Transcript Hedge Funds – Maintaining the Private Placement Exemption

Hedge Funds –
Maintaining the Private
Placement Exemption
[Advanced]
2008 NSCP Midwest
Membership Meeting
Chicago, Illinois
April 28, 2008
© Copyright, Briggs and Morgan, Professional Association, 2006-2008
Disclaimer
• This publication is circulated to bring useful and timely
information to our clients and colleagues. The
publication is for general information purposes only and
is not legal advice. You should not rely on any
information or views contained in the publication in
evaluating any specific legal issues you may have.
Please consult your Briggs and Morgan attorney for
specific legal advice. Any U.S. Federal tax advice
contained in this communication (whether distributed by
mail, email or fax) is not intended or written to be used,
and it cannot be used by any person for the purpose of
avoiding U.S. Federal tax penalties or for the purpose of
promoting, marketing or recommending any entity,
investment plan or other transaction. (The foregoing
legend has been affixed pursuant to U.S. Treasury
Regulations governing tax practice.)
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Summary
• Introduction to Hedge Funds
• Maintaining Private Placement
Exemption
• Marketing
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Resources
• Principles and Best Practices for Hedge Fund Investors
– Report of the Investors’ Committee to the President’s
Working Group on Financial Markets
– April 15, 2008
• Best Practices for the Hedge Fund Industry
– Report of the President’s Working Group on Financial
Markets
• Alternative Investment Management Association (AIMA)
– AIMA’s Guide to Sound Practices for Hedge Fund Valuation,
March 2007
• International Organization of Securities Commissions
(“IOSCO”)
– Principles for the Valuation of Hedge Fund Portfolios,
March 2007
• Hedge Fund Working Group – January 28, 2008, Hedge
Fund Standards: Final Report.
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What is a Hedge Fund?
• D.C. Circuit: “Entity that holds a pool of securities or
other investments that does not register its offerings
under the Securities Act, and is not registered under the
Investment Company Act.”
• PWG: Pooled investment vehicle (i) not marketed to
general public; (ii) investors are limited to high net
worth individuals and institutions; (iii) not registered as
an investment company; (iv) professional asset
manager; (v) investing in liquid portfolio of securities
and other assets; (vi) periodic but restricted or limited
redemption rights. (MFA, Sound Practices for Hedge
Fund Managers, 2007).
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Hedge Funds, con’t.
• Alternative investment vehicle
– Trades in stock, securities, other
instruments
– Free of regulatory constraints
• Originally, designed to reduce market
risk through “hedging”
– Hedge funds “market” inefficiencies
• No longer market neutral
– Often employ “straddles” that bet whether
trading ratio will contract or expand
between two securities
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Hedge Funds, con’t.
• Wide varieties
• Long and short investments in equities,
fixed income securities, currencies,
commodities, and their derivatives
• Leveraged
• Usually managed through a
combination of long and short positions
to limit exposure
• Counterparty risks
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Hedge Fund v. Private Equity Fund
• Hedge Fund is NOT a private equity fund
• Liquidity
– Hedge fund has more liquidity
– Private equity investor is long term
• Hedge fund should have a perpetual life
• Hedge fund investor disposes of investment in
a single transaction
• Hedge fund has a broader investment
mandate
• Private equity funds often look to buy stakes
in companies
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Hedge Fund v. Mutual Fund
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Hedge fund is not a mutual fund
Both invest in marketable securities
Both have liquidity
Hedge fund tries to generate positive
returns in all environments
– Mutual fund return is compared to
“benchmarks”
• Different in market risk, investors, fees,
diversification, leverage and regulation
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Differences: Hedge Fund v. Mutual Fund
• Fees
– Hedge fund manager charges fee as a fixed
percentage of gain
– Mutual fund cannot
• Mutual Funds are registered under ’33 Act
– Hedge funds are not registered
– Exempt from registration, § 4(2) of the Act
• Most hedge funds exempt from ’40 Act
– § 3(c)(1), which excludes funds with 100 or less
investors
– § 3(c)(7), which excludes funds with “qualified
purchasers”
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Advantages of not registering
• By not registering as investment company
– Avoids leverage constraints on open ended fund
– Avoids § 18(f) limits fund in issuing senior securities
– Avoids §§ 12(a)(i) and (3) limitation on short selling
and margin
• Portfolio manager did not register as an
Advisor under the Advisors Act of 1940
– § 203(b)(3) exempts a manager with less than 15
clients
• Each hedge fund is a client
– Carry can be charged under the Advisor’s Act for
“qualified client[s]”
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SEC Release IA-2333
• SEC endeavored to amend Rules to require
“look through” hedge fund to count all the
investors
• Required portfolio manager to register as an
advisor under the Advisor’s Act
• June 23, 2006 D.C. Circuit reversed finding
that the term “client” of a manager could not
include an investor in hedge fund
