Category Archives: Hedge Fund Structure

Hedge Fund Carried Interest Tax Increase?

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Legislation Introduced to Eliminate Carried Interest “Loophole”

As we are all well aware, the partnership structure of hedge funds allows the management companies of these funds to receive an “allocation” of the fund’s income.  Under general partnership taxation principles, this allocation is taxed to the management company (and the other investors in the hedge fund) according to the characteristic of that income (at the partnership level).  That is, if the income was long-term capital gain at the partnership level, such income would be allocated to all partners (including the management company) and would retain such characterization.  Long-term capital gains are currently taxed at 15% (as compared to a 35% tax rate for most ordinary income).

Last week Representative Sander Levin reintroduced legislation to tax the carried interest at ordinary tax rates.  The tax would only apply to the managers of partnerships to the extent that such managers did not have an underlying investment in the fund.  I will not introduce any political opinions regarding such a tax, but I will note that I take issue with the way that the press and lawmakers define the issue.  The most glaring omission in all of these reports is that the carried interest (or performance allocation) is only taxed at long-term capital gains rates if there are underlying long-term capital gains.  These articles (including the press release reprinted below) insinuate that all allocations made to a manager will be subject to long-term capital gains rates.  Not all income to hedge funds is long term capital gain – in fact, many hedge funds have no long-term capital gains at all because their programs focus on short term or intermediate term trades.

We have discussed this issue a number of times before and believe that the best way for this issue to be addressed is through the political process and we hope that all lawmakers involved take a considered and academic approach when crafting any future tax legislation (see Hedge Fund Taxes may Increase Under Obama).

The press release below is from the office of Representative Sander Levin and provides a sort of question and answer regarding the proposed legislation.  I am interested to read your comments on this issue below.

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For Immediate Release
April 3, 2009

FOR MORE INFORMATION:
Hilarie Chambers
Office: 202.225.4961

Levin Reintroduces Carried Interest Tax Reform Legislation

Bill to Tax Fund Managers’ Compensation at Same Rates as All Americans

(Washington D.C.)- Rep. Sander Levin today reintroduced legislation to tax carried interest compensation at the same ordinary income tax rates paid by other Americans.  Currently, the managers of private investment partnerships are able to receive compensation for these services at the much lower capital gains tax rate rather that the ordinary income tax rate by virtue of their fund’s partnership structure.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money.  They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%.  The President’s budget recognizes that this is unfair.  The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law.”

The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.

“This proposal is not about taxing investment, it’s about ensuring that all compensation is treated equally for tax purposes.  Anyone who actually invests money in these funds will continue to receive capital gains treatment, including the managers.  So there is no reason to expect that the amount of capital available for these kinds of investments will be reduced,” concluded Levin.

Levin introduced similar legislation in the 110th Congress, which was subsequently included in several tax packages approved by the Ways & Means Committee and the House of Representatives.  A similar proposal is also included in President Obama’s FY 2010 budget request.

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Levin Carried Interest Legislation – H.R. 1935

H.R. 1935 would treat the “carried interest” compensation received by investment fund managers as ordinary income rather than capital gains.  In exchange for providing the service of managing their investors’ assets, fund managers often they receive a portion of the fund’s profits, or carried interest, usually 20 percent.  H.R. 1935 clarifies that this income is subject to ordinary income tax rates rather than the much lower capital gains rate.

Carried Interest: The Basics

Why is Congress concerned about this issue?

Many investment funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner.  The managers often take a considerable portion of their compensation for managing the funds’ investments as a share of the funds’ profits using a mechanism called “carried interest.”  Partnership profits are taxed not to the partnership; instead partners are taxed on allocations of partnership income, and the nature of that income (capital or ordinary) “flows-through” to the partners.  As a result, the investment managers are able to have income for performance of services taxed at the 15% capital gains rate.  Essentially they are able to pay a lower tax rate on income from their work than other Americans simply because of the structure of their firm.

What does the legislation do?

It clarifies that any income received from a partnership, capital or otherwise, in compensation for services is ordinary income for tax purposes.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested in the partnership.

What kinds of investment firms will be affected?

This is part of a broad consideration of tax fairness.  The principle at work is that compensation for services should be treated as ordinary income and taxed accordingly, regardless of its source.  Any investment management firm that takes a share of an investment fund’s profits as its compensation (i.e. in the form of carried interest), will be affected.  This will apply to any investment management firm without regard to the type of assets, whether they are financial assets or real estate.  The test is the form of compensation, not the type of assets the firm is managing, its investment strategy, or the amount of compensation involved.

What is the effective date of the legislation?

This legislation is designed to create a structure under which this income should be taxed.  Decisions on the effective date will be made as part of the legislative process.

