Hedge Fund Defined
A "hedge fund" is a private investment vehicle organized for the purpose of pooling investors' assets. The sponsor of the hedge fund, commonly referred to as the hedge fund manager, invests the hedge fund's assets pursuant to a predetermined investment strategy. In the absence of such a pooling vehicle, an investor, on its own, would not be able to diversify its assets or have the resources to monitor, evaluate and implement the investing and trading strategies to be engaged in by the manager. Although historically the defining characteristic of a hedge fund was to "hedge" against market risk and volatility, hedge funds today apply a variety of investment techniques. Unlike mutual funds, which are highly regulated, hedge funds: (i) are not required to redeem investors' assets within seven days from the date on which it receives a notice for redemption from an investor; and (ii) may take illiquid positions without limitation and may engage in leveraged transactions with greater freedom.
The legal structure of a hedge fund largely depends who its investors will be. For example, a private investment vehicle formed for the benefit of persons who reside outside of the United States will be organized differently than an investment vehicle formed for the benefit of United States residents.
For the purpose of managing the assets of persons residing in the United States, a hedge fund is ordinarily organized as a limited partnership. By purchasing an interest in the partnership, an investor becomes a limited partner of the partnership.
In an attempt to limit personal liability, the manager of a domestic fund usually forms an entity to provide advisory services to the partnership. This entity serves as the general partner of the partnership. Depending on the laws of the state in which the general partner will maintain its office, the hedge fund manager will organize the general partner as a limited liability company, corporation or limited partnership. In certain cases, however, the manager will form two entities, one entity to serve as the general partner and the other entity to serve as a management company.
The use of an entity as the general partner or management company, however, will not shield an individual manager from personal liability for fraud and other claims under the federal securities laws
For the purpose of managing the assets of persons residing outside of the United States, an offshore fund is ordinarily structured as a corporation and organized in a tax haven jurisdiction (e.g. Bermuda, British Virgin Islands, Cayman Islands, Ireland). The jurisdiction in which the fund is organized often depends on the countries in which investors reside and the type of entity the sponsor desires to form. Also, certain jurisdictions, such as the Cayman Islands, have a well-developed regulatory system for organizing and maintaining investment funds but are more expensive than other jurisdictions, such as the British Virgin Islands, which do not have as extensive a regulatory scheme.
Often, the manager of an offshore fund forms a corporate entity to provide advisory services to the fund. This entity serves as the investment manager of the fund. If the hedge fund manager already manages the assets of a domestic partnership through a single corporate entity, the general partner of the partnership may also serve as the investment manager of the offshore fund. If the sponsor is managing the assets of a partnership through two corporate entities, the entity serving as the management company of the domestic partnership will ordinarily serve as the investment manager to the fund.
Offshore funds are also attractive to United States tax-exempt organizations (e.g. individual retirement accounts, qualified pension and profit sharing trusts) as a method for avoiding unrelated business taxable income. A United States tax-exempt investor who has purchased an interest in a domestic partnership utilizing leverage may be subject to income tax on any debt-financed income. For example, if a tax exempt organization purchases an interest in a limited partnership and that partnership purchases stock in a company and finances fifty-percent (50%) of the purchase price with debt and then subsequently sells the stock for a gain, the tax exempt organization would have unrelated business tax income equal to its share of fifty-percent (50%) of the gain offset by fifty-percent (50%) of its share of net interest cost. A tax-exempt organization must prepare and file a tax return and pay taxes if it receives $1,000 or more of gross income in computing the unrelated business tax income.