• December 13, 2006: SEC proposed new antifraud rules that would prohibit making of false
of misleading statements. Applies to all
portfolio managers
• Effective on September 13, 2007: Rule
206(4)-8
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Rule 206(4)-8
• Applies to both registered and unregistered Investment
Advisers
• Applies to pooled investment vehicles exempt from ’40 Act §§
3(c)(1) or 3(c)(7)
• Does not matter whether malfeasance occurs when selling,
offering or redeeming
– Includes RFP process
• Rule prohibits advisers from
– Making false or misleading statements to investors or prospective
investors in hedge funds and other pooled investment vehicles
– Otherwise defraud these investors
• “Rule clarifies that an adviser’s duty to refrain from fraudulent
conduct under the federal securities laws extends to the
relationship with the ultimate investors [in the fund]”
– Commission may bring enforcement actions against investment
advisors who defraud investors in those pooled investment
vehicles
• Intent is to prohibit all fraud, without proving scienter
• No private right of action
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Fund Structures
• Structures of Hedge Funds
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Single Entity
Master-Feeder
Parallel
Multi-Manager
• Single Entity
– Partnership or Limited Liability Company
– Manager or GP receives a carried interest
• Fixed percentage of the net gains of the fund
• However, must be alert to effective carried interest
– May have two entities that manage the fund
• Divide between the manager and the portfolio manager
• Reduces tax burden
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Master-Feeder Funds
• Taxable investors, tax-exempt investors and
foreign investors
• Foreign feeder is a holding company
– Tax-exempt and foreign investors make contribution
here
• Organized in low-tax jurisdiction as a
corporation for tax purposes
• Avoids Unrelated Business Taxable Income
• But, will be subject to federal tax if it engages
in a United States trade or business
– If it “trades” or “invests”, exempt
• Acts to increase after tax returns to feeder and
its shareholders
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Parallel Funds
• Mirrors the Master-Feeder
• Two members of a hedge fund complex
populated by same investors
• Parallel entity is created in a low-tax
jurisdiction
• Invests in tandem with on-shore fund
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Fund of Funds
• Invests in different hedge funds
• Gives exposure to different market
segments
– Investor may not have time or qualifications
to diversify
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Types of Funds
• Arbitrage Funds
– Errors in market price
– Often long and short positions in same
stock
• Profit based upon whether profit exceeds loss
• Distressed Securities Funds
– Invests in debt securities of bankrupt,
insolvent or troubled company
– Participates in restructuring
– Takes over company by controlling debt
• Futures Funds
– Futures market
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Types of Funds
• Event Funds
– Anticipates certain corporate events, often spin-offs
– Short one stock and purchased other
– Sandell Asset Management
• Opportunistic Funds
– Broad discretion to manager
• Macro Funds
– Invests based upon macro events
– Short or long asset classes
• Market Timing Funds
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Investors
• Individuals
• Public companies
• Tax-exempt investors; e.g., Pension
Funds
– Issue of fiduciary responsibility
– UBTI issues
• Foreign Investors
– Tax issues
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Private Placement
• § 4(2) of the Securities Act
– Secrecy
• Reg. D
– Accredited investors
• Sophisticated investors
• No general solicitations
– Adverse tax issues:
• Market Rules (no violations)
• Secondary Market Rule (includes redemption)
– See, Fortress Investment Group Holdings
Registration Statement
• Limited transferability of interests
• State regulation
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Disclosure
• Private Placement Memorandum
– Effort to achieve disclosure required by Registration
Statement
• Although exempt from registration, still
subject to anti-fraud provisions
• Disclosure may be governed by
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Securities Act of 1933
Securities Exchange Act of 1934
Investment Company Act of 1940
Investment Advisors Act of 1940
State statutes
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Disclosure
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PPM
Annual audited financial statements
Performance information
Investor communications
Guidelines for disclosing conflicts of
interest
• Qualifications of fund investors
• Disclosure to counterparties
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PPM—General
• Investment philosophy, strategies,
products, risks
• Made in advance of the offer to
subscribe
• New investments: supplement when a
material shcnage has occurred
– Review at least annually
– Updated PPM should be provided to all fund
investors
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PPM—Specific
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Legal structure
Objectives and strategies
Management
Terms
Withdrawal or redemption rights
Fees
Trade allocation policies
Liability and indemnification of Mgr
Information framework
Valuation framework: GAAP and NAV
Third parties
Valuation policy and oversight
Methodologies
Side Pocket arrangements
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PPM—Specific, con’t.
