Monthly Archives: October 2008

Hedge Fund Management Fees

The hedge fund management fee, or asset management fee, is a periodic fixed fee payable to the hedge fund manager based on the amount of the hedge fund’s assets.

How often do most managers take the asset management fee?

The management fee can be taken during any period of time but most managers will take the management fee either monthly or quarterly. Some managers may take the fee annually, or semi-annually, but this is much less common.

What is the most common management fee?

Most management fees range from 1% to 2% of assets under management.

The amount of the management fee will differ from manager to manager based on a number of factors including the strategy of the fund. In theory, the management fee is supposed to cover all of the manager’s expenses and costs such as the manager’s rent, salary for employees, computer equipment, etc. For certain strategies, the above expenses will be relatively low and for other strategies the expenses will be high. This should be one of the factors that a manager considers when deciding on the asset management fee.

Another consideration is the historical returns of the fund. Many of the major blue chip hedge funds will charge a larger management fee (in addition to a larger performance fee), which may be anywhere from 2.5% to 5%.

Hedge fund-of-funds will usually charge a management fee of 0.5% to 1.5%, with a vast majority of managers charging 1%. For hedge fund-of-funds, I most typically see a quarterly management fee that usually corresponds with the quarterly reports sent to investors.

HFLB note: if a manager is a state-registered investment advisor, the manager may not be able to have a management fee higher than 3%. Specifically, California has said a California-registered investment advisor cannot have a management fee which exceeds 3%. Additionally, the manager would probably need to include a disclaimer stating that a 3% management fee is in excess of the industry standard.

Management fees and leverage

Some hedge fund managers utilize leverage in their investment programs and they will want to receive the management fee based on the amount of assets being managed with the leverage as opposed to simply the capital account balances of the limited partners. Depending on what is provided in the offering documents, this may or may not be the default and managers who wish to receive the higher management fee should discuss this with their hedge fund attorney.

Some other articles you may be interested in:

Please feel free to contact us if you have any questions.

Solicitors for Registered Investment Advisory Firms

2 Replies

A common question for investment advisory firms is how they can pay persons for referring them separately managed account clients. For SEC-registered investment advisors, any such fee would need to be paid pursuant to the requirements of Rule 206(4)-3 – the rule regarding cash payments for client solicitations.

Rule 206(4)-3 defines the term “solicitor” broadly to include any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser. The rule also requires that fees paid to solicitors pursuant to the following guidelines:

– the solicitor is not disqualified by the rule;
– there is a written agreement between the solicitor and the IA firm;
– the solicitor provides the client with a statement which details certain parts of the arrangement; and
– the client signs an acknowledgment of the relationship

The above bullet points are generally what is required and if you have questions on your specific situation you should discuss with your attorney or compliance person. I have also posted the complete rule below. Additional information was provided by the SEC at the time of the rule’s release which can be found here: Investment Advisers Act Release No. 688. Please contact us if you have any questions.

Rule 206(4)-3 – Cash Payments for Client Solicitations

(a) It shall be unlawful for any investment adviser required to be registered pursuant to section 203 of the Act to pay a cash fee, directly or indirectly, to a solicitor with respect to solicitation activities unless:

(1)

(i)The investment adviser is registered under the Act;

(ii) The solicitor is not a person (A) subject to a Commission order issued under section 203(f) of the Act, or (B) convicted within the previous ten years of any felony or misdemeanor involving conduct described in section 203(e)(2)(A) through (D) of the Act, or (C) who has been found by the Commission to have engaged, or has been convicted of engaging, in any of the conduct specified in paragraphs (1), (5) or (6) of section 203(e) of the Act, or (D) is subject to an order, judgment or decree described in section 203(e)(4) of the Act; and

(iii) Such cash fee is paid pursuant to a written agreement to which the adviser is a party; and

(2) Such cash fee is paid to a solicitor:

(i) With respect to solicitation activities for the provision of impersonal advisory services only; or

(ii) Who is (A) a partner, officer, director or employee of such investment adviser or (B) a partner, officer, director or employee of a person which controls, is controlled by, or is under common control with such investment adviser: Provided, That the status of such solicitor as a partner, officer, director or employee of such investment adviser or other person, and any affiliation between the investment adviser and such other person, is disclosed to the client at the time of the solicitation or referral; or

(iii) Other than a solicitor specified in paragraph (a)(2) (i) or (ii) of this section if all of the following conditions are met:

(A) The written agreement required by paragraph (a)(1)(iii) of this section: (1) Describes the solicitation activities to be engaged in by the solicitor on behalf of the investment adviser and the compensation to be received therefor; (2) contains an undertaking by the solicitor to perform his duties under the agreement in a manner consistent with the instructions of the investment adviser and the provisions of the Act and the rules thereunder; (3) requires that the solicitor, at the time of any solicitation activities for which compensation is paid or to be paid by the investment adviser, provide the client with a current copy of the investment adviser’s written disclosure statement required by Rule 204-3 (“brochure rule”) and a separate written disclosure document described in paragraph (b) of this rule.

(B) The investment adviser receives from the client, prior to, or at the time of, entering into any written or oral investment advisory contract with such client, a signed and dated acknowledgment of receipt of the investment adviser’s written disclosure statement and the solicitor’s written disclosure document.

(C) The investment adviser makes a bona fide effort to ascertain whether the solicitor has complied with the agreement, and has a reasonable basis for believing that the solicitor has so complied.

