Capital Introduction for Hedge Funds

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Capital introduction is the term used to describe investor referrals to hedge funds by prime brokers.  Many prime brokers and even mini-prime brokers will provide capital introduction services to their customers.  Typically this is done as a favor to the hedge fund and does not carry the high costs of a third party marketer.  However, unlike a third party marketer, the prime broker is probably not actively looking for investors for the fund and therefore actual capital introductions may be rare, depending on a number of factors including the individual broker and the investment strategy.  Continue reading →

Hedge Fund Investors and Increased Due Diligence: GAO Report

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This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here. Continue reading →

What is Forex? Information on Retail Off Exchange Foreign Currency Transactions

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(www.hedgefundlawblog.com in conjunction with www.forexregistration.com)

Forex Overview

Forex or FX or retail off-exchange foreign currency transactions all refer to the same thing – trading foreign currencies for gain, usually in the spot market.  The Forex markets have grown tremendously over the last few years and both individual investors and money managers are trading foreign currencies to make money.  Unfortunately, many fraudsters have used the lure of the Forex markets to perpetuate scams and for some Forex has a negative connotation. Continue reading →

Survey of Hedge Fund Costs

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All too often start up hedge fund managers do not realize that starting a hedge fund is really starting a business and that considerations need to be given to managing the business as well instituting the trading program.  In a perfect world the hedge fund manager would be able to simply implement his program and have all of the back office, IT, compliance and other services outsourced.  One option obviously is a hedge fund hotel which provides this type of support to beginning managers.  For those managers who do not use hedge fund hotels, greater emphasis needs to be placed on understanding the business they are getting into.

Continue reading →

Overview of Schedule K-1 for Hedge Fund Investors

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Hedge funds are usually established as Delaware limited liability companies (LLC) or Delaware limited partnerships (LP).  In addition to providing investors with a certain amount of liability protection (generally to the extent of their investment), these vehicles are also more tax efficient than other structures like corporations because LLCs and LPs can be taxed as partnerships.  Unlike a corporation which is subject to double taxation (that is, tax at both the corporate level and the investor level), a partnership is only subject to tax at the investor level. Continue reading →

Congress to examine Hedge Fund AML Requirements Next Year

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In an article yesterday we discussed the withdrawal of proposed rules which would require hedge funds to implement anti-money laundering compliance programs (see Hedge Funds and AML Requirements).  Yesterday Senator Carl Levin, a democrat from Michigan, released a statement condemning the withdrawal of proposed hedge fund AML rule by the Treasury.  Senator Levin statement said, “The Administration’s five-year failure to extend anti-money laundering controls to hedge funds with offshore money – despite the hedge fund industry’s willingness to accept those controls – is inexplicable, ill-timed, and unwise.”  Futher, Sentor Levin noted that Congress will face the issue in the future.   “The absence of anti-money laundering controls on hedge funds is another regulatory gap that the Congress will have to tackle after the election.”  The full statement, reprinted below, can be found here.

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FOR IMMEDIATE RELEASE
November 3, 2008
Contact: Press Office
Phone: 202.228.3685

Statement of Senator Carl Levin on Treasury Withdrawal of Proposed Rule to Require Anti-Money Laundering Controls at Hedge Funds

Senator Carl Levin, Chairman of the U.S. Senate Permanent Subcommittee on Investigations, today released the following statement regarding anti-money laundering controls at hedge funds. Section 202 of S. 681, a 2007 bill Levin introduced to stop a wide range of offshore abuses, would require Treasury to issue a final rule requiring hedge funds to implement anti-money laundering controls.

“Last week, with no warning, the Bush Administration revoked a 2002 proposed rule to require hedge funds to install anti-money laundering controls. Hedge funds are unregulated financial companies that can handle millions of dollars in offshore money without any legal obligation to check who is behind the funds or report suspicious activities. A 2006 investigation by my Subcommittee showed how hedge funds can bring suspect offshore funds into the United States, highlighted the lack of hedge fund regulation, and recommended Treasury finalize its proposed anti-money laundering rule.

“But instead of plugging the hedge fund regulatory gap by issuing a final rule, the Administration went the opposite way, withdrew its anti-money laundering proposal, and offered nothing in its place. The Administration’s five-year failure to extend anti-money laundering controls to hedge funds with offshore money – despite the hedge fund industry’s willingness to accept those controls – is inexplicable, ill-timed, and unwise. The absence of anti-money laundering controls on hedge funds is another regulatory gap that the Congress will have to tackle after the election.”

