Hedge funds. a basic overview
Upcoming SlideShare
Loading in...5
×
 

Like this? Share it with your network

Share

Hedge funds. a basic overview

on

  • 1,731 views

The law firm's investment management practice represents a full range of U.S. domestic and non-U.S. clients ...

The law firm's investment management practice represents a full range of U.S. domestic and non-U.S. clients
in all aspects of their organization and operations. Our clients include start-up investment managers/advisers and
investment funds, seasoned private equity and venture capital professionals and established/industry-recognized investment companies and institutions.

Statistics

Views

Total Views
1,731
Views on SlideShare
1,731
Embed Views
0

Actions

Likes
1
Downloads
54
Comments
0

0 Embeds 0

No embeds

Accessibility

Upload Details

Uploaded via as Microsoft PowerPoint

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

Hedge funds. a basic overview Presentation Transcript

  • 1. HEDGE FUNDS: A BASIC OVERVIEW
  • 2. DEFINITION: HEDGE FUND• Hedge Fund – a lightly regulated investment vehicle that may use a variety of investment techniques and may invest in a vast array of assets to generate higher returns for a certain level of risk when compared to conventional investments. 2 www.maliklawgroup.com
  • 3. HEDGE FUND OVERVIEW• Reduced regulatory oversight• Private in nature• Often more aggressive investment strategies  Absolute-return funds  Directional funds  Short Selling  Leverage• Greater investment flexibility• Performance fees or incentive allocations• Frequently substantial investment by advisers and portfolio managers 3• Tax benefits from fund’s structure
  • 4. REDUCED REGULATORY OVERSIGHT• Do not have to register with the U.S. Securities and Exchange Commission (SEC), National Association of Securities Dealers (NASD), or Commodity Futures Trading Commission (CFTC)• Some hedge funds nonetheless elect to register with these governing bodies• Registered or not, hedge funds cannot commit fraud, participate in insider trading, or violate 4 other local, state, or federal law
  • 5. PRIVATE IN NATURE• Private securities offering, i.e. not registered under federal or state securities laws• Under current law, cannot be offered or sold to the general public, must be limited to:  Accredited investors– individuals with net worth of at least $1 million or an annual income of $200,000 ($300,000 for a married couple)  Qualified purchasers—individuals, trust accounts, or institutional funds with at least $5 million in investible assets• Rationale: people with high net worth generally understand investment risks and returns better than the average person and can afford to lose money if the investment does not work out 5
  • 6. AGGRESSIVE INVESTMENT STRATEGIES• Absolute return funds—designed to generate steady return regardless of what the market is doing  More appropriate for a conservative investor (wants low risk and willing to give up some return in exchange)  Generate bond-like returns (in long run returns higher than bonds, but lower than stocks)• Directional funds– funds that don’t hedge fully by maintaining exposure to the market, but trying to get higher than expected returns from the amount of risk taken  More appropriate for an aggressive investor (willing to take some risk to gain potentially higher returns)  Generate stock-like returns 6  Not as steady as absolute return funds, but over long run returns are higher
  • 7. AGGRESSIVE INVESTMENT STRATEGIES (CONTINUED)• Short selling–when securities look like they will go down in price, you “borrow” them from investors who own them and then sell the securities in an attempt to buy them back at lower prices to repay the loans• Leverage– borrowing money to increase return, relative to the amount of money the fund has  Fund has to repay the loan regardless, so can increase risk  Funds may sometimes use leverage for low-risk investment strategies to increase the return without taking on undue risk  Key difference between hedge fund and other investments which are 7 not permitted to employ leverage
  • 8. GREATER INVESTMENT FLEXIBILITY• Portfolio manager may employ a broad array of investment techniques that are not permissible for a tightly regulated investment vehicle• Generally not constrained in investment activities by diversification requirements applicable to mutual funds 8
