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  1. 1. The Institute for International Research 8th Annual Hedge Fund Forum New York, NY May 21-22, 2001 REGISTERED HEDGE FUNDS AND INTERVAL FUNDS: BRINGING ALTERNATIVE INVESTMENTS TO A BROADER MARKET Kenneth S. Gerstein Partner Schulte Roth & Zabel LLP I. BACKGROUND A. Industry Trends. 1. During the past several years, mutual fund advisory firms and other institutional investment managers have begun to add alternative investments to their product menus. 2. Some advisory firms have built their own infrastructures to manage alternative investments. Others have partnered with managers of private funds and formed joint ventures to offer alternative investment products. Examples of joint ventures include: • Putnam Investments/Thomas H. Lee Company (private equity products) • ML/Zweig-DiMenna L.P. (private investment fund offered by Merrill Lynch) • Scudder Weisel Capital LLC (private equity) (now abandoned) 3. A principal impetus for these developments has been the accumulation of wealth among individual investors and the resulting increased focus of traditional managers and distributors of investment services on the high net worth market. 4. A 1997 change in the provisions of Subchapter M of the Internal Revenue Code of 1986 (the "Code") eliminated the "short-short" test and made it possible for mutual funds to use a wider range of investment strategies and financial
  2. 2. instruments. Mutual funds that pursue alternative investment strategies include: • Barr Rosenberg Market Neutral Fund • Phoenix-Euclid Market Neutral Fund • Warburg, Pincus Long-Short Market Neutral Fund, Inc. • The Mallard Fund, Inc. (closed-end fund of fund investing in hedge funds) • Salomon Smith Barney Multi-Strategy Market Neutral Investments (fund assets allocated to three independent investment managers that pursue alternative investment strategies) B. Use of Registered Funds to Offer Alternative Investments. 1. As discussed below, investment companies that are registered under the Investment Company Act of 1940 ("registered funds") are not subject to various restrictions that apply to offerings of interests in private investment partnerships. 2. For this reason, as advisory firms have sought to deliver alternative investment products to the mass affluent market, they are making increased use of registered funds. C. New Registered Fund Product Offerings. 1. Interval Funds. Advisory firms have organized publicly offered, closed-end interval funds that invest a significant portion of their assets in private equity investments. These products include: • Seligman New Technologies Fund, Inc. (invests up to 35% of its assets in private equity) • Seligman New Technologies Fund II (invests up to 50% of its assets in private equity and pays a performance fee) • Munder @Vantage Fund (invests up to 40% of its assets in private equity, either directly or through investments in private investment funds) 2
  3. 3. 2. Registered Hedge Funds. Some firms have created so- called "registered hedge funds" -- private investment funds organized as limited partnerships (or limited liability companies) that are registered as closed-end funds under the 1940 Act and are taxable as partnerships. These funds have generally been privately offered. The investment programs of these funds have included a variety of alternative investment strategies. Some of the funds invest a significant portion of their assets in private equity investments. Others are funds of funds. Registered hedge funds have been organized by: • CIBC World Markets Corp./CIBC Oppenheimer Advisers, L.L.C. • PaineWebber Incorporated • J.P. Morgan & Company, Inc. • United States Trust Company • Global Asset Management II. INTERVAL FUNDS INVESTING IN PRIVATE EQUITY A. Features of Interval Funds. 1. Interval funds are registered under the 1940 Act as closed- end funds. 2. By complying with Rule 23c-3 under the 1940 Act, a closed-end fund can have a policy of making periodic offers to repurchase its shares without being deemed to have issued a "redeemable security" (which would cause the fund to be an open-end company and subject it to rules applicable to open-end funds). 3. The interval fund concept allows for a hybrid investment vehicle that: (i) is not subject to the 15% of net assets limitation on the purchase of illiquid securities that applies to open-end funds; (ii) need not offer daily liquidity through redemptions like a mutual fund and (iii) can provide limited liquidity to investors through periodic share repurchases (i.e., issuer tender offers). 3