(b) The separate written disclosure document required to be furnished by the solicitor to the client pursuant to this section shall contain the following information:

(1) The name of the solicitor;

(2) The name of the investment adviser;

(3) The nature of the relationship, including any affiliation, between the solicitor and the investment adviser;

(4) A statement that the solicitor will be compensated for his solicitation services by the investment adviser;

(5) The terms of such compensation arrangement, including a description of the compensation paid or to be paid to the solicitor; and

(6) The amount, if any, for the cost of obtaining his account the client will be charged in addition to the advisory fee, and the differential, if any, among clients with respect to the amount or level of advisory fees charged by the investment adviser if such differential is attributable to the existence of any arrangement pursuant to which the investment adviser has agreed to compensate the solicitor for soliciting clients for, or referring clients to, the investment adviser.

(c) Nothing in this section shall be deemed to relieve any person of any fiduciary or other obligation to which such person may be subject under any law.

(d) For purposes of this section,

(1) Solicitor means any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.

(2) Client includes any prospective client.

(3) Impersonal advisory services means investment advisory services provided solely by means of (i) written materials or oral statements which do not purport to meet the objectives or needs of the specific client, (ii) statistical information containing no expressions of opinions as to the investment merits of particular securities, or (iii) any combination of the foregoing services.

Hedge Fund Separately Managed Accounts

5 Replies

A common criticism or complaint about hedge funds is that they lack transparency. While many funds provide transparency to their investors through monthly or quarterly account statements, oftentimes these account statements do not detail the actual positions of the hedge fund. Because of this some investors who desire more transparency, generally large institutional investors and hedge fund of funds, will ask managers to manage money through a separately managed account structure (also known as a SMA structure or arrangement).

In the separately managed account structure the investor establishes a brokerage account and gives the hedge fund manager power of attorney over the trading account (also known as a “POA account”). Because the investor is the ultimate owner of the account the investor can see the exact positions in the account, although the manager will have the ability to trade the account. The POA can be as broad or as narrow as the parties agree and will be memorialized through two different documents: (i) a POA authorization with the brokerage firm and (ii) an investment advisory contract. The investment advisory contact will be drafted by the hedge fund lawyer and will include the business and legal terms which will govern the relationship.

The separately managed account structure is generally not common, however the need does arise from time to time when a side letter cannot address the concerns of an investor. For instance, some investors cannot invest in pooled investment vehicles which are not regulated under the Investment Company Act of 1940. A hedge fund manager who is not registered as an investment adviser will need to take care when entering into these arrangements as it will increase the number of clients that the manager has. Additionally, if a manager is registered as an investment advisor with the SEC or the state securities commission, the advisory contract may need to include certain state-specific items and the advisor’s Form ADV and Form ADV Part II will need to be amended within two weeks of entering the relationship.

Please feel free to contact us if you have any questions on the separately managed account structure.

Hedge Fund Side Letters

5 Replies

The side letter is one of the most important items for a hedge fund manager. While the hedge fund will run pursuant to the terms of the hedge fund offering documents drafted, the side letter will give the manager some flexibility to go outside the terms of the documents for certain investors.

A hedge fund side letter is simply an agreement between the hedge fund manager and the investor that outlines different terms that will apply to the investor’s investment into the fund. The side letter is drafted by the hedge fund attorney and will be signed by the investor at the same time that the investor signs the hedge fund subscription documents.

Overview of side letter provisions

Below are some of the reasons a hedge fund manager may use a side letter arrangement

Reduced Fees – the hedge fund manager will reduce or waive the management fees or performance fees for the investor.

Lock-up and liquidity – the hedge fund manager may reduce or waive the lock-up for a specific investor. The manager may also allow for greater liquidity (i.e. monthly withdrawals instead of quarterly withdrawals).

Information – the manager may agree to provide an investor with greater informational rights such as the ability to request a description of the exact positions of the fund at any given time.

Most favored nation’s clause – this allows an investor to get the best deal that the manager gives to any other investor. This clause is usually reserved for very large or very early investors.

There are many different ways which any of the above concepts can be implemented into the side letter and generally it will depend on the business points negotiated by the manager and the investor. As an alternative to a hedge fund investment and side letter arrangement, an investor may simply enter into a separately managed account (known as a “SMA”) arrangement with the hedge fund manager.

Side letters and raising money for the hedge fund

The hedge fund side letter can be an important tool for raising assets. Typically the letter will be used to entice early investors to invest in the fund; it can also be used to attract investors who will contribute a large amount of assets to the fund. The side letter can also be used to try to get a current investor to contribute more assets to the fund.

What the SEC says about side letters

During the late part of 2007 and the early part of 2008, there was a lot of chatter within the hedge fund industry that the SEC would increase its investigation of hedge fund side letters. Presumably they would have tried to accomplish this through audits of hedge fund managers registered as investment advisors. While there was much concern within the industry at the time, that concern has subsided as the market events of 2008 began to take on greater importance.

Testimony from SEC regarding hedge fund side letters

The following comes from testimony by a SEC official to Congress regarding hedge funds and side letters:

Side Letter Agreements. Side letters are agreements that hedge fund advisers enter into with certain investors that give the investors more favorable rights and privileges than other investors receive. Some side letters address matters that raise few concerns, such as the ability to make additional investments, receive treatment as favorable as other investors, or limit management fees and incentives. Others, however, are more troubling because they may involve material conflicts of interest that can harm the interests of other investors. Chief among these types of side letter agreements are those that give certain investors liquidity preferences or provide them with more access to portfolio information. Our examination staff will review side letter agreements and evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.