This structure, also known as a "hub and spoke," allows investors residing in the United States and investors residing offshore to invest, indirectly, in the same offshore corporate entity commonly known as the "master fund." The master fund is typically structured as a limited partnership. Ordinarily, U.S. taxable investors investing in a master-feeder structure directly invest in a limited partnership organized in the United States. This limited partnership is referred to as the "domestic feeder." The domestic feeder invests its assets in the master fund. The offshore investors and U.S. tax-exempt organizations (e.g. IRAs) directly invest in an offshore corporation. This offshore corporation is referred to as the "offshore feeder." The offshore feeder also invests its assets in the master fund. The hedge fund manager then purchases and sells securities in an account held in the name of the master fund. (See Diagram 1 below.)
In a side-by-side structure, U.S. investors typically invest in a limited partnership organized in the United States and offshore investors invest in an offshore corporation. The prime broker typically allocates trade tickets between the domestic fund and the offshore fund.
For hedge fund managers seeking to establish both a domestic and an offshore fund, there are various tax, administrative and other issues the manager should consider in determining whether to utilize a master feeder or a side-by-side structure. The choice will depend on the manager's strategy and goals.
Compensation to Hedge Fund Manager
A hedge fund manager may receive several forms of compensation. The manager often receives a performance allocation equal to a percentage (usually 20%) of realized and unrealized appreciation of the hedge fund's assets payable on a yearly basis. In addition, the manager typically receives a management fee equal to a percentage (usually 1% annually) of assets under management, which may be payable quarterly or monthly. When two management entities are used, ordinarily the general partner receives the performance allocation and the management company receives the management fee. In such instances, the management company is responsible for paying the hedge fund manager's overhead expenses (e.g. rent, furniture, equipment) and employs the manager's personnel. The general partner, however, should not employ any personnel and be solely responsible for managing the hedge fund's assets.
Exemption From Registration As An Investment Company
Hedge funds are not required to register as an investment company with the SEC in reliance upon an exemption pursuant to either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940. Section 3(c)(1) of the Act, in part, provides an exemption from the Act's registration requirement for an investment company whose securities are owned by not more than 100 "persons." Section 3(c)(7) of the Act, in part, exempts investment companies from the Act's registration requirement without limitation as to the number of its beneficial owners as long as the securities are owned exclusively by "qualified purchasers" as defined in the Act. A hedge fund with 500 or more investors, however, is required to register its securities with the SEC. Sections 3(c)(1) and 3(c)(7) of the Act have different investor qualification requirements. See "QUALIFICATION OF INVESTORS IN A SECTION 3(C)(1) HEDGE FUND" and "QUALIFICATION OF INVESTORS IN A SECTION 3(C)(7) HEDGE FUND."
Hedge fund managers most commonly rely upon the exemption from registration as an investment company available under Section 3(c)(1) of the Act. A hedge fund operating pursuant to an exemption under either Sections 3(c)(1) or 3(c)(7) of the Act, however, may not make any public offering of its securities under the Securities Act of 1933. There are numerous restrictions against advertising and general solicitation by hedge funds relying on either the Section 3(c)(1) or Section 3(c)(7) exemption, and managers should exercise proper caution in their selling efforts to ensure that the fund's exempt status is not compromised.
Determining The Number of Investors in a Hedge Fund
For purposes of counting investors in connection with the 100-person limitation imposed by Section 3(c)(1) of the Investment Company Act of 1940, normally, each person is counted separately. The Act defines "person" to mean a "natural person or a company." The SEC staff, however, will "look-through" a company that invests in a hedge fund and count each of the security holders of that company as a separate investor of the fund, if: (i) the company investing in the hedge fund is either a registered investment company or a private investment company organized pursuant to an exemption under either Section 3(c)(1) or Section 3(c)(7) of the Act; and (ii) the company beneficially owns 10% or more of the outstanding voting securities of the hedge fund. Under a series of SEC interpretations, the SEC may apply the "look-through" analysis to other situations in which a pooled investment vehicle invests in a hedge fund and the SEC determines that such investment is a circumvention of the 100-person requirement. For offshore funds relying on Section 3(c)(1) that accept U.S. tax-exempt investors, only U.S. owners are counted towards the 100-person limitation.
