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Hedge Fund Law & Regulation There are a number of statutes and regulations that do impact on the operations and activities of U.S. hedge funds. These statutes and regulations include the federal securities laws, state securities and corporate laws, federal and state tax laws, federal pension laws, regulations enacted by self-regulatory organizations and rules established by the SEC, the Internal Revenue Service (IRS), and the Department of Labor (DOL). New laws such as the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank 2010) and the Jumpstart Our Business Startups Act (JOBS Act 2012) added risk and liability to the hedge fund landscape.
Securities Act of 1933 Absent an available exemption, the Securities Act of 1933 (Securities Act) requires that offers and sales of securities be registered with the SEC. Often referred to as the "truth in securities" law, the Securities Act governs the offering process for securities and establishes civil liability for false registration statements. The Securities Act also has anti-fraud provisions. Since limited partnership, LLC and other issuer interests offered to investors fall within the definition of “securities” for purposes of the Securities Act, hedge funds must rely on an exemption to avoid registration under the Securities Act. Offerings of hedge funds in the United States rely on one of the private offering exemptions allowed under Regulation D (see below).
Investment Advisers Act of 1940 The Advisers Act regulates investment advisers, including unregistered investment advisers. To the extent a manager for a hedge fund is registered under the Advisers Act, there may be implications with respect to, among other things, performance fees, custody of fund assets, books and records, and principal and agency cross-trades. With certain exceptions, this Act requires that firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors.
Investment Company Act of 1940 The Investment Company Act regulates open- and closed-end investment companies, as well as their advisers and principal underwriters. The Investment Company Act also provides for certain investment restrictions on investment companies, whether registered or not under the Act. This Act requires companies (including mutual funds) that in invest and trade in securities to register with the SEC. Hedge funds can operate under one of two exemptions from registration under the Investment Company Act of 1940. Section 3(c)(1) allows a fund to have up to 100 investors. Section 3(c)(7) allows a fund to have up to 2,000 investors, but requires a significantly higher net worth suitability requirement for each investor.
Section 3(c)(1) Exclusion Section 3(c)(1) of the Investment Company Act excludes from the definition of investment company any issuer whose outstanding securities are beneficially owned by not more than 100 accredited investors. These hedge funds must comply with Section 4(2) of the Securities Act and frequently do so by relying on the safe harbor available Rule 506 under Regulation D under that Act. Most startup hedge funds are structured as 3(c)(1) funds. Learn More About Accredited Investors
Section 3(c)(7) Exclusion Section 3(c)(7) of the Investment Company Act excludes from the definition of investment company any issuer whose outstanding securities are owned exclusively by “qualified purchasers” (see below). A 3(c)(7) fund must be owned by “qualified purchasers.” Section 3(c)(7) funds may technically have unlimited investors but typically limit the number of investors to 2,000 to avoid registration under the Securities Exchange Act of 1934 as a publicly traded partnership. In our experience the 3(c)(7) exemption is typically used only by established funds backed by institutional investors. Learn More About Hedge Fund Regulations and Contact Hedge Fund Attorney Hannah Terhune for a Consultation Section 2(a)(51) of the Investment Company Act defines a "qualified purchaser” to be: (1) any natural person who owns not less than $5 million in investments; (2) any family-owned company (as described in that section) that owns not less than $5 million in investments; (3) any other trust the trustee and settlor(s) of which are qualified purchasers that was not formed for the specific purpose of acquiring the securities of the Section 3(c)(7) fund; and (4) any person acting for its own account or the accounts of other qualified purchasers, that owns and invests on a discretionary basis not less than $25 million in investments.
JOBS Act The JOBS Act is the Jumpstart Our Business Startups Act, a federal law that was enacted in 2012. Through the JOBS Act, the United States lifted the ban on hedge fund advertising for hedge fund's operated by fund managers registered with either the SEC or a state regulator. Issuers relying on the Rule 506(c) exemption can generally advertise their offerings through the Internet, social media, seminars, print, or radio or television broadcast. Only accredited investors, however, are allowed to purchase in a Rule 506(c) offering that is widely advertised, and the issuer must take reasonable steps to verify the accredited investor status of its investors.Learn More About Hedge Fund Marketing & Raising Capital Rule 506(c) of Regulation D bans industry "bad actors" (i.e., certain felons) from operating or marketing a hedge fund under Regulation D in the United States. The full text of the SEC's rule adopting the Bad Actor Disqualification rule is available here. The U.S. SEC's fact sheet summarizing the Bad Actor Disqualification rule is available here and a summary of the law available here.