ERISA considerations

Hedge funds which are ERISA hedge funds will need to be careful about their side letter activities and should always consult with their hedge fund attorney before entering into such arrangements. Specifically, the Department of Labor is concerned about different informational rights, especially with regard to plans which have subordinated rights.

If you have any questions regarding side letters, please contact us.

LP and LLC Fund Taxation

6 Replies

Hedge funds are popular vehicles for hedge fund investors because of the manner in which they are taxed. Hedge funds are usually structured as limited partnerships or limited liability companies. Such entities by default are taxed as partnerships under Subchapter K of the Internal Revenue Code.

The partners in a partnership, and not the partnership itself, are taxed on the partnership’s income. In this manner the partnership is markedly different than a corporation which is subject to double taxation (tax at both the corporate and shareholder level). Because of the manner of taxation, partnerships are referred to as “flow through” vehicles because the income is taxed at the investor level instead of (or in addition to) the entity level.

Yearly LP and LLC Fund Tax Returns

Each year a hedge fund will need to file a tax return with the federal government. In addition the hedge fund will probably need to file a tax return with the state where the manager resides. These issues should be discussed with a hedge fund auditor or accountant, who will typically prepare the partnership’s tax returns. The IRS specifically states with regard to Form 1065:

Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. The partnership return must show the names and addresses of each partner and each partner’s distributive share of taxable income. The return must be signed by a general partner. If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return.

A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.

The hedge fund will also need to send each investor a Schedule K-1 so that the investor can prepare its tax returns for the year. The accountant will help the hedge fund manager to prepare these items.

Schedule K-1 can be found here: Schedule K

Other Tax Items

Some other partnership taxation topics which we will be discussing in the future include:

–   Gains and losses from securities transactions
–   Constructive sales
–   1256 contracts
–   Original Issue Discount
–   Itemized deductions
–   Allocations of the fund’s income, deductions and/or loss
–   AMT
–   UBTI
–   Passive Activity Losses
–   Distributions
–   Section 754 Adjustments
–   “Stuffing” provisions

Overview of Investment Advisers Act of 1940

9 Replies

One of the most important set of the federal securities laws which relate to hedge fund managers is the Investment Advisers Act of 1940 (Investment Advisers Act). The Investment Advisers Act provides the manner in which investment advisers will register with the SEC, provides the laws that must be followed as an investment advisor, and makes it illegal for both registered and unregistered investment advisors to act fraudulently toward any investors.

If a hedge fund manager is registered as an investment advisor with the SEC then the manager should make sure he understands all parts of the Investment Advisers Act. Below I’ve highlighted and discussed those provisions which are most important to a hedge fund manager. The entire act can be found here: Investment Advisers Act of 1940.

Definition of Investment Adviser

The term investment adviser is very broad. Section 202(a)(11) provides:

“Investment adviser” means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities;

but does not include

(A) a bank, or any bank holding company as defined in the Bank Holding Company Act of 1956, which is not an investment company, except that the term “investment adviser” includes any bank or bank holding company to the extent that such bank or bank holding company serves or acts as an investment adviser to a registered investment company, but if, in the case of a bank, such services or actions are performed through a separately identifiable department or division, the department or division, and not the bank itself, shall be deemed to be the investment adviser;

(B) any lawyer, accountant, engineer, or teacher whose performance of such services is solely incidental to the practice of his profession;

(C) any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore;

(D) the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation;

(E) any person whose advice, analyses, or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act; or

(F) such other persons not within the intent of this paragraph, as the Commission may designate by rules and regulations or order.

Pre-requiste for Registration

Only those managers which manage at least $25 million in assets are eligible to register with the SEC. If a manager has less than $25 million of assets under management, then the manager will be subject only to the registration with the managers state of residence (if required). Specifically Section 203A(a)(1)(A) provides:

No investment adviser that is regulated or required to be regulated as an investment adviser in the State in which it maintains its principal office and place of business shall register under section 203, unless the investment adviser – has assets under management of not less than $ 25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; …

Investment Adviser Registration Requirement

In general, all investment advisors must register with the SEC pursuant to Section 203(a).

Except as provided in subsection (b) and section 203A, it shall be unlawful for any investment adviser, unless registered under this section, to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.

Exemption from registration

While the definition of investment adviser is sufficiently broad to include most all hedge fund managers, there is a widely used exemption from the registration provisions. Section 203(b)(3) provides:

The provisions of subsection (a) [the registration provisions noted above] shall not apply to … any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under title I of this Act, or a company which has elected to be a business development company pursuant to section 54 of title I of this Act and has not withdrawn its election. For purposes of determining the number of clients of an investment adviser under this paragraph, no shareholder, partner, or beneficial owner of a business development company, as defined in this title, shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner;

There are two important items to note here. First, the investment adviser cannot have more than 15 clients over a 12 month rolling period. A hedge fund counts as a single client for these purposes. Second, the investment adviser

Prohibited Transactions

The act has very strong anti-fraud provisions. Most SEC actions against investment advisers will be based on this section of the act. Section 206, in full, provides:

It shall be unlawful for any investment adviser, by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly –

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;

(3) acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction. The prohibitions of this paragraph (3) shall not apply to any transaction with a customer of a broker or dealer if such broker or dealer is not acting as an investment adviser in relation to such transaction;

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.

