4
Operational and Organizational Structures
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From a functional perspective, hedge funds are very similar to traditional investment companies. Both are separate collective investment schemes that issue shares to investors and manage pools of securities on their behalf. The primary differences are to be found on the organizational and legal sides. Mutual funds tend to be simple onshore organizations, while hedge funds need to be set up using complex onshore and offshore structures.
Ten years ago, a stand-alone hedge fund manager could open shop in relative obscurity with minimal cost and little or no infrastructure. He could operate with no internal or external control, and still have investors flocking to invest. This is less and less the case. Regulators have turned the spotlight on to the hedge fund industry and hedge fund investors are doing more and more organizational and structural due diligence. Hedge fund managers can no longer hope to operate purely as traders and outsource everything. They need to care about the quality of their organization, and so do their investors. In this chapter, our goal is therefore to “open the black box” and start looking at the different components that form the operational engine of a hedge fund.
4.1 LEGAL STRUCTURES FOR STAND-ALONE FUNDS
In essence a stand-alone hedge fund – or more generally an alternative investment fund – is an unregulated pool of capital contributed by a variety of sophisticated investors. The legal structure of this pool largely depends on who its investors will be and where the fund will be registered. For example, an onshore private investment vehicle formed for the benefit of US residents will be organized completely differently from an offshore investment vehicle formed for the benefit of non-US residents.
In this chapter, we will discuss the different structures available within and outside the US to create a stand-alone hedge fund. To keep things simple, we will denote by “onshore” anything that is located in the US and “offshore” anything outside the US.
4.1.1 In the United States (“onshore”)
In the United States, the principal forms of business organization are sole proprietorships, partnerships (general or limited), corporations (C or S types), and limited liability companies. However, most of these forms are not suitable for establishing a hedge fund. Sole proprietorships have no separate legal identity. General partnerships’ partners must assume unlimited liability. C-type corporations are separately taxable entities, i.e. their profits are taxed when realized at the corporation level and later when they are distributed as dividends at the investor level. Lastly, S-type corporations are restricted to no more than 75 shareholders and cannot have non-US residents as shareholders.
Figure 4.1 A typical limited partnership structure
We are therefore left with two possible pooling vehicles that could serve the particular needs of hedge funds, namely the limited partnership and the limited liability company. Both are separate legal entities that are created by a state filing. Both offer the same limited liability protection – the owners are typically not personally responsible for the debts and liabilities of the business. Both are pass-through entities, i.e. no tax is payable at the fund level and the tax attributes of the various investments are passed through directly to the investors. However, there are a few differences between them.
• A limited partnership has one or more general partners and raises money from investors who become limited partners. The general partners are responsible for running the fund and can be held personally responsible for any debts the partnership incurs.57 Limited partners, in contrast, have no responsibility for making investment or management decisions and they are not liable for the partnership debts. The most they can lose is their investment – though with a hedge fund that is often a substantial amount.
• A limited liability company is a business entity with some characteristics that resemble a corporation and other characteristics that resemble a partnership. It consists of property and a single type of owner, who is called a member. Members are the equivalent of shareholders of a corporation or limited partners of a limited partnership in that they own an economic interest in the limited liability company. Unlike limited partners, some members (called manager members) can be officers of the limited liability company and can manage and control it. However, none of the members, including the manager members, is liable for the debts and obligations of the company.
The limited partnership (Figure 4.1) has historically been the preferred structure in the US for domestic funds, because it can easily accommodate investors subject to US income taxation (pass through) and avoid the problems linked to a public offering of securities (limited number of partners). The partnership structure also gives fund managers (general partners) the ability to take performance fees as a profit allocation rather than as fee income, which reduces the investors’ adjusted gross income (AGI). This can be an advantage because itemized deductions on the investors’ individual returns are limited at higher levels of AGI.
Figure 4.2 A typical limited liability company structure
However, limited liability companies (Figure 4.2) have recently emerged in several states as a viable alternative.58 Delaware in particular has become the home of numerous hedge funds structured as limited liability companies because of its pro-business attitude, sophisticated filing system and knowledgeable employees, which makes the formation process relatively painless. In addition, Delaware generally allows more flexibility in the structure and operation of a business entity than other states (e.g. greater ability for the shareholders to act by written consent instead of via a shareholder meeting, and more permissible types of shareholder voting agreements).
Note that non-US investors in a US-based hedge fund are subject to withholding tax on any distributions, which makes US registration unattractive. Locating the fund in an offshore tax haven eliminates the problem of withholding tax on distributions for non-US investors.
4.1.2 Outside the United States (“offshore”)
Hedge funds domiciled outside the United States are generally structured as offshore open-ended companies. The majority of them are registered in sunny jurisdictions such as the Cayman Islands, British Virgin Islands, Bahamas, Netherlands Antilles or Bermuda for funds investing in North and South America. Alternatively, Ireland (Dublin) may be used for funds targeting Europe and willing to be registered there, while Mauritius, Hong Kong and Singapore are the favourite offshore centres for Far East investing. The advantages offered by these jurisdictions are obvious. They offer well-thought-through legislation, an easy registration process, a reasonable level of confidentiality, limited reporting responsibilities, and last but not least, a benign level of taxes. By contrast, when offshore funds come into contact with the United States, they and their promoters encounter one of the most highly regulated investment management jurisdictions and complex tax codes in the world (Figure 4.3).
The choice of a particular place of incorporation is extremely important for a hedge fund. Several requirements will usually dictate the final choice, including:
• The tax-free or tax-favourable nature of the jurisdiction (profits, capital gains, distributions, withholding taxes, deferring of incentive fees, etc.). Most offshore hedge funds operate tax free as long as no nationals from the jurisdiction of organization are investors and local operations are limited primarily to administrative operations. Therefore, the tax characteristics of the underlying income no longer pass through directly to the shareholders (as in the limited partnership) but the income is not truncated.
• The public image of the country, since this will directly affect the fund. In particular, the Financial Action Task Force of the OECD has identified a series of jurisdictions that are non-cooperative with respect to fighting money laundering. Most hedge funds will attempt to avoid countries mentioned on this list to protect their image.
• The availability of competent local service providers, such as banks, lawyers, accountants, administrators and staff.
• The various types of investment vehicles available.
• The operating costs. Some countries have developed a comprehensive scheme for the organization and administration of investment funds. This provides additional security to potential investors, but increases the costs of establishing and maintaining a fund there.
• The convenience of the location in terms of travel time, time-zone difference, language, etc. In particular, the time difference with European offshore jurisdictions can create important administrative difficulties for US managers.
• The local regulations regarding confidentiality and secrecy, money laundering, restrictions on investment policy, etc. In particular, most non-US investors do not want any information about them reported to the US tax authorities.
• The targeted investments and their location.
• The targeted investors and their countries’ regulations.
Figure 4.3 A typical offshore corporation structure
In practice, most offshore funds maintain their custody and administration in the offshore country, while the hedge fund adviser is located elsewhere, e.g. in the United States or Europe.
Offshore hedge funds generally attract the investment of non-US residents, who prefer to retain their anonymity and avoid paying Uncle Sam taxes. They might not, however, escape the scrutiny of their home tax jurisdiction, and this might result in a prohibitive level of taxation. German tax authorities, for instance, consider any increase in the value of the fund as being dividend income and tax it as such.
Offshore hedge funds also attract the assets of US tax-exempt entities, such as pension funds, charitable trusts, foundations and endowments. The reason is that US tax-exempt investors are subject to taxation in respect of unrelated business taxable income (UBTI) if they invest in domestic limited partnership hedge funds – see Box 4-1.
Box 4.1 Unrelated business taxable income (UBTI)
Under US income tax laws, most tax-exempt organizations engaging in an investment strategy that involves borrowing money are liable to tax on unrelated business taxable income, notwithstanding their tax-exempt status. In practice, UBTI includes any income earned from investments that are financed with indebtedness. Yet, the entire strategy of a hedge fund revolves around using leverage, which allows it to increase gains for the shareholders. For that reason, tax-exempt investors, bodies or individuals would generally prefer to invest in a corporation – including an offshore one – rather than in a domestic partnership. As a result, fund sponsors usually organize separate offshore hedge funds for US tax-exempt investors. This is the simplest way for tax-exempt entities to legally avoid paying US taxes.
However, offshore hedge funds are usually not attractive to other traditional US investors primarily for tax reasons. Indeed, prior to 1986, US individuals could invest in an offshore corporation and avoid paying tax on any income from the investment until they disposed of it. This situation changed in 1986 with the application of the so-called passive foreign investment company (PFIC) rules. These rules were primarily designed to dissuade US investors from deferring recognition of the income earned in a passive investment vehicle. According to them, the income earned by an investor in a PFIC may be taxed in one of three different ways:
• Qualified electing fund: the US investor elects on his income tax return to pay tax on a current basis on the ordinary income and net capital gains from the offshore corporation, almost as if the corporation was a limited partnership.59 However, this requires that the offshore fund issue to each US investor an annual statement detailing the investor’s share of ordinary earnings and net capital gains generated by the fund during the year. Not all hedge funds are in a position to calculate and supply such information. In addition, the offshore fund must agree to allow the investor and the US Internal Revenue Service (IRS) to inspect its records so that the income can be verified. Most offshore funds object to this requirement, which may jeopardize the confidentiality of the other investors.