Fiduciary Rule Under Employee Retirement Income Security Act of 1974 (ERISA) ERISA establishes principles of fiduciary conduct and responsibility applicable to persons who manage or control the assets of an employee benefit plan. ERISA applies to most private employee benefit plans. A 2017 ruling expanded the application of the "fiduciary rule" to include defined-contribution plans: four types of 401(k) plans, 403(b) plans, employee stock ownership plans, Simplified Employee Pension (SEP) plans and savings incentive match plans (simple IRA), defined-benefit plans (pension plans or those that promises a certain payment to the participant as defined by the plan document) and Individual Retirement Accounts (IRAs). If the assets of a hedge fund are deemed to be “plan assets” for purposes of ERISA and/or Code Section 4975, the fund manager will be an ERISA “fiduciary” with respect to all ERISA plans participating in the fund and will be required to comply with fiduciary responsibility rules under ERISA and prohibited transaction restrictions imposed by ERISA and Code Section 4975. These rules and restrictions may have a substantial impact on fund operations ranging from the manager’s fees to the types of investments the fund may make.
State Securities and Corporate Law States securities laws are primarily concerned with the registration of securities, broker-dealers and smaller investment advisers. Managers may be subject to state investment adviser registration even where a manager may be exempt from registration under the Advisers Act. State corporate law governs matters with respect to, among other things, the organization of the hedge fund and its corporate structure, voting issues, dissolution of a fund and state taxation.
Internal Revenue Code of 1986 as Amended (Code) The Code and the regulations thereunder govern the tax treatment of hedge funds, including distributions to their owners. There are a variety of tax issues depending on who the participants in a fund are and the structure of the hedge fund. For example, hedge funds that are taxed as partnerships offer pass-through tax treatment with respect to their investments.
Foreign Laws To the extent a hedge fund has overseas operations or is offered overseas, applicable foreign laws may apply. Moreover, a number of hedge funds are incorporated in offshore jurisdictions and require compliance with local laws regarding the formation and registration of such funds.
What Is Regulation D? Issuers of unregistered products and debt securities also may rely on Regulation D. Regulation D originated as an effort to facilitate capital formation, consistent with the protection of investors, by simplifying and clarifying existing rules and regulations, eliminating unnecessary restrictions those rules and regulations placed on issuers, particularly small businesses, and achieving uniformity between federal and state exemption sissuers of all sizes conduct offerings in reliance on Regulation D, in general, and Rule 506(b) in particular. A securities offering exempt from registration with the SEC is sometimes referred to as a private placement or an unregistered offering. Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available. Generally speaking, private placements are not subject to some of the laws and regulations that are designed to protect investors, such as the comprehensive disclosure requirements that apply to registered offerings. Private and public companies engage in private placements to raise funds from investors. Hedge funds and other private funds also engage in private placements. When reviewing private placement documents, you may see a reference to Regulation D. Regulation D includes three SEC rules—Rules 504, 505 and 506—that issuers often rely on to sell securities in unregistered offerings. The entity selling the securities is commonly referred to as the issuer. Each rule has specific requirements that the issuer must meet.
Rule 504An amendment to Rule 504 of Regulation D enacted on January 20, 2017allows issuers to raise up to $5 million (the previous cap was $1 million). Like Rule 506, issuers qualifying under Rule 504 are exempt from SEC registration and are only required to file Form D. These offerings can be offered to non-accredited investors. However, Rule 504 offeringds are not covered securities and the issuer must comply with each state’s securities laws where the offering takes place.
Rule 505Under Rule 505, issuers may offer and sell up to $5 million of their securities in any 12-month period. There are limits on the types of investors who may purchase the securities. The issuer may sell to an unlimited number ofaccredited investors, but to no more than 35 non-accredited investors. If the issuer sells its securities to non-accredited investors, the issuer must disclose certain information about itself, including its financial statements. If sales are made only to accredited investors, the issuer has discretion as to what to disclose to investors. Any information provided to accredited investors must be provided to non-accredited investors.
Rule 506(b) and Rule 506(c) Accredited Investor Crowdfunding An unlimited amount of money may be raised in offerings relying on one of two possible Rule 506 exemptions. Similar to Rule 505, an issuer relying on Rule 506(b) may sell to an unlimited number of accredited investors, but to no more than 35 non-accredited investors. However, unlike Rule 505, the non-accredited investors in the offering must be financially sophisticated or, in other words, have sufficient knowledge and experience in financial and business matters to evaluate the investment. This sophistication requirement may be satisfied by having a purchaser representative for the investor who satisfies the criteria. An investor engaging a purchaser representative should pay particular attention to any conflicts of interest the representative may have. As with a Rule 505 offering, if non-accredited investors are involved, the issuer must disclose certain information about itself, including its financial statements. If selling only to accredited investors, the issuer has discretion as to what to disclose to investors. Rule 506(c) limits offerings to accredited investors only and the issuer must go further by taking “reasonable steps” to verify the accredited investor status of each purchaser. This means that an issuer cannot simply rely on an investor questionnaire to determine accredited investor status like it can in a Rule 506(b) offering. In a Rule 506(c) offering, accredited investor status is verified by the issuer or a trusted advisor of the investor (e.g. CPA or attorney) who confirms in writing that the investor meets the net worth or income requirements.