Carried Interest: Myths vs. Facts

Myth: This is a tax increase on investment that will hurt economic growth.

Fact: Investors are not affected by this legislation at all.

Any person or institution who invests money in a fund whose managers receive a carried interest will continue to pay the capital gains rate on their profits.  In fact, the bill explicitly protects the investments that fund managers make themselves.  To the extent they have put their own money in the fund, managers still get capital gains treatment, but to the extent they are being compensated for managing the fund, they will have to pay ordinary income tax rates like other service providers.   Since investors are not affected, there is no reason to believe that the amount of capital available for these kinds of investments will be reduced at all.

Myth: Taxing carried interest is just about raising revenue.

Fact: Fairness requires treating all taxpayers who provide services the same.

This proposal would raise revenue, but it is not just an offset.  Congress has a responsibility ensure that our tax code is fair, that it makes sense.  A broad spectrum of experts, including the Chairman of the Cato Institute and senior economic advisors to the last three Republican Presidents, agree that carried interest really represents a performance based fee that investors are paying to fund managers and that it should be taxed accordingly.  Allowing some service providers to pay the 15 percent capital gains rate on their income when everyone else has to pay up to 35 percent risks undermining people’s confidence in our voluntary tax system.

Myth: Fund Managers are just like entrepreneurs who get founder’s stock in their company, so they too should be taxed at the capital gains rate.

Fact: Fund Managers are fundamentally different than the founder of a company.

When someone starts an enterprise, he or she actually owns that business.  Sometimes that business becomes enormously valuable, but quite often it fails altogether and the entrepreneur loses her business. When an investment partnership purchases an asset, be it a stake in a small start-up company, a large corporation that wants to go private, a portfolio of securities, or a piece of real estate, the partnership does truly own those assets.  The general partner or fund manager though is really only an “owner” to the extent he or she has contributed capital to the partnership.  The carried interest the general partner receives for managing the fund’s assets is a right to a portion of the fund’s profit, not to the fund’s actual assets: the manager has no downside risk.  If the fund fails completely and all of the partnership’s assets are lost, the limited partners have lost their money.  The manager has lost the time and energy he has put into the running the fund, and the potential to share in the profits, but he is not actually out of pocket.

Myth: Fund managers deserve capital gains treatment because a carried interest is risky.

Fact: Many other forms of compensation are risky, and they are all ordinary income.

When a company gives its CEO stock options, it is trying to give her an incentive to increase the company’s share price, to growth the value of shareholders’ investment.  If the CEO does a good job and the share price goes up, she pays ordinary income tax rates when she exercises those options.  Real estate agents only make money if they actually sell a house, no matter how hard they work.  Authors receive a portion of their book’s profits.  Waiters get tips based on the quality of the service they provide.  All of these people pay ordinary income tax rates on their compensation.  Only private equity and other fund managers get to pay capital gains rates on their compensation.

Myth: Taxing carried interest will hurt the pension funds that invest in these funds.

Fact: This has nothing to do with pension funds and their returns will not be affected.

One pension trustee, who also happens to be a hedge fund manager, called the idea that this debate is about workers’ pensions “ludicrous.”  As tax-exempt investors, pension fund certainly will not be affected directly, and the assumption that fund managers can charge higher fees than they do today as a result of their having to pay ordinary income rates is extremely questionable. In fact, an attorney representing the hedge fund industry testified before the Ways & Means Committee that investors would be unlikely to accept increased fees.  The National Conference on Public Employee Retirement Systems has said that its members do not believe this legislation will affect them.

Myth: This change to the taxation of carried interest will harm every “mom and pop” partnership in America.

Fact: The change would only affect those partnerships where service income is being improperly converted to capital gains.

This legislation would have no effect whatsoever on the vast majority of partnerships that are engaged in ongoing businesses and whose profits are already being properly taxed an ordinary income tax rates.  It does apply to investment fund partnerships where the investors in the fund choose to compensate the people managing their assets through a carried interest.  In practice, this means hedge funds, private equity funds, venture capital funds and real estate partnerships.  The reality is that the fund managers and general partners who would be asked to pay ordinary income tax rates on their compensation are a very small, very well-paid group of professionals.  It is also important to note that the bill does not discriminate among partnerships based on the kind of assets they purchase.

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Other related hedge fund tax articles:

MFA Releases Sound Practices Guide for Hedge Funds

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Guide Focuses on Hedge Fund Risk Management and Other Operational Issues

Unfortunately the new world of hedge fund investing and hedge fund due diligence has become more complicated and hedge fund management companies now need to increase their focus on operational and business issues.  While many managers are happy to attend to their trading strategies and risk management procedures, the managers who will be able to grow their AUM most successfully in the coming years are those managers who focus on many of the business and operational issues which investors are now wholly concerned with.  The updated 2009 Sound Practices guide by the Managed Funds Association (press release below) provides an outline of the major issues which managers should address with respect to their businesses.