• Excess distribution: US investors are taxed on a PFIC investment when they receive a distribution in the form of a dividend or when they receive cash from the redemption or sale of shares. To balance the implicit deferral, there is an interest charge to be paid in addition to the tax liability.
• Mark to market: if the PFIC fund is traded on an exchange, the investor can make a mark-to-market election on his income tax return. Unrealized gain is treated as ordinary income and unrealized loss is treated as an ordinary loss.
The choice between the three taxation approaches is at the discretion of the taxpayer. However, in practice, the first option is not always possible if the fund manager cannot comply with the associated requirements, the second option is extremely complex, and the third option requires a fund listing, which is not always available. Consequently, most US investors choose to stay away from offshore hedge funds. Last but not least, offshore entities are always surrounded by an aura of suspicion by the IRS.
Figure 4.4 The typical hedge fund network
4.2 A NETWORK OF SERVICE PROVIDERS
Contrary to mutual funds, which tend to be large integrated monolithic structures with a large number of staff, a typical hedge fund business is small, at least at the outset (Figure 4.4). Most hedge funds operate through various external service providers to which certain functions are delegated. This allows a small number of personnel to easily access a wide skill base. In return, the service providers receive a specified fee from the fund pursuant to various agreements.
The use of specialized external service providers has often resulted in a better quality of service at a lower cost than doing everything in house. This explains why quality hedge funds tend to have better operational environments than traditional investment managers.60 In addition, since hedge funds are loosely regulated, spreading responsibilities minimizes the risk of collusion between parties to perpetrate a fraud. Most hedge funds recognize these benefits and, before starting operations, they establish relationships with all the necessary industry service providers. Of course, the danger is that a network of service providers is only as strong as its weakest link, and vulnerability arises in the coordination of activities between the various service providers. It is therefore imperative to ensure that they work in harmony and that they all perform the tasks they were initially expected to perform. Let us now focus on the various roles of each player.
4.2.1 The sponsor and the investors
The sponsor is usually the creator of the hedge fund. Most sponsors are entrepreneurs in nature – they are former traders, stock analysts or portfolio managers who left investment banks, investment management firms and other large financial institutions to establish their own firm. They were lured by the potential earnings but also by the idea of owning their own company and leaving the burden of a traditional institution behind them. If the hedge fund is structured as a company, the sponsor typically receives founder shares. If the fund is a limited partnership, the sponsor (or an entity that he controls) is usually its general partner. In either case, the sponsor controls the management of the fund apart from a limited number of major decisions, and he receives an allocation of income from the fund based on performance – typically, 20% of the realized and unrealized appreciation of the fund each year over the high-water mark.
Investors contribute capital and receive some form of ownership – in companies, they hold shares and in limited partnerships they are the limited partners and have a capital account. Most of the time, the sponsor will also be an investor and contribute his own capital.
4.2.2 The board of directors
Most offshore hedge funds have a board of directors to oversee the way the fund operates and to ensure that corporate policies are followed. A board of directors normally contains both interested and independent directors. Interested directors are typically employees of the fund’s investment adviser. Independent directors, in contrast, should not have any significant relationship with the fund’s adviser, which allows them to provide an independent check. They are usually prominent individuals with diverse backgrounds in business, government or academia, often with distinguished careers and experience.
In theory, the board of directors has a long list of duties:
• To review and approve the investment advisers’ contracts and fees, the selection of independent auditors and attorneys, and the appointment of the fund’s transfer agent, custodian, etc.
• To regularly verify whether the selected service providers have the relevant expertise to work with the fund’s particular strategy. For instance, administrators must have the skills and resources to value all the fund’s assets and not allow fund managers to overwrite valuations of certain instruments; custodians must understand the legal aspect of ascertaining ownership of the instruments they hold; lawyers must understand the strategy and the underlying investments in order to recommend the disclosures and risk factors that are appropriate in the offering documents, etc.
• To ensure compliance with the fund’s prospectus and the fair treatment of all investors.
• To oversee matters where the interests of the fund and its shareholders differ from the interests of its investment adviser or its portfolio manager.
• To ensure that risk management guidelines are adhered to.
• To review the manager’s risk management system and check that it is relevant to the chosen investment strategy.
• To review the operations of the fund manager himself and in particular issues such as crossselling between funds, allocation of trades, and personal dealings.
In practice, however, it is questionable whether boards of directors have a sufficient understanding of the nature of the investment strategies utilized by hedge funds; their judgements about investment strategy will therefore be of limited value. In addition, if ownership of a hedge fund is concentrated in the hands of a limited number of sophisticated shareholders, the role of the independent directors remains unclear. What criteria would they use that did not involve substituting their judgement of risk for that of the investors they represent?
4.2.3 The investment adviser
The fund adviser is often the linchpin of a hedge fund. Most of the time closely related to the sponsor, his role is to establish the hedge fund, organize it and run it. The activity of the hedge fund adviser usually starts by overseeing the preparation of the legal and subscription agreement, as well as the applicable limited partnership or limited liability company agreement and the arrangements with external service providers. The adviser is also often in charge of marketing and distributing the fund’s shares to investors, as well as providing periodic reports to investors about the fund’s performance.
Having a separate entity to function as the fund adviser offers several advantages. First, it allows the distribution of equity interests in the investment adviser entity to retain, motivate, and compensate key personnel. Second, in many cases, the incentive compensation is paid directly to the investment adviser rather than to the sponsor. The incentive compensation can take the form of a performance fee, in which case it is an item of expense that is paid by the hedge fund. Alternatively, if the investment adviser is, or is intended to become, a partner (e.g., an investor) in the hedge fund, the incentive compensation can also take the form of a performance allocation. The latter is a special allocation to the investment adviser’s capital account of net investment income, realized capital gains, and unrealized capital appreciation that would otherwise be allocated to investors.
The size and organization of hedge fund advisers varies greatly. It can range from one individual with multiple hats and few formal procedures to large organizations with sophisticated systems and numerous employees. However, in the US since February 2006, almost all hedge fund advisers have been subject to many of the same requirements as mutual fund advisers – see Chapter 3. This includes in particular registration with the SEC, the designation of a chief compliance officer, the implementation of policies to prevent the misuse of non-public customer information and ensure that the votes of client securities are used in the best interests of the client, and the implementation of a code of ethics. In addition, the SEC is allowed to inspect all registered hedge fund advisers at any time and may deny the registration of anyone convicted of a felony or having a disciplinary record.
4.2.4 The investment manager or management company
The investment manager’s primary responsibility is to manage the portfolio of the fund from an operational perspective and implement the recommendations of the investment adviser. The investment manager normally covers his operating expenses by an asset-based fee.
In the case of an onshore fund, the investment manager is usually structured as a company that belongs to or is affiliated to the fund sponsor. This limits the sponsor’s responsibility and is often more efficient from a tax perspective. In the case of offshore funds, a single entity may act as both sponsor and investment manager.
4.2.5 The brokers
Unless a hedge fund has direct access to the market, it needs to place its orders with brokers. The traditional solution was to use the services of an executing/clearing broker, which compiled the best bids and offers, executed trades, and provided full reconciliation as well as limited administrative services. These brokers were typically rewarded explicitly by a fee for custodial and trade processing services, and competition was only about best execution, basic clearing services and consolidated reporting statements. This was possible because there were very few firms that catered to hedge funds in this capacity and consequently there was little pressure on providers to improve their services. However, over the years, the increased importance of hedge funds combined with their demand for additional services beyond simple trade execution convinced a large number of investment banks to enter the market and develop their prime brokerage activities.
Today, prime brokers should be seen as full service providers across the core functions of execution and operations. Among the key services that they can offer are:
• Clearing the trades: Prime brokers clear trades, which are executed with their own broker – dealer, or if desired by the fund, which are executed with other brokers. When a fund designates a prime broker, it instructs all its executing brokers to settle its trades with a single firm. Then, when there is a trade, both the hedge fund and its executing brokers report the trade to the prime broker. The latter settles the trade, custodies the securities or reports to the designated custodian if the details match, or resolves the case with the fund and the executing broker in the case of a mismatch. Trade allocation, confirmation and settlement are consolidated with the prime broker, allowing hedge funds to maintain a small operations staff but still execute complex and high-volume trades.
• Acting as global custodian: A key item of information for a hedge fund is the consolidated reporting of trades, positions and performance. It is therefore common to see prime brokers acting as global custodian for hedge funds.
• Margin financing: Most hedge funds use leverage to implement their investment strategy, but commercial banks are usually unwilling to take credit exposure directly to all but the largest hedge funds. Since prime brokers are able to take and monitor full asset collateral on their loans, they can intermediate and provide the leverage that hedge funds require, typically through revolving lines of credit, loans, or repurchase transactions. This streamlines the credit and documentation process, given that the hedge fund is subject to only one internal credit review and executes one master trading agreement and credit support annex with the prime broker, rather than many agreements with multiple credit providers.