Commodity Exchange Act of 1934 The CEA governs trading in futures contracts and commodity options. Hedge funds may be subject to the provisions of the CEA if they trade in these instruments. Moreover, a manager of a hedge fund that trades in these instruments may need to register as a commodity pool operator (“CPO”) or commodity trading advisor (“CTA”) under the CEA. CPO or CTA registration may have, among others, record keeping and disclosure obligations.
The Commodity Exchange Act prohibits fraudulent practices in trading futures contracts and other commodity derivatives, and provides for regulation of the managed futures industry. Any hedge fund manager trading in commodities or futures must comply with the Commodities Exchange Act.
Anti-Money LaunderingThe Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT Act) represents a far-reaching expansion of the Bank Secrecy Act of 1970 (BSA) and sets broad goals for financial institutions to identify and prevent, in the first instance, possible money laundering activity. Banks have been dealing with extensive anti-money laundering laws and regulations since the passage of the BSA. The USA PATRIOT Act extends many of these responsibilities to non-bank financial institutions and creates new responsibilities for all financial institutions. Additional requirements are imposed by the Office of Foreign Assets Control (OFAC).
Restricted Securities Restricted securities are securities acquired in unregistered, private sales from the issuing company or from an affiliate of the issuer. Investors typically receive restricted securities through private placement offerings, Regulation D offer. If you want to sell your restricted or control securities to the public, you can meet the applicable conditions set forth in Rule 144. The rule is not the exclusive means for selling restricted or control securities, but provides a "safe harbor" exemption to sellers. There are two principal things to think about before buying restricted securities. The first is that unless you have made arrangements with the issuer to resell your restricted securities as part of a registered offering, you will need to comply with an exemption from registration to resell. One rule commonly relied upon to resell requires you to hold the restricted securities for at least a year if the company does not file periodic reports (such as annual and quarterly reports) with the SEC. You may wish to hire an attorney to help you comply with the legal requirements to resell restricted securities. Issuers may require a legal opinion that you satisfy an exemption to resell your restricted securities. The second thing to think about is whether they are easy to sell. This issue primarily affects the sale of restricted securities in private companies. Information about a private company is not typically available to the public, and a private company may not provide information to you or your buyer. The restricted status of your securities may also transfer to your buyer. For these reasons, it may be difficult to attract buyers. In addition to these considerations, specific contractual restrictions that you may enter into when investing may prevent you from freely transferring the securities.
Call Us First We are experts in international hedge funds and tax. Click on any reference below to our leading articles:
Strategic Hedge Fund Planning by Hannah Terhune. Wilmott Magazine Ltd. (Volume 2013, Issue 63, pages 8-11 January 2013).
Trading Foreign Index Contracts? Know the Tax Rules Before You Trade by Hannah M. Terhune and Roger D. Lorence. Stocks, Futures and Options (June 2005).
Capital Management Service Group, Inc. is dedicated to providing the highest quality of services on a personal level and in a timely manner. We offer flat-fee engagements, which include start-to-finish legal services and counsel with all aspects of launching a domestic or offshore hedge fund. No two funds are identical. We use a client-based approach to our fund structuring and analysis. Our clients routinely comment on the excellence of our personal service and the time we take to properly understand and implement the client’s unique circumstances and objectives. Call Us at +1 (307) 213-4732, Email Us and Read What Our Client Say About Us on LinkedIn
Hannah Terhune Interview with Real World Trading Hi, My name is Dave Goodboy. I am executive producer of Real World Trading. Traders and money managers often dream about one day running their own hedge fund, managing large sums of money, and competing head to head with the world’s top traders. For many, this dream remains an unfulfilled desire since they really don’t know where to begin. My guest this week will answer your questions, simplify this often complex subject, and point you in the right direction. Hannah Terhune is chief attorney and member manager of Capital Management Services Group.com, Inc. Get ready for a tours de force education!
Dave: Greetings Hannah, Thank you for joining me today. Let’s start right at the beginning. Exactly what is a hedge fund?