• Risks
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Incentive fee
Key personnel
Lack of assurance of success
Strategies
Valuation
Liquidity and restrictions on withdrawal
Leverage and margin
Broker and other counterparty risk
Foreign investments
Regulatory ovesight (or lack thereof)
Conflict of interest
• Other
– Tax, regulatory and other
– Third Party Administrators
– Prime Brokers
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Trading
• Limited
• Accredited Investors
• QIBs
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Ongoing Informatioin
• Updated material information
• Risk Reports
• Performance related financial
information
• Investment Related Financial
Information
– FAS 157
– GAAP
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FAS 157
• Fair value is market-based measurement
– Value based upon highest and best use for the asset
or liability
– Principal market be used to determine fair value (if
such a market exists)
• Principal market = largest volume and activity
• Three tier valuation hierarchy
– Tier I – quoted price on active market
– Tier II – Market observable inputs used to price
– Tier II – Significant unobservable inputs needed to
determine fair value
• Additional financial statement disclosure to be included
here
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FAS 157, con’t
• Discounts can no longer taken when valuing a
large block of securities
– Securities must be valued at quoted price
• Single broker quote in a non-liquid security
may fall within Tier II if the broker will trade
at such price
– Indicative price, then Tier III
• Fund of funds are required to determine
whether NAVs provided by underlying funds
are “fair value”
– If underlying fund has limited liquidity, should a
discount be taken?
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FINRA
• Rule 2210(d) – Content Standards
– Member communications with the public shall be
based on principles of fair dealing and good faith,
must be fair and balance, and must provide a sound
basis for evaluating the facts…. No member may
omit any material fact or qualification, if the
omission, in the light of the context of the material
presented would cause the communication to be
misleading.
• No false, exaggerated, unwarranted or
misleading statements or claims
– No distributioni of statement that the member knows
or who has reason to know is false or misleading
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FINRA
• Legend – only in event that such
placement would not inhibit investor’s
understanding
• No prediction of performance
– May use hypothetical illustration of
mathematical performance, provided that it
does not predict performance of the
proposed strategy
• No testimonials unless the person
making it has the experience and
knowledge
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FINRA – Altegris Investments & Risk Disclosure
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Speculative Nature
Leverage
Loss of Investment
Lack of Diversification
Lack of Liquidity
Limited Transferability
Volatility
Foreign Exchanges
Fees
Incorporated Risk Disclosure: It is insufficient
to refer to an accompanying offering
document for risk disclosure information
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FINRA -- Performance
• Realated Performance
– Rule 2210 generally prohibits use of related performance.
May not publish or distribute sales materials containing
any performance information other than the actual
performance of the offered fund
• Related Performance: performance of other funds or
accounts managed by the advisors, clone funds or funds
or accounts that preceded or were converted into the
advertised hedge fund
• However, FINRA member may use sales material that
include related performance information for funds
exempt from registration under Section 3(c)(7) of
Investment Company act if the investors are “qualified
purchasers” under Section 2(a)(51).
– Still fall under Rule 2210 – communications must be
fair and balanced
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FINRA -- Performance
• Can’t use target returns unless the
member provides a “sound basis” for
the returns
– UBS Financial Services violated
2210(d)(1)(A) and 2110 because
presentations did not include substantial
basis for evaluation
• Substantial basis – No guidance.
– So, evaluate if meet and risk if do not meet
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FINRA – Project Returns
• Rule 2210(d)(1)(D) prohibits use of
projected returns
• Citigroup Global Markets
• Can’t use hypotheticals and backtesting because could use actual
returns.
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