Other Important Sections

There are other important sections to the act which include the following:

Section 204 – Record Keeping Requirements

Section 205 – Investment Advisory Contracts

Section 222 – State Regulation of Investment Advisers

Hedge Fund Auditor – Hedge Fund Audit Information and Questions

6 Replies

A hedge fund auditor is a service provider to the hedge fund; the main job of the auditor is to audit the accounting practices of the hedge fund.

During the audit period, the auditor will work with the hedge fund manager to review the hedge fund’s valuation methodology as well as the implementation of that methodology. The auditor will also review the fund’s account statements, including the profits and losses. Usually the auditor will work with the hedge fund administrator as the administrator is the one who has prepared the fund’s financial statements.

Hedge Fund Audit Costs

As with all of the service providers which I have discussed, there is not a one size fits all solution to hedge fund audits. There are three general groups of audit firms and costs

Small audit firm – the small audit firm may be a one to five or more person shop. Like the small administrator, the small audit firm is going to be able to give the hedge fund manager the most one-on-one time and really provide good insight and advice to the manager on his business, in addition to the audit work. The costs for the small audit firm will range anywhere from about $6,000 to $10,000 per year, depending on the nature of the investment program.

Medium sized, boutique hedge fund audit firm – there are a few audit firms that specialize in hedge fund auditing. These firms are well recognized in the industry and are well regarded by most institutional investors. These firms are going to be larger than the small audit firm and may not be able to provide as much face time to the manager. The costs for medium sized firms are going to be in the $12,000 to $18,000 range, depending on the nature of the investment program.

Big four accounting firms – big four accounting firms have large hedge fund audit practices. These firms are very expensive and thus these firms are usually retained by funds with at least $250 million in assets. The costs for a big four accounting firm will probably be at least $25,000 per year.

Funds with less than $250 million should not use a big four accounting firm. One client with $100 million in assets under management used a big four accounting firm and they were put at the end of the line. The accounting firm actually completed the audit late and the client could never get a hold of anyone in the office – our client’s account was a very low priority to this firm. The client made the switch to a boutique hedge fund audit firm and has been happy with the results.

Note on costs. The costs above will generally not include the costs for tax preparation work, which will run extra. Additionally, if the hedge fund invests in certain instruments that are hard to value, the costs may run higher. If you have an unusual asset class, like life settlements, then you will need to discuss your program with your auditor during the offering document drafting process. If there is a master-feeder structure in place, there will be added costs because of the additional entities involved.

Hedge Fund Audit Questions

1. Do domestic hedge funds need to be audited on a yearly basis?

Generally there is no requirement for a domestic hedge fund to have a yearly audit. However, if the manager is registered as an investment advisor with the SEC, then the manager will need to have an annual audit. If the manager is registered as an investment advisor with a state securities commission, the manager will probably need to have an annual audit.

While for some managers an audit may not be required, it is always recommended as investors give great weight to the fact that a fund has an audit. If the fund does not have a yearly audit, it will raise a red flag to potential investors.

2. Do offshore hedge funds need to be audited on a yearly basis?

This will depend on the jurisdiction of the offshore hedge fund. If the hedge fund is based in the Cayman Islands, the hedge fund will need to have a yearly audit and the audit will need to be completed by a Cayman based audit firm. Most hedge fund auditors will have a Cayman based partner which will be able to complete the audit for the fund. This may add a little extra to the cost of the audit.

In the BVI there is no present requirement for a hedge fund audit.

Previous SEC Testimony to Congress Regarding Hedge Funds

2 Replies

As noted in an earlier post, I have started a new section which will deal with the potential for new hedge fund regulations. In order to get an idea of where we might be headed, I have looked backed to see what the SEC has said to Congress about hedge funds previously. Below is a transcript of Susan Ferris Wyderko’s testimony before a Senate Subcommittee. Some of the more interesting parts of this speech include:

background of hedge fund industry
hedge fund regulation
hedge fund fiduciary obligation
cases against fraudulent hedge fund managers
discussion of prime brokerage

Please note that the discussion on investment advisor registration for hedge fund managers is no longer accurate thanks to Phillip Goldstein of Bulldog Investors who successful challenged the SEC’s registration rule. The link for this testimony can be found here.

Testimony Concerning Hedge Funds

by Susan Ferris Wyderko
Director, Office of Investor Education and Assistance
U.S. Securities & Exchange Commission
Before the Subcommittee on Securities and Investment of the
U.S. Senate Committee on Banking, Housing, and Urban Affairs
May 16, 2006

Chairman Hagel, Ranking Member Dodd, and Members of the Subcommittee:

I. Introduction

Thank you for inviting me to testify today about hedge funds, the role they play in our securities markets, and the Commission’s role in their oversight. The Commission has a substantial interest in the activities of hedge funds and their advisers, which only recently have become major participants in our securities markets.