Hannah: Although there is no universally accepted definition of the term hedge fund,” the term generally is used to refer to an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which are not registered as an investment company under the Investment Company Act. Alfred Winslow Jones is credited with establishing one of the first hedge funds as a private partnership in 1949. That hedge fund invested in equities and used leverage and short selling to “hedge” the portfolio’s exposure to movements of the corporate equity markets. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments and engage in a wider variety of investment strategies. Today, in addition to trading equities, hedge funds may trade fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options and other non-securities investments. Furthermore, hedge funds today may or may not utilize the hedging and arbitrage strategies that hedge funds historically employed, and many engage in relatively traditional, long-only equity strategies. In short, the term generally identifies an entity that holds a pool of securities and perhaps other assets that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act. Hedge funds are also characterized by their fee structure, which compensates the adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation. Hedge fund advisory personnel often invest significant amounts of their own money into the hedge funds that they manage. As discussed in the Report, although similar to hedge funds, there are other unregistered pools of investments, including venture capital funds, private equity funds and commodity pools that generally are not categorized as hedge funds. Hedge funds are often compared to registered investment companies. In addition, unregistered investment pools, such as venture capital funds, private equity funds and commodity pools, are sometimes referred to as hedge funds. Although all of these investment vehicles are similar in that they accept investors’ money and generally invest it on a collective basis, they also have characteristics that distinguish them from hedge funds.
Dave: When did this concept originate? Briefly, what’s the history? Hannah: Hedge funds, while representing a relatively small portion of the U.S. financial markets, have grown significantly in size and influence in recent years. The SEC recognized over 30 years ago that hedge fund trading raises special concerns with respect to their impact on the securities markets. The growth in hedge funds has been fueled primarily by the increased interest of institutional investors such as pension plans, endowments and foundations seeking to diversify their portfolios with investments in vehicles that feature absolute return strategies – flexible investment strategies which hedge fund advisers use to pursue positive returns in both declining and rising securities markets, while generally attempting to protect investment principal. In addition, funds of hedge funds (“FOHF”), which invest substantially all of their assets in other hedge funds, have also fueled this growth.
Dave: What are the parts of a hedge fund? Hannah: The parts of a hedge fund include the private placement memorandum, the subscription agreement, and the operating agreement for the fund. Hedge fund advisers typically provide information to investors during an investor’s initial due diligence review of the fund, although some, more proprietary, information may not be provided until after the investor has made a capital commitment to the fund, if at all. Most hedge funds provide written information to their investors in the form of a private offering memorandum or private placement memorandum (“PPM”). This reflects market practice and the expectations of the sophisticated investors who typically invest in hedge funds. It also reflects the realization of the sponsors and their attorneys that the exemptions from the registration and prospectus delivery provisions of Section 5 of the Securities Act available under Section 4(2) of the Securities Act and Rule 506 there under do not extend to the antifraud provisions of the federal securities laws. The disclosures furnished to investors serve as protection to the principals against liability under the antifraud provisions. Some of the information may be disclosed less formally in one-on-one conversations between investors and the hedge fund adviser. Hedge fund advisers may also provide information to hedge fund investors in the form of letters, conference calls and financial statements. In addition, some hedge fund advisers may provide prospective investors with access to their prime brokers and other service providers, such as administrators, both during the investor’s initial due diligence of the hedge fund and subsequently.
Hedge fund investors must often spend significant resources, frequently hiring a consultant or a private investigation firm, to discover or verify information about the background and reputation of a hedge fund adviser. In practice, even very large and sophisticated investors often have little leverage in setting terms of their investment and accessing information about hedge funds and their advisers. As a matter of practice, hedge funds generally provide investors with a PPM before an investment is made. As with any other offering solely to accredited investors, there are no specific disclosure requirements that pertain to the PPM under Section 4(2) or Rule 506. While we are not passing on the adequacy and content of PPM disclosure generally, we note that certain basic information about the hedge fund’s adviser and the hedge fund is typically disclosed. The information disclosed in PPMs varies from adviser to adviser, however, and often is general in scope. PPMs generally discuss in broad terms the fund’s investment strategies and practices. They also typically disclose that the hedge fund’s investment adviser may invest fund assets in illiquid, difficult-to-value securities and that the adviser reserves the discretion to value such securities as it believes appropriate under the circumstances. The PPM also may disclose that the adviser may exercise its discretion to invest fund assets outside the stated strategy or strategies. PPMs also generally discuss qualifications and procedures for a prospective investor to become a limited partner, as well as provide information about the hedge fund’s operations. For example, PPMs generally discuss fund expenses, allocations of gains and losses, tax aspects of investing in the fund and may incorporate the hedge fund’s financial statements. PPMs disclose any lock-up period that new investors must observe, as well as laying out the specifics for when investors will be able to redeem some or all of their investments out of the hedge fund. PPMs also may name frequently used service providers to the fund. PPMs may generally disclose potential conflicts of interest to investors, frequently under the heading of “risk factors.” A hedge fund’s PPM may note that the fund’s valuation practices give rise to an inherent conflict of interest because the level of fees that the investment adviser earns is based on the value of the fund’s portfolio holdings as determined by the fund’s adviser. PPMs also may discuss potential conflicts arising from the adviser’s “side-by-side management” of multiple accounts, including the hedge fund, private accounts, proprietary accounts and registered investment companies. A hedge fund’s PPM may also disclose the investment adviser’s conflicts in allocating its time and certain investment opportunities among its clients. Some PPMs spell out allocation policies with respect to limited investment opportunities in great detail, while others may list, and only briefly discuss, the factors on which such allocations will be decided. PPMs also often provide information concerning the use of affiliated services providers, including affiliated broker-dealers. Some PPMs also may note that the hedge fund may direct brokerage business to, and use other services of, firms that introduce investors to the fund. PPMs may disclose that the adviser may use soft dollars to pay for research and other services used by the adviser to benefit other accounts that it manages, and may further disclose that soft dollars.