Other HFLB articles:

Hedge Funds and Counterparties: Report by GAO

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This article is part of a series examining the statements in a report issued by the Government Accountability Office (GAO) in February 2008.  The items in this report are important because they provide insight into how the government views the hedge fund industry and how that might influence the future regulatory environment for hedge funds. The excerpt below is part of a larger report issued by the GAO; a PDF of the entire report can be found here.

I found this section reprinted below to be especially informative on the issues involved when hedge funds utilize credit.  The section provides a history on hedge funds and counterparty risk management and has concluded that the counterparty risk management procedures have tightened from the late 1990’s when we saw the crash of Long Term Capital Management.  It is likely that in this current environment that even stricter risk management procedures will become common and that due diligence by counterparties (banks and brokerage firms) will also increase.

If a manager has any questions on receiving credit or leverage, the manager should talk with the fund’s broker and/or banker well before any credit or leverage is needed – as always, managers are urged to give themselves plenty of time when negotiating credit and leverage terms.  Please feel free to contact us if you would like to discuss anything discussed herein.

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Creditors and Counterparties Can Impose Some Market Discipline on Hedge Fund Advisers as Part of Credit Extension, but the Complexity of Counterparty Credit Risk Management Poses Ongoing Challenges for Financial Institutions:

By evaluating hedge fund management, the fund’s business activities, and its internal and risk management controls, creditors and counterparties exert discipline on hedge fund advisers. According to market participants, entering into contracts with hedge funds as creditors or counterparties is the primary mechanism by which financial institutions’ credit exposures to hedge funds arise, and exercising counterparty risk management is the primary mechanism by which financial institutions impose market discipline on hedge funds. According to the staff of the member agencies of the PWG [the President’s Working Group on Financial Markets, please see this article for more information], the credit risk exposures between hedge funds and their creditors and counterparties arise primarily from trading and lending relationships, including various types of derivatives and securities transactions.[1] As part of the credit extension process, creditors and counterparties typically require hedge funds to post collateral that can be sold in the event of default. According to market participants we interviewed, collateral most often takes the form of cash or high-quality, highly liquid securities (e.g., government securities), but it can also include lower-rated securities (e.g., BBB rated bonds) and less liquid assets (e.g., CDOs). They told us they take steps to ensure that they have clear control over collateral that is pledged, which according to some creditors and counterparties we interviewed, that was not the case with LTCM. Creditors and counterparties generally require hedge funds to post collateral to cover current credit exposures (this generally occurs daily) and, with some exceptions, require additional collateral, or initial margin, to cover potential exposures that could arise if markets moved sharply.[2] Creditors to hedge funds said that they measure a fund’s current and potential risk exposure on a daily basis to evaluate counterparty positions and collateral.

To control their risk exposures, creditors and counterparties to generally large hedge funds told us that, unlike in the late 1990s, they now conduct more extensive due diligence and ongoing monitoring of a hedge fund client. According to OCC, banks also conduct “abbreviated” underwriting procedures for small hedge funds in which they do not conduct much due diligence. OCC officials also told us that losses due to the extension of credit to hedge funds were rare. Creditors and counterparties of large hedge funds use their own internal rating and credit or counterparty risk management process and may require additional collateral from hedge funds as a buffer against increased risk exposure. They said that as part of their due diligence, they typically request information that includes hedge fund managers’ background and track record; risk measures; periodic net asset valuation calculations; side pockets and side letters; fees and redemption policy; liquidity, valuations, capital measures, and net changes to capital; and annual audited statements. According to industry and regulatory officials familiar with the LTCM episode, this was not necessarily the case in the 1990s. At that time, creditors and counterparties had not asked enough questions about the risks that were being taken to generate the high returns. Creditors and counterparties told us they currently establish credit terms partly based on the scope and depth of information that hedge funds are willing to provide, the willingness of the fund managers to answer questions during on-site visits, and the assessment of the hedge fund’s risk exposure and capacity to manage risk. If approved, the hedge fund receives a credit rating and a line of credit. Several prime brokers told us that losses from hedge fund clients were extremely rare due to the asset-based lending they provided such funds. Also, one prime broker noted that during the course of its monitoring the risk profile of a hedge fund client, it noticed that the hedge fund manager was taking what the broker considered to be excessive risk, and requested additional information on the fund’s activity. The client did not comply with the prime broker’s request for additional information, and the prime broker terminated the relationship with the client.