• Securities lending: The ability of a hedge fund to take short positions is a key part of its trading strategy and it is the securities lending desk at the prime broker that mainly facilitates this process. Prime brokers maintain a securities-lending network, comprising banks, large institutional holders and other broker-dealers, and act again as intermediaries – most institutional securities lenders would not accept the credit risk of dealing directly with hedge funds whereas they are more than happy to take exposure to the prime broker. Although some pure custodians do offer limited securities lending and financing to hedge funds, this is on a very small scale compared to the operations of prime brokers operating out of broker-dealers.
• Risk reporting: As collateralized lenders (see below), prime brokers need to have robust risk monitoring systems in place to protect them. It is therefore relatively easy for them to provide customized periodic reports at no extra cost to their clients. These reports may concern the pricing of securities, or the risk of the portfolio (value at risk, liquidity, etc.), or may even allow fund advisers to provide investors with some limited transparency information.
• Research: Prime brokers can provide access not only to their own research but also to third party research, which might complement hedge funds’ own research and lead to additional trades.
• Collateral management: To cover their exposure in the borrowing and securities lending obligations incurred by the hedge fund and ensure their rights of legal recourse in the event of default by the fund, prime brokers usually request some collateral. This collateral may take the form of either a full transfer of some assets or a conventional mortgage or charge over the hedge funds assets. Most prime brokers offer cross-margining facilities, i.e. the positions that need collateral are grouped and margined together. Such an approach, where offsets and hedges are taken into account, allows for the most efficient use of capital and optimizes the collateral management process.61
• Capital introduction: Brokers are entitled to distribute private hedge fund information to their own customers (i.e. potential hedge fund investors), even though the hedge fund itself has no pre-existing relationship with the brokers’ customers. Prime brokers regularly arrange for hedge fund managers to speak at various conferences they arrange, where high net worth clients of the prime brokers are likely to be in attendance.62
• Valuation: Some brokers may also function as a source of pricing for certain types of securities.
It is essential to understand that the prime brokerage relationship still allows hedge funds to maintain relationships and execute trades with multiple brokers (Box 4.2), and yet provides them with a centralized source of information and leverage. In fact, a prime broker transaction occurs when a trade is executed by one party (the executing broker) on behalf of a hedge fund which directs that the trade be forwarded to another party (the prime broker) for clearance and settlement. The hedge fund then faces its prime broker as counterparty – the prime broker mirrors the transaction with the executing broker as counterparty, effectively intermediating between the two. The hedge fund obtains the economic benefit of the transaction, as intended, while the prime broker assumes the credit risk of the executing broker.
Overall, the move to prime brokers was a paradigm shift that was both significant and beneficial for the hedge fund industry. Most of the time, it resulted in simplified operational procedures, better service and lower costs. Today, prime brokers provide a wide range of essential services to the hedge fund universe, and many hedge funds would be unable to carry out their investment strategies efficiently without them. However, this is also a win-win strategy. With the development of this business model, prime brokerage-derived revenues have burgeoned. Anecdotal evidence suggests that prime brokerage now accounts for more than half of the equities division revenue of several leading investment banks. Big bonuses should follow ...
Box 4.2 Trade execution
When (1) a hedge fund executes a trade with executing brokers, (2) those brokers inform the prime broker and “give up” the trade. (3) The fund manager provides all trade information to the prime broker. (4) The prime broker reconciles the positions between the fund and the brokers, consolidates all securities and reports back to the fund manager (Figure 4.5).
Figure 4.5 Trade execution with a prime broker – the simplified view
In reality, the detailed execution of a trade via a prime broker is far more complex than it first appears. As an illustration, let us review the various steps of a prime broker transaction on a US stock executed with Morgan Stanley (Figure 4.6).
Figure 4.6 Details of a trade using Morgan Stanley as prime broker
1. The fund manager places his order with an executing broker.
2. The executing broker submits the trade to a settlement agency.
3. The fund manager communicates the executed trade to Morgan Stanley Prime Brokerage, which processes the trade into its system.
4. The processed trade is submitted to the settlements system to set up a delivery vs payment (DVP) or receipt vs payment (RVP) instruction to the settlement agent (e.g. a depository trust account (DTC), or Bank of New York) vs the executing broker. The DTC does an automated overnight match of instructions and sends back data of matched and unmatched trades.
5. The processed trade information and the settlements system information are submitted to the portfolio system.
6. The portfolio system feeds the trade and position data to the client – the client may have a direct feed to the system or use Morgan Stanley portfolio reports.
7. The portfolio system produces hard-copy reports for the client representative and the operations liaison team.
8. The client has the option of sending Morgan Stanley a feed of position and cash balance data to be reconciled with the portfolio system data using Morgan Stanley internal software.
9. The reconciliation software produces reports of breaks between the client and Morgan Stanley’s prime brokerage portfolio data.
For international trades, the process is similar, but the prime broker settlement system sends instructions to the international depositories and agent banks. International trades executed in a currency other than the local currency have a simultaneous transfer of cash and securities. For offshore accounts, the prime broker can also provide automated links to offshore administrators for communicating portfolio information.
Prime brokers’ fees vary greatly depending on the nature of the services they provide. Moreover, obtaining comparable figures is usually hard. There are several different ways in which prime brokerage firms can be remunerated for services rendered, e.g. directly via a global fee or indirectly using spreads, ticket charges, stock loans or credit interest. In addition, several prime brokers bundle their fees and use soft dollars, so that the exact amount a fund pays for a particular service can be an elusive figure.
Today, the business of prime brokerage is concentrated in the hands of a few investment banks (see Figure 4.7). Owing to their existing asset management, securities lending and custody activities, these banks have natural competitive advantages and are able to offer a complete front-to-back suite of technology products. However, as the prime brokerage business has grown it has also become increasingly competitive and has moved from a demand-driven to a supply-driven state. A few years ago, prime brokers were able to impose strict criteria for being accepted as their client, such as minimum capital requirements, minimum volume of transactions, minimum size of debit balances or volume of shorting transactions. Today, a number of prime brokers offer capital introduction as an additional service at no extra cost in an attempt to obtain more hedge fund business, or even serve as hedge fund incubators, providing newly created funds with the technology, infrastructure, office space and back-office services that they need to grow.
Several prime brokers have attempted to lock hedge fund managers into exclusive relationships by offering them value-added services such as exclusive research, tax-compliance reporting, online communication, and trade date versus settlement date reconciliation. But the desire to reduce counterparty risk, to preserve some privacy for their proprietary trades and to clear and settle trades in multiple time zones has gradually persuaded the largest funds to use several prime brokers simultaneously. This reduces the potential consequences of a major prime broker failure but it also increases the complexity of the administrator’s task, since he must ensure that he has all the feeds necessary to produce a daily profit and loss or position statement. If the administrator fails in this task, or even worse, there is no administrator, the consequences may be dramatic (see Box 4.3).
Figure 4.7 Top ten prime brokers as of March 2006 based on the number of hedge funds as clients (data from the CogentHedge database)
Box 4.3 The cases of Michael Berger’s Manhattan Fund and David Mobley’s Maricopa family of funds
In 1996, Michael Berger, a 29-year-old Austrian, started a hedge fund called The Manhattan Investment Fund Ltd. Following a strategy based on the overvaluation of the market, specifically the internet sector, Berger engaged in short selling. He immediately started to suffer losses but kept reporting large positive gains to his investors. This allowed him to raise over $350 million of capital over a period of three years, while most short sellers were displaying negative performance figures.
The reality came to light at the beginning of the year 2000: The Manhattan Investment Fund had lost more than $300 million, but Berger had failed to disclose these losses. His tricks were quite simple. The fund administrator used to calculate the fund’s net asset value on the basis of daily statements sent by Bear Stearns that summarized the securities held by Bear Stearns on the fund’s account. From September 1996, Michael Berger had started producing fictitious statements from Financial Asset Management, supposedly another broker to the fund, and sent them to Bear Stearns. The latter used both statements to compute the net asset value, overstating the true value of the fund. As an illustration, the reported net market value for August 1999 was $427 million, whereas the true value was less than $28 million. The fund’s auditor naturally requested information from Financial Asset Management. The latter forwarded the request to Berger, who simply responded to the auditors as if the information was coming from Financial Asset Management, again producing fictitious reports and overstating assets. Following the fund’s collapse, several investors filed a lawsuit at the SEC against Berger (the fund manager), Bear Stearns (the prime broker), Deloitte and Touche Bermuda (the auditors) and Fund Administration Services (Bermuda), an Ernst and Young LLP affiliate (the administrator). The outcome is still unknown, but the case resulted in closer monitoring by administrators, particularly when more than one broker is alleged to be holding a fund’s assets. In November 2000, Berger pleaded guilty to one charge of fraud, but he was never convicted. In August 2001, he changed his plea to “not guilty”. A federal judge in New York first ruled on 9 October 2001 that Manhattan Investment Fund had to pay back $20 million to investors, representing fees collected. Since the fund only has about $240,000 left, it is hard to believe that investors will ever receive anything. As a matter of comparison, total legal costs are already above $9.5 million. Berger failed to appear at his sentencing hearing on 1 March 2002, in New York City.
