There are many reasons why a registered investment advisor will choose to become a hedge fund manager.  Or, manage a hedge fund in addition to managing separately managed accounts.  Besides higher fees, there are other advantages of the hedge fund structure over the traditional asset management business.

Advantages of the Hedge Fund Structure

The three central advantages of the hedge fund structure over the separately managed account structure are (1) ease of management, (2) potentially lower transaction costs, and (3) tax efficiencies.

1.  Ease of management – one of the great things about running a hedge fund is that the manager only has to manage one single brokerage account.  With a separately managed account business a manager will need to make separate trades for each account or do a block trade and then allocate the trade among a number of clients.  Either way the separately managed account manager is subject to much more back office and paperwork which is not only time consuming, but costly as well.

2.  Potentially lower costs – depending on the structure, the hedge fund structure could potentially save on costs to the account holders.  Whereas the individual accounts would be subject to trading fees on each transaction, the costs are lower for the hedge fund which only manages one account.

3.  Tax efficiencies – probably one of the more attractive aspects for an advisor to a hedge fund is the ability for the manager to receive more attractive tax results.  As a general partner in the hedge fund, the manager will generally receive an “allocation” of income instead of a fee.   When the manager receives an “allocation” instead of a fee then the underlying tax attributes will remain.  That is to say if the fund allocates the manager gains and a portion of those gains are characterized as long term at the fund level, then the gains will also be long term for the manager which will result in a lower tax bill.  In a separately managed account structure the manager would not be able to get the allocation.

Other Potential Hedge Fund Structure Advantages

In addition there is the possibility that the manager which was registered as an investment adviser with the SEC or state securities commission would not need to be registered.  For example if a manager had 20 SMA clients and managed more than $30 million, it would be required to register with the SEC.   However, if all of the clients subscribed to a hedge fund managed by the manager, the manager would not need to be required to register with the SEC because of the exemption from registration provided by Section 203(b)(3) of the Investment Advisers Act of 1940.

One of the other things to note is that in the hedge fund structure the manager will usually invest alongside the investors.  Sometimes the investment can represent a large percentage of the manager’s liquid net worth; this should provide some comfort to investors to know that the manager’s interests are aligned with their own.  This is not usually present in the typical separately managed account structure.

Potential Objections from Separate Account Clients

Generally the above Most of the above benefit the manager instead of the SMA client, who will lose transparency and freedom to pull assets at any time.  For a manager switching SMA clients to a hedge fund clients they may encounter these objections – in these instances the maanger may decided to accommodate the client by providing certain transparency or liquidity preferences to the (former) SMA client through a side letter arrangement.

Please contact us if you have a question or would like to start up a hedge fund.  Related HFLB articles:

• Overview of Hedge Fund Investment Advisors
• Hedge Fund Side Letters
• Hedge Fund Separately Managed Accounts