Overview of Sound Practices Guide

The Sound Practices guide is similar to the President’s Working Group report Hedge Fund Best Practices, but also includes more information for managers.  I skimmed through the Sound Practices guide (it is 277 pages) and found that much of the information is extremely useful.  One of the overarching themes of the guide is that it does not ask managers to take the “one size fits all” approach, but asks managers to individually assess whether or not a certain practice is appropriate for their particular business.

I found the section dealing with the disclosures and hedge fund offering documents particular good.  As a reminder to hedge fund managers, offering documents should be updated at least annually, or more frequently if there are material changes in the fund’s investment program, structure or management company.  Additionally, any changes to offering documents should be communicated to all existing investors (either by sending out a new PPM or through another type of disclosure).

Other sections I was particularly interested in were: (i) the section dealing with investor letters and communications, (ii) side letters and parallel separately managed accounts (which are becoming more popular), (iii) valuation and policies, (iv) risk management, (v) due diligence, (vi) AML.  A due diligence guide for hedge fund investors was also included, but I felt like this was a pretty weak DD questionnaire – managers are likely to receive much more detailed requests for information.

Recommendation for Hedge Fund Managers

I recommend that hedge fund managers who are immediately seeking capital from institutions and high net worth investors read through this Sound Practices guide and take notes.  Managers should reach each practice and asses whether it applies to their fund operations and, if so, how such a practice should be implemented.  Managers may want to highlight certain items and ask their attorney what they should do.  These sound practices will help managers to create strong businesses which are able to grow over the long run.

[http://www.hedgefundlawblog.com]

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Managed Funds Association Takes Steps to Restore Investor Confidence with Enhanced Best Practices & Investor Due Diligence Recommendations

WASHINGTON, Mar 31, 2009 — Managed Funds Association (MFA) today took steps to restore investor confidence in the markets with the release of its newly enhanced Sound Practices for Hedge Fund Managers, including a due diligence questionnaire for investors to use as they consider whom to trust with their investments.

The 2009 edition of Sound Practices, MFA’s fifth version of its pioneering guidance that was first published in 2000, incorporates the recommendations provided in the final President’s Working Group’s (PWG) Best Practices for the Hedge Fund Industry Report of the Asset Managers’ Committee plus additional guidance that goes above and beyond the scope of those recommendations.

Richard H. Baker, MFA President and CEO, said, “The hedge fund industry has a strong role in helping to restore financial stability and investor confidence, and to hasten economic recovery. While policy makers consider sweeping regulatory reforms in the U.S. and abroad, and economic leaders gather for the G-20 in London, on April 2, the hedge fund industry is taking steps to restore investor trust through the promotion of sound business practices and tools for investors to use as they conduct ongoing due diligence of money managers.”

Sound Practices is the cornerstone of the Association’s initiative to collaborate with international organizations with the goal of establishing uniform global principles and guidance. MFA, the PWG Asset Managers’ Committee and the Alternative Investment Management Association (AIMA) have committed to providing the Financial Stability Forum (FSF) with a set of unified principles of best practices before April 30, 2009.

“The hedge fund industry recognizes its responsibilities as liquidity providers and risk dispersers in the markets, and continues to take the lead in its approach to disclosure and investor protection as well as active market disciplines such as risk management and valuation which contribute to market soundness and investor protection. This latest edition of MFA’s seminal Sound Practices concludes many months of diligent work by leading hedge fund managers, service providers and MFA staff to provide updates and revisions for voluntary adoption by hedge fund managers.

“MFA has a decade-long tradition of robust Sound Practices. Today, more than ever before, investors will benefit from our due diligence questionnaire as they undertake robust diligence when considering an investment in a hedge fund. Investors can also benefit from reviewing the recommendations in Sound Practices as they consider operational, governance and other matters as part of their diligence when making an investment.” added Baker.

The 2009 edition of Sound Practices provides comprehensive updates in every area of guidance including recommendations for disclosure and responsibilities to investors; valuation policies and procedures; risk management; trading and business operations; compliance, conflicts of interest, and business practices; anti-money laundering; and business continuity and disaster recovery practices.

Major Revisions

Sound Practices is a dynamic blueprint written by the industry, for the industry, to provide peer-to-peer guidance to:

  • Strengthen business practices of the hedge fund industry through a strong framework of internal policies and practices;
  • Encourage individualized assessment and application of recommendations on one size does not fit all; and
  • Enhance market discipline in the global financial marketplace.

