Category Archives: Hedge Fund Structure

Hedge Fund Side Letters

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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

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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

Hedge Fund Auditor – Hedge Fund Audit Information and Questions

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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.

Hedge Fund Prime Brokerage

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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.

Hedge Fund Administrator – What is a Hedge Fund Administrator?

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A hedge fund administrator is a service provider to the hedge fund; the main job of the administrator is to provide certain accounting and back office services to a hedge fund as detailed below.

Hedge fund administrator services

Generally, administrators will provide a variety of services to the hedge fund manager.  The central service is monthly or quarterly accounting of investor contributions and withdrawals and computing the profits and losses for the accounting period.  The administrator may also provide other back end services such as transfer agent services (handling the subscription documents and making sure checks are cashed or wires are appropriately handled).

A relatively new service which some administrators provide is a “second signer” service which is designed to give investors greater confidence that a hedge fund manager will not run off with their money.  Under a “second signer” agreement, the hedge fund manager will need to get a sign off from the administrator before the manager can make a transfer or a withdrawal from the fund’s account.

In addition to the above, the hedge fund administrator may perform the following duties:

  • calculating the management fee and performance fee
  • working with the auditor
  • keeping certain financial records
  • may act as the registered agent and registrar (offshore hedge funds)
  • Anti Money Laundering review (generally only for offshore hedge funds)

Three types of hedge fund administrators

Small administration firms – these types of administrators are very lean organizations which are controlled and run by one or two people.  Typically the one or two people will have significant experience in the hedge fund industry, many times with other administration firms, hedge fund audit firms and hedge fund consultants.  The typical client will be a start-up hedge fund.  While these administrators can handle funds with assets of up to and sometimes beyond $500 million, most of their clients will generally start with less than $50 or $100 million.

These administrators are going to be the most cost-effective solution for a start up hedge fund.  Additionally, these administrators often provide some of the best customer service – usually the manager will be able to talk to the principal at any time.  For these administrators, the manager will be looking at a start-up fee of anywhere from $500 – $1,500 and then a monthly administration fee of $750 – $1,500.

Medium-sized firms – these firms are usually established businesses with strong structure, have been around for a while, and have a fairly large and established client base.  It is expected that a medium-sized firm would have one to two principals with 10-20 years of experience in the hedge fund industry.  These firms will have clients that range in size from $50 to $500 million and may have clients which have $2 to $5 billion in assets.

Medium-sized firms will charge a start-up fee of $1,500 or more and will usually base their administration fee as a percentage (basis points) of AUM, subject to a minimum monthly fee which is usually around $2,000.

Large firms – these firms are well-established within the hedge fund industry and are thriving businesses themselves.  These firms may be subsidiaries of large international banks or (former) investment banks.  The principals of these firms are well-connected to the major players in the industry and most of the clients of these firms are the large hedge funds.  If a hedge fund uses a large firm for administration, the fund should expect to pay a minimum of around $5,000 a month.  Because of the relatively high costs of the large administrators, it may not make sense for a fund with less than $250 million to use such an administrator.

Offshore hedge fund administration

Offshore hedge fund administration generally refers to the administration of an offshore hedge fund.  Typically the process and function will be the same, but there are more issues that come into play with an offshore hedge fund.  Because offshore hedge fund fees can be structured in a variety of ways, the administrator may want to discuss the structure with the hedge fund attorney if there are any uncertainties with the structure.

Questions on hedge fund administrators

1.  How do I find a hedge fund administrator?

There are many ways you can find a hedge fund administrator and other hedge fund service providers.  Your hedge fund attorney can help recommend a administrator based on the needs of your fund.  Please note that not all administrators offer services to all types of hedge funds.  Please contact us if you would like us to recommend a hedge fund administrator (or if you have any other hedge fund administration questions).  Additionally, you can reference this survey of hedge fund administrators.

2.  Who pays for the costs of the administrator?

As I noted in an article on hedge fund expenses, the costs of the administrator are usually paid by the fund and not by the management company.  Some managers may choose to pay the administration costs so that these costs will not be a drag on performance.  You should discuss this issue with your attorney.  Additionally, please note that the costs above are general guidelines – if your strategy requires more in-depth valuation practices  (i.e. the fund trades hard to value instruments), the administration costs may be higher.