The case of David Mobley is even more striking. In 1993, he announced that he had created a “black-box” timing tool to predict market movements and he started a group of hedge funds (Maricopa Investment Fund, Ltd, Maricopa Index Hedge Fund, Ltd, Maricopa Financial Corporation, Ensign Trading Corporation, etc.). Until the end of 1999, he regularly provided statements to his investors showing stunning gains of above 50% per year without any losing year. However, his performance was not audited, officially because it would be too easy to copy his proprietary trading system. The reality was that during these seven years, David Mobley used most of his clients’ money to fund his lavish lifestyle and to actively invest in many of his own businesses as well as in local charities. All Mobley’s close relatives held the fund’s top positions, including his older brother William (President) and his 25-year-old son David Jr (Vice-President and Head Trader). Furthermore, it was revealed later that David Mobley had a grand-theft indictment, had been convicted of passing bad cheques, had made false representations on his application to the National Futures Association and had also previously declared personal bankruptcy.
The establishment of a prime brokerage arrangement requires specific legal documentation that sets forth the rights and responsibilities of the client, the prime broker, and any executing dealers. This document usually includes:
• A prime brokerage agreement, in which the prime broker agrees that the hedge fund may enter into transactions with dealers approved by the prime broker, and that the prime broker, rather than the hedge fund, will become the party to these transactions. Lastly, the agreement describes the procedure by which the prime broker will be notified of the transaction and specifies a list of allowable products and the applicable limits in terms of amounts.
• A give-up agreement between the prime broker and the executing dealer, in which the executing dealer agrees to give up its trades, on a principal basis, to the prime broker for trade processing, subject to compliance with specified terms. As such, the prime broker becomes the credit and accounting consolidation vehicle, managing the customer’s settlements, confirmations, record keeping and other administrative tasks. A give-up agreement is normally executed as a master ISDA agreement, supplemented by a give-up agreement notice for each prime-broker client that will execute trades with the applicable executing dealer. The give-up agreement notice clearly identifies the client (in our case: the hedge fund) and specifies the allowable products, tenors and specific limits that apply to the trades that the prime broker must accept for that client. This allows an executing broker to verify for a given trade and a given hedge fund whether the prime broker is obliged to accept the give-up of the transaction. If a trade falls outside the limits specified in the give-up agreement, the prime broker can still be contacted for explicit approval, but he may decline the execution.
• A compensation agreement between the hedge fund and the executing broker. This agreement provides for the compensation of losses, costs or expenses incurred in the close-out of a position in the event that the give-up of a transaction is not accepted by the prime broker. In practice, the risk of a prime broker rejecting a trade is minimal, but it is always preferable to provide for such risk and its consequences in advance, rather than after the event.
Needless to say, a prime broker must always maintain a complete separation between its prime brokerage operation and its proprietary trading desks, if any. This separation should also include technology, research and operations departments. Prime brokers are also required to give equal treatment to their clients’ transactions, whether executed with their own trading desk or with other brokers.
4.2.6 The fund administrator
Historically, as long as the hedge fund industry operated on a fairly modest scale, the role of the hedge fund administrator was rather limited. Most onshore hedge funds were internally administered and only offshore hedge funds outsourced their valuation to external offshore administrators, primarily to avoid US taxation.63 Most of these offshore administrators were small boutiques often seen but not heard, and they played a very limited role for hedge fund managers.
As the hedge fund industry developed and the product offerings expanded, hedge fund managers had to cope with more and more challenges such as a changing regulatory landscape, the increased demand from investors for additional services and more frequent reports, and the request for full independent pricing and net asset value (NAV) calculation. The role of fund administrator therefore started to strengthen and the small boutiques metamorphosed into a number of highly professional businesses, operating with the help of highly advanced technological systems.64 Today, the primary role of a hedge fund administrator is to provide back-office support by taking responsibility for the operations, administrative, accounting and valuation services, and the investors interface, thereby allowing the fund manager to concentrate on his trades. However, the level and scope of work involved varies substantially, depending on the type of hedge funds covered, their sophistication, and the activities already covered by the prime broker.
The NAV calculation is of paramount importance for a hedge fund and its investors, since its result will be used as the basis for all subscriptions, redemptions, and performance calculations. The first step in calculating the NAV is normally to download the daily trade activity of the fund manager from his custodian and/or prime broker(s). Then, the corresponding portfolio listing is matched to corporate action data supplied by various vendors to accrue dividends, coupons, etc. Automatic reconciliation matches the portfolio to the trades fed from the manager and to the holdings indicated by prime brokers.
The next step in the NAV calculation is to price all the positions. For non-concentrated investments in liquid securities, fair and impartial valuations are fairly easy to achieve, as recent transaction prices as well as marketable bids and offers are readily available from major data feeds (Bloomberg, Reuters, IDC, etc.). But for many other less-liquid, restricted or more complex investments favoured by some types of hedge funds, this is not necessarily the case. Transactional prices may not be available, or securities may be difficult to value without use of mathematical models. In such cases, the administrator must have a clear procedure to determine a fair value for these securities independently from the portfolio manager. This procedure should normally be outlined in detail in the offering document or in a separate document, which must be properly approved by the fund’s board of directors.
In extreme market circumstances, when valuation becomes really problematic and the fund’s board of directors may have to suspend dealing. For instance, during the 1998 Russian crisis, some previously liquid Russian securities traded at US$ 11 bid/US$ 23 ask. If the valuation formula for a particular hedge fund had stated that the NAV should be calculated on the basis of the mid-price, then investors would have been able to indirectly buy and sell at $17. The problem is that anyone buying or selling at the NAV would be diluting the remaining investors. The simplest solution in such a case is to suspend dealing in the fund’s shares until markets stabilize and become liquid.
The importance of having the fund valuation performed independently from those charged with managing the fund cannot be overemphasized (see Box 4.4). In particular, a person who performs, checks or approves net asset values should never receive incentives or inducements based directly on the performance of the investment being valued, and should not report to managers who do. People such as traders or portfolio managers should never perform final valuations, or communicate prices to the administrator – except in very exceptional, fully disclosed and auditor-approved circumstances. This separation of duties and independence in mark-to-market has long been a fundamental principle of control in financial institutions, but it is still inconsistently applied in the hedge fund industry. Not surprisingly, failures to separate duties and lack of independence have often been important factors in recent valuation-related hedge fund failures.
Box 4.4 Beware of valuation problems
A study by the financial services consultancy and technology provider Capco offers some grist to the proponents of minimizing operational risk. The study investigated 100 hedge fund failures over the last 20 years and found that half of them were caused by operational problems rather than poor investment decisions. Valuation problems were an obvious concern in a large number of cases (35%), and they were generally caused by one of the following three factors (Figure 4.8):
• Fraud/ misrepresentation, such as a deliberate attempt to inflate the value of a fund, either to hide unrealized losses, to be able to report stronger performance, or to cover up broader theft and fraud. Examples of such cases include the failure of the Manhattan Investment Fund and Lipper Convertible Arbitrage.
• Mistakes or adjustments, either for illiquid securities, or for large blocks where any attempt to sell would move the market. Significant variations were observed depending on which “correct” price was being used – i.e. the bid, offer or mid-point – especially when it came to instruments where bid/ offer spreads were sizeable.
• Process, systems or procedural problems, particularly for over-the-counter (OTC) instruments that cannot be handled by automated processing systems. Faults included incorrect pricing, but also positions being incorrectly captured on the fund’s books and records.
Figure 4.8 Causes of valuation issues implicated in hedge fund failures, according to the consulting firm Capco
As mentioned in the Capco report, “the devil is in the details”, namely the procedures for obtaining prices from independent third parties on a regular basis and verifying the capability of these third parties to provide accurate prices. In cases of hedge fund failures due to valuation issues, Capco found that fraud and misrepresentation was the cause in 57% of cases, followed by process, procedural or systems problems (30%) and mistakes or adjustments (13%).
According to Capco, some strategies are obviously more sensitive to valuation problems than others. Let us mention in particular convertible arbitrage (limited liquidity, complex option clauses), mortgages, mortgage-backed securities and asset-backed securities (limited liquidity, high dispersion of market marker quotes), credit default swaps, OTC derivatives, bank debt, loans and distressed debt (illiquid and difficult to model), emerging markets (liquidity issues), and highly concentrated positions, and positions that make up a large proportion of a single issue (high market impact).
