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
Schulte Roth & Zabel LLP
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
• Putnam Investments/Thomas H. Lee Company (private
• ML/Zweig-DiMenna L.P. (private investment fund
offered by Merrill Lynch)
• Scudder Weisel Capital LLC (private equity) (now
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
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
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
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
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
• 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
• Munder @Vantage Fund (invests up to 40% of its
assets in private equity, either directly or through
investments in private investment funds)
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
• 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-
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).
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
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
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
• 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
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
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
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
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
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
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
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
• 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
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
• 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
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.
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
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
• 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
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
• 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
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
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.
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
• 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
manager's existing funds and accounts needs to be
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
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
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
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
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.
REGISTERED HEDGE FUND STRUCTURE
LIMITED INDIVIDUAL MANAGER/
PARTNERS GENERAL PLACEMENT AGENT
1% Management Fee
PRIME Limited Partnership
BROKER (Registered Closed-End Fund)
20% Incentive Allocation
ACCOUNTING GENERAL PARTNER