The Commission recognized the growing importance of hedge funds almost four years ago when it directed the staff of the Division of Investment Management to undertake a fact-finding mission aimed at reviewing the operation and practices of hedge funds and their advisers. That review led to the publication by the Commission of a staff report entitled “Implications of the Growth of Hedge Funds,” in which the staff described in detail the organization of the hedge fund industry, its growth, and regulation.1

While identifying a number of concerns and making several policy recommendations, the report also described the many benefits hedge funds provide investors and our national securities markets. They contribute substantially to market efficiency, price discovery and liquidity. By actively participating, for example, in markets for derivative instruments, hedge funds can help counterparties reduce or manage their own risks, thus reducing risk assumed by other market participants. Moreover, many hedge funds provide an important risk management tool for institutional investors wishing to allocate a portion of their portfolio to an investment with low correlation to overall market activity.2

II. Background

Hedge funds are pools of investment capital that are managed by professional investment advisers and that are not offered generally to the public. They are operated so that they are not subject to the same regulatory requirements of mutual funds, which are governed by the Investment Company Act of 1940 which contains many safeguards for retail investors. Hedge funds are not characterized by a single dominant investment strategy, although many seek to obtain returns that are not correlated to market returns and instead seek to obtain an “absolute return” in a variety of market environments. Some adopt a “multi-strategy” approach that permits the adviser to determine, at any given time, what investment strategy to follow to pursue returns for the investors. Hedge funds also do not have a single risk profile. Some utilize leveraging techniques that expose investors to substantial risks, while others adopt investment strategies more similar to mutual funds.

Hedge funds do, however, share some organizational characteristics that distinguish them from most mutual funds. Most are organized by advisers that retain a substantial equity participation in the fund, and who receive compensation based, in large part, upon gains achieved by the fund (a “performance fee”). A typical fee arrangement will pay the adviser two percent of the total amount of assets under management and 20% of both realized and unrealized gains. Hedge fund managers view these fee structures as better aligning their interests with the interests of their investors and providing substantial incentives for good performance.

Hedge fund managers usually have a great deal of flexibility in managing the fund, which permits them to take advantage of market opportunities that may not be available to other types of institutional investors. They can change investment strategies, trade rapidly, and utilize leveraging techniques not permitted to mutual funds. And, in contrast to mutual funds, which must disclose publicly their portfolio holdings quarterly, many hedge funds do not even disclose portfolio holdings to all of their investors. Hedge fund advisers do, however, often offer disclosure to their investors about the extent and flexibility of their investment strategies.

1. Growth and Significance of Hedge Funds

The ability of some hedge fund managers to generate significant returns has attracted a great deal of investor interest. It is estimated that hedge funds today have more than $1.2 trillion dollars of assets, a remarkable growth of almost 3,000% in the last 16 years.3 In 2005, an estimated 2,073 new hedge funds opened for business.4 One report recently projected that assets of hedge funds may grow to $6 trillion by 2015.5

Much of the growth of hedge funds is attributable to increased investment by institutions, such as private and public pension plans, endowments and foundations.6 Many of these investors sought out hedge funds during the recent bear markets in order to address losses from traditional investments.

The ability of hedge fund managers to sustain above-market returns is a matter of some debate, as is the likelihood that hedge funds as an asset class will continue to grow.7 Nonetheless, hedge funds play and will likely continue to play an important role in the securities markets, the significance of which exceeds the amount of their assets. Although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume.8 They are highly active in the convertible bond and credit derivatives markets. Moreover, hedge funds are becoming more active in the markets for corporate control,9 private lending, and crude petroleum. Their activities affect all Americans directly or indirectly.

2. Application of the Federal Securities Laws

Press articles typically refer to hedge funds as “lightly regulated” investment pools. In a sense, they are correct. As noted above, hedge funds are organized and operated so that they are not subject to the Investment Company Act of 1940. In addition, hedge funds issue securities in “private offerings” that are not registered with the Commission under the Securities Act of 1933, and hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. However, hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary obligations as other investment advisers.

III. The Commission’s Oversight of Hedge Fund Activities

The Commission’s oversight responsibilities with respect to hedge fund activities generally fall into three principal areas: fiduciary obligations; market abuse; and risks to broker-dealers. Each is described below.

1. Fiduciary Obligations

Hedge fund managers are “investment advisers” under the Investment Advisers Act of 1940. As a result, a hedge fund manager owes the fund and its investors a fiduciary duty that requires the manager to place the interests of the hedge fund and its investors first, or at least fully disclose any material conflict of interest the manager may have with the fund and its investors. Hedge fund advisers have this fiduciary obligation as a matter of law regardless of whether they are registered with the Commission.

The Advisers Act provides the Commission with authority to enforce these obligations, which the Commission has exercised vigorously in order to protect investors. Over the past several years the Commission has brought a number of enforcement cases against hedge fund advisers who have violated their fiduciary obligations to their hedge funds and investors. These cases involve advisers who have engaged in misappropriation of fund assets; portfolio pumping; misrepresenting portfolio performance; falsification of experience, credentials and past returns; misleading disclosure regarding claimed trading strategies; and improper valuation of assets. In some cases we have worked with criminal authorities.

Recent examples of significant cases brought by the Commission include:

* SEC v. Samuel Israel III; Daniel E. Marino; Bayou Management, LLC et al. The Commission alleged that the advisers of a Connecticut-based group of hedge funds defrauded investors in the funds and misappropriated millions of dollars in investor assets for their personal use. Over $450 million was raised from investors. The advisers issued fictitious account statements to investors and used a sham accounting firm to forge audited financial statements in order to hide substantial losses. These losses resulted from, among other things, the theft of funds by the advisers who withdrew “incentive fees” to which they were not entitled. On September 29, 2005, the Commission filed an action in U.S. District Court seeking injunctions, disgorgement of ill-gotten gains, prejudgment interest, and civil money penalties.10 Also on that date, Israel and Marino pleaded guilty in a companion criminal case. They have not yet been sentenced. On April 19, 2006, the defendants in the civil case consented to an order permanently enjoining them from future violations of the antifraud statutes of the federal securities laws.11

