Transcript Risk, Regulation and Organizational Structure

Risk, Regulation and Organizational
Structure
Hedge Fund Investing Risks
Risks in Hedge Fund Investing
Portfolio Level Issues
Liquidity
Transparency
Benchmarking
UBTI1
Headline Risk
Terms and Conditions
Survivorship Bias
Complexity
Leverage
Investment Level Issues
Business
People
Investment
Process/Strategy
Operational Controls
Key-Person
Strategy Failure
Regulatory Change
Client Composition
Integrity/Behavior
Style Drift
Failure of Prime Broker
Changes in Capital Base
Focus, Drive Motivation
Leverage
Counterparty Risk
Conflicts of Interest
Depth & Breadth of
Team
Liquidity
Concentration
Correlation Spike in
Stressed Markets
Compensation Structure
Unstable Correlations
Systemic
Failure of Major
Financial Institution
Note 1: UBTI, Unrelated Business Taxable Income, is income regularly generated by tax-exempt entities by means of taxable
activities. In the case of hedge funds, it includes debt-financed income, on which tax-exempt investors would then need to pay
taxes. This issue can be circumvented through the use of offshore hedge funds.
Source: Grosvenor Capital Management
Risks
 Many hedge funds managers are inherently more comfortable
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taking risks compared to non-hedge fund managers and are willing
to consider a much broader array of investment alternatives
In addition, hedge funds frequently use derivatives, which
sometimes carry risks that are problematic to analyze and value
However, derivatives can also mitigate risk, if used properly
Systemic risk relates to the possibility that many financial
institutions fail simultaneously in response to a single major event
Hedge funds can create systemic risk in two ways
 the failure of several large hedge funds at the same time could create contagion across
many classes of financial assets as the failing funds are required to unwind their
investment positions at fire sale prices
 hedge funds can create large losses for the banks that lend to them if collateral is
inadequate or valuation methodologies are inaccurate
Leverage
 Most, but not all, hedge funds use leverage, including off-balance
sheet leverage associated with derivatives, to increase their returns
 Leverage works well when returns are positive, but it backfires
when returns are negative
 Assuming a hedge fund borrows $70 after receiving $30 from
investors and a $100 investment is made with the total proceeds, if
the investment increases by 10%, investors gain 33% , but if the
investment declines by 10%, investors suffer a loss of 33%
 A large proportion of hedge fund leverage is collateralized by
assets and so, although notional leverage amounts can be very
large, marginal leverage (uncollateralized by assets) is much
smaller
Leverage
Hedge Fund Leverage
Assets under management and estimated total investable assets, $ in trillions
Leverage through derivative positions
6.5
6.6
Leverage through debt
Assets under management
4.8
3.3
3.4
2.9
3.6
2.6
1.7
1.5
0.4
Implied
Leverage
Ratio2 (total)
-64%
3.9
1.3
1.5
0.8
0.8
0.7
0.6
2.4
0.9
0.3
1.9
1.9
1.0
1.1
1.4
2004
2005
2006
2007
2.9
3.1
3.4
3.4
1.4
1.2
H1-08
H2-08
Q1-09
3.5
2.6
2.0
Note 1: Includes leverage from debt and off-balance sheet leverage through derivatives and other instruments
Note 2: Leverage ratio = (total leverage + AUM) / AUM
Source: McKinsey Global Institute; Global Capital Markets Survey; Dresdner Kleinwort Equity Research; International Financial
Services, London; Financial Risk Management, Ltd.; Financial Services Authority
Leverage
Leverage Can Accelerate Forced Selling
(1) Hedge fund owns $100 worth of stock with
20% margin
(3) Hedge fund sells $20 worth of
stock to restore 4.0x leverage ratio
Assets
Liabilities
Assets
Liabilities
Stock
($100)
Loan
($80)
Stock
($75)
Loan
($60)
Leverage
of 4.0x
Equity ($20)
Equity ($15)
(4) Margin increases to 25% and so hedge
fund must sell $15 worth of securities to
achieve new leverage of 3.0x
(2) Stocks decline 5% in value
Assets
Liabilities
Assets
Liabilities
Stock
($95)
Loan
($80)
Stock
($60)
Loan
($45)
Equity ($15)
Restore
leverage
of 4.0x
Leverage has
increased to
5.3x
Equity ($15)
Source: McKinsey Global Institute; “Hedge funds: The credit market’s new paradigm,” Fitch Ratings 5 Jun. 2007
Achieve
leverage
of 3.0x
Short Selling
 Many hedge funds sell securities short as a way to express a
bearish view
 This short selling action creates a theoretically limitless
exposure if the shorted security increases in value
 A long position in a security has a loss potential that is
limited by the value of the security, but there is no such limit
in a short position
 However, short sale positions that are hedges against a long
holding are considered risk mitigators, rather than risk
augmenters
Regulation
 U.S. hedge funds have historically been able to rely on the “private adviser
exemption” to reporting under the Investment Advisers Act of 1940 (’40 Act),
as long as a hedge fund adviser “has fewer than fifteen clients and neither holds
himself out generally to the public as an investment adviser nor acts as an
investment adviser” to a registered investment company
 Since nearly all hedge fund advisers manage fewer than fifteen separate hedge
funds, they are were not compelled to register under the ’40 Act
 As a result, U.S. hedge funds were not subject to as much direct oversight from
financial regulators, compared to mutual funds and most other investment
managers who are not exempt from the ’40 Act
 However, banks (the principal counterparties to hedge funds in trading and
lending transactions) are highly regulated and therefore “indirect” regulation
(including the U.S. Fed’s Reg T limitations on margin) applied to hedge funds
Regulation
 Hedge funds are sold through private placement offerings, which means that
funds cannot be offered or advertised to the general public, and are normally
offered under Regulation D of the Securities Act of 1933
 This process basically limits hedge fund offerings to accredited investors
 An accredited investor is an individual with a minimum net worth of $1.5
million or, alternatively, a minimum income of $200,000 in each of the previous
two years and a reasonable expectation of reaching the same income level in the
current year
 The Dodd-Frank Act passed during 2010 requires all hedge fund advisers that
manage more than $150 million to register with the SEC, maintain and share
with the SEC extensive records about their investment and business practices,
hire a chief compliance officer to design and monitor a compliance program,
and be subject to periodic SEC examinations and inspections
Regulations (2)
 Regulations are designed to protect “little guys”
 Over regulations may induce risk taking
 Remember Bernie Madorff?
