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HEDGE FUNDS CURRENT ISSUES 2007 NSCP National Membership Meeting October 17th-19th, 2007 Gerald T. Lins, ING Investment Management Americas Christopher J. Mahon, Deutsche Bank Securities, Inc. Frank A. Taylor, Briggs and Morgan, P.A. © Copyright, Briggs and Morgan, Professional Association, 2006-2007 Summary • • • • • • Introduction to Hedge Funds Maintaining Private Placement Exemption Conflicts of Interest Trading Practices Valuation Proposed Registration What is a Hedge Fund? • 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 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 Hedge Fund v. Mutual Fund • • • • 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 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” 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]” 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 anti-fraud rules that would prohibit making of false of misleading statements. Applies to all portfolio managers • Effective on September 13, 2007: Rule 206(4)-8 Rule 206(4)-8 • 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 Fund Structures • Structures of Hedge Funds – – – – 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 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 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 Fund of Funds • Invests in different hedge funds • Gives exposure to different market segments – Investor may not have time or qualifications to diversify 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 Types of Funds • Event Funds – Anticipates certain corporate events, often spinoffs – Short one stock and purchased other • Opportunistic Funds – Broad discretion to manager • Macro Funds – Invests based upon macro events – Short or long asset classes • Market Timing Funds Investors • Individuals • Public companies • Tax-exempt investors; e.g., Pension Funds – Issue of fiduciary responsibility – UBTI issues • Foreign Investors – Tax issues Private Placement • § 4(2) of the Securities Act • Reg. D – Accredited investors • • • • Sophisticated investors No general solicitations Limited transferability of interests State regulation 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 – – – – – Securities Act of 1933 Securities Exchange Act of 1934 Investment Company Act of 1940 Investment Advisors Act of 1940 State statutes Side Letters • Different investors in same fund negotiate different deals – Creates difficulties in the event of litigation • Expect increasing regulatory scrutiny • Reduce risk – Alert potential investors to the different arrangements – Describe those arrangement in PPM or Form ADV, Part II – Make sure that side letters do not conflict with disclosure Side by Side Management • Simultaneous service as advisor to hedge fund and mutual fund advisor – Performance based fee versus managed assets based fee account • Trading Practices – Fairness Standard: trade allocation must be “fair and equitable over time.” – Policies and Procedures should try to achieve consistency over time Valuation • • • • Illiquid assets Much discretion to manager Conflicts of interest Domicile of ownership interest if investor is a pension plan • Often the area of greatest concern Best Practices for Valuation • • • • • Written policies and procedures Reliable and recognized pricing sources Settlement of disparate valuations Valuation Committees Independent third-party valuation testing Pension Funds • Offshore money – – – – How do you catch a thief living abroad? Can you collect? Where is the money? Do you have a remedy? What law applies? • Valuation – AICPA places the responsibility to determine “fair value” rests with plan’s named fiduciary – A plan auditor cannot give an unqualified opinion if the fiduciary cannot determine fair value – Hedge funds may suspend computation of NAV, causing offcycle redemptions to be unfairly valued • Assets should be custodied in U.S. – Certificates of ownership safe kept in the U.S. Registration • Proposed Rule 206(4)-8 under the Advisors Act was Adopted on 7/11/07 – Gives the SEC authority to bring enforcement actions by requiring registration as Investment Advisors • Proposed Rule 509 – Increases limited for accredited investors • Legislative Initiatives • Registration of the interests