* SEC v. Sharon E. Vaughn and Directors Financial Group, Ltd. The Commission alleged that an Illinois hedge fund adviser registered with the Commission defrauded fund investors by improperly investing fund assets in a fraudulent “prime bank” trading scheme contrary to the fund’s disclosed trading strategy. According to the Commission’s complaint, the adviser and its principal had an undisclosed profit sharing agreement with one of the trading program promoters. The adviser and principal consented to injunctions and agreed to disgorgement of over $800,000.12 As a result of the SEC’s action and a subsequent criminal action brought by the U.S. Attorney’s office involving individuals associated with the trading program, hedge fund investors were returned most of their principal investment and profits prior to investment in the trading program.

a. New Registration Requirement

Until recently, registration with the Commission was optional for many hedge fund advisers. In February of this year, new rules became effective that require that most hedge fund advisers register with the Commission under the Advisers Act.13 The new rules do not regulate hedge fund strategies, risks or investments. The new rules have given the Commission basic census data about hedge fund advisers. In addition, registration has required hedge fund advisers to implement compliance programs to prevent, detect and correct compliance violations and to designate a chief compliance officer to administer each adviser’s compliance program. Registration also has provided the Commission authority to conduct compliance examinations of registered hedge fund advisers. Based upon registration data we now know that 24% of the 10,000 investment advisers currently registered with the Commission advise at least one hedge fund. Of the 2,456 hedge fund advisers registered with us as of the end of April, 1,179 (45%) registered in response to the new rule.14 The vast majority of the hedge fund advisers (88%) registered with the Commission are domiciled in the United States.

b. Examinations

As mentioned above, registered hedge fund advisers may be subject to on-site compliance examinations by SEC examiners in the Office of Compliance Inspections and Examinations (OCIE). The SEC maintains a risk-based examination program, and determines which firms to examine based on their risk characteristics. Hedge fund advisers have been included in the same pool as other registered advisers, and thus, like other advisers, the staff determines which firms to examine based on the compliance risks the firm presents to investors. Examination staff are working with the Division of Investment Management and Office of Risk Assessment to develop improved metrics to assess the compliance risks of registered advisers in order to continue to focus our exam resources. In addition, OCIE has developed a specialized training program to better familiarize examiners with the operation of hedge funds and thus improve the effectiveness of our examination of hedge fund advisers.

During a routine compliance examination, the staff reviews the effectiveness of the compliance controls that every registered investment adviser must have in place to prevent or detect violations of the federal securities laws. In those areas where controls appear to be weak, our examiners will obtain additional information to determine if the weak control environment has resulted in a violation of the securities laws. The staff also reviews disclosure documents, including any private placement memoranda provided to hedge fund investors, to determine whether the disclosure appears to accurately reflect the hedge fund adviser’s management of the fund. In addition, the staff identifies areas of potential conflicts of interest with respect to the hedge fund adviser and the fund that it advises to determine whether appropriate disclosure has been made.

It is the staff’s experience that many of the compliance issues raised by an adviser’s management of a hedge fund are similar to those raised by other advisers’ asset management activities. For example, these compliance issues include: the use of soft dollar arrangements, the allocation of investment opportunities among clients, the valuation of securities, the calculation of performance, and the safeguards over customers’ assets and non-public information. In this regard, let me identify a few areas in which we plan to focus our examinations of hedge fund advisers:

Side-by-Side Management. Some hedge fund managers also advise other types of advisory accounts, including mutual funds.15 Because the adviser’s fee from the hedge fund is based in large measure on the fund’s performance-and because the adviser typically invests heavily in the hedge fund itself, this “side-by-side” management presents significant conflicts of interest that could lead the adviser to favor the hedge fund over other clients. The staff will focus on whether the hedge fund manager appears to have sufficient controls in place to prevent such bias and whether, in fact, the adviser has favored its hedge funds over other clients.

Valuation of Fund Assets. A hedge fund manager typically values the assets of the hedge fund using the market value of those securities. When the fund holds publicly traded securities, that process is fairly simple. Many hedge funds, however, own thinly traded securities and derivative instruments whose valuation can be very complicated and, in some cases, highly subjective. Unlike a mutual fund, hedge fund valuation practices are not overseen by an independent board of directors. A number of the Commission’s enforcement cases against hedge fund advisers involve the adviser’s valuation of fund assets in order to hide losses or to artificially boost performance. Thus, a review of valuation policies and practices is a key element of hedge fund adviser examinations.

Custody of Fund Assets. A hedge fund manager typically has access to and directs the use of fund assets. Such access presents a significant risk to fund investors — as demonstrated in a number of the Commission’s enforcement actions involving theft or misuse of fund assets by a hedge fund manager. Therefore, Commission examiners focus attention on the controls used to protect fund assets.

2. Market Abuse

Hedge fund advisers’ active trading plays an important role in our capital markets. The federal securities laws and Commission regulations establish rules designed to prevent market abuses. When market activity by hedge fund advisers-like any other participant in the securities markets-crosses the line and violates the law, the Commission has taken appropriate remedial action. In the past year, the Commission has brought enforcement actions against hedge fund advisers for a variety of market abuses, including insider trading, improper activities in connection with short sales, market manipulation, scalping, and fraudulent market timing and late trading of mutual funds.