Knowledgeable employees of a hedge fund and certain of its affiliates may acquire securities issued by a hedge fund without being counted for purposes of the fund's 100-person limit. A "Knowledgeable Employee" is defined to include the directors, executive officers or general partners of the fund or an affiliated person of the fund that oversees the fund's investments, as well as persons who serve in capacities similar to directors, such as trustees and advisory board members.
The Integration Doctrine
When a hedge fund begins to approach the limitation on the number of investors (e.g. 100 persons), the manager cannot avoid the limitation by forming another hedge fund identical to the prior fund.
To prevent managers from creating identical hedge funds each time they approach the 100-person limitation, the SEC applies the "integration" doctrine. In the event that two or more hedge funds, which are managed by the same sponsor, are substantially similar, the SEC will "integrate" such funds so that they will be deemed to constitute one issuer. If the SEC integrates two or more hedge funds, it combines the number of each fund's investors to determine whether the funds, in the aggregate, are owned by more than 100 persons.
When determining whether to integrate two or more funds, the SEC applies a "reasonable person test." If a reasonable investor would conclude an investment in one of the hedge funds is materially different from an investment in the other fund(s), the funds will not be integrated. Some of the factors looked at by the SEC staff, include the hedge funds' investment objectives (e.g. one fund's performance geared to an index), investment styles (e.g. use of leverage, different portfolio securities) and whether the funds are targeting different groups of investors (e.g. taxable and tax exempt investors, domestic and offshore investors).
The staff of the SEC will not integrate two hedge funds if one was formed pursuant to an exemption under Section 3(c)(1) of the Investment Company Act of 1940 and the other fund was formed under Section 3(c)(7) of the Act. Additionally, the SEC staff normally does not integrate domestic hedge funds and their offshore counterparts.
Qualification Of Investors In A Section 3(C)(1) Hedge Fund
Section 3(c)(1) of the Investment Company Act of 1940 provides an exemption from having to register as an investment company under the Act for a hedge fund whose securities are not publicly offered and are owned by not more than 100 persons. Set forth below are the qualification requirements for investors in hedge funds relying on the exemption from registration under Section 3(c)(1) of the Act.
For a hedge fund relying on the Section 3(c)(1) exemption, interests in the fund are typically offered to prospective investors pursuant to an exemption from the public registration requirements for securities offerings under Rule 506 of Regulation D of the Securities Act of 1933. Securities offered under Rule 506 may be sold solely to "accredited investors" and up to 35 "sophisticated investors".
An "accredited investor" is deemed to include, in part:
- A natural person with an individual net worth, or joint net worth with his or her spouse, at the time of purchase in excess of $1,000,000;
- A natural person with an individual income in excess of $200,000, or in excess of $300,000 with his or her spouse, in each of the two most recent years and who has a reasonable expectation of an income in excess of $200,000 individually, or in excess of $300,000 with his or her spouse, in the current year;
- Any executive officer, director or general partner of the issuer of the securities offered;
- An employee benefit plan within the meaning of Title I of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), (a) whose investment decisions are made by a plan fiduciary, as defined in Section 3(21) of ERISA, which is either a bank, insurance company or registered investment adviser; or (b) having total assets in excess of $5,000,000; or (c) if self-directed, the investment decisions are made solely by persons that are accredited investors;
- A trust, with total assets in excess of $5,000,000 which was not formed for the specific purpose of acquiring an interest in the hedge fund, whose purchase is directed by a sophisticated investor; and
- An entity in which each of the equity owners are accredited investors.
A person is a "sophisticated investor," if the investor either alone or with the investor's purchaser representative(s) has such knowledge and experience in financial and business matters that the investor is capable of evaluating the merits and risks of an investment in the hedge fund.
Many industry professionals believe that accredited investors are less likely to initiate litigation against the hedge fund and its manager than non-accredited investors, and, in the event of litigation, juries are less sympathetic to accredited investors than they are to non-accredited investors.
