Hedge fund
Objectives,
legal structure,
fee structure, and
classifications of hedge funds;
CFA LOS
i. discuss the descriptive accuracy of the term “hedge fund,” define hedge fund in
terms of objectives, legal structure, and fee structure, and describe the various
classifications of hedge funds;
Reference/Reading: International Investments, by Bruno Solnik and Dennis McLeavey
Solnik and McLeavey say the original concept of a hedge fund was to offer plays against markets, using short selling, futures and other derivative products.
Today the common denominator of hedge funds is not their investment strategy but the search for absolute returns.
Professional money management has progressively moved toward relative performance, performance relative to a bench mark. A fund manager's performance is evaluated relative to some market index which is assigned as a benchmark in his mandate or investment policy document.
The development of hedge funds can be seen as a reaction against this trend and hedge funds try to achieve absolute returns. This means that hedge funds may be termed more appropriately as isolation funds, funds isolated from market trends..
Legal structure: In USA, there are typically set up as a limited partnership, or as limited liability company or as an offshore corporation. These legal structures provide the flexibility to the fund managers to take short positions in any asset, use all kinds of derivatives, and to leverage without restrictions of regulators. In contrast mutual funds are allowed only long positions.
Hedge funds based in United States most often take the form of a limited partnership organized under section 3(c)(1) of the Investment Company Act, thereby gaining exemption from most U.S. Securites and Exchange Commission (SEC) regulations. The fund is limited to no more than 1,009 partners, who must be accredited investors
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Section 3(c)(1) of the Investment Company Act
c. Further exemptions. Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:
1. Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:
A. Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company's outstanding securities (other than short-term paper).
B. Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.
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Some hedge funds in US are organized under section 3(C)(7) of the Investment Company Act. This form also provide exemption from most SEC regulations. In this case, the fund is limited to no more than 500 investors, who have to be qualified purchasers. The fund is prohibited from advertising.
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Section 3(C)(7) of the Investment Company Act.
7.
A. Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
B. Notwithstanding subparagraph (A), an issuer is within the exception provided by this paragraph if--
i. in addition to qualified purchasers, outstanding securities of that issuer are beneficially owned by not more than 100 persons who are not qualified purchasers, if--
I. such persons acquired any portion of the securities of such issuer on or before September 1, 1996; and
II. at the time at which such persons initially acquired the securities of such issuer, the issuer was excepted by paragraph (1); and
ii. prior to availing itself of the exception provided by this paragraph--
I. such issuer has disclosed to each beneficial owner, as determined under paragraph (1), that future investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons; and
II. concurrently with or after such disclosure, such issuer has provided each beneficial owner, as determined under paragraph (1), with a reasonable opportunity to redeem any part or all of their interests in the issuer, notwithstanding any agreement to the contrary between the issuer and such persons, for that person's proportionate share of the issuer's net assets.
C. Each person that elects to redeem under subparagraph (B)(ii)(II) shall receive an amount in cash equal to that person's proportionate share of the issuer's net assets, unless the issuer elects to provide such person with the option of receiving, and such person agrees to receive, all or a portion of such person's share in assets of the issuer. If the issuer elects to provide such persons with such an opportunity, disclosure concerning such opportunity shall be made in the disclosure required by subparagraph (B)(ii)(I).
D. An issuer that is excepted under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] relating to the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer.
E. For purposes of determining compliance with this paragraph and paragraph (1), an issuer that is otherwise excepted under this paragraph and an issuer that is otherwise excepted under paragraph (1) shall not be treated by the Commission as being a single issuer for purposes of determining whether the outstanding securities of the issuer excepted under paragraph (1) are beneficially owned by not more than 100 persons or whether the outstanding securities of the issuer excepted under this paragraph are owned by persons that are not qualified purchasers. Nothing in this subparagraph shall be construed to establish that a person is a bona fide qualified purchaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (1).
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As the number of partners is limited, the minimum investment is typically more than $200,000.
Institutional investors can also become partners.
For U.S. hedgefund, Delaware is a fund-friendly state and funds prefer fund friendly states for registration.
Offshore funds also have attractive legal structures and U.S. investors are investing in such funds. Offshore funds are incorporated in British Virgin Islands, Cayman Islands, Bermuda, or such locations that offer fiscal and legal benefits.
Fee Structure
The manager is compensated through a base management fee based on the assets under management (AUM) now typically about 1 percent fo the asset base plus an incentive fee - a percentage of the realized profits (ranging from 15% to 30%, the typical value being 20%). In some agreement, the incentive fee is applied to profits in excess of a specified risk-free-rate. In some agreement, a condition is there that if in some years, the fund declines in value, the fund would first have to recover the decline before realized profit is recognized and incentive fee is paid.
Classification:
Solnik and Mcleavey provide the following classificastion
Long/short funds
Market-neutral funds
Global macro funds
Futures funds
Emerging-market funds
Even driven funds
Distressed securities funds
Risk arbitrage in mergers and acquisitions
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