Recent significant cases have included:

* In the Matter of Millennium Partners, L.P., Millennium Management, L.L.C., Millennium International Management, L.L.C., Israel Englander, Terence Feeney, Fred Stone, and Kovan Pillai. The Commission brought an action against hedge fund managers alleging that the managers generated tens of millions of dollars in profits for their hedge funds through deceptive and fraudulent market timing of mutual funds at the expense of the mutual funds and their shareholders. The adviser and its principals agreed to disgorgement and civil monetary penalties, and have undertaken to implement particular compliance, legal, and ethics oversight measures.16

* SEC v. Hilary Shane. The Commission alleged a particular type of insider trading involving a PIPE transaction, where the hedge fund adviser agreed to buy shares of a public company in a private offering – a transaction that the Commission alleged was likely to have a significant dilutive effect on the value of the company’s shares – and then misused information she had been given (and which she had agreed to keep confidential) about the private offering by short-selling the company’s shares. The adviser agreed to disgorge the trading profits, paid a civil penalty, and has consented to be barred from the broker-dealer industry and suspended from the investment advisory industry.17

* SEC v. Scott R. Sacane, et al. The Commission alleged that hedge fund advisers manipulated the market by creating the appearance of greater demand for two stocks than actually existed. The individual defendants in this case have both pled guilty to related criminal charges and have been barred by the Commission from associating with an investment adviser. In addition, one of the defendants has agreed to pay disgorgement and a civil penalty in the Commission’s civil action, which remains pending against the other defendants.18

Not only has the Commission brought enforcement actions against the hedge funds and hedge fund advisers that engage in these transactions, it has brought actions against fund service providers who facilitated these unlawful securities trading activities. Recently, for example, we settled an enforcement action against a large broker-dealer that helped hedge funds foil the efforts of mutual funds to detect the hedge funds’ market timing, and made it possible for certain favored hedge fund clients to “late trade” mutual fund shares.19

3. Risks to Broker-Dealers

Hedge funds can (although we understand many do not) make significant use of leverage. Most hedge funds use one or more “prime brokers,” which provide clearing and related services to the fund and its adviser. One core service prime brokers offer their hedge fund customers is secured financing, notably margin lending, where the hedge fund borrows from the prime broker in order to buy securities, which then serve as collateral for the loan.20

The Commission continues to focus attention on broker-dealers’ exposure to hedge fund risks and the broader implications this aspect of the financial system may have. The Commission staff meets regularly with other members of the President’s Working Group on Financial Markets, and works with the industry members that comprise the Counterparty Risk Management Policy Group. In addition, the Commission’s consolidated supervision program for certain investment banks now allows the staff to examine not only the broker-dealer entities within a group, but also the unregulated affiliates and holding company where certain financing transactions with hedge funds are generally booked. Commission staff meets at least monthly with senior risk managers at these broker-dealer holding companies to review material risk exposures, including those resulting from hedge fund financing and those related to sectors in which hedge funds are highly active.

IV. Looking Forward

As a result of our recently-implemented hedge fund adviser registration rulemaking, the Commission now has more data about hedge funds and their advisers. The staff is in the process of evaluating those data and considering methods to refine its ability to target our examination resources by more precisely identifying those advisers, including hedge fund advisers, that pose greater compliance risks.

In addition, the Commission staff is working with the United Kingdom’s Financial Services Authority, to coordinate policy and oversight of the 165 hedge fund advisers registered with the Commission that are located in the United Kingdom. The staff also expects to coordinate examinations with the Commodity Futures Trading Commission (CFTC). To that end, we recently provided information to the CFTC indicating the identities of hedge fund advisers registered with the Commission who report on their registration forms that they are also actively engaged in commodities business (approximately 350 firms).

V. Conclusion

In conclusion, I would like to thank the Subcommittee for holding this hearing on a subject of growing importance to us and to all American investors. Hedge funds play an important role in our financial markets. With respect to hedge funds, their advisers and all market participants, the Commission will continue to enforce vigorously the federal securities laws.

Endnotes

1 Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission (Sept. 2003), available at http://www.sec.gov/news/studies/hedgefunds0903.pdf.

2 A recent study reported that 78% of institutional investors surveyed said that hedge funds reduced the volatility of their portfolio. State Street Corporation, Hedge Fund Research Study (Mar. 2006) at 4.

3 See Hedge Fund Research, HFR Q1 2006 Industry Report.

4 See Hedge Fund Research, HFR Q1 2006 Industry Report. During 2005, 848 funds were liquidated. Id.

5 Van Hedge Fund Advisers, International, LLC, Hedge Fund Demand and Capacity 2005-2015 (Aug. 2005).

6 See Hennessee Group, 2004 Hennessee Hedge Fund Survey of Foundations and Endowments (reporting that the investors surveyed had an average commitment of 17% of assets, and a projected commitment of 19% by 2005).

7 See Nicholas Chan, Mila Getmansky, Shane M. Haas, and Andrew W. Lo, “Systemic Risk and Hedge Funds,” (Aug. 1, 2005) (unpublished manuscript, to appear in M. Carey and R. Stulz, eds., The Risks of Financial Institutions and the Financial Sector, Chicago, IL: University of Chicago Press).

8 See Pam Abramowitz, “Trade Secrets,” Institutional Investor’s Alpha, January/February 2006.

9 Mara Der Hovanesian, “Attack of the Hungry Hedge Funds,” Business Week (Feb. 2006); Henry Sender, “Hedge Funds: The New Corporate Activists–Investment Vehicles Amass Clout In Public Firms, Then Demand Management Boost Share Price,” The Wall Street Journal (May 13, 2005).