Dave: Are these documents boiler plate or created individually for each fund?
Hannah: They are created individually for each client.
Dave: Does this paperwork need to be filed with the SEC or anyone? Hannah: Form D is filed with the SEC and other forms may be required to be filed with each state where investors are located.
Dave: What is the definition of “accredited investor”? Hannah: The safe harbor protection most often relied upon by hedge funds under Rule 506 exempts offerings that are made exclusively to “accredited investors.” Issuers are permitted under these provisions to sell securities to an unlimited number of “accredited investors.” In addition, if the offering is made only to accredited investors, no specific information is required to be provided to prospective investors. The term “accredited investors” is defined to include: Individuals who have a net worth, or joint worth with their spouse, above $1,000,000, or have income above $200,000 in the last two years (or joint income with their spouse above $300,000) and a reasonable expectation of reaching the same income level in the year of investment; or are directors, officers or general partners of the hedge fund or its general partner; and Certain institutional investors, including: banks; savings and loan associations; registered brokers, dealers and investment companies; licensed small business investment companies; corporations, partnerships, limited liability companies and business trusts with more than $5,000,000 in assets; and many, if not most, employee benefit plans and trusts with more than $5,000,000 in assets.
Dave: Does everyone who invests in a hedge fund need to be an “accredited investor” or high net worth individual? Hannah: No.
Dave: I have several friends who would love to invest in a hedge fund, but don’t meet the above criteria. Is there anyway around the regulation? Hannah: Yes, non accredited investors can invest in a hedge fund. It depends on the fund manager’s discretion.
Dave: Does the manager need to have a Series 7 or other licenses? Hannah: No, a Series 7 is not relevant to this discussion.
Dave: How about registration? Does the manager need to register with the SEC? Hannah: Yes, in certain cases, given recent law changes.
Dave: Does the manager need to register in the state the fund is domiciled in? Hannah: Form D needs to filed with the SEC.
Dave: What about the funds trader (s). Do they need to register with anyone? Hannah: Yes, in certain cases. This requires a state-by-state determination.
Dave: What if the investors are from different states? Does the manager need to register in every state an investor is from? Hannah: Yes, usually a notice filing is required as long as they are registered in another state or with the SEC.
Dave: Is this in all cases? What about very small start up funds? Hannah: It depends on the state and the structure the fund manager opts to use.
Dave: Is there anyway to legally avoid registration? Hannah: You either have to register or you fall within an exemption.
Dave: If the manager is a CTA does he still need to register as a fund manager? Hannah: The difference between a CPO and a CTA is that a CTA manages individual accounts, while a CPO manages only the hedge fund, or Pool. Few of our clients remain interested in the CTA option once they realize the administrative hassle associated with managing the separate accounts. No sponsor is needed to take the Series 3 exam. The Series 3 exam is given under the auspices of the NASD’s testing program. Two different testing services provide their services to the NASD. Unlike a traditional hedge fund (where the SEC may end up being a regulator if enough money is under management), the government regulator that may associated with CPOs is the CFTC—the Commodity Futures Trading Commission.
The CFTC has allowed the National Futures Association (NFA) to become the primary regulator of futures and commodity products (as a Self-Regulatory Organization, similar to the NASD’s status with the SEC). It is my opinion that the NFA is a very effective and competent regulator.