Note that there still exist a series of hedge funds that perform their valuations internally rather than externally. The reasons vary from a lack of confidence in external administrators to fear of the loss of a certain amount of control, or a focus on securities that are extremely difficult to value – in some cases, the hedge fund is the market. Our view is that this approach is definitely not acceptable for smaller boutique funds, where generally the organization is not large enough to allow appropriate segregation of duties and an appropriate level of checks and balances. It might be acceptable in the case of large organizations, provided there is sufficient segregation of duties and that appropriate checks and balances are in place. In addition, these funds should have a detailed written valuation policy.
In such cases, it is also essential to ensure the independence of the financial/accounting team running the valuations from the portfolio manager. This team should report directly to the Chief Financial Officer or the Chief Operating Officer of the fund management company, but not to the fund manager, and should be compensated on the basis of the overall profitability of the management company rather than directly on the performance of any of the investment vehicles managed by the firm. In addition, the fund should regularly use an external third party such as an independent auditor to verify the accuracy of these valuations – a periodicity of once a year is generally not sufficient.
In addition to net asset value calculations, most administrators also provide several administrative services, such as accounting and book-keeping, payment of fund expenses, including the calculation of performance fees and equalization factors,65 preparation and mailing of reports to existing shareholders at regular time intervals called break periods, 66 help with tax assessment, basic legal support and even investor relations. In the US, hedge fund administrators may also ensure blue-sky laws compliance, prepare and file tax returns, including the realized and unrealized capital gains, and sometimes send some of the standard reports required by the SEC.
Administrators may also act as an independent body to ensure that the rules defined in the prospectus and other documents are respected, and that laws and regulations are followed. This includes activities such as paying the funds’ filing fees on time, making sure that accounts are filed, and verifying that stock exchange rules and, more generally, international rules are followed, etc.67 Lastly, administrators also provide hedge funds with several important documents, e.g. a full set of financial statements, including a statement of assets and liabilities, a statement of operations, a statement of changes in net assets and a portfolio. This is often backed up by portfolio analysis and other statistics of interest to the fund adviser, such as value-at-risk calculations. In the author’s opinion, the administrator may supply such data but should not participate in the fund’s risk management function. The reason is that this latter task is judgemental and should therefore be performed by another independent party. Nevertheless, in times of crisis, the administrator should remain proactive in the interests of shareholders.
Naturally, a fund administrator charges fees for his services. Depending on the complexity of the fund and the number of tasks performed, the administrator’s fees may be as little as a few thousand dollars a year or go up to as much as 0.5% of the net assets per annum. However, to know the true amount it is important to dig deeper than the announced figure because some fees may be hidden or not immediately disclosed.68 Needless to say, most of the administrator’s services are common to all hedge funds, and substantial economies of scale can be gained by centralizing these functions and using cutting-edge technology and experienced personnel.
It should be noted that some offshore jurisdictions explicitly require the use of an independent administrator operating within their borders. These administrators are usually subject to specific licensing, auditing and record-keeping requirements as well. They are subject to anti-money laundering provisions, which set forth client identification and record-keeping requirements in addition to obligations to report to the relevant authority in that jurisdiction any suspicious activity with respect to the funds they administer (see Figure 4.9).
Figure 4.9 Top ten administrators as of November 2005 based on the assets under administration (data from the Hedge Fund Manager/Advent Software Hedge Fund Administrator 5th bi-annual survey)
4.2.7 The custodian/trustee
The primary duties of the custodian (referred to as “trustee” in the case of a unit trust) relate to the requirement to take into custody the assets of the investment fund on behalf of the fund. After all, what is a fund’s extraordinary performance if the assets are not properly recorded in the fund’s name? For simple stocks and bonds, this is not a problem, but for more complex financial instruments, the legal document certifying ownership may take a different shape and form and this could cause a risk to a hedge fund if the legality of ownership is not properly ascertained at the right time.
In addition, the custodian is in charge of providing payment when securities are bought and receiving payment when securities are sold, as well as monitoring corporate actions such as dividend payments and proxy-related information. Most of the time, the fund’s assets consist of cash and securities that the custodian does not possess but maintains on an accounting system through a central depository. Lastly, the custodian is also responsible for providing periodic reports on the transactions within the account, and ensuring that the operations of the fund are conducted in accordance with its constitutive documentation and the relevant regulations.
The custodial fee can be a fixed fee or a percentage of net asset value, but when a prime broker acts as de facto custodian, he may also charge on a transactional basis (see Figure 4.10).
4.2.8 The legal counsel(s)
Legal counsels (Figure 4.11) assist the hedge fund with any tax code and/or legal matters, and ensure compliance with domestic investment regulations as well as with regulations of countries where the fund is domiciled or distributed. They usually prepare the key hedge fund documents, e.g. the private placement memorandum, the offering documentation, and the partnership and subscription agreement, as well as all necessary questionnaires (access-accredited investors, qualified purchasers and new issues, etc.). They are also involved in specific transactions and may address tax issues. A hedge fund should appoint a legal counsel in appropriate jurisdictions, including where the hedge fund is domiciled and where the hedge fund manager is located and operates (Figure 4.12).
Figure 4.10 Top ten custodians as of March 2006 based on the number of hedge funds under custody (data from the CogentHedge database)
Figure 4.11 Top ten legal counsels as of March 2006 based on the number of hedge funds as clients (data from the CogentHedge database)
Figure 4.12 Top ten offshore counsels as of March 2006 based on the number of hedge funds as clients (data from the CogentHedge database)
4.2.9 The auditors
The auditors’ role is to ensure that the hedge fund is in compliance with accounting practices and any applicable laws, and to verify its financial statements (Figure 4.13). The audit usually takes place annually, in conformity with the relevant legislation under which the hedge fund is established, regulatory requirements or the constitutive documents of the fund. The auditors report and the financial statements are then sent to investors.
Investors tend to forget that, although the work of auditors is essential, the latter do not normally review fund valuations in detail, unless explicitly requested to do so – for example, in the case of funds that do self-valuations. In a recent survey by PricewaterhouseCoopers entitled “Global Hedge Fund – Valuation and Risk Management Survey”, more than 25% of respondents stated that they rely on the auditors for an independent review and verification of the portfolio valuation. In reality, any testing of the portfolio valuation is usually restricted to only one specific date (the balance-sheet date on which reporting is made) and/or sample tested. Other hedge fund reports, e.g. weekly estimated net asset values, monthly statements and quarterly reports, usually remain unaudited.
Figure 4.13 Top ten auditors as of March 2006 based on the number of hedge funds as clients (data from the CogentHedge database)
4.2.10 The registrar and transfer agent
The registrar and transfer agent retains and updates a register of shareholders of the hedge fund. He also processes and takes necessary action for subscriptions and withdrawals of shares in the fund as well as for the payment of any dividends and distributions, if any. The registrar and transfer agent also checks the anti-money laundering documentation, and ensures that funds are collected, matched to their application and paid over to the fund or back to the investor.
When a fund has no dedicated registrar and transfer agent, the administrator usually performs the function.
4.2.11 The distributors
Some hedge funds handle their distribution internally, that is, without a separate distributor. Their investors purchase shares in the fund directly from the fund or its registrar and transfer agent. However, in some cases, shares are distributed through a sales force, which may either be affiliated to the fund or independent, e.g. employees of independent broker-dealer firms, financial planners, bank representatives, and insurance agents. This sales force will contact potential clients directly in jurisdictions where this is legally possible, or assist clients willing to invest in the fund on an “unsolicited basis”. In both cases, investors pay for the marketing and distribution of fund shares through a front-end load charge that usually varies from 2 to 5% of the amount invested and is deducted from the net proceeds.69
The use of commission-based external sales forces in the US calls for great wariness. Someone who introduces investors to the fund as a finder, does not need to be registered as a broker-dealer. However, a finder implies a one-time situation involving a one-time payment. If the introduction of clients becomes a regular event, the distributor must be registered as a broker-dealer in the corresponding state or with the NASD.70 Otherwise, the introduction is not valid, which means the private placement is not valid either. If the fund loses money, the investor who was sold his shares by a non-registered entity could sue the fund and ask for his full investment back on the basis that the offer was not valid. In addition, the state could sue the fund for violation of broker-dealer rules.
Figure 4.14 Top ten listing sponsors as of March 2006 based on the number of hedge funds as clients (data from the CogentHedge database)
4.2.12 The listing sponsor
Many institutional investors are restricted or prohibited from investing in unlisted securities or securities which are not listed on a recognized or regulated stock exchange. A listing on a recognized and regulated exchange can therefore provide a valuable marketing tool for hedge fund and fund of hedge funds promoters. Several exchanges dedicated to hedge funds have been established, notably the Irish Stock Exchange, the Channel Island Stock Exchange and the Bermuda Stock Exchange. Most of the time, these exchanges offer no real liquidity or trading opportunities, but they facilitate the marketing of the shares/units to specific categories of investors.
Each hedge fund that wishes to list on the exchange is usually required to appoint an approved listing sponsor (Figure 4.14), which is registered at the exchange. The listing sponsor provides the fund with fair and impartial advice and guidance as to the application of the listing rules It is also responsible for ensuring the fund’s suitability for listing prior to submission of an application, and for dealing with the exchange on all matters in relation to the application for listing. When a fund has been granted a listing on the exchange, the listing sponsor usually continues to act as the primary contact for the fund with the exchange.