10 Litigation Release No. 19406 (Sept. 29, 2005).

11 Litigation Release No. 19692 (May 9, 2006).

12 Litigation Release No. 19589 (Mar. 3, 2006).

13 The Commission’s recent rulemaking required certain hedge fund advisers to register as investment advisers with the Commission under the Investment Advisers Act of 1940, under which registration previously had been optional for many hedge fund advisers. Commissioners Glassman and Atkins dissented from the rulemaking. Registration Rule at 72089. With respect to the management of hedge funds whose advisers are registered with the Commission, the Commission in adopting the adviser registration requirement observed that, “The [Advisers] Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments.” Registration Rule at section II.A. [Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2, 2004), 69 FR at 72060, petition for review filed (D.C. Cir. No. 04-1434 (argued Dec. 9, 2005). (“Registration Rule”).]

14 Registration forms indicate that these advisers report just over 13,000 hedge funds with aggregate assets of about $2 trillion. Because reported assets include assets of “feeder” funds as well as “master” funds in which they invest, total reported assets likely are higher than if assets of “feeder” funds were excluded.

15 Almost 15% (379) of the hedge fund advisers registered with the Commission report that they also advise at least one mutual fund.

16 Investment Advisers Act Release No. 2453 (Dec. 1, 2005).

17 Litigation Release No. 19227 (May 18, 2005). Because she entered into the short sales prior to the effective date of the registration statement for the PIPE and then covered her short sales with those she obtained in the PIPE offering, the Commission also alleged that Ms. Shane violated section 5 of the Securities Act.

18 Litigation Release No. 19424 (Oct. 12, 2005). See also In the Matter of Scott R. Sacane, Investment Advisers Act Release No. 2483 (Feb. 8, 2006); In the Matter of J. Douglas Schmidt, Investment Advisers Act Release No. 2491 (Feb. 28, 2006); SEC v. Scott R. Sacane, et al., Litigation Release No. 19515 (Dec. 22, 2005); SEC v. Scott R. Sacane, et al., Litigation Release No. 19605 (Mar. 9, 2006).

19 In the Matter of Bear, Stearns & Co., Inc., and Bear, Stearns Securities Corp., Securities Act Release No. 8668 (Mar. 16, 2006) (defendants agreed to censure, payment of disgorgement and civil monetary penalties, and have undertaken to implement particular compliance oversight measures).

20 Prime brokers may also structure these financing transactions as repurchase agreements, where they buy the securities from the hedge fund subject to the fund’s obligation to repurchase the securities from the broker in the future at a specified price. Prime brokers may also produce similar economics through the use of over-the-counter derivative contracts with hedge funds.

Hedge Fund Prime Brokerage

9 Replies

Hedge fund prime brokerage is provided by a prime broker. While the central service the prime broker provides to a hedge fund is trading services, the prime broker provides many other services to hedge funds as well.

Trading and execution

Generally a hedge fund prime broker will act as a hedge fund’s central broker and will execute most of the hedge fund’s trades. Many prime brokers have online interfaces and/ or programs which allow a manager to automate many trades. Additionally, the prime broker will be able to execute trades in large blocks and will also be able to execute trades in illiquid securities for the fund.

Custodial and settlement services

One of the main advantages of having a prime broker is that the broker will act as a custodian of the fund’s assets. If the hedge fund executes trades through other brokers, the prime broker’s back office will work with the back office of the executing broker-dealer to make sure that the assets are settled and transferred over to the fund’s account at the prime broker.

There are a couple of advantages of having the assets custodialized at one institution: (i) reporting of the fund’s positions is easier when there is one custodian and (ii) the prime broker can use all of the fund’s assets for margin purposes (instead of simply part of the fund’s assets if there are multiple brokers or custodians).

Other Services

In addition to custodial and execution services, the prime broker can provide a whole host of other services including:

Leverage and margin – prime brokers can provide the fund with leverage and margin, depending on the fund’s investment program and circumstances.

Short sales – prime brokers generally have a “short box” of securities which can be borrowed to be sold short.

IPOs – prime brokers will often have access to initial public offerings. Some hedge funds will choose a prime broker based on the broker’s ability to allocate IPOs to the fund.

Capital introduction – a prime broker may, in certain circumstances, introduce potential investors to the hedge fund.

Reporting – the prime broker can produce period reports which can be sent to the hedge fund administrator or to hedge fund investors.

Soft dollars – the prime broker may be able to provide certain research and other items to the hedge fund manager. Under revised soft dollar guidance, soft dollars cannot be used for non-research items such as computer equipment or rent for the hedge fund’s management company.

Office space and IT support – some prime brokers (and other broker-dealers) will provide office space and IT support for hedge funds. Such arrangements are often called by the perjorative term “hedge fund hotels.”

Stress test analysis and other portfolio monitoring

Joint Back Office (JBO) arrangements – these arrangements allow a hedge fund to receive more margin by becoming a broker-dealer. These arrangements used to be more popular but the margin rules changed to a risk-based model which, for many hedge funds, abrogated the need for many JBO arrangements.

Deciding on a prime broker

The prime broker is definitely a major piece of the hedge fund puzzle. You should discuss prime brokers with your hedge fund attorney; your attorney will be able to give you some recommendations based on your trading program and other factors. Please contact us if you have any questions.

New Hedge Fund Regulations – SEC to Conduct Roundtable Today

Hedge Fund Law Blog

Hedge fund laws, starting a hedge fund, news and events…