Through continuous monitoring of counterparty credit exposure to hedge funds, creditors and counterparties can further impose market discipline on hedge fund advisers. Some creditors and counterparties also told us that they measure counterparty credit exposure on an ongoing basis through a credit system that is updated each day to determine current and potential exposures. Credit officers at one bank said that they receive monthly investor summaries from many of their hedge fund clients. The summaries provide information for monitoring the activities and performance of hedge funds. Officials at another bank told us that they generally monitor their hedge fund clients on a quarterly basis and may alter credit terms or terminate a relationship if it is determined that the fund is not dealing with risk adequately or if it does not disclose requested information.

Some creditors also said that they may provide better credit terms to hedge funds that consolidate all trade executions and settlements at their firm than to hedge funds that use several prime brokers because they would know more about the fund’s exposure. However, large hedge funds may limit the information they provide to banks and prime brokers for various reasons. Unlike small hedge funds that generally depend on a single prime broker for a large number of services ranging from capital introductions to the generation of customized accounting reports, many large hedge funds are less dependent on the services of any single prime broker and, according to several market participants, use multiple prime brokers as a means to protect proprietary trading positions and strategies, and to diversify their credit and operational risks.

Despite improvements in disclosure and counterparty credit risk management, regulators noted that the effectiveness of market discipline may be limited or market discipline may not be exercised properly for several reasons. First, because large hedge funds use several prime brokers as creditors and counterparties, no single prime broker may be able to assess the total amount of leverage used by a large hedge fund client. The stress tests and other tools that prime brokers use to monitor a given counterparty’s risk profile can incorporate only those positions known to a trading partner. Second, the increasing complexity of structured financial instruments has raised concerns that counterparties lack the capacity (in terms of risk models and resources) to keep pace with and assess actual risk, illustrating a possible failure to exercise market discipline properly. More specifically, despite improvements in risk modeling and risk management, the Federal Reserve believes that further progress is needed in the procedures global banks use to manage exposures to highly leveraged counterparties such as hedge funds, in part because of the increasing complexity of products such as structured credit products and CDOs in which hedge funds are active participants. The complexity of structured credit products can add to the already complex task of measuring and managing counterparty credit risk. For example, another Federal Reserve official has noted that the measurement of counterparty credit risk requires complex computer simulations and that “the management of counterparty risk is also complicated further by hedge funds’ complicated organizational structures, legal rights, collateral arrangements, and frequent trading. It is important that banks develop the systems capability to regularly gather and analyze data across diverse internal systems to manage their counterparty credit risk to hedge funds.” One regulatory official further noted the challenges faced by institutions in finding, developing and retaining individuals with the expertise required to analyze the adequacy of these increasingly complex models. The lack of talented staff can affect counterparty credit risk monitoring and the ability to impose market discipline on hedge fund risk taking activities. Third, some regulators have expressed concerns that some creditors and counterparties may have relaxed their counterparty credit risk management practices for hedge funds, which could weaken the effectiveness of market discipline as a tool to limit the exposure of hedge fund managers. They noted that competition for hedge fund clients may have led some to reduce the initial margin in collateral agreements, reducing the amount of collateral to cover potential credit exposure.

[1] A derivative is a financial instrument, such as an option or futures contract, the value of which depends on the performance of an underlying security or asset. Securities financing transactions include repurchase agreements, securities lending transactions, and other types of borrowing transactions that, in economic substance, utilize securities as collateral for the extension of credit. A repurchase agreement is a financial transaction in which a dealer borrows money by selling securities and simultaneously agreeing to buy them back at a later date.

[2] According to the literature, (1) current exposure represents the current replacement cost of financial instrument transactions, i.e., their current market value; (2) potential exposure is an estimate of the future replacement cost of financial instrument transactions; and (3) an initial margin is the good-faith deposit that protects the counterparty against a loss from adverse market movements in the interval between periodic marking-to-market.

Other related HFLB articles:

Comments on the Series 65 and Series 66 Exam

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I received a couple of comments regarding my posts on the Series 65 exam and the Series 66 exam which I would like to share with the community.  Both comments were made by Chuck Lowenstein, a Senior Editor – Securities at Kaplan Financial Education.

Regarding the post Differences between the Series 65 and Series 66 Exam, I received the following comment:

I must take issue with the statement that the Series 66 exam is easier to pass than the Series 65 for those with a Series 7 registration. Our experience with many thousands of students who have taken these tests indicates differently. An applicant with a Series 7 license will almost always have an easier time passing the Series 65 than the 66 and there are several obvious reasons for this.

1) Passing score on the 65 is only 68.5% while it is an industrywide high requirement of 71% on the Series 66.