  4. 4. 4. These features make an interval fund well suited as the structure to make private equity investment programs available on a retail basis. 5. Unlike hedge funds which cannot engage in public offerings, an interval fund can make a public offering of its shares. 6. Typically, interval funds that invest in private equity are not publicly traded. B. Key Requirements of Rule 23c-3. 1. An interval fund must have a fundamental policy (which can be changed only by a majority vote of shareholders) of making repurchase offers at periodic specified intervals (quarterly, semi-annually or annually). 2. Generally, the amount offered to be repurchased in each repurchase offer must be not more than 25% nor less than 5% of the fund's outstanding shares. However, a discretionary repurchase offer without limitation on the percentage of shares repurchased is permissible every two years. 3. Shares must be repurchased for cash at the net asset value determined on the "repurchase pricing date," and payment must be made by the "repurchase payment deadline." • The repurchase pricing date must occur no later than the 14th day after the deadline by which investors must submit a repurchase request (the "repurchase request deadline"). • The repurchase payment deadline must occur seven days after the repurchase pricing date. 4. A periodic repurchase offer can be suspended only by vote of a majority of the fund's directors, including a majority of the "independent directors," and only under the limited circumstances specified in Rule 23c-3 (similar to those applicable to open-end funds, but also if the repurchase offer would cause the fund to lose its status under Subchapter M of the Code or to be "de-listed"). 5. If a repurchase offer is over subscribed, tendered shares must be repurchased on a pro rata basis as prescribed by Rule 23c-3. 4
  5. 5. 6. Tenders of shares may be withdrawn by an investor at any time prior to the repurchase request deadline. 7. A majority of the directors of an interval fund must be directors who are not "interested persons" of the fund, and those directors must select and nominate any other disinterested directors. In addition, a recent amendment to Rule 23c-3 requires that any person who acts as legal counsel for the disinterested directors be an "independent legal counsel." See, Release No. IC-24816 (Jan. 2, 2001). 8. An interval fund must have liquid assets equal to at least 100% of the repurchase offer amount from the time the required notification of the offer is sent to shareholders through the repurchase payment deadline. 9. The issuer tender offer rule under the Securities Exchange Act of 1934 (the "1934 Act") does not apply to interval fund repurchase offers pursuant to Rule 23c-3. See, paragraph (h)(7) of Rule 13e-4 under the 1934 Act. C. Private Equity Interval Funds. 1. Recently organized interval funds investing in private equity have been publicly offered. They have elected to be taxed like mutual funds under Subchapter M of the Code, rather than as partnerships. 2. The funds are not publicly traded. 3. Some of the funds pay performance fees to their investment advisers. In these cases, Rule 205-3 under the Investment Advisers Act of 1940 (the "Advisers Act") applies and shares can be sold only to investors who are "qualified clients." (See IV.A.1. infra.) 4. The funds plan to offer their shares to investors on a periodic basis or on a continuous basis. 5. To the extent that these funds make significant investments in securities for which market quotations are not readily available, the "fair value" of such investments has to be determined in accordance with procedures adopted by the boards of directors (trustees) of the funds. These values will determine the net asset value at which shares of the funds are sold and repurchased. It may be difficult to calculate the fair value of certain private equity investments. 5
  6. 6. III. REGISTERED HEDGE FUNDS A. Hybrid Product. 1. The concept of a hedge fund registered under the 1940 Act -- that is, a registered investment partnership -- is one that overcomes many of the obstacles associated with marketing private investment funds to a broad market and can provide other desirable benefits. 2. This hybrid product essentially takes the features and attributes of a private investment partnership and adjusts them to meet applicable regulatory requirements of the 1940 Act. B. Structure of Registered Hedge Funds. 1. Unlike a mutual fund, which is typically organized as a corporation or business trust, a registered hedge fund is organized as a limited partnership or a limited liability company. 2. The fund manager serving as the investment adviser of the partnership is the general partner of the partnership. Alternatively, the general partner may be a joint venture entity between the fund manager and the product distributor. In either case, the general partner must be registered as an investment adviser under the Advisers Act. 3. Like other private investment funds, interests in the partnership are typically sold to high net worth individuals and institutions in private placements. 4. Investors are subject to incentive allocations (i.e., a percentage of net profits is allocated to the general partner). In addition, the partnership typically pays a management fee computed as a percentage of net assets. 5. The partnership registers as a closed-end management investment company under the 1940 Act. 6. To satisfy 1940 Act governance requirements, the partnership has individual general partners. These persons perform the duties required to be performed by directors of investment companies under the 1940 Act. Normally, at least 40% of such persons must be persons who are not 6