Figure 4.15 A typical side-by-side structure
4.3 SPECIFIC INVESTMENT STRUCTURES
It is often the case that hedge fund advisers need to deal simultaneously with US and non-US investors, or to provide particular conditions to specific investors (more transparency, better liquidity terms, etc.). Fortunately, there exists a series of well-established solutions to these requirements.
4.3.1 Mirror funds
In mirror funds, also called “side-by-side structures” (Figure 4.15) or “clone funds”, two separate funds are created with identical or substantially similar investment policies, a common investment adviser, a common portfolio manager and a common custodian/administrator. The portfolio composition of the two funds is all but identical, although tax considerations and some differences of investment opportunities may cause portfolio and performance differences.71 The cloning process essentially consists of facilitating bunched trades among the cloned funds and rebalancing cloned funds that have experienced different cash flows.
Mirror funds represent an effective solution to the problems inherent in reconciling inconsistent regulatory regimes, because each cloned portfolio maintains its distinct legal character and can implement individualized investment parameters. Take, for instance, the case of a hedge fund investing in US securities. The adviser could establish an onshore limited partnership or an onshore limited liability company for US investors, and a separate offshore company for non-US investors. This offshore entity allows offshore investors to remain outside the US tax and regulatory regime while allowing them to invest in the strategy pursued by the investment adviser. The investment adviser usually has an investment management agreement with the offshore fund under which the adviser’s fees are paid – this permits the investment adviser to elect tax-advantaged fee deferrals from the offshore entity.
Mirror funds are very convenient for dealing with tax planning and tax-sensitive investments. As each type of investor has its own structure, no conflict of interests arises. However, the potential conflicts of interest are usually found in the trade allocation – at the end of each day, the trades made by the investment adviser must be allocated between the domestic fund and the offshore fund. In addition, side-by-side structures do not provide for economies of scale in terms of account aggregation.
4.3.2 Master/feeder structures
Rather than running separate portfolios in parallel, some investment advisers prefer to aggregate their investments in one master fund. In such a case, the master/feeder structure is an efficient alternative.72 Simply stated, a master/feeder is a two-tiered investment structure in which investors invest their capital in a “feeder” fund, which in turn invests in a “master” fund managed by the same investment adviser (see Box 4.5). The master fund has substantially the same investment objectives and policies as its feeders and will conduct all the investment activities. Each feeder shares in the profits and losses of the master fund according to its contributed capital. The flow of funds is of course reversed when an investor redeems his shares: the master fund makes a distribution to the feeder, which in turn pays back the investor. Thus, the feeder fund is where investing starts, but the master fund is the entity where most of the trading activity occurs (see Figure 4.16).
Box 4.5 Master fund tax allocation
Master-feeder accounting is anything but simple. As an illustration, consider the example of a master fund with two feeders. Initially, the offshore feeder invests $1 million in the master, while the onshore feeder invests nothing. The first month, the master earns $50 000 of unrealized gain, which goes entirely to the offshore feeder. Then, the onshore feeder invests $1 050 000 and becomes a 50% owner of the master. The second month, performance is nil, and the securities are sold at the end of the month. Each feeder fund will receive $25 000, i.e. 50% of the $50 000 realized gain. For tax purposes, though, that is not appropriate, as the onshore feeder did not participate in any of the unrealized gain from the first month. Although taxes do not apply to the shareholders in the offshore feeder, this is significant for the partners in the onshore feeder, who are more acutely aware of tax issues.
To avoid the problem, it is necessary to track each feeder’s historical participation in the master in order to determine how much taxable realized gain it should receive from the master. A possible approach is the “aggregate allocation” or “book-tax differential” method, which works as follows. New partners acquire a percentage of the entire partnership and not a percentage of each individual asset, and the administrator maintains a “memorandum account” to track each partner’s share of realized and unrealized gains and losses in the partnership.73 Moreover, a similar calculation must be performed at the onshore feeder level to fairly distribute taxable income based on each investor’s historic participation.
Note that it is relatively simple to determine how to allocate gains and losses to the feeders invested in a master fund when all investors participate in the gains and losses on a pro-rata basis. However, the situation gets more complicated when some investors are restricted to participating in some securities such as new issues, as we will see later in this chapter.
Figure 4.16 A typical master/feeder structure
There are several advantages to using a master/feeder construction:
• Each feeder fund can have its separate identity, regulator, management, fee structure, investment minimum and/or distribution channel.
• Several categories of investors can participate in the same investment strategy. As an illustration, fund sponsors may find it desirable, for tax or any other reasons, to establish separate investment vehicles for US investors and for foreign investors. Rather than establishing two separate investment vehicles (as is the case with the side-by-side structure), the sponsor may establish an offshore master fund with a domestic feeder for US investors and an offshore feeder for non-US investors.
• Master/feeders remove the administrative burden of splitting trades or using average prices to allocate securities between several funds. In the master/feeder structure, all transactions are centralized in one place.
• Master/feeders increase the critical mass of assets. This allows for a reduction in the number of transactions and reduces the trading costs. It also increases the collateral available for leveraged transactions, therefore yielding better terms for both feeders.
• Incentive fees can be taken either as a profit allocation from the master fund, or at the feeder level. In the latter case, they can be structured as a profit allocation from the domestic partnership and as a straight fee from the offshore corporation. This allows the fund adviser to defer recognition of the income and thus the payment of the tax liability associated with the performance fees earned.
On the negative side, the following should be considered:
• Master/feeder constructions can result in a conflict of interests between the tax-planning needs of taxable US investors and the lack of such needs on the part of both non-US and tax-exempt US investors. This conflict may relate to the realization of capital gains or losses, or the payment of withholding taxes – see Box 4.5. It may also relate to US dividend tax rules, as US taxable investors generally prefer their stocks not be loaned so they can potentially earn qualified dividend income (QDI), whereas non-US and tax-exempt investors, who do not qualify to earn QDI, prefer their stocks be loaned to generate additional income.
• Offshore investors and their feeders often have more favourable redemption terms than their onshore counterparts. When facing adverse market conditions, offshore investors may decide to redeem their shares, forcing the fund to realize losses and affecting the continuing onshore investors, who do not have the option to redeem.
• Due to the duplication of entities, master/feeder funds entail additional fees in terms of operations and organization. This will be negligible for large funds, but may significantly affect small start-up funds.
• When an offshore feeder feeds into a master fund, the offshore administrator may have to rely on the valuation of the master fund to produce the NAV of the feeder, but has no access to the master fund’s underlying data. This may result in a serious problem if the valuation of the master fund is provided by the manager.
An essential question is: Where should the master fund be located? Two common types of hedge fund structures exist – the US master-feeder and the offshore master-feeder. The tax implications differ for each depending on the type of investor.
• In offshore master-feeders, the master fund is located offshore and is typically structured as a corporation under local law. The master fund can remain offshore and eliminate the potential risk of being classified as a US investment company and the necessity of blue-sky compliance, or it can choose to “check the box” and elect to be taxed as a partnership for US tax purposes. In the latter case, the onshore feeder will receive “pass-through” treatment for its share of the master fund’s profit and losses.
• In onshore master-feeders, the master fund is located onshore (Figure 4.17). This allows US investors to invest directly in the master fund without having to set up another feeder.
In both cases, US source dividends earned by non-US investors in the feeder are subject to a 30% US withholding tax.
Figure 4.17 A typical onshore master/feeder structure
4.3.3 Managed accounts
Some hedge fund advisers offer managed accounts rather than fund shares to some of their clients, typically for accounts larger than $100 million. Simply stated, a managed account can be seen as a segregated investment account in which the investor has direct ownership of the individual securities in the account.
From an operational perspective, a managed account simply takes the form of an account opened by the client at a prime brokerage house or at a bank. The fund adviser receives a mandate to manage the account by giving orders to purchase and sell securities on behalf of the client, as if he was managing his own fund. However, this mandate can be withdrawn without notice, and the assets are held in the name of the client in a segregated account. The advantages for the investor are full transparency and high liquidity, since he receives daily reports from the prime broker about his position and can easily close his position within a few days. In addition, since it is run independently, a managed account can be tailored to his unique circumstances and objectives, including tax considerations, risk versus return requirements, and other financial goals.
Several financial intermediaries have taken the managed account concept one step further by creating managed account platforms (Figure 4.18). For a fee or a retrocession, these platforms offer the full range of middle – and back-office services as well as independent valuation and risk monitoring to fund managers that want to offer their clients managed accounts. In this case, the fund manager is simply employed as an investment adviser, an agent, of the managed account platform under the terms and conditions of an investment advisory agreement. He can still run his own hedge fund independently of the managed account platform.