3.  Does a start-up hedge fund need an administrator?

Yes.  While there is no law that requires a domestic hedge fund to have an administrator, there is no real good reason why a hedge fund should not have an administrator.  Outside verification of a hedge fund’s numbers, especially given the current state of the capital markets, is becoming a requirement for hedge fund investors.  Additionally, there are law firms which will not work with start-up hedge funds that do not have an administrator.  Another consideration is the audit – if there are no independent third party numbers to review, the audit becomes more difficult and potentially more costly.

Hedge Funds in the BVI – new requirement to submit annual information

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The British Virigin Islands (BVI) is a popular jurisdiction for many offshore hedge funds to be located.  The BVI is known to have good financial oversight and relatively reasonable offshore hedge fund formation fees.  Over the past year the BVI Financial Services Commission (FSC) has become more involved in hedge fund oversight as political pressure increases.  It is expected that the BVI’s Mutual Funds Law will undergo changes within the next 6 months to a year because of this political pressure.

In addition, on September 9 the FSC surprisingly announced that BVI hedge funds (known as “mutual funds” in the BVI) will need to submit a yearly Annual Return to the FSC which provides information about the fund to the FSC.  This is a new requirement for all BVI based hedge funds.  Before this year the FSC had a voluntary mutual funds survey which requested information similar to the information requested in the Annual Return.  Certain closed end funds (generally private equity funds established in the BVI) will not need to submit the Annual Return.

BVI Annual Return Requirement

The items a fund will need to submit are:

–    Basic information on the fund and its service providers, including the registered agent
–    Financial information including:

Beginning NAV
Total subscriptions
Total redemptions
Net income/ net loss
Dividends/ distributions
Ending NAV
Year end gross assets

–    General description of the fund’s asset allocation (but not individual positions)

The Annual Return will need to be submitted to the FSC by June 30 of 2009.  Funds which do not submit the Annual Return by that date may face an enforcement action.

A sample Annual Return can be found here: sample-annual-return

What this means for offshore hedge funds

With regard to this new requirement, current BVI funds are going to need to complete the Annual Return.  While the Annual Return will not be a huge resource drain, it will take some time to complete.  Generally most of the questions can be answered fairly quickly by the hedge fund manager or by an assistant.  Some of the information may require input from the hedge fund administrator and potentially the hedge fund attorney as well.

In the future, this seems to be the first step towards greater scrutiny and disclosure requirements from offshore hedge fund jurisdictions.  However, it is unclear whether this will affect the number of start up funds which will be based in the BVI as the intrusion is relatively mild.  However, it may mean that other offshore jurisdictions such as Nevis, Guernsey and Dubai become more popular in the future.

Please see guidance from here from Maples and Calder, an offshore law firm: BVI Annual Return Requirement

Hedge Fund Liquidation Procedure

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It has been a tough year for many managers and there are many funds that will be shutting their doors before the end of the year.  Funds may decide to close their door for many reasons which might range from poor performance to large amounts of investor withdrawals.  While many of the managers and traders at these funds will go on to work for other firms, many of these managers and traders will start new hedge funds and potentially with some of the same investors.

In either case, there are a few things that a hedge fund manager will need to do in order to ensure the orderly liquidation and winding down of the hedge fund.

Liquidation pursuant to the offering documents

The hedge fund limited partnership agreement or LLC agreement (part of the hedge fund offering documents) will set out the manner in which the dissolution and liquidation of the fund will proceed.  Generally there will be some sort of liquidation and then final accounting.  The timing of these will be determined by the offering documents.

Talk with the hedge fund service providers

A manager should first contact his hedge fund attorney to inform him of the plans to close down the fund.  The lawyer will be able to help guide the manager through the process and will be able to help with any issues which may arise.  The auditor, broker and administrator should also be contacted so that these service providers can begin their own processes for winding the fund down.  During the wind down process, the manager should expect to talk with each of the service providers a few times.