  • 9. PERFORMANCE & MANAGEMENT FEES• “Industry standard” 2 and 20 arrangement– fund manager receives an annual fee of 2% of the assets in the fund and an additional bonus of 20% of the year’s net profits  May be different percentages, but management fee + bonus is standard  Management fee typically mean to cover operating expenses  Manager only receives a bonus if the fund makes money  Performance fees frequently conditioned with a loss carryforward provision, whereby no fee is paid on 9 profits that replace prior losses
  • 10. PERFORMANCE & MANAGEMENT FEES (CONTINUED)• Key difference in hedge fund versus other investments (SEC prohibits mutual funds from charging performance fees)• Downsides:  After accounting for fees, a hedge fund’s outsized performance relative to other investments may be reduced  If a fund has a negative year, manager has incentive to close the fund and start over instead of foregoing a performance fee while recovering prior losses 10
  • 11. SUBSTANTIAL INVESTMENT BY ADVISERS AND MANAGERS• Managers usually become partners with the investors by making significant investments of their own into the fund or by paying the fund’s organizational expenses• Financial commitment by managers can be important in attracting outside investors, as the fund manager carries the same investment risks as the investors and both groups’ interests are, therefore, aligned 11
  • 12. TAX BENEFITSFlow-Through Tax Treatment:Unlike a LP, a corporation is taxed on its profitsand its shareholders pay taxes on any dividendsthey receive— “double taxation.” LPs, however,act as “flow through” entities and no tax is paid atthe entity level. Instead, the LP’s members areindividually taxed on their allocable share of theentities’ income, gain, or loss (whether or notdistributed or realized). Accordingly, each memberreceives a report of their allocable share onInternal Revenue Service Form 1040, ScheduleK-1, and similar state tax forms, issued by the LP. 12
  • 13. SAMPLING OF HEDGE FUND STRATEGIES• Long only • Credit Funds• Long/Short • Event-driven• Market Neutral Arbitrage• Short-Bias • Distressed Securities• Macro • Energy Funds• Sector • Emerging Markets• Convertible Bond and • Crossover Funds Convertible Arbitrage • Managed Futures• Fixed-Income Arbitrage 13
  • 14. LONG ONLY• Purchase and sell securities• Does not sell short very often, if at all 14
  • 15. LONG/SHORT• Take both long and short positions in securities• Seeks to benefit from fund manager’s view on undervalued/overvalued assets in the market instead of directional movements in the market 15
  • 16. MARKET NEUTRAL• Similar to long/short strategy• Seeks to eliminate or minimize impact of the market on the fund’s return  Relies almost entirely on portfolio manager’s investment analysis• Various techniques:  Take offsetting positions in same security  Take long and short positions in same types of securities 16
  • 17. MARKET NEUTRAL (CONTINUED)• Different ways to be neutral:  Beta Neutral fund has same level of overall market risk in long and short positions  Dollar neutral fund has same overall dollar amounts committed to long and short positions  Sector neutral fund has same dollar amounts committed to long and short positions within each sector or industry 17
  • 18. SHORT-BIAS• Invests primarily in short positions, focusing on identifying overvalued stocks to sell short  Selling stocks short  Buying put options  Selling stock index futures• Almost always net short the market 18
  • 19. MACRO• Seeks returns in major changes in global economic or financial trends• May use a high degree of leverage• Relatively volatile• May take positions in several types of instruments  Securities  Currencies  Commodities  Derivatives 19
  • 20. SECTOR• Focuses in particular industries or economic/financial sectors 20
  • 21. CONVERTIBLE BOND AND CONVERTIBLE ARBITRAGE• Invests in convertible bonds (bonds that can be converted into the issuer’s stock at a certain price)• Provides a degree of exposure to equities with controlled risks  Aims to generate profits while protecting itself from risks• Often take positions in both convertible bonds and underlying equity of a company  May separate convertible bonds into constituent debt and equity parts, keeping some portions and selling others  May purchase distressed convertible bonds or use credit derivatives to protect against credit risk, depending on how 21 aggressive or conservative the fund strategy is