Dave: How about if the manager has a series 7. Is registration still required? Hannah: A Series 7 is of no particular value to either an RIA or a CPO. If someone has a current Series 7 (they’ve been registered within the past two years with a broker/dealer), they can choose to take the Series 66 instead of the Series 65. The Series 7 plus the Series 66 is always (in all states) equivalent to the Series 65. After two years of not being with a broker/dealer, all prior registrations (such as a Series 7) expire and are no longer valid. Similarly, if someone previously passed the Series 65 but has not had it registered with either a broker/dealer or an investment advisory firm, the exam has expired and will need to be taken again. Some states will not consider someone for investment advisory status unless they were previously registered as a Series 7 with a broker/dealer.
Dave: Is there a minimum capital amount that you feel is needed before launch? Hannah: No.
Dave: What about someone who does not have any investors yet, who just wants to set up the fund structure for the future? Set up an incubator fund? I know your firm runs some type of “hedge fund incubator” Can you explain what this is? Hannah: It’s a start up process for a prospective fund manager to develop and document a track record that could be legally marketed to prospective investors when he or she is ready to open the fund to outside investors.
Dave: Do you actually do capital introductions? Hannah: Yes, often, as a professional courtesy to our clients. We do not accept referral fees from non lawyers, as we are prohibited from accepting such fees by the rules governing the practice of law. We have an extensive network of contacts worldwide. We endeavor to set up our clients for success and look toward a long term relationship as well as build global relationships.
Dave: How about hooking a fledging manager up with a prime broker? Hannah: Yes, as a professional courtesy to our clients. We do not accept referral fees from non lawyers, as we are prohibited from accepting such fees by the rules governing the practice of law. We have an extensive network of contacts worldwide. We endeavor to set up our clients for success and look toward a long term relationship.
Dave: I see, your firm is really a “one stop shop”. Do you do the back office stuff too? Hannah: Yes, of course.
Dave: While we are on this topic, what is a “back office”? Hannah: Many clients are accustomed to being one-person businesses, trading from their home office. They are interested in trading for others to leverage their knowledge and make more money, but they don't want to change how they work. They don't want to have to hire accountants and secretaries, or rent an office or gain tons of paperwork. They don't want to spend their days with attorneys, accountants, consultants and business operation hassles. We provide a full service, virtual Web-based and e-commerce solution takes all the hassle out of entering the hedge fund business. Clients can continue working from home, without any of the above mentioned hassles. We handle all of the charges to your investors for the management fees and the performance allocations as well as prepares the statements for investors. Most of clients use our hedge fund accounting services on a monthly basis; others on a weekly, quarterly, annually basis, or whenever they like. The work product includes NAV, performance records, brokerage statement reconciliation, advisory fee billing, performance allocation, investor changes, and other related reports generated from the software programs.
Dave: When the fund grows, are there capital levels or partner numbers that need to be watched? What I mean is, is there additional regulation, registration, et al on a 100 million dollar fund than there is on a 250k startup? Hannah: No.
Dave: Recently, I have noticed a proliferation of off shore funds. What exactly is an off shore fund? What reasons would a manager want to set up an off shore fund? Hannah: The word “offshore” has a certain mystique to many. Offshore hedge funds are investment vehicles organized in offshore financial centers (“OFC”). OFCs are countries that cater to the establishment and administration of mutual and hedge funds (“funds”). Offshore funds offer securities primarily to non-U.S. investors and to U.S. tax-exempt investors (e.g., retirement plans, pension plans, universities, hospitals, etc.). U.S. money managers who have significant potential investors outside the United States and tax-exempt investors typically create offshore funds. In many OFCs, the low costs setting up a company along with a kind tax environment make them attractive to establishing funds. Offshore hedge funds are typically organized as corporations in countries such as the Cayman Islands, British Virgin Islands, the Bahamas, Panama, the Netherlands Antilles or Bermuda. Offshore funds generally attract investment of U.S. tax-exempt entities, such as pension funds, charitable trusts, foundations and endowments, as well as non-U.S. residents. U.S. tax-exempt investors favor investments in offshore hedge funds because they may be subject to taxation if they invest in domestic limited partnership hedge funds. Offshore hedge funds may be organized by foreign financial institutions or by U.S. financial institutions or their affiliates. Sales of interests in the United States in offshore hedge funds are subject to the registration and antifraud provisions of the federal securities laws. Offshore hedge funds typically contract with an investment adviser, which may employ a U.S. entity to serve as sub adviser. An offshore hedge fund often has an independent fund administrator, also located offshore, that may assist the hedge fund’s adviser to value securities and calculate the fund’s net asset value, maintain fund records, process investor transactions, handle fund accounting and perform other services. An offshore hedge fund sponsor typically appoints a board of directors to provide oversight activities for the fund. These funds, especially those formed more recently, may have directors who are independent of the investment adviser.