Inform your investors

A manager will need to inform the investors that the fund will be winding down.  The manager will probably want to do this through some sort of letter.  After the manager has discussed the wind down with the attorney, the attorney can help the manager draft the letter.  The letter should inform the investors that the fund will be closing and also let the investors know what steps are being taken before the final liquidation is complete.  The manager may also ask the investor how the final proceeds should be sent to the investor – either through wire or through a check.  Additionally, if the manager is going to be starting a new hedge fund, he may want to mention this in the letter.  (However, the manager will need to be careful that the mention of the new fund does not rise to the level of a public offering – the attorney can discuss this with the manager.)

During this time, it is critical for the manager to keep the lines of communication with the investor open.  During a wind down when emotions are high, investors may be looking for any reason to complain or create a reason for a suit against the general partner.  It is most important to be honest during these times.

Make the final wind down and distributions

The final wind down is the process of liquidating all of the fund’s positions to cash and then transferring the fund’s assets to the fund’s bank account.  From the bank account, the manager will then be able to distribute the assets to the investors pursuant to the final accounting by the administrator and/or auditor.

Provide the final audit

The auditor will provide final audited financial statements to the manager who will then provide these statements to all of the investors in the fund.  Usually the final audit will be completed prior to the actual distribution of the assets to the investors in the fund.

Close down the entities

After the final audit and distribution to the investors, the manager will want to close down, or cancel, the fund entity.  To do this the attorney will:

  1. Submit articles of cancellation to the Delaware Secretary of State to close down the entity.  The filing fees for this are typically $200-$300 dollars payable to Delaware.
  2. Pay any outstanding Delaware franchise taxes.  Generally these are going to be less than $200, but it will depend on the fund.  The attorney will be able to contact Delaware to determine the amount of the taxes owed.
  3. Provide the manager with an explanation of how to contact the IRS about the canceled entity.
  4. Contact the registered agent in Delaware to cancel registered agent services with them.

The above is a rough outline of the steps involved in closing a Delaware entity and will usually be completed by a paralegal in a few hours.  There are more steps involved with the process of closing down an offshore entity which will depend on the jurisdiction of the fund.  Generally the wind down process for each offshore entity will range in cost from $800 – $3,000 or more depending on the circumstances of the wind down.
Additionally, the hedge fund manager should also decide whether the hedge fund management company will also need to be wound down.  In many cases, the entity will be kept alive in order to serve a future purpose for the manager; in some cases the management company will serve as the general partner to a new hedge fund.

Potential roll over issues

For mangers who are simultaneously closing one hedge fund and starting another, a common practice is to simply roll the assets from the old fund to the new fund.  In such instances the manager will definitely need to have close contact with all of the service providers to ensure a smooth transition.  Additionally, there may be some issues which the manager will need to discuss with counsel if there are tax-exempt entities in the old fund.

If you have any questions on the process, please feel free to contact us at any time.

Hedge Fund IRA Investments

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Individual retirement account (IRA) investments into hedge funds are increasing rapidly.  Below are some common questions hedge fund managers have about potential investments by IRAs.

Can an IRA invest in a hedge fund?

Generally yes, however the IRA and the hedge fund must make sure to follow certain regulations which a manager should discuss with a hedge fund attorney.    A manager should not accept IRA investments into the hedge fund without first discussing this with his lawyer.

How does an IRA actually make the investment into the hedge fund?

Each IRA investment into the hedge fund needs to be made by the custodian of the IRA.  That is, the beneficial owner of the IRA cannot simply take the money out of his IRA account and then place the money in the hedge fund – this would be deemed to be a withdrawal from the IRA and would be subject to very negative tax consequences.

In order to avoid these negative tax consequences the custodian needs to directly transfer the IRA assets to the hedge fund.  Typically this is done through a self directed IRA account at a brokerage firm.  Many brokerage firms do not have these self directed programs in place.  If the brokerage firm does not have such a program in place the beneficial owner of the IRA would need to transfer the IRA to another custodian which does.  Our law firm has worked with many custodians who have these programs and we can make recommendations.