  7. 7. affiliated with the investment adviser or otherwise "interested persons," as defined by the 1940 Act, of the partnership or its investment adviser. As an alternative to having individual general partners, management responsibilities can be assigned to a board of managers. 7. Under the 1940 Act, partnership investments and similar assets must be maintained in the custody of a custodian bank retained by the partnership. Although a prime broker may be utilized to facilitate settlements, short sales and margin borrowings, the prime broker cannot generally hold the partnership's securities and similar assets. 8. The partnership elects to be taxed under the Code as a partnership, unlike a mutual fund which is taxed as a corporation under Subchapter M of the Code. 9. To avoid taxation as a corporation under the Code's provisions applicable to publicly traded partnerships, limited partnership interests in the partnership are not redeemable or readily tradable. The partnership from time to time makes repurchase offers, which must comply with the issuer tender offer rule under the 1934 Act, to provide liquidity to investors. Repurchase offers made more frequently than on a semi-annual basis may make the partnership a publicly traded partnership. 10. The partnership may elect to be an interval fund and comply with Rule 23c-3. However, registered hedge funds have generally opted not to be subject to the conditions of Rule 23c-3. This provides greater flexibility in the timing and terms of repurchase offers, but means that the partnership cannot promise to make repurchase offers on a regular periodic basis. 11. The basic registered hedge fund structure is illustrated in Annex 1. IV. PROS AND CONS OF REGISTERED FUNDS A. Benefits of Using Registered Funds. 1. Broader Market Potential. Registration of a fund under the 1940 Act eliminates the 100 beneficial owner limitation that applies to an investment partnership that relies on Section 3(c)(1) of the 1940 Act for its exclusion from 1940 Act registration (a "Section 3(c)(1) fund"). Interests in a 7
  8. 8. Section 3(c)(1) fund must be sold on a private placement basis to no more than 100 beneficial owners. Registration also avoids the requirements applicable to an investment partnership that relies on Section 3(c)(7) of the 1940 Act for its exclusion from registration (a "Section 3(c)(7) fund"). Interests in a Section 3(c)(7) fund must be sold on a private placement only to persons who are "qualified purchasers"; generally, institutional investors and entities having investments of not less than $25 million and individual investors having investments of not less than $5 million. Registration under the 1940 Act also moots the "integration" issue that applies to Section 3(c)(1) funds (i.e., the risk that a single 100 beneficial owner limit will apply to two or more Section 3(c)(1) funds that have similar risk/return characteristics). Because registration under the 1940 Act permits broad distribution, there is no need to impose a high minimum investment requirement. In addition, a registered fund can also offer shares or interests in a public offering, if it registers under the Securities Act of 1933, which further enhances distribution potential. • If shares/interests are offered in a private placement, it will generally be necessary to limit the offering to persons who are "accredited investors" as defined in Regulation D under the Securities Act of 1933 (the "1933 Act") (i.e. an individual investor having a net worth exceeding $1 million, or who had income in excess of $200,000 in each of the two most recent years (or joint income with a spouse of $300,000) and has a reasonable expectation of reaching the same income level in the current year). • If shares/interests are privately offered, procedures are necessary to assure compliance with the Regulation D "safe harbor" for private placements. Among other things, this entails the use of subscription documents, to be completed by investors, to verify that investors are "accredited," and the implementation of procedures to prevent general solicitation and general advertising of the offering (which are prohibited by Regulation D). • When a performance based incentive allocation or fee is imposed, investors in a registered fund -- as is true for private investment partnerships advised by registered investment advisers -- must be "qualified clients" as defined by Rule 205-3 under the Advisers Act (i.e., an 8
  9. 9. investor with a net worth exceeding $1.5 million or with assets under the investment adviser's management of at least $750,000). • Thus, shares/interests in an interval fund or a registered hedge fund can be offered and sold in a private offering to an unlimited number of accredited investors, each having a net worth of more than $1.5 million (or having at least $750,000 of assets under the management of the fund's adviser). • Alternatively, shares/interests can be registered under the 1933 Act and publicly offered. In such a case, there is no need to comply with Regulation D and general solicitation and advertising are permissible. Shares/interests can be sold in a public offering to an unlimited number of investors (subject only to compliance with the net worth or assets under management tests of Rule 205-3 if a performance based allocation or fee is imposed). Registration under the 1933 Act enables interval funds and registered hedge funds to be offered and "ticketed" like traditional mutual funds. 