Qualification Of Investors In A Section 3(C)(7) Hedge Fund
Section 3(c)(7) of the Investment Company Act exempts a hedge fund from having to register as an investment company without limitation as to the number of its beneficial owners as long as its securities are not publicly offered and its investors qualify as "qualified purchasers". A Section 3(c)(7) fund with 500 or more investors, however, is required to register its securities with the SEC. A person may not invest in a hedge fund relying on the Section 3(c)(7) exemption unless such person meets the definition of a "qualified purchaser."
The Act defines the term "qualified purchaser" to include, in part:
- Any natural person who owns at least $5 million in investments; and
- Any other person (e.g., an institutional investor) that owns and invests on a discretionary basis at least $25 million in investments.
Knowledgeable employees of a hedge fund and certain of its affiliates are not required to meet the definition of a "qualified purchaser" for purposes of investing in a Section 3(c)(7) hedge fund. A "Knowledgeable Employee" is defined to include the directors, executive officers or general partners of the hedge fund or an affiliated person of the fund that oversees the fund's investments, as well as persons who serve in capacities similar to directors, such as trustees and advisory board members.
Registration As An Investment Adviser
The Investment Advisers Act of 1940 defines an "investment adviser" generally to include a natural person or entity who for compensation engages in the business of providing advice to others regarding securities. Whether a person is "in the business" of providing investment advice depends on the frequency and regularity with which a person or entity provides advice with regard to securities. Compensation may include any form of direct or indirect economic benefit (e.g. compensation paid directly from the person receiving advice or compensation paid by a third party).
Irrespective of the broad definition of the term "investment adviser," certain persons whose activities are already regulated are excluded from the definition, such as:
- Broker dealers and registered representatives, provided that the investment advice provided is solely incidental to their brokerage business, and that the broker or registered representative does not receive any special or additional compensation for providing the investment advice.
- The publisher of a bona fide publication of general and regular circulation which provides "impersonalized" investment advice. This exemption has been expanded to include telephonic stock recommendation services and stock recommendation services provided through electronic mail.
Although all hedge fund managers fall within the definition of an "investment adviser," they may not be required to register as an investment adviser pursuant to an exemption for "private" investment advisers. The SEC and each state impose different registration requirements and exemptions from registration for investment advisers.
A hedge fund manager is exempt from registering as an investment adviser under the Advisers Act which is enforced by the SEC, if such person or entity:
- Has had fewer than 15 clients within the past 12 months;
- Does not hold itself out to the public as an investment adviser; and
- Does not provide advisory services to a registered investment company or a business development company.
For the purpose of counting clients in connection with the registration requirement, a hedge fund is counted as single client, provided that the hedge fund manager renders advice to the investors in the hedge fund based upon the hedge fund's objectives, rather than tailoring advice to each individual investor's objectives.
The element of "holding out" has been interpreted broadly to include, in part the following:
- Advertising related to advisory activities;
- Maintaining a listing as an investment adviser in either a telephone directory or building directory; and
- Using letterhead or business cards with reference to providing investment advisory services
Notwithstanding the federal exemption for private investment advisers with fewer than 15 clients and similar exemptions in the majority of states based on the number of clients, several states require a sponsor managing a single hedge fund to register as an investment adviser with the state regulatory body. For example, California, Hawaii and Texas require hedge fund managers to register as an investment adviser if the manager maintains an office in the state.
In the event that a hedge fund manager is required to register as an investment adviser, a determination must be made as to whether the manager registers with the SEC or the securities agency of the state in which it maintains its principal office and place of business. Federal and state responsibility for regulating investment advisers is determined, in part, by the amount of assets under the manager's management. A hedge fund manager must have at least $25 million of assets under management to register as an investment adviser with the SEC. If a manager's assets under management are between $25 and $30 million, the manager may, at its discretion, register as an investment adviser with either the SEC or the securities agency of the state in which it maintains its principal office and place of business. If the hedge fund manager has less than $25 million in assets under management, it must register with the securities agency of the state in which it maintains its principal office and place of business. There are several exceptions to this asset-based determination (e.g. the manager has a reasonable expectation that it will meet the asset-based test within 120 days of registration).