Each custodian has different requirements for an investment into a hedge fund from an IRA.  Typically the hedge fund manager is going to need to fill out a few pages of paperwork with the custodian and provide custodian with the fund’s offering documents.  After the custodian’s compliance department has reviewed the paperwork, the custodian will be able to make the investment into the fund on behalf of the IRA.  During this process the hedge fund manager is going to be spending time talking with the custodian and the compliance department.  Additionally the law firm may need to be involved with the process as well; however, this is usually to a much lesser extent.

Are there any other issues with IRA investments into hedge funds?

Yes.  There are many issues which a hedge fund manager should be aware of which include the following:

1.  The manager should be sure that the hedge fund and the management company do not engage in any prohibited transactions with respect to the fund and the IRA.  [More on this in a later article.]

2.  The manager should make sure that if it uses any sort of leverage that such activities are clearly discussed in the fund’s offering documents.  In certain circumstances where there is leverage, an IRA could be subject to tax on its unrelated business taxable income or UBTI.

3.  The manager should make sure that the fund does not stray from its investment program.  IRA are not allowed to make certain investments like investments in life insurance policies (life settlements).
As noted in an earlier article on hedge funds and ERISA, while IRAs are not specifically ERISA assets, they do count towards the 25% threshold and thus the manager needs to be aware of the amount of IRA and other ERISA assets in the hedge fund.

HFLB Note

Because of the gravity of the tax consequences to potential IRA investors, please contact your hedge fund attorney or accountant if you have specific questions about IRA investments into your fund.  Additionally, savvy hedge fund investors will usually want to make sure that their own tax advisors have reviewed the hedge fund offering documents before investing in the fund.

Please contact us if you have any questions on the above.  Also, please read our disclaimer with regard to discussions about tax items.

Hedge Fund UBTI (unrelated business taxable income)

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Hedge fund investors are always cognizant of the potential tax consequences of an investment into a hedge fund.  One of the issues which a hedge fund manager should be aware of is the concept of unrelated business taxable income or UBTI.

What is UBTI and why is it important?

As it relates to a tax-exempt investor in a hedge fund, UBTI is debt financed income derived by the hedge fund which does not relate to the activities of the tax-exempt investor.  As hedge funds are “flow through” vehicles, the designation of income as UBTI flows through the tax-exempt investor.  This is important because the tax-exempt investor must pay tax (called the unrelated business income tax or UBIT) on that portion of the income received by the fund which is UBTI.  UBTI is generally going to be taxed at a 35% rate.
Is there a way to get around UBTI?

There are two ways to make sure that tax-exempt investors do not receive any UBTI.  The first and most obvious is to make sure that the fund will use no leverage.  Because this might not be an option for some hedge funds, and because these funds would like to receive assets from tax-exempt entities, another option is for the fund to create an offshore hedge fund (either through a side by side structure or a master feeder structure).  In these structures that income does not “flow-through” to the investors like with the domestic hedge fund, but rather the income is paid to the investors through a dividend which is generally not taxable to a tax-exempt organization.  Using an offshore structure in this manner is often described as using a “blocker” because the UBTI is blocked out.

Do short sales give rise to UBTI?

Short sales alone do not give rise to UBTI.  The IRS has specifically provided guidance to the hedge fund community on this issue.  Please see Revenue Rule 95-8.  However, if a hedge fund borrowed money to engage in the short sale, this would probably give rise to UBTI.  If the fund utilizes short sales and engages in no leverage activities, then the there will likely be no UBTI with regard to the short sales.

What are the tax code provisions dealing with UBTI?

The following are links to the tax code dealing with UBTI:

Section 511 – provides for a tax on UBTI

Section 512 – defines UBTI and provides for the pass through treatment of UBTI to tax-exmpt investors in a fund (see 512(c))

Section 513 – provides a definition for “unrelated trade or business.”

Section 514 – provides additional definitional support for determining the amount of UBTI under section 512.

Hedge Fund CPO Exemptions

[Editor’s note: this article will be updated shortly.  Please note that 4.13(a)(4) is no longer available for managers.  05-121-17]

As I’ve detailed before, under the Commodities Exchange Act (CEA), hedge funds which invest in commodities/ futures or in other hedge funds which invest in commodities/ futures are deemed to be commodity pools.  The managers of these commodity pools will need to be registered as commodity pool operators (CPOs) unless the manager fits within an exemption from the registration provisions. For more information on registration with the National Futures Association (NFA), please see article on how to register as a CPO.

