge funds. The proposal was that managers who previously did not have to register because they had fewer than 15 clients would have to count each investor in a hedge fund, as opposed to the fund itself, as a client for purposes of the 15 client rule, forcing more funds to register.
By avoiding regulation, hedge funds can adopt investment strategies that involve greater risk of loss than mutual funds.
So hedge funds tend to target investors who could:
Economically make an investment of $100K or more and bear the risk of loss if it occurred.
Willingly traded greater risk of loss for chance at higher return
Did not require the daily liquidity of open-end mutual funds or the public trading market for closed-end mutual funds.
Hedge Fund liquidity
Hedge funds that invest in the public securities market typically offer their investors the opportunity to redeem their interests at least annually, but usually no more frequently than monthly.
Though not required by law, most funds try to pay the bulk of the redemption price, usually 90%, with 10-15 days of redemption date
Some hedge funds invest in equity positions that promise substantial long-term return, but in the interim are illiquid
When a fund holds such illiquid investments, managers place them into a “side pocket”, which is a separate account in the firm’s books.
Hedge funds lack a secondary trading market of closed-end mutual funds, although promoters will sometimes help to place an interest in the fund for an investor who wants to dispose of one.
Investment Act of 1940 Exemptions
A sponsor or advisor of a private fund has the goal of operating subject to the smallest number of regulations possible
What does the act do? Why avoid?
It limits transactions with affiliated persons (i.e. does not allow fund manager to participate in gains)
Requires funds to maintain sufficient liquidity to redeem shares when an investor wants to pull out
Regulates corpor
ot counted toward the 100 investor limit
Key Analysis:
What is a security issued by the pool?
Howey Test- Supreme Court defined an “investment contract” as any transaction that in which: 1) a person invests money 2) in a common enterprise AND 3) is led to expect profits 4) solely from the efforts of others
If it gets a loan from the bank and then the pool sells securities that the pool buys back:
That may be a security, but because bank loan is debt, it might not
Is there less than 100 investors?
Is the offering public?
“Does not presently propose to make a public offering”
Conversations about when you go public may count
INTEGRATION:
Integration is a major concern when dealing with two or more § 3(c)(1) funds
Integration occurs when: multiple exempt offers are combined into one
ie one offering cannot be considered separate from another in order to benefit from an exemption or safe harbor-
Consequently, a hedge fund manager cannot circumvent section 3(c)(1) by creating multiple 3(c)(1) funds, none of which individually exceed the 100-beneficial-owner limitation but which in the aggregate exceeds that threshold, unless they are truly different.
The SEC will look at factors including the strategies pursued by the funds, their portfolios, their risk/return characteristics, and whether the two funds are intended for two distinct groups of investors to determine if an investor would view them as being engaged in essentially the same type of investment program.
Whether a reasonable investor would view an interest in one fund as materially different from another?
Is this integrated for purposes of 100 person limit of 3(c)(1)?
Integration occurs when an interest in one offering is identical to another: So look for material differences
Portfolios, people they are meant for, taxation are differentiating factors.
If hey are TAXED differently no integration
PUNISHMENT:
If integration: You lose your exemption, and all contracts are voidable, including the ones investors signed, and they can take their money out
§ 3(c)(7) of the Investment Company
Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities.
Generally, these funds don’t really have to worry about the “manner of offering” test because they are only open to qualified purchasers, and qualified purchasers already meet the accredited investor threshold.