Dave: Sounds like a good way to avoid taxes. Does the manager of a fund domiciled off shore still need to pay capital gain taxes, etc? Hannah: The Do’s and Don’t of offshore funds are can be summed up as follows:
Do: Consider setting up an offshore fund is you manage money for either foreign and/or U.S. tax-exempt individuals and businesses. Under U.S. income tax laws, a tax-exempt organization (such as an ERISA plan, a foundation or an endowment) engaging in an investment strategy that involves borrowing money is liable for a tax on “unrelated business taxable income” (“UBTI”), notwithstanding its tax-exempt status. The UBTI tax can be avoided by the tax-exempt entity by investing in non-U.S. corporate structures (i.e., offshore hedge funds).
Don’t: Go offshore to avoid U.S. taxation. This is the wrong reason to consider an offshore fund. In short, setting up an offshore fund is not a tax minimization strategy as U.S. citizens, resident aliens (e.g., green card holders) are taxable on their worldwide income. The U.S. tax results depend on the nationality and domicile of the fund manager and his or her management company.
Dave: Am I able to set up an off shore fund without ever even visiting the country? Hannah: Yes, of course. Our firm liaisons with foreign legal counsel. Everything is handled on a turnkey basis. You don’t need to stop trading or take a break from the markets. Just call us as we will work around your trading schedule.
Dave: What countries are most hospitable to off shore funds? Hannah: Investment fund managers typically create offshore funds in Caribbean OFCs, although a European offshore entity may be more appropriate if a significant number of European investors are involved. Funds legally domiciled in OFCs hold around half of the hedge fund assets reported by the TASS hedge fund data base, with the British Virgin Island and the Cayman Islands being the most popular location. It has been estimated that over half of the world’s funds are incorporated in the British Virgin Islands However, management of funds is often conducted in or near major international financial centers such as London and New York although the actual fund is registered in an OFC. Ask where a hedge fund is domiciled and you are likely to hear the name of a handful of places worldwide. In the United States, domestic hedge fund businesses tend to cluster in a few states, in particular California, Delaware, Connecticut, Illinois, New Jersey, New York and Texas. Each state has different tax and regulatory laws. Outside the United States, several centers in the Caribbean and Europe present different benefits and costs to fund managers. Regulatory burdens and expenses can be worth bearing, depending on the nature of the investment vehicle and its clients.
Dave: Is there anywhere you would avoid and why? Hannah: Any country lacking monetary or political stability.
Dave: Moving onto the next structure. Master-Feeder funds. What are they? Hannah: The corporate structure of a hedge fund depends primarily on whether the fund is organized under U.S. law (“domestic hedge fund”) or under foreign law and located outside of the United States (“offshore hedge fund”). The investment adviser of a domestic hedge fund often operates a related offshore hedge fund, either as a separate hedge fund or often by employing a “master-feeder” structure that allows for the unified management of multiple pools of assets for investors in different taxable categories. The master/feeder fund structure allows the investment manager to collectively manage money for varying types of investors in different investment vehicles without having to allocate trades and while producing similar performance returns for the same strategies. Feeder funds invest fund assets in a master fund that has the same investment strategy as the feeder fund. The master fund, structured as a partnership, engages in all trading activity. In today's trading environment, a master/feeder structure will includes a US limited partnership or limited liability company for US investors and a foreign corporation for foreign investors and US tax-exempt organizations. The typical investors in an offshore hedge fund structured as a corporation will be foreign investors, US tax-exempt entities, and offshore funds of funds. Although certain organizations, such as qualified retirement plans, generally are exempt from federal income tax, unrelated business taxable income (UBTI) passed through partnerships to tax-exempt partners is subject to that tax. UBTI is income from regularly carrying on a trade or business that is not substantially related to the organization's exempt purpose. UBTI excludes various types of income such as dividends, interest, royalties, rents from real property (and incidental rent from personal property), and gains from the disposition of capital assets, unless the income is from "debt-financed property," which is any property that is held to produce income with respect to which there is acquisition indebtedness (such as margin debt). As a fund's income attributable to debt-financed property allocable to tax-exempt partners may constitute UBTI to them, tax-exempt investors generally refrain from investing in offshore hedge funds classified as partnerships that expect to engage in leveraged trading strategies. As a result, fund sponsors organize separate offshore hedge funds for tax-exempt investors and have such corporate funds participate in the master-feeder fund structure. If US individual investors participate in an offshore hedge fund structured as a corporation, they may be exposed to onerous tax rules applicable to controlled foreign corporations, foreign personal holding companies, or a passive foreign investment companies (PFIC). To attract US individual investors, fund sponsors organize separate hedge funds that elect to be treated as partnerships for US tax purposes so that these investors receive favorable tax treatment. These funds participate in the master/feeder structure. Under the US entity classification (i.e., check-the-box) rules, an offshore hedge fund can elect to be treated as a partnership for US tax purposes by filing Form 8832, "Entity Classification Election," so long as the fund is not one of several enumerated entities that are required to be treated as corporations.