2) The “extra” material added to the Series 65 is on subjects very familiar to most Series 7’s. For example, there are questions on common and preferred stock, mutual funds, options and limited partnership programs; all topics thoroughly covered on an Series 7 training program. There is extensive coverage of economics and analysis, but very little that is not part of the Series 7 exam.

3) 80 of the 100 questions (80%) of the Series 66 are based upon state and federal laws, while only 45 questions (35%) of the Series 65 cover this topic. Because these questions deal with the intracies of the law, these are typically the most difficult questions for students to handle.

The real advantage in taking the Series 66 is that, for those who will be selling securities as well as giving advice, is that it “kills two birds with one stone”. That is, instead of being required to sit for both the Series 65 and the Series 63 (Uniform Securities Agent State Law Examination), taking the Series 66 covers one for both.

Regarding the post The Series 65 Exam, I received the following comment:

Hi:

Thanks for the kind words about the Kaplan course. I have recently taken the responsibility for editing the Series 63, 65 and 66 exams and was amazed at the number of errors. Although most were typographical in nature, there were far too many where one would mark the correct answer to a question only to be told that it was wrong.

Our 4th Editions of the Series 65 and Series 66 are just released and I believe I have caught virtually all of these mistakes. In addition, our new platform allows us to post errata on our website on a daily basis so, just in case there is something that I overlooked, it will be posted for all to see.

Hedge Fund Due Diligence Firm Releases Whitepaper on Hedge Fund Industry

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Castle Hall Alternatives, a hedge fund due diligence firm, has just released a new white paper entitled “Hedge Fund Investing in a New World: Five Questions for Investors.”  We greatly respect the thoughts and opinions of Christopher Addy, President and CEO of Castle Hall, who has allowed us to repost some of his earlier blog posts (please see Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).

In this article, I have summarized the thoughts presented in the white paper and added my own thoughts as well.  The thesis of the white paper is that the hedge fund industry will change because of the recent market events.  The paper is broken up into five different questions and each answer discusses how the current industry trends and what the trends will likely (or should) look like in the future.  The issues the white paper raised are:

1.  Is 2 and 20 fundamentally flawed?

In this section Castle Hall believes that there may be more hurdle rates in the future, that performance fees periods will need to mirror lock-up periods and that performance fees on hard to value assets need to be reconsidered.

HFLB: We agree with some of the points made in this section.  While the fee structure will ultimately be decided by the market, whatever the manager decides upon can be implemented by the attorneys in the hedge fund offering documents.  A good hedge fund attorney should discuss the above issues with hedge fund managers who have hard to value assets or long lock-up periods.

2. Do Hedge Funds Need Better Corporate Governance?

In this section Castle Hall argues that hedge funds, especially offshore funds, have very low corporate governance standards and that there may need to be greater oversight in the future.  The paper states, “As an immediate priority, investors need a Board which can provide genuine, active oversight in two key areas: portfolio valuation and situations in which funds elect to impose gates or suspend redemptions.”

HFLB: We agree generally and in principle.  However, investors will ultimately pay for the expense of greater corporate governance.  If investors show themselves willing to pay for the added expenses then it seems there should not be a lot of push back from the hedge fund managers.

3.  Is there an ‘Expections Gap’ in the administration industry?

Castle Hall notes that “vigilant oversight from an independent administrator remains by far the most effective protection investors have against manager errors, be they honest or dishonest.”  CH then goes on to discuss how hedge fund administrators do not all provide the same services to hedge fund managers and many administrators provide “NAV Lite” services.  CH believes that administrators need to have clearly defined and delineated roles which should include real asset valuation (not just rubber stamping a manager’s good faith valutation).  CH notes that third party valuation specialists may be a solution but that this could be an expensive option for hedge fund managers and investors.

HFLB: We agree.  The term “hedge fund administrator” is one of the loosest terms in the industry right now.  Administrators may be full service, provide “NAV lite” or provide mid and back office support as stated in the paper.  Sometimes hedge fund offering documents do not thoroughly discuss the actual duties of the hedge fund administrator and we believe that disclosure in the offering documents will increase in the future.  In the future hedge fund managers may want to include the actual administration contract in the offering documents as an exhibit.

With regard to third party valuation specialists, we agree that these types of firms will provide valuable services to both hedge funds and administrators in the future.  Hedge fund managers should discuss this option with their hedge fund attorney.

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.

5.  Is it possible to hold illiquid assets in an open ended vehicle?

Castle Hall questions whether funds which hold illiquid assets should have open contribution and withdrawal periods.  If there are open contribution or withdrawal periods then illiquid assets must be valued so that there can be a NAV calculation.