2. Favorable Basis of Compensation. The general partner of a registered hedge fund typically is entitled to receive an incentive allocation -- an allocation of a specified percentage of the fund's net profits. This differs from advisory fees paid by mutual funds to their investment advisers (including incentive fees paid by interval funds), which are taxable to the advisers at ordinary income tax rates. To the extent an incentive allocation is derived from realized capital gains, it will be taxable at capital gains rates. Taxation at favorable capital gains rates can enhance after-tax income for the owners of advisers that are pass- through entities for tax purposes. 3. No ERISA Look-Through. The assets of a registered investment company are not treated as plan assets for purposes of the Employee Retirement Income Security Act of 1974 ("ERISA"). As a result, employee benefit plans can hold more than 25% of the interests in an interval fund or a registered hedge fund without any ERISA look- through to the assets of the fund and without subjecting the fund and its adviser to certain fiduciary duties and prohibited transaction rules under ERISA. 9
  10. 10. 4. Differentiation from Mutual Fund Offerings. Because the registered hedge fund has all of the attributes of a private investment partnership, potential investors will not view the product as simply another "plain vanilla" mutual fund offering. 5. Exclusion from NASD Hot Issues Rule. An interpretation of the Conduct Rules of the National Association of Securities Dealers, Inc. ("NASD"), IM-2110-1, prohibits the allocation by NASD member firms of "hot issues" (i.e., public offerings that trade at a premium in the secondary market when secondary market trading begins) to persons affiliated with brokerage firms and certain other persons engaged in the securities business, who are deemed to be "restricted persons." • The interpretation generally requires a look-through to investors in investment funds that purchase hot issues. Thus, hedge funds must establish special "hot issues accounts" to assure that profits from hot issues are not allocated to investors who are restricted persons under the NASD interpretation. • However, the NASD Hot Issues Rule does not require a look-through to investors in a 1940 Act registered investment company. As a result, restricted persons (including investment adviser personnel) can participate in profits derived from hot issues purchased by an interval fund or a registered hedge fund and there is no need for these funds to establish special hot issues accounts. 6. Exemption from CFTC Regulation. Rule 4.5 of the Commodity Futures Trading Commission ("CFTC") provides an exemption under which registered investment companies may make limited use of futures contracts without being deemed to be commodity pools, subject to regulation, and without the need for commodity pool operator ("CPO") registration. This exemption is not available for hedge funds. • Offering documents of commodity pools must contain certain required disclosures and be filed with and reviewed by the National Futures Association ("NFA"). These requirements do not apply if interests in a pool are offered solely to persons who are "qualified eligible participants" ("QEPs"). 10
  11. 11. • Interval funds and registered hedge funds can generally rely on Rule 4.5 to eliminate the applicability of CFTC regulatory requirements and the need for CPO registration. Thus, shares/interests in an interval fund or a registered hedge fund relying on Rule 4.5 may be sold to investors who are not QEPs without triggering disclosure and NFA filing requirements. 7. Benefits of Partnership Taxation. Unlike shareholders of a mutual fund (and just like investors in a typical private investment partnership), investors in a registered hedge fund or an interval fund that is taxed as a partnership will not be taxed on income and realized capital gains except insofar as they actually receive such income or gains. Under the Code, mutual funds must make certain required distributions of income and gains. Those distributions are taxable to a shareholder of a mutual fund despite the fact that, economically, the distributions may represent a return of invested capital and not profits earned by the shareholder. B. Issues to Consider. 1. Applicability of 1940 Act Investment Restrictions. Registered hedge funds and interval funds are subject to certain investment limitations imposed by the 1940 Act. Among other things, the 1940 Act limits the use of leverage by imposing an asset coverage requirement. The registered hedge fund and interval fund concepts are feasible for delivering alternative investment strategies to investors only where the investment programs fit within the 1940 Act regulatory scheme. Generally, most investment programs will be feasible, except for those that involve highly leveraged strategies. 2. Costs of 1940 Act Regulation. The 1940 Act imposes certain governance requirements, which require investment companies to have independent directors and require that these directors (and sometimes also shareholders of the funds) approve certain matters. The books and records of registered investment companies are subject to SEC examination. Thus, a registered hedge fund or interval fund will incur various regulatory related costs. These costs should not be substantial or burdensome, assuming a reasonable level of net assets. 11