There are a few rules under the CEA exemptions from the registration provisions which I have detailed below.  Many will not be applicable to the average hedge fund manager.  Generally hedge fund managers are going to rely on 4.13(a)(3) below, or if the fund is a 3(c)(7) hedge fund, then they may rely on 4.13(a)(4).  The CPO exemptions are:

Rule 4.13(a)(1) – closely held pool

This rule provides relief from CPO registration if all of the following provisions are met:

1.    Manager operates only one pool at a time;

2.    Manager does not receive any form of compensation;

3.    Manager does not advertise; and

4.    Manager is not otherwise required to register with the NFA

Please see Rule 4.13(a)(1).

Rule 4.13(a)(2) – small pool

This rule provides relief from CPO registration if the following provisions are met:

1.     The manager does not operate any pools which have 15 or more investors (excluding the manager and certain related persons); and

2.    The total gross capital contributions in all pools operated or intended to be operated by the manager do not in the aggregate exceed $400,000 (certain capital contributions, including those of the manager, will not be counted for the purposes of this rule)

Please see Rule 4.13(a)(2).

Rule 4.13(a)(3) – deminimus rule

This rule provides relief from CPO registration if the following provisions are met:

1.    The commodity pool interests are exempt from registration under the Securities Act of 1933, and such interests are offered and sold without marketing to the public in the United States;

2.    All of the investors in the pool must be an accredited investors (or similar qualification as specified in the rule); and

3.    One of the following tests is met:

a.    The aggregate initial margin and premiums required to establish such positions, determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; or

b.    The aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into.

Please see Rule 4.13(a)(3).

Rule 4.13(a)(4) – all QEPs

NOTE: THIS EXEMPTION IS NO LONGER AVAILABLE FOR MANAGERS

This rule provides relief from CPO registration if the following provisions are met:

1.    The commodity pool interests are exempt from registration under the Securities Act of 1933, and such interests are offered and sold without marketing to the public in the United States; and

2.    Investors must generally be qualified purchasers.  (HFLB note: the definition makes reference to qualified eligible persons but in this case it will generally include only those investors who are qualified purchasers.)

Please see Rule 4.13(a)(4).

Rule 4.5 Exemption

Certain management entities which are already registered with other regulatory bodies do not need to also be registered as a CPO with the NFA.  Some of these entities include managers to registered mutual funds, insurance companies, banks and ERISA fiduciaries.  A CPO claiming rule 4.5 exemption must file of notice of the exemption with the NFA and make certain disclosures to the investors in the pool.

Please see Rule 4.5.

Rule 4.7 Exemption

Registered CPOs must adhere to certain disclosure and reporting requirements as specified in the rules under the CEA.  With regard to certain commodity pools which they manage, managers may want to consider running certain funds under the “lite-touch” rule 4.7 which allows CPOs to run their fund pursuant to lighter regulations.  Specifically, the CPO would be exempt from the specific requirements of Rule 4.21, Rule 4.22(a) and (b), Rule 4.24, Rule 4.25 and Rule 4.26 with respect to each exempt pool.  To claim this exemption all of the investors in the commodity pool must be qualified eligible persons which generally will mean that they are qualified purchasers.  CPOs claiming rule 4.5 exemption must still file of notice of the exemption with the NFA.

Please see Rule 4.7.

Rule 4.12 Exemption

Like the rule 4.7 exemption, the rule 4.12 exemption is for registered CPOs.  While under 4.7 there is no limitation to the amount of commodities held by the pool, rule 4.12 limits the amount of commodities held to 10% of the pools assets and requires that all commodity trading be solely incidental to securities trading activity.  Under this exemption the CPO will need to file a notice with the NFA and will need to adhere to certain disclosure regulations. Both the 4.7 and 4.12 exemptions are used less often than the 4.13 exemptions.

Please see Rule 4.12.