HFLB: We agree that hedge funds need to have valuation methodologies if a fund will hold illiquid or hard to value assets.  We do not necessarily agree that funds which hold illiquid assets need to be closed ended (i.e. have a private equity fund structure).  Hedge fund attorneys will usually address this issue in a couple of ways: (1) through specifically delineated valuation practices to be utilized on valuation dates or (2) side pocket or similar structures.   We do note that in certain instances the manager, as well as the investor, would be better served through a closed end or private equity fund structure.  These are issues which the manager will need to discuss with their hedge fund attorney.

Conclusion

Castle Hall concludes with the following statement: “Ultimately, challenge brings opportunity: we remain convinced that a better, stronger hedge fund industry can emerge from the difficulties of today’s markets.”

HFLB: We agree.  I have stated before that we think the hedge fund industry will come back strong.  As regulations are added and due diligence increases, hedge funds should continue to grow as investors grow more comfortable with hedge funds as an asset class.

The full white paper can be found here.  The press release reprinted below, can be found here.

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November 03, 2008

Castle Hall Releases White Paper on Hedge Fund Investing in a New World

Castle Hall Alternatives, a leading provider of hedge fund operational due diligence, today published “Hedge Fund Investing in a New World: Five Questions for Investors and Managers.”

Chris Addy, Castle Hall’s President and CEO, said “the credit crisis and market events over the past year have challenged the hedge fund industry as never before. Alternative investments will remain integral to diversified, institutional portfolios, but there will unavoidably be a re-evaluation of the hedge fund model.”

Castle Hall’s focus on hedge fund operational risk has helped the firm identify five questions relevant to both investors and managers in this “New World”. The firm’s White Paper asks whether the typical “2 and 20” fee structure is fundamentally flawed; whether hedge funds need better corporate governance; and whether there is an “expectations gap” in the fund administration industry. The White Paper also questions whether the fund prospectus should be written to protect the manager or the investor and asks if it is possible to hold illiquid assets in an open ended vehicle.

“The structures and conventions accepted in the past may not be the best for the hedge fund industry going forward” said Addy. “We have highlighted a number of areas where current practices are weak and, in the New World, we expect investors to be more vocal and require greater protection and control when allocating to hedge funds. Investors will also focus more intently on operational, structural and business issues in addition to performance and strategy.”

Hedge Fund Investing in a New World, the first in a series of thought leadership papers to be published by Castle Hall, can be accessed on our Website, under the Publications section.

Please feel free to contact us if you have any comments or questions.  Other relevant HFLB articles include:

Hedge Funds and Anti-Money Laundering (AML) Requirements

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Hedge fund managers are often confused about their anti-money laundering (AML) obligations and seem to receive different information from various sources.  In general, domestic hedge fund managers do not have any AML obligations.  Additionally, it is unlikely that domestic hedge funds will be subject to any AML requirements in the near future.

The rise of the AML regulations came from the PATRIOT ACT, which required financial institutions to adopt AML procedures.  These regulations did not apply to domestic hedge funds specifically, but the Treasury promulgated proposed rules which would have applied the AML requirements to domestic hedge funds.  The proposed rule would have required hedge funds to (i) have internal AML polices, procedures and controls, (ii) have an AML officer, (iii) have ongoing compliance training for employees and (iv) have an annual audit of the AML program.

An article by the Washington Post recently announced that the Treasury has withdrawn the proposed AML requirements for hedge funds. The article states that the central reason why the AML requirements for hedge funds did not go through is that it is unlikely that terrorist groups would use hedge funds as a way to launder money.  The article states that hedge funds may be too risky for terrorists.

This announcement does not affect other financial institutions, such as banks and broker-dealers, which have specific AML and Know Your Customer (KYC) requirements.  The fact that the proposal was withdrawn does not mean, however, that hedge funds are free from any sort of AML.  As noted above, banks and broker-dealers are subject to their own AML requirements and may require their customers (hedge funds) to also implement AML policies.  If a bank or BD does require this, then the hedge fund manager should discuss the situation with the fund’s attorney to determine the appropriate next steps.  Offshore hedge funds, too, are subject to the anti-money laundering regulations of the jurisdiction in which they are domiciled.  The withdrawal of the proposed AML requirements does not affect these offshore hedge funds.

Please also note that state securities commissions may try to require hedge funds to incorporate AML requirements.  Currently we do not know of any state securities commissions with these requirements, but Texas has tried to implement a requirement like this in the past.

Please contact us, or another hedge fund attorney, if you have any questions.  Other related HFLB articles include: