Because life settlements are a unique investment which has characteristics not associated with other types of investments creative managers can choose to structure a life settlement hedge fund in many different ways. This article will detail (i) the potential life settlement hedge fund structures, (ii) life settlement investment program considerations, and (iii) a brief overview of life settlement taxation issues.
Potential Life Settlement Fund Structures
Hedge fund structure – the hedge fund structure with net asset valuations on contributions and redemptions is a common structure but it might not be the best structure unless a valuation mechanism is put in place. Because life settlements are not traded on an established exchange the manager will need to develop some valuation policy which might include using outside appraisers or “marking to model.” The method of valuation will need to be appropriately constructed and will be based on the needs of the funds structure.
Private equity fund structure – the private equity structure gets around the valuation issue but also presents a problem if the fund will own a large amount of policies and/or policies which have widely different expected maturities. The private equity fund structure will require and good understanding of the cash management issues for the fund to make sure that the IRR is satisfactory over the life of the fund. (The central issue being how to redeploy capital from an early maturity.) Such funds may choose to have quarterly distributions of profit after a certain date.
Hybrid fund structure – some managers may choose some sort of hybrid between the above two structures which avoids valuation periods, but allows inflows and redemptions. Usually this would be accomplished through side pocket accounts. However, managers should note that these structures may present accounting issues; we therefore recommend that the manager discuss the proposed program with all of the service providers (attorney, administrator, auditor) prior to finalization of the program.
Debt structure – the offering could be structured as a debt offering. There are many different ways that the debt structure could work, including: (i) the fund could pay the investor a variable coupon based on the fund’s returns, (ii) the fund could pay the investor a fixed coupon which is payable yearly or quarterly after a certain amount of time, or (iii) the fund could pay the investor a fixed coupon which is payable at the end of the life of the fund. There are many issues with the debt structure including the possibility of unattractive returns for the management company if the life settlements do not pay off according the actuarial schedule. There also may be some “phantom income” issues with some of these debt strategies.
All of the structures above contemplate a robust back office of the management company as well as an administrator which is able to deal with the specific issues attributable to these funds (note: many administrators will not be able to handle the administration of these funds).
Description of the Investment Program
The manager should understand his life settlement program will work. A business plan may be helpful in thinking through some of the issues which will arise. Additionally, the following questions should probably be addressed in the description of the investment program or within the offering documents.
- What types of policies (whole, term, variable, etc.)?
- What are life expectancies of the insureds? How old will the life expectancy reports be?
- How old can the insured be?
- Cash management policies for the premium payments.
- Will all policies be past the contestability period?
- Will there be required insurance company ratings? Will there be reinsurance?
- Will there be diversification criteria for the policies (carriers, life expectancies, etc.)?
- Will the program (i) buy and sell policies, (ii) buy and hold policies to maturity or (iii) a combination of the two?
The above list is not a full list of the potential issues which will need to be addressed. The manager’s hedge fund attorney will be able to identify areas which need greater clarification or information.
Taxation of Life Settlements
Practitioners can disagree as to the tax treatment of life settlement policies and oftentimes the tax treatment will be dependant on the facts of the particular situation. As a general matter, though, if a fund holds a life settlement policy to maturity then the gain will likely be ordinary income; if a fund sells a life policy before maturity then the gain would likely be capital gain. Prospective managers are urged to discuss this issue in depth with their formation attorney.
Additionally, while many hedge funds allow IRA investments, life settlement hedge funds probably should not allow investments from IRAs. This issue should also be discussed in depth with the attorney.
Start a Life Settlement Hedge Fund Today
Life settlement hedge funds can be up and running in as little as three weeks depending on the manager and the program (which may or may not require investment advisor registration, please see Are Life Settlements Securities? for more information). The costs are likely to be similar to costs for a private equity type fund – I’ve seen some funds which cost $80,000 and more but boutique law firms should be able to establish these funds in the $20,000 to $30,000 range.
Our experienced attorneys can assist you with any questions you have about starting your life settlement hedge fund. Please contact us to start your fund.
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