The revised edition includes substantially updated and expanded guidance in seven areas:

  • Disclosure and Investor Protection: Establishes practices intended to assist a hedge fund in fulfilling its responsibilities to its investors;
  • Valuation: Establishes a framework, governance and policies and procedures for valuations of assets;
  • Risk Management: Establishes an overall approach to risk monitoring, measurement and management. Also describes types of risk and recommendations on management thereof;
  • Trading and Business Operations: Establishes policies and procedures for management of trading operations including relationships with counterparties, use of service providers, accounting, technology, best execution and soft dollar arrangements;
  • Compliance, Conflicts and Business Practices: Establishes guidance for the adoption of a culture of compliance including a code of ethics, compliance manual, record keeping, conflicts of interest, training/education of personnel and more;
  • Anti-Money Laundering: Updates MFA’s seminal AML guidance; and
  • Business Continuity/Disaster Recovery: Establishes general principles, contingency planning, crisis management and disaster recovery.

Baker noted that, “Ultimately, each hedge fund manager must determine whether and how to tailor these Sound Practices to its individual business. We believe that the strong business practices in Sound Practices are an important complement to a smart regulatory framework and that strong business practices and robust investor diligence are critical to addressing investor protection concerns.”

For a copy of Sound Practices please visit: www.managedfunds.org

About Managed Funds Association

MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the primary source of information for policy makers and the media and the leading advocate for sound business practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York. For more information, please visit: www.managedfunds.org

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Other related hedge fund law articles include

Bunched Orders and Separately Managed Accounts

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Separately Managed Account Managers May Bunch Orders for Better Execution

One reason why the hedge fund structure is so popular with investment managers is that a single investment strategy can be implemented in one account.  Separately managed account managers, however, often have multiple accounts and need to execute the same transaction in each of those separate accounts.  Not only is this more time consuming than entering a single trade, there is the possibility that some accounts would receive poorer execution than other accounts (if the trades cannot all be executed for the same prices).  To combat this problem, many brokers offer “bunched” orders which allow a manager to enter into a trade (or series of trades) and then allocate those trades to individual accounts pursuant to a pre-defined allocation method.  In this way trades are allocated to accounts in what may be deemed a more “fair” way.

Types of Bunched Account Allocation Methods

In the event a bunched order is not filled at one total price (called a “partial fill”), there are two central ways to allocate trades to individual accounts from a bunched order – average pricing or high-low.

Average Pricing

Under the average pricing method, the broker’s back end will add up all of the buys or sells at their particular price levels, multiply the trades by the number of contracts (or securities) at each particular price level, and divide by the total number of contracts (or securities) to determine an average price for the whole bunched order.  The trades are allocated to the individual accounts and the price for the trade will reflect the average price.

High low

Under the high-low method, the higher fill prices will be allocated to the higher account numbered clients for both buys and sells, and the lower fill prices to the lower account numbered clients for both purchases and sales.

Issues for CTAs and Investment Advisors

Generally, separately managed accounts fit within the realm of commodity trading advisors and investment advisors.  However, many hedge fund managers are beginning to take on separately managed account clients as well.  The central issue for any of these managers is going to be how the allocation process is described in the investment advisory brochure/contract, disclosure documents or offering documents.  Managers will need to make sure that this issue has been discussed with both the attorney and the broker so that everyone is aware of the actual mechanics of the allocation.  Additionally, I recommend that the broker’s back office review the disclosure documents to ensure that the allocation language is accurate and precise.  If the offering documents state one method and the broker uses another method, there may be some liability for the manager.  Additionally, if the manager is ever subject to examiniation by the SEC, NFA or state securities division, this could be a topic for review.

For hedge fund investors, part of your due diligence process should be to find out whether a hedge fund manager also manages separately managed accounts with the same investment program as the fund.  If so, the investors should ask the manager to explain the allocation process for trades.  While this should be disclosed in the offering documents I have a hunch that this issue is often overlooked by many funds – especially those funds which enter into the SMA agreements after the fund has been in business for a period of time.

Please feel free to contact us if you have any questions on this article or if you are interested in starting a hedge fund.  Other related articles include:

Hedge Fund Start Up Presentation

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How to Start a Hedge Fund in 2009

Below is a link to a powerpoint presentation in which I detail the background information a hedge fund manager must have prior to starting the hedge fund formation process.  The presentation is designed to familiarize a manager with the process of forming a fund while identifying potential issues which the manager should be aware of during the process.

The presentation is 18 slides long and is about 40 minutes.  I will also be posting a video here shortly.

Hedge Fund Presentation with Voice

Starting a hedge fund in 2009 (voice) (voice-over powerpoint)

For more viewing options, please see our Hedge Fund Lawyer youtube profile.