Hedge Fund Phenomena Hedge funds manage over two trillion dollars in assets worldwide and they are a prominent feature on the investment landscape. The size of the hedge fund market has grown dramatically in recent years, and issues arising from hedge fund investments and management now have broad implications for the entire financial industry. Hedge funds may involve complex, illiquid or opaque investments and investment strategies and receive little regulatory oversight. Hedge funds are suitable only for sophisticated investors who are able to evaluate, select, monitor, and exit these investments. The hedge fund industry differs from the traditional asset management industry in several ways. The hedge fund industry itself is relatively young and has been an important source of new investment management ideas. Managers are often early adopters of investment strategies and new securities, and they frequently use investment vehicles and techniques that are unavailable to more constrained investors. It is important to note that hedge funds are lightly regulated vehicles that usually operate with a broad investment mandate and few limits on the investment authority of the funds.
Exactly what is a hedge fund? Although there is no universally accepted definition of the term hedge fund,” the term generally is used to refer to an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which are not registered as an investment company under the Investment Company Act. Alfred Winslow Jones is credited with establishing one of the first hedge funds as a private partnership in 1949. That hedge fund invested in equities and used leverage and short selling to “hedge” the portfolio’s exposure to movements of the corporate equity markets. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments and engage in a wider variety of investment strategies. Today, in addition to trading equities, hedge funds may trade fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options and other non-securities investments. Furthermore, hedge funds today may or may not utilize the hedging and arbitrage strategies that hedge funds historically employed, and many engage in relatively traditional, long-only equity strategies.
The term “hedge fund” refers to an investment pool that provides exposure to a set of financial risk factors not typically associated with traditional (equity and fixed income) long-only investments. This may include investments in limited partnerships, limited liability corporations, or other vehicles. These vehicles carry out the investment program under the direction of an investment manager. The term "hedge fund" may also refer to the manager of the investments of a hedge fund.
Hedge Fund Defined Hedge funds invest in a wide variety of financial instruments using a variety of investment techniques. Hedge funds use a broad range of portfolio strategies and are exposed to a similarly broad range of risks. Hedge funds do not represent a single asset class, but are a type of investment vehicle that provides exposure to a range of investment strategies. Hedge funds come in different sizes and have different management strategies and styles. They follow different administrative, valuation, and disclosure practices. Management of a hedge fund portfolio must be appropriate for its particular investments. Historically, hedge funds have focused on publicly traded securities, commodities, currencies, and their derivatives in such a way as to be “hedged”, in large measure, from material changes in stock and bond markets. Increasingly, however, hedge funds have exposure to a broader investment spectrum, including not only traditional markets but also sectors typically associated with other investment vehicles, such as private equity and real estate.
In short, the term generally identifies an entity that holds a pool of securities and perhaps other assets that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act. Hedge funds are also characterized by their fee structure, which compensates the adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation. Hedge fund advisory personnel often invest significant amounts of their own money into the hedge funds that they manage. As discussed in the Report, although similar to hedge funds, there are other unregistered pools of investments, including venture capital funds, private equity funds and commodity pools that generally are not categorized as hedge funds.
Hedge funds are often compared to registered investment companies. In addition, unregistered investment pools, such as venture capital funds, private equity funds and commodity pools, are sometimes referred to as hedge funds. Although all of these investment vehicles are similar in that they accept investors’ money and generally invest it on a collective basis, they also have characteristics that distinguish them from hedge funds.
When did this concept originate? Briefly, what’s the history? Hedge funds, while representing a relatively small portion of the U.S. financial markets, have grown significantly in size and influence in recent years. The SEC recognized over 30 years ago that hedge fund trading raises special concerns with respect to their impact on the securities markets. The growth in hedge funds has been fueled primarily by the increased interest of institutional investors such as pension plans, endowments and foundations seeking to diversify their portfolios with investments in vehicles that feature absolute return strategies – flexible investment strategies which hedge fund advisers use to pursue positive returns in both declining and rising securities markets, while generally attempting to protect investment principal. In addition, funds of hedge funds (“FOHF”), which invest substantially all of their assets in other hedge funds, have also fueled this growth.
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