  12. 12. 3. Public Reports. Registered investment companies must send audited annual reports and unaudited semi-annual reports to their investors. The reports contain financial information, including a statement of investments. The reports are filed with the SEC and publicly available. 4. Administration and Compliance Issues. Operating a registered investment company requires the implementation of systems to assure compliance with the 1940 Act and other applicable laws. In addition, the adviser or another organization will have to furnish necessary fund accounting and transfer agent services. An outside administrator and transfer agent can be retained by a fund to supply these services. Frequently, the functions of an administrator will include supervision of regulatory and tax compliance. 5. Need for Adviser Registration. An adviser may be reluctant to manage a registered hedge fund or an interval fund if the adviser is not already registered under the Advisers Act. The investment adviser of a registered fund must be registered under the Advisers Act. Registered advisers are required to maintain certain books and records, which are subject to examination by the SEC and its staff. • The Advisers Act and its rules impose other requirements, including rules governing advertising, custody of client funds and securities, and cash referral arrangements, and a prohibition on principal transactions in securities with clients without consent. Although many of these rules apply to unregistered advisers, SEC oversight necessitates that greater attention be paid to compliance issues by registered advisers. • Performance fees and allocations imposed by registered advisers must comply with Rule 205-3 under the Advisers Act. If an unregistered adviser registers, existing fee and allocation arrangements with clients (such as existing private investment funds) may have to be modified to comply with the rule. 6. Ability to Manage Additional Assets. Depending on the nature of a fund manager's investment program, there may be consequences associated with the management of substantial additional assets. The potential adverse impact of additional assets on the investment performance of a 12
  13. 13. manager's existing funds and accounts needs to be evaluated. C. Benefits for Advisers. 1. Access to Distribution Systems and Investor Base. Investment advisory firms can use the registered hedge fund and interval fund concepts as means to partner with financial advisors and with financial services firms, such as banks, brokerage firms and insurance companies, to gain access to their broad high net worth distribution systems. 2. Ability to Leverage Off Institutional Infrastructure. Where a smaller fund adviser partners with a large financial institution, the adviser may gain access to a sophisticated institutional infrastructure that can be used to handle fund administration, fund accounting and investor relations and servicing for a registered hedge fund or interval fund product. D. Benefits for Financial Advisors and Financial Services Firms. 1. Enhanced Ability to Attract/Retain Individual Clients. By creating registered hedge funds or interval funds in partnership with fund managers that specialize in alternative investments, financial advisors and financial services firms can expand their product offerings and provide high net worth clients access to select managers. The concept can be used to deliver a variety of alternative investment products, including private equity funds, venture capital funds and funds of funds. The availability of these products can help attract new clients and facilitate the retention of existing clients who might otherwise turn elsewhere to for products and services. 2. Increased Capability to Serve Institutional Clients. A broader product set enables a financial services firm to market a wider array of services to its existing institutional client base, including pension funds, endowments and foundations. 3. Immediate Expertise in Alternative Investments. Instead of building expertise from the ground up, which can involve a substantial time and capital commitment, creating a registered hedge fund or an interval fund in partnership with a fund manager that specializes in alternative 13
  14. 14. investments provides immediate capability in the alternative investment arena. 4. Ability to Acquire Performance Record. Partnering with a fund manager with alternative investment expertise may enable a financial advisor or financial services firm to offer a product that can be marketed using the track record of the fund manager. 5. Retention of Financial Advisor as Distributor for Funds. A financial advisor or financial services firm can be retained as a placement agent for registered hedge funds or interval funds organized and advised by other firms. Broker-dealer registration will generally be required for any firm that serves as a placement agent. 14