Hedge Fund Presentation without Voice
Starting a Hedge Fund

Thoughts on Hedge Fund Offering Documents

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FAQs on Offering Documents

I recently read an article by a hedge fund administration firm which discussed hedge fund offering documents and start up hedge fund expenses.  I thought this was an interesting topic and one which is popular with many of my start up clients.  Below I discuss some of the common questions regarding the offering documents and also provide reasons why a start up manager should use my law firm for starting a hedge fund.

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Offering documents are just boilerplate – why are they so expensive?

This is a common misperception.  Offering documents (if done correctly) are not merely boilerplate where the attorney pops in the fund name and the address – offering documents are a tailored to the specific needs of the client based on the client’s investment program and fund structure.

For instance, there are at least 12 different questions related to the management fee and performance fee/ performance allocation.  There are at least 22 different questions related to the fund’s contribution periods and withdrawal periods.  This level of customization does not come from a boilerplate form.  Furthermore, many of these questions or options may have specific implications for the manager’s business either from a legal standpoint or a business standpoint.  Many times the lawyer will need to have an in-depth discussion with the manager to help the manager determine which option is right for the fund.

Why are offering documents so long?

Offering documents are long – there is no getting around it.  The structure of the offering documents are determined by the federal and state securities laws and thus there is not really any wiggle room.  While it is often said that the hedge fund industry is “not regulated” or “lightly regulated” there are many hedge fund laws and regulations which managers must follow.   These laws dictate many aspects of the documents and are why offering documents are so long (and also why offering documents from different firms are structured so similarly).

In this prior post, discussing “Prospectus Creep” we discussed the length of offering documents:

4.  Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers.  Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program.  The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents.  However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.


Can I draft offering documents myself?  I have a friend who has some documents I think I can modify.

No.  You should never draft offering documents yourself.  I have seen countless examples of people who have tried to draft their own offering documents based on another fund.  Many times these people will ask me to “check the documents.”  Ninety-five percent of the time a brief skim of the documents will reveal major errors that cannot simply be fixed with a 2 hour review.   In most all occasions the documents will need to be completely scrapped.

Are all law firm offering documents the same?

No, but law firm documents are all very similar.

It is an interesting phenomenon in the hedge fund legal world that attorneys are always interested in (or obsessed with) reading the other law firms offering documents. As one of those lawyers that is very interested in the differences between the offering documents, I have studied the documents from most all of the major hedge fund law firms including the firms listed below which are considered to be the best in the industry.

  • Sidley Austin
  • Shartsis Friese
  • Seward & Kissel
  • Kleinberg, Kaplan, Wolff & Cohen
  • Katten Muchin Rosenman
  • Schulte Roth & Zabel
  • Akin Gump Strauss Hauer & Feld
  • K&L Gates

I have probably read through 500 different offering documents (many from the same large law firms) and have found most documents to be quite similar. For the most part with a name brand firm you are going to get a quality product that is probably pretty equal to another large or name brand law firm.  These documents will very likely protect you in all of the necessary ways.

However, that is not to say that all large law firm offering documents are perfect.  I have seen offering documents which cost over $70,000 with typos and errors.  Many times expensive offering documents are sloppy in certain respects – I expect this is because many large law firms use inexperienced associate attorneys to draft the offering documents.

Does price equal quality?

Not necessarily.  While you are less likely to receive white glove service from a document shop, BigLaw does not necessarily equate to fine quality – especially for small and start up managers.  In a large law firm you are going to probably initially talk with a partner about your program who will then relay the information to an associate who will be in charge of your project.  This means that your offering documents are likely drafted by an overworked associate who has relatively little experience.

I always recommend a start up manager ask the law firm who will be drafting the offering documents and how much experience the person has.  Many large law firms will say that an associate will draft the documents but the partner will review prior to finalization.  I find it hard to believe that a partner will review offering documents – many times this is not true.

Low cost offering documents – are you getting less quality?

In some cases yes, but in the case of my law firm documents the answer is a resounding NO.  While my firm will charge around $13,000 to $18,000 for offering documents (considered to be on the lower end), this does not mean that the quality of my work is less than any other firm.

As I have mentioned before on this site, I have worked with a substantial number of start up hedge funds and have drafted the offering documents or worked on around 150 funds.   Also, I have spent a great deal of time dissecting offering documents from a large number of firms.  My dedication to completely understanding the offering documents, along with my passion for the industry and helping managers with their business issues makes my services a compelling alternative to other firms which may cost more.

Additionally, I value the client relationship and always strive to return emails and phone calls promptly.

Conclusion

While the offering documents are the tangible item which you receive from your hedge fund lawyer, it is not the only part of the representation.  The offering documents are not valuable as objects, but really as a representation of the prior experience of the attorney who prepared those documents for your fund, based on your needs.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about becoming registered as a CPO or CTA, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Fees | Discussion of Future Trends

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The following article is by Christopher Addy, President and CEO of Castle Hall Alternatives, a hedge fund due diligence firm.  We have published a number of pieces by Mr. Addy in the past (please see Hedge Fund Due Diligence Issues, Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).  The following post can be found here.

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Hedge Fund Fees: Is It Worth It To Pay For A Star Hedge Fund?

An article in the current week’s edition of the Economist asks whether one-and-ten will become the new two-and-twenty.

The discussion notes that there will be clear fee pressure on fund of funds.  We will return to the question of fund of funds in a later post: as a quick precis of our views, while Madoff has raised long overdue questions about whether fund of funds really complete due diligence (saying no always gets in the way of making money) we still see plenty of room for fund of funds who genuinely can serve as expert intermediaries.  Fund of funds as a provider of expertise rather than a provider of capacity, and, separately, fund of funds offering funds of managed accounts, both seem like valid models going forward.

For single strategy managers, the Economist makes several points in a single paragraph:

“Those funds with excellent records will manage to maintain their fee rates. Big diversified managers with mediocre performance will have to cut fees to hold on to their assets. Given the “high watermarks” in place, which require that losses be recouped before performance fees can be charged, they may struggle to retain top staff, although they should at least be able to stay in business. The real threat is to smaller operators—half of all hedge funds manage less than $100m. Lower management fees may not cover their fixed costs, such as salaries, accommodation and IT. The era of hedge-fund managers being unable to pay the rent may soon be dawning.”

While these points are valid, we remain very unconvinced by the argument that “those funds with excellent records will manage to maintain their fee rates.”  More precisely, we agree that the largest funds with good performance will likely keep their fee schedules: but we are unconvinced that those fees are worth it when they are above 2 and 20.

If 2008 has shown us anything, it’s that – as we noted in our last post – you can’t rely on a “best of the best” hedge fund to deliver guaranteed performance.

Plenty of articles have been published commenting on the relative performance of some of the industry’s largest funds – Bloomberg in this piece commented on a variety of funds: while there were winners such as Paulson, Brevan Howard and Winton, there were also plenty of losers, notably Citadel.  Another excellent Bloomberg article on Fortress noted that the firm’s Drawbridge Global Macro was down -26% while Drawbridge Special Opportunities lost 18%.  This article from early November commented on performance from a number of funds: it only got worse by year end.  Any hedge fund investor looking down their portfolio sees the same pattern of apparently random winners and losers among what were previously Top 100, star managers.

Ex post, therefore, some big funds funds have proved themselves to be worth their fees.  Plenty of them, however, have proved not to be.  Investors couldn’t predict the winners and losers beforehand during this market crisis: will they somehow be better at picking the big hedge funds that will be winners rather than losers when we have the next Black Swan event?  Why should investors pay, ex ante, excess fees to any hedge fund based solely on a historical track record?

This line of thinking raises some broader questions.  From our side, we have always been very skeptical of the largest hedge funds.  Indeed, back in early November 2007 we wrote a post called “People are spooked…so let’s invest in big hedge funds.  Is there really a flight to quality?” In that post, we wrote the following:

“This redirection of capital inflows [towards the biggest hedge funds] does seem to be driven by institutional investors.  If we were to ask ourselves, however, what are the three most important issues for institutions considering a hedge fund allocation, we expect the answer would be:

1) Transparency
2) Fees
3) Independent oversight

But…the Top 25 hedge funds now receiving such large allocations of institutional capital have the most restrictive transparency, the highest fees and no independent oversight (virtually all do not appoint an independent administrator, meaning that investors must rely on the manager to calculate each NAV and price all the assets with no third party check.)

We’re really puzzled by this paradox – there’s obviously a big difference between what institutions say they want, and what they are prepared to invest in.

Why is this?  Obviously, there’s strength in numbers, and it’s easy to justify an allocation to a firm if pretty much everyone else in the industry has already invested.  But, to point out the obvious again, the Bear Stearns funds were run by the Wall Street house with the reputation for the greatest expertise in mortgage and structured securities available in the industry.  Amaranth was one of the most sophisticated multi strategy funds available.  Sowood was formed by superstar managers from the Harvard Management Company.  Basis Capital in Australia had the highest possible, 5 star rating from Standard & Poors.  The list goes on, and on.

The lesson, therefore, is simple and obvious: do not to take anything for granted.  Certainly, asking hard questions – and being prepared to walk away – would have served potential investors in the above funds well.  This is not the last time hedge fund investors will learn this lesson.”