In determining assets under management, the hedge fund manager may consider any account of which at least fifty-percent (50%) of the total value consists of securities. "Securities" does not include real estate, commodities and collectibles. Cash and cash equivalents (e.g., demand deposits), however, may be counted towards the fifty-percent (50%) threshold.
Limitation on Registered Advisers Charging Performance Based Fees
Generally, a hedge fund manager registered as an investment adviser may receive performance-based compensation from its investors, if each of the investors is a "qualified client."
Under the Investment Advisers Act of 1940, a person is deemed to be a qualified client if the hedge fund manager has a reasonable belief that the investor has a net worth in excess of $1,500,000 at the time of investment or the investor has at least $750,000 under the management with the manager. Certain states, however, use a lower standard, whereby an investor must have a net worth in excess of $1,000,000 or assets of $500,000 under management with the hedge fund manager. There are additional restrictions, however, imposed on managers who are registered as an investment adviser by states utilizing the lower standard.
Non-U.S. persons are not required to meet the requirements of a "Qualified Client".
A hedge fund relying on an exemption pursuant to Section 3(c)(1) of the Investment Company Act of 1940 seeking to invest in another hedge fund is deemed to be a "qualified client" of the investee fund if each of its beneficial owners are "qualified clients." A hedge fund relying on the Section 3(c)(7) exemption from registration under the Company Act seeking to invest in another hedge fund is automatically deemed to be "qualified client."
Registration Under The Commodity Exchange Act
A hedge fund manager must register as a commodity pool operator, commonly referred to as a CPO, under the Commodity Exchange Act if the fund trades any commodity futures contracts or options thereon. As a CPO, the manager is subject to various record-keeping, reporting and disclosure requirements under the Commodity Exchange Act and the regulations thereunder adopted by the Commodity Futures Trading Commission.
In addition to the registration requirement, the hedge fund's offering document must, ordinarily, be approved by the National Futures Association prior to its use. If, among other things, the hedge fund's aggregate initial margin and option premiums for commodity transactions do not exceed 10% of the fund's assets, or if investors in the fund are limited to "qualified eligible participants," the fund may request an exemption from many of the regulatory requirements otherwise applicable to it as a CPO.
A "qualified eligible participant" includes any person who the hedge fund manager reasonably believes, at the time that person invests in the fund:
The Employee Retirement Income Security Act of 1974 ("ERISA")
- Owns securities (including pool participations) of issuers not affiliated with such participant and other investments with an aggregate market value of at least $2,000,000; and
- Has had on deposit with a futures commission merchant, for its own account at any time during the six-month period preceding the date of sale to that person of an interest in the fund, at least $200,000 in exchange-specified initial margin and option premiums for commodity interest transactions.
In the event that the investment assets of "benefit plan investors," in the aggregate equal or exceed, at any time, twenty-five-percent (25%) of the aggregate equity of a hedge fund, the hedge fund manager will be deemed to be managing "plan assets" and thus, become a "plan fiduciary" under ERISA. As a fiduciary under ERISA, the hedge fund manager, in part, would be prohibited from participating in or entering into any transaction that would result in a conflict of interest with the benefit plan investors. Employee benefit plans, individual retirement accounts and Keogh accounts are some of the types of investors considered to be "benefit plan investors."
Each time there is an investment or withdrawal in a hedge fund, the hedge fund manager or an agent of the manager is required to calculate the percentage of assets held by benefit plan investors in the aggregate. The value of the managers account(s) is not included in the calculation to determine the percentage of assets held by benefit plan investors in the aggregate.