 “More related” does not mean “less risky”
 Take a look at page 189 to 191 of Jaeger’s book
Organizational Structure
Hedge Fund Investment Partnership
Registered
Investment
Advisor
Employee
Contracts
LTD or LLC Investment
Manager
CFTC
LLC as GP
Key Employees’
L.P.’s of GP LTD
Partnership
GP LTD
Partnership
Pension
Plan
20%
2%
Managed
Accounts
Fringe
Benefits
2%
20%
Offshore
Administrator
Prime Broker
Master
Feeder
Source: Morgan Stanley
Domestic
Partnership
Organizational Structure
 Hedge funds usually organize as a limited partnership for U.S.-based taxable
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investors
The general partner of the limited partnership is usually the hedge fund
investment manager and investors are limited partners
Offshore investors that are non-U.S. entities and U.S. entities that do not pay
taxes (such as pension funds) invest through a separate offshore vehicle
Both onshore and offshore funds usually invest in a master feeder fund, which
then co-invests in a master fund, which is managed by the hedge fund
investment manager
This structure creates optimal tax and regulatory advantages for both onshore
and offshore investors, while enabling the investment manager to manage all
invested funds together
If organized properly, this structure enables taxable investors to avoid paying
taxes twice, and also enables tax-exempt investors to participate in the same
investment management pool as taxable investors
Domicile
 Many hedge funds are registered offshore, principally in the
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Cayman Islands, British Virgin Islands and Bermuda
Onshore hedge fund registrations are principally in the U.S.
(65%-mostly in Delaware) and in Europe (31%)
The domicile chosen depends on the tax and regulatory
environment of the fund’s investors
By creating an offshore domicile, the fund can avoid paying
taxes on the increase in the value of its portfolio
However, investors in the fund will still pay individual taxes
on any profit realized in their investment with the fund and
the hedge fund manager will pay taxes on management fees
Open-Ended Partnership
 Hedge funds typically operate as open-ended partnerships
 An open-ended fund is able to periodically issue additional
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partnership interests or shares directly to new investors at a
price that is equal to NAV/share or interest
Investors are able to redeem their interests or shares at the
prevailing NAV/share or interest on the date of redemption
Shares or interests in open-ended funds are typically not
traded
Profits associated with these shares or interests are usually
not distributed to investors before redemption
By contrast, a closed-end fund distributes profits to
shareholders and allows shares to be traded
Delivery systems of Hedge Funds
(Chapter 12 Jaeger)
 Limited partnership
 Limited liability company
 An offshore company (see page 188, Jaeger)
 Tax haven countries, like Bermuda, British Virgin Islands, the
Cayman Islands. Funds need pay various administrative fees.
Taxable investors typically
 A commodity pool
 Futures pools (page 188-189)
 A specialized separated account
Mutual funds vs Limited
Partnerships
 Mutual funds are companies
 A private investment partnership is not a company but a
business arrangement based on the distinction between a
general partner and a limited partner.
 The partners do not own shares in a company; they own a
fractional interest
 General partner runs the business and bears unlimited liability
for anything that might go wrong
 Limited partners bear limited liabilities
Further differences in these two (1)
 Liquidity: mutual fund investors have access to daily liquidity,
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while hedge funds don’t provide this access. They offer
quarterly or even annual liquidity
Number of investors: mutual funds are designed to serve a
large number of small investors; hedge funds (limited
partnerships) are designed to serve a small number of large
investors
Marketing: mutual funds are allowed to market to the general
public while limited partnerships are not
Investments: restrictive to mutual funds, not to HFs
Turnover: short short run for MFs, repealed in 1998 (page
185)
Further Differences (II)
 Distributions: MF: all taxes are paid by the investors. MFs must
distribute to their investors 95% of its income and realized capital
gains. No such requirements for HFs
 Custody: MFs are required to hold their assets in a segregated
account at a bank. HF assets may be held in a brokerage account.
 Investment management fees: MFs cannot charge a percent of
profits fee. Fulcrum fee is allowed (page 186). 1-and-20 for HFs
 Governance: MFs must have a board of directors while limited
partnership are not subject to any governance rule. HFs could
have advisory boards, while it does not hold fiduciary
responsibilities