Well yes.

As we noted nearly 18 months ago, the biggest firms typically have the highest fees, have limited transparency and often don’t have independent oversight over their NAVs.  We would also add that it is typically the largest firms that ask for the longest lock ups: investors who signed up in ’06 and ’07 to 3 and 5 year lock classes must be pretty unhappy right now.  Moreover, the biggest firms usually have the tightest gates and most restrictive redemption provisions in their offering documents: 2008 has shown that many (most?) of the industry’s largest funds have chosen to suspend redemptions, impose involuntary restructurings etc.

Where does that leave investors?  We don’t deny that some of the largest hedge funds remain deeply resourced, highly skilled money managers.  On the other hand, our point is not to write off the small guy.

For many reasons, we believe that there is a real value in being a “bigger fish in a smaller sea”.  Thinking of operational issues, a larger investor in a smaller fund has so much more leverage:

  • Power to negotiate fees
  • Power to influence the terms of the offering document, and particularly to impact provisions related to gates, suspensions, side pockets etc.
  • Better operational transparency
  • Ability to engage in a constructive dialogue about operational controls: smaller funds are, for example, much more likely to have an administrator.  Smaller managers typically also give more information about their procedures, enabling investors to get a better understanding of key controls such as valuation.  Moreover, if a small firm needs to improve, they are much more likely to listen to a large, strategic investor – in fact, they are much more likely to listen full stop.

Investing in a smaller hedge fund – particularly now – gives the investor much better power to enter into that investment in a spirit of partnership.  It also provides more flexibility on the way in and on the way out.  That is massively different from going to a large multi strat and still facing an unappetizing menu of terms such as a 3 year lock class, a 8% rolling quarterly redemption provision, a 2 and 25, 3 and 30 fee structure et al et al.

One of the questions we always ask ourselves when we visit a hedge fund is about the culture of the manager.  Put simply, does it feel as if the manager thinks we are doing him a favor by giving him our capital, or is there a sense that the manager feels he is doing us a favor by letting us in.

Right now, we would always pay less for a receptive manager than pay more for a fund which still thinks that that we need them more than they need us.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence

Hedge Funds and OTC Products

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Some hedge funds use OTC products as part of their main investment strategy, or as a supplement to their main strategy.  In either event, there are a number of issues which hedge fund managers should consider when they decide to utilize OTC products within an investment strategy.  First and foremost, the OTC investment strategy should be adequately described in the hedge fund’s offering documents.  Secondly, the manager should consider the “back office” requirements for processing the OTC investments.  The following article gives a good background of the OTC processing requirements and issues.

Please contact us if you have any questions or you are interested in starting a hedge fund.

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The 5 Pillars of OTC Processing
Ron Tannenbaum, co-founder, GlobeOp Financial Services

As the OTC derivatives market expands in volume, complexity and sector interest, many funds face equally complex post-trade processing challenges in terms of operational processes & efficiencies. Can the key elements of a successful operational infrastructure to support a competitive OTC strategy be defined?

As a significant opportunity for alpha, the growing attraction of OTC derivatives is confirmed both at the industry level and on the “production floor”.  Supplementing Morse’s recent focus group confirmation that 64% of firms increased derivative contracts volume in the last 6 months, new trades by GlobeOp’s OTC clients in the same period increased 100%; monthly open positions increased 18%.

GlobeOp: Daily Average OTC Trade Volume

GlobeOp Monthly OTC open positions by Product Type, August 2008

In addition to traditional hedge fund activity, mutual funds liberated by the UCITS III directive are also increasingly including OTC derivatives in their trading strategies.  Exponential OTC volume growth, combined with the current market turbulence, is challenging in-house operational systems as never before. Legacy and “bolt-on” software systems struggle to communicate with each other. Spreadsheets strain to handle volumes and complexity they were never designed for, increasing the risk of error with each update. In parallel with portfolios becoming more complex, funds are facing increased investor pressure to demonstrate enhanced operational control, independent valuation, higher levels of disclosure and more transparent performance reporting. For many funds, processing derivatives internally quickly becomes cumbersome, inefficient and error-prone, increasing operational risk instead of delivering competitive advantage.

Is a water-tight process for OTC trade processing possible and if so what would it look like?
Eight years of daily OTC processing has provided GlobeOp with a crystallized perspective of the elements essential to a fund’s requirement for effective OTC derivative post-trade processing. Five core, integrated processes are needed to manage, track and report on trades end–to-end throughout their lifecycle:

  • Trade capture
  • Operations
  • Valuations
  • Collateral management
  • Documentation

Rigorous, reliable, daily reconciliation underpins much of the process, while scalability in terms of people and technology is needed to respond nimbly and promptly to trade volume growth, new products or unexpected market events.