Figure 4.18 Organization model of an advanced managed account platform – based on Giraud (2005)
Marketers often cite managed accounts as the panacea when it comes to hedge fund investing and investor protection. However, the truth is that managed accounts also suffer from serious limitations. In particular, the monitoring of security level positions remains a challenge in itself, which is absolutely not resolved by managed accounts. The transparency offered by the managed account may be at the security level, but it is completely useless if the investor or the managed account platform does not have sufficient resources to analyse risk exposures on a daily basis, verify the pricing of all securities, check the risk limits, etc. And just looking at the numbers is generally not sufficient. For instance, the Beacon Hill Fund, which collapsed in 2002, was offering managed accounts. The average leverage Beacon Hill historically employed was eight times but the most that they could use was set at 15 times. So when Beacon Hill’s leverage rose towards 15 times prior to collapsing, no alarm bells started ringing at any managed account platform as this was still within the maximum permitted. Indeed, managed account owners generally require a deep infrastructure to support the ongoing legal, operational, administration, risk management and daily oversight of the account – but not many platforms actually have all these elements.
In our experience, another key limitation is that the best hedge fund managers are in so much demand that they do not offer investors the facility of a separate managed account.74 Indeed, managers agreeing to – not to say, needing to – offer managed accounts tend to be:
• New hedge fund managers who are having difficulties raising assets by themselves and hope to grow by agreeing to do a managed account.
• Established managers who have gone through a period of poor performance, or a poor environment for their strategy leading to poor performance, or faced redemptions, and therefore are looking for new capital.
• Managers with weak or immature operational infrastructures in their main fund. Investors often believe that the security and protection of a managed account will be sufficient to negate or reduce operational risks while they will help the manager on his learning curve to improve this part of his business. Needless to say, this belief is illusory. If a manager’s infrastructure is not up to standard in his own fund, it is not going to be sufficient to meet the demands of running the additional burden of a separate managed account.
• Managers that the investor does not trust sufficiently to invest in his fund. Here again, investors somehow believe that having a managed account will protect them from the risk of fraud or other operational risks. It is again our view that if you do not trust the manager or have any reservations about his integrity or infrastructure, then you should not invest with him, whatever the investment vehicle. Hoping to turn lead into gold by using managed accounts is a pipe dream.
Last, but not least, managed accounts often depend on the institution behind the managed account platform and its trading capabilities. Divergences in execution and restrictions in terms of trading instruments or markets may result in important discrepancies between the managed account and the original fund, particularly when considering less liquid instruments or OTC derivatives. Moreover, in thinly traded markets, the fund manager will be doing the trade on his own fund, but will have to wait for approval to allow the trade to be done on the managed account . . . possibly until after the prices have moved.
Nevertheless, despite these disadvantages, managed accounts have taken off in recent years for a number of reasons, including (i) the greater demand by institutional investors for transparency, (ii) the growing use of structured products leading to increased liquidity requirements and (iii) the increasing appetite for investable hedge fund indices, which are largely based on managed account platforms. Indeed, managed accounts are the only practical solution for investors wishing to invest in hedge funds but requiring extreme liquidity conditions, e.g. weekly or daily. But they should carefully assess the real costs and benefits of their decisions before taking the plunge.
4.3.4 Umbrella funds
Invented more than 20 years ago in Europe, the concept of an umbrella structure has become popular among some hedge fund managers. Umbrella funds are simply a collection of sub-funds with a common or central administration and brand. Each sub-fund has a separate investment policy and a separate portfolio of assets, and is run by a team of portfolio managers and analysts (Figure 4.19). A net asset value is calculated separately for each sub-fund, and shareholders are entitled only to the assets and earnings of the sub-fund in which they have invested.
Umbrella funds are tax-efficient, since investors can usually transfer shares from one sub-fund to another without creating a capital gain, which would be taxable. Should investment objectives and needs change over time, investors in an umbrella fund can usually also switch between the sub-funds available, incurring reduced or minimal charges. They also provide fund managers with greater market proximity and quicker reaction to customer requests, as well as cost-effective sales within a standardized marketing concept.
The danger of umbrella funds is that under some regulations (for instance the British Virgin Islands), the rights of creditors against one of the sub-funds would apply to all the assets of the fund vehicle, implying a potential risk of cross-liability for other sub-funds’ shareholders. One common way of limiting this risk is for each sub-fund to trade exclusively through a separate trading subsidiary in order to ring-fence any liabilities.
As an alternative, several countries have implemented a protected cell company (PCC) regulation, which allows for segregation of assets and liabilities between sub-funds of an umbrella structure. Technically, there is only one legal entity, but the assets of each sub-portfolio are, as a matter of law, ring-fenced and are thus not available to creditors of other portfolios. In Delaware, where most US limited partnerships are formed, similar legislation is in place.
Figure 4.19 A typical umbrella fund structure
4.3.5 Multi-class/multi-series funds
Some hedge funds have a single portfolio of investments but issue different classes of shares to investors. This typically allows, for instance, distribution and accumulation shares to be offered simultaneously, or different expense charges to be applied, depending on the investor type, the amount invested and/or the redemption policy.
Another reason justifying the use of multiple shares concerns the fund’s participation in the “new issues” market. A new issue refers to the securities of a public US offering that trade at a premium to their offered price immediately after public trading has started. According to the US National Association of Securities Dealers, certain categories of investors are barred from participating in new issues. Hedge funds have therefore the choice of (i) staying away from new issues, (ii) refusing restricted investors, or (iii) establishing a specific profit allocation procedure (e.g. separate brokerage accounts and independent verification) to isolate returns from new issues and deny participation in new issue profits to restricted investors. The last-mentioned choice is relatively easy to implement with multiple shares, although the accounting may be quite complicated if multiple shares are combined with a master/feeder structure – see Box 4.6.
Box 4.6 New issues and feeders
When there is a new issue and a non-new issue class in a master/feeder structure, there exist essentially two methods of allocating the profits and losses from new issues to the feeders: the “pro rata” method and the “look through” method (Figure 4.20). In the former, the new issue profit or loss is simply divided based on the feeder’s ownership of the master. In the latter, the administrator peers into the attributes of each participant’s capital to see whether he is new-issue-eligible or not, and then comes up with the exact ratio.
Consider the following example. Feeders 1 and 2 each invested $200 in the master fund. Using the pro rata method, since each feeder invested $200, they would each receive 50% of the new profit or loss from the master. Using the look-through method and drilling down into the attributes of each partner’s ability to participate in new issues, the onshore new issue partner would get 60% or $150 while the offshore new issue partner would receive 40% or $100.
Figure 4.20 New issues participation and feeders – the “look-though” method
4.3.6 Side pockets
In recent years, many hedge funds have started combining illiquid – or what are sometimes referred to as “special” or “designated” – investments in the same pool as traditional hedge fund assets, which are by their nature marketable. If the designated investment is held in the general portfolio and some but not all investors redeem, the remaining investors will hold a disproportionately large interest in the illiquid and perhaps non-marketable investments owned by the fund. This creates a serious liquidity threat, but also a valuation issue. Since designated investments are by their very nature difficult to accurately price until their realization or the occurrence of a liquidity event such as a public offering or take-over, their presence in the general portfolio may distort the net asset value (NAV) of the fund. If the distortion is on the high side, this will benefit investors redeeming before the distortion is determined to the detriment of those redeeming later. If the distortion is on the low side, the opposite but equally unfair result occurs. And related to valuation is the question of the manager’s fees that are typically based on a percentage of NAV and a performance incentive over a hurdle or high-water mark. In extreme cases, the distortion in NAV arising from mixing liquid and illiquid assets may be so significant as to cause the NAV to be suspended because of the uncertainty in valuation.
Several hedge funds have resolved these issues by creating mini-funds within the hedge fund – often referred to as “side pockets”. A side pocket is in essence similar to a singleasset private equity fund. When the fund acquires a designated investment, a portion of every investor’s holding in the general portfolio at the relevant time is redeemed and exchanged for a portion of the newly issued class of shares representing this designated investment. Investors then have two classes of shares, the original ones (in lesser amount) and a side pocket (just created). Investors continue to keep the same redemption rights in relation to the liquid portion of the general portfolio, but they must hold the side pocket until the designated investment is liquidated, which may take several years. Then, the proceeds of the liquidation are either paid to the investor or reinvested by way of subscription into the general portfolio shares. Of course, investors that subscribe fund shares after the creation of the side pocket will not be affected by its existence. Side pockets, however, technically remain a part of the same fund and are included in its NAV, so their valuations must be calculated at least monthly to comply with generally accepted accounting principles.75
Owing to their illiquidity, side pockets must be structured properly to align the interests of investors and the fund adviser. In particular:
• It should be clearly specified when the fund adviser can decide that an investment will be structured as a side pocket. Otherwise, there may be a temptation to sideline a non-producing asset in order to maximize the performance fee on better performing investments.
• Management fees should typically be charged on side-pocket assets based on their cost, although some advisers mark-to-market for this purpose.
• Incentive fees should be charged only on realized proceeds, i.e. at the liquidation of the side pocket.76 Note that this may result in conflicting situations if not properly understood by investors. For instance, a poorly performing side pocket may flatten the fund’s NAV, but the adviser will still receive a performance fee based on the positive returns from the larger liquid portion. However, if the more liquid portion of the fund has a negative performance while the side pockets do well and bring the fund’s NAV into positive territory, the adviser will not receive any performance fee – at least until the side-pocket investment is realized.
• The funds’ constitutional documents and offering document should clearly disclose limitations on the overall level of investments which may be allocated to side pockets (typically a percentage of the overall assets) and which may require ongoing disclosure of allocation and realization events as they occur. It is normally the role of administrators to monitor the agreed upon side-pocket limit to make sure it is not exceeded.
When properly used, a side pocket is a useful tool, which adds flexibility to traditional hedge fund structures. The side pocket’s ability to segregate illiquid and liquid investments for accounting purposes allows hedge funds to take advantage of investment opportunities that would otherwise cause valuation and liquidity issues. Side pockets can create a potential private equity type vehicle of reasonable size within a hedge fund. In a sense, they even provide more flexibility than a private equity fund, because they have no fixed maturity and therefore no requirement to liquidate at a certain date.
4.3.7 Structured products
When there are legal, tax, currency or regulatory barriers to investing directly in a hedge fund, it is usually possible to create a structured product that miraculously accommodates the investor’s needs and provides similar economic benefits. Structured products are discussed at length in Chapter 26, but the key structures that are used to create them are as follows.
In most cases, a structured product involves the creation of a special purpose vehicle (SPV) – see Figure 4.21. This SPV acquires the hedge fund shares or becomes a limited partner in the hedge fund and issues a back-to-back structured product that investors can buy. In the simplest case, this structured product may take the form of a zero-coupon note whose principal is linked to the performance of the hedge fund. The final investors are then note holders rather than direct shareholders or limited partners in the hedge fund. In more complex cases, the structured product may be engineered to provide capital guarantees, leverage, specific coupons, etc.
Figure 4.21 A typical structured product on a hedge fund, involving a special purpose vehicle
4.4 DISCLOSURE AND DOCUMENTS
Hedge fund advisers typically provide information on their fund in a limited series of documents. Rather than being widely distributed, these documents are restricted to serious prospective investors.
4.4.1 Private placement memorandum (PPM)
As a matter of practice, the private offering memorandum or private placement memorandum (PPM) is one of the principal vehicles by which hedge funds are introduced to potential investors. It is an overview document designed to provide a summary of the key elements needed to make an investment decision. The information disclosed in a PPM varies from one adviser to another, but it is often general in scope and includes a considerable amount of surplus verbiage. The reason is that this document serves many purposes, including legal ones.
The cover page of the PPM usually contains the name of the issuer, a summary description of the securities to be sold, a date and a handwritten number inscribed to help record the destination of each PPM. In addition, the first page often includes some self-serving exculpatory language relative to the limited and private nature of the offering and the confidentiality of the associated information.
There is no standard but the main sections of a PPM typically include: (i) an executive summary; (ii) the firm and fund investment philosophy and objectives; (iii) the biographies of key investment professionals and members of the board of directors; (iv) a summary of the terms and conditions, including the fees and expenses; (v) the investment track record and prior fund performance; (vi) legal and tax matters; (vii) inherent investment risks and potential conflicts of interest to investors, which serve as a notice of caveat emptor; (viii) accounting and reporting standards; and (ix) information concerning the use of affiliated services providers.
4.4.2 Memorandum and articles of association
The memorandum and articles of association of a hedge fund together act as its constitution. The memorandum is the charter of the company vis-à-vis the outside world, in particular the parties with whom the company will transact business, either directly or indirectly. The articles (sometimes called “by-laws”) set out the regulations for a company’s internal management and ordinarily govern, among other things, quorums for ordinary and extraordinary meetings of shareholders, quorums for meetings of the board of directors, voting rights of shareholders and directors, various procedural rules for the conduct of such meetings, election of directors, the binding signatory power of the company, the frequency of subscriptions and redemptions, and the valuation procedures.
4.4.3 ADV form
The ADV form is simply a form filed with the SEC by registered investment advisers. The form contains information about assets under management, types of fee arrangements, types of investments, other business activities, adviser backgrounds (including a 10-year disciplinary history) and a firm balance sheet – see Chapter 3.
4.4.4 Limited partnership agreements
Investors in hedge funds structured as limited partnerships enter into a specific limited partnership agreement. These agreements specify the respective rights and responsibilities of the limited partners and the general partner, who is usually the investment adviser. For example, these documents frequently list any restrictions on the percentage of an investor’s assets in the hedge fund that a hedge fund will repurchase at any one time.
4.4.5 Side letters
Over the past few years, the hedge fund industry has witnessed a significant increase in the use of side letters, particularly among early-stage and institutional investors. For the record, a side letter is essentially a document that gives an investor contractually binding assurances from either the hedge fund or its investment manager that modify the rights and entitlements of that investor. Most commonly and in their purest form, side letters are used to cut side deals outside the constitutional or contractual arrangements of the hedge fund with specific investors, sometimes to the detriment of other investors.
Common terms in side letters include:
• Different fees: Investors love to negotiate reduced incentive and management fees on their investment. Typically, these fees are specified by a side letter between the investor and the investment manager whereby the manager agrees to rebate to the investor a part of the fee it receives from the fund. Note that nothing in these side letters is unfair – some investors end up paying more in fees than others, but all investors pay the fees they agreed to at the time of their investment.
• Secured capacity: A hedge fund’s capacity depends upon the resources of its manager and the strategy it employs. An investor may require from the manager access to a predetermined amount of a fund’s future capacity in excess of his previous investment.
• Preferred liquidity terms: Side letters often require a fund to provide notice of important events such as the resignation, death or other termination of a principal of the investment manager, a large number of redemptions, a redemption by a principal of the investment manager, a significant fall in the net asset value per share; or an investigation by a regulator of the fund or of the investment manager. Special redemption rights for the beneficiary of the side letter usually accompany such notification provisions. In practice, the principle of preferred liquidity terms is highly questionable. If a crisis occurs, certain shareholders will have advance notice and will be able to redeem their shares sooner than other shareholders. The early redeemers will take whatever cash and liquid assets are available, and leave the remaining shareholders holding the baby. The remaining shareholders will actually be worse off than if the shareholders with the side letters had never invested in the fund. The directors of the fund have to be extremely cautious before agreeing to such terms for fear of being held personally responsible for any loss suffered by an investor who did not have the benefit of such a side letter.
• Key man clause: In the event that a hedge fund manager is principally owned or controlled by a few key persons, the fund’s success will depend primarily on their skill and acumen. A typical key man provision provides that if the key man dies, becomes legally incapacitated or ceases to be involved in the management of the hedge fund for more than a certain number of consecutive days, the manager will notify the investors who may then immediately redeem their investment.
• Transparency: some investors may require additional information or specific reporting regarding the fund’s portfolio.
• Grandfathering: Grandfathered investors are ensured that, if there is an adverse change in the terms of the offer of shares set out in the subscription agreement or the private placement memorandum for new investors (e.g. an increase in the management fee), this change will not apply to their existing and future investments.
• Payment of redemption proceeds: Side letters often include a term stating that redemption proceeds shall be paid all in cash rather than in securities-in-kind, and within a certain period of time, which is usually sooner than the time period set out in the private placement memorandum.
• Most favoured nation: As the use of side letters has become more common, investors have sought to protect themselves from less favourable terms or conditions than those provided to other investors. An investor having the most favoured nation status is ensured that no other current or future investor will be offered more favourable terms for investing unless the same terms are offered to him.
As the use of side letters by hedge fund investors appears to be increasingly common, several questions and concerns arise:
• Do any terms of the side letter result in a breach of fiduciary obligation by the hedge fund’s general partner, managing member or board of directors? If the answer is positive, then the side letter might be non-enforceable, as fiduciaries to a hedge fund owe an identical obligation to each investor. In such a case, it is preferable to create a separate class of shares for any investor who requests specific terms or conditions. Otherwise, the directors of the fund may be in breach of their fiduciary duties and may be personally liable for the losses of these other investors, if any.
• How can the adherence to numerous side letters be monitored, and in particular, how can one avoid conflicting side letters? If a hedge fund is subject to the terms of several different side letters, it is essential to ensure not only that the terms of individual side letters are tracked, but also that no conflict arises.
• Do the fund’s offering documents disclose that certain investors have received preferential terms?
• Does the systematic demand for the same type of side letter indicate that the hedge fund’s offering documents are “biased”? Whenever possible, the manager should attempt to address investors’ genuine concerns in an organized and comprehensive manner, e.g. by building common side-letter items into the corporate documents.
Some regard side letters as “ticking time bombs”. However, side letters are also useful, particularly for investors who have specific needs or reporting requirements that may not be covered by a hedge fund’s offering documents. In order to avoid any detonation, hedge fund directors and investment managers should therefore simply ensure that their side letters are not unfairly advantageous to some or prejudicial to others.
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