The 5 Pillars

Trade capture – real-time, cross-product

Trade data entry sounds such a basic process that it is often underestimated as the cause of many issues further along the process. Incomplete and/or inaccurate detail risks being created when data is aggregated into an internal system from disparate silos or when bolt-on software is unable to communicate completely with front office configurations or legacy systems.

Also, due to their bilateral nature, derivative instruments do not always have established identifier codes, making them more difficult to process than securities with their standard ISIN, CUSIP or Bloomberg reference codes.

A real-time, cross-product, electronic trade capture environment can support the trading desk in developing and trading new OTC products.  Trades should only ever be recorded once, to eliminate the risk of errors associated with manual entry and spreadsheets.

Operations – the litmus test

Trade operations are the ‘litmus test’ of the entire process, encompassing the settlement of trades and reconciliation of cash and securities positions associated with individual derivatives transactions. Having cash and securities obligations in position at the time of settlement are essential to efficiently transferring ownership and moving funds.

Valuations – transparency, independence

The challenge of accurate, independent valuation can be addressed by pricing models that can adapt to new and complex instruments, and that are tolerance-checked against counterparty prices and other external industry and data sources.

Depending only on counterparty prices due to either insufficient valuation expertise or technology can increase the risk of a domino of delays to timely and reliable trade reconciliation, NAVs and investor reporting or returns.

Mutual funds face an additional regulatory dimension to their valuation challenges. In exchange for reducing mutual fund barriers to OTC derivative trading, the February 2007 UCITS III directive placed a high premium on transparent and independent valuation and risk management.

The requirement for mutual funds to demonstrate their ability to provide fully independent daily valuations and risk analytics can affect both mutual funds and their custodian bank. A mutual fund’s back office is often well-equipped to manage the long-only investments the fund traditionally makes. Operational knowledge, systems, models and capacity for complex derivatives is, however, either absent or insufficient. This is compounded when, as we have seen repeatedly, most mutual funds also initially tend to significantly underestimate their derivative trading volume,

Thus challenged, and to meet the UCITS lll independence criteria, the mutual fund turns to its custodian bank, its historic provider of a wide range of support services. While willing in spirit, most custodian banks quickly recognize that complex OTC trade processing, valuation and risk analytics exceed both their expertise and spreadsheet-based systems.

Collateral management – exposure management

Current market turbulence has sharpened the spotlight on the value of real-time, online collateral management to accurate trading and exposure management. What collateral is on the books, with whom, at what rate, for how long? What pledges are held vs. outstanding? Accurate, transparent collateral reporting will remain vital to the front office for months to come.

Effective collateral management usually includes ensuring the fund is net present value collateralised with each of its counterparties on a daily basis. In addition, an integrated facility should ensure appropriate movement of cash and securities to support revaluations and margin calls.

Documentation – integrated STP

According to recent ISDA statistics, approximately 60% of the hedge fund industry’s OTC instruments are still confirmed manually. This is not only time-consuming, but it also increases the incidence of error and leaves funds vulnerable to compliance risk, due to the high level of positions which remain based on verbal agreements. Integrated, straight-through-processing (STP) for managing, exchanging and storing trade documentation better enables both trade partners to reconcile economic terms with counterparties and meet auditor and regulatory compliance obligations.

Conclusion

A successful OTC trading strategy requires underpinning by an integrated platform of people, processes and technology that deliver post-trade processing and reporting that enables the fund to focus on its core objective of generating investor returns and expanding the capital base.

Informal industry estimates indicate that building an internal OTC processing infrastructure involves significant fund investment in cost and time — up to $50 million and five years of testing and development. Often unspoken are the risks that continued market and fund strategy evolution may result in a design neither suitable or scalable for long-term requirements, or able to deliver sufficient economy of scale.

The attraction of OTC derivative instrument strategies remains robust. As funds consider their future strategies, recent market events have only served to reinforce the need for post-trade processing and infrastructures whose key deliverables are:

  • Data and document management across the lifecycle of the trade that is timely, transparent, accurate, reconciled and real-time
  • Robust, scalable, online support
  • Independent, risk-based valuation that is tolerance-checked within well defined limits.

Incubator Hedge Funds

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How to Create an Auditable and Marketable Trackrecord

One of the biggest hurdles that start up hedge fund managers face is the issue of having a marketable track record. Many managers do not have an audited marketable trackrecord for any number of reasons. While it is not strictly necessary to have an audited marketable trackrecord, it will help with the marketing efforts when soliciting investors, especially institutional investors. To solve this problem many start up managers establish incubator hedge funds. Continue reading →