  • 22. FIXED INCOME ARBITRAGE• Seeks to take advantage of price inefficiencies between debt instruments (mortgage-backed securities, corporate, and government bonds, and interest rate derivatives)  Cross credit arbitrage simultaneous long and short positions in debt securities of different issuers to profit from differences in their credit quality  Capital structure or balance sheet arbitrage simultaneous long and short positions in debt securities of the same issuer  Convergence trades designed to produce profits as perceived inefficient prices converge over time• Because of small profit potential on each investment, the fund often uses a significant 22 amount of leverage to enhance returns
  • 23. CREDIT FUNDS• Extends credit to various companies 23
  • 24. EVENT-DRIVEN ARBITRAGE• Seeks to profit from price differences of securities involved in announced corporate events (ex., mergers, acquisitions, restructuring)• Major risks:  Possibility of transaction failing to be completed  Difficulty and expense in borrowing shares to sell short  Lack of mergers or other transaction critical to the strategy • To protect against risks, fund diversifies risk across many sectors and transactions 24
  • 25. DISTRESSED SECURITIES• Sometimes referred to as “Vulture Funds”• Investing in distressed securities, seeking to profit from special opportunities  Bonds, loans, trade claims, receivables, or equity of companies in severe economic distress, possibly facing bankruptcy, reorganization/restructuring or recapitalizations• Often limit investor withdrawals by imposing a lock-up period because the lengthy amount of time it takes to turn a profit on these securities and the fund’s holdings illiquid nature 25
  • 26. DISTRESSED SECURITIES (CONTINUED)• “Second lien loans” direct loans to struggling companies, taking short positions in the company stock or playing an active role in any workout of the company• “Orphan equities” acquire restructured equity in companies which trade at discounted rates since analysts and markets don’t follow them• “Loan to own” when holding substantial amounts of distressed securities, may end up owning the company if it becomes insolvent• “When issued basis” trade securities about to be 26 issued in a reorganization on a when issued basis
  • 27. ENERGY FUNDS• Focus on various aspects of green technology and resource industries  Commodities • Crude oil, natural gas, coal  Green technologies • Emission and carbon trading • Renewable energy 27
  • 28. EMERGING MARKETS• Investing in equities or fixed income securities of corporate or sovereign issuers in emerging markets• High risk/ High return  Greater potential for significant price appreciation  Increased Illiquidity  Increased Volatility  Foreign laws and regulations governing trading can add significant risks and costs 28
  • 29. CROSSOVER FUNDS• Seeking opportunities in other’s fields (convergence)• Hybrid between hedge fund and private equity fund  Seeks to profit by holding publicly traded and private securities• Greater investment flexibility, broader range of potential investment opportunities• Frequently longer lock-up periods than other types of hedge funds 29
  • 30. MANAGED FUTURES• Futures and options on futures contracts• Generally is considered a commodity pool by the CFTC• Commodity pool adviser and any trading advisors must be registered, absent an exemption 30
  • 31. HEDGE FUND STRUCTURE• Fund Manager– may do all trading and research himself or hire a staff to give him advice:  Traders– execute buy-sell decisions, operating in real time  Analysts –make projections about future value of securities• Fund Administrator• Investors• Legal Counsel – help navigate regulations, registration obligations, exemptions and compliance responsibilities• Other Consultants – advise investors, monitor fund performance, and market fund managers to 31 new clients
  • 32. HEDGE FUND STRUCTURE (CONTINUED)• Usually structured as Limited Partnership (but could also be an LLC)  General partner—controls the fund  Limited partners– invest in the fund Portfolio Transactions Manage (and frequently General invest in) the fund Partner Limited - Custody Partnership - Reporting - Settlement - Other services Limited Partner Invest Limited Prime Broker Limited Partner 32 Partner
  • 33. FUND MANAGER/ GENERAL PARTNER• Responsible for the overall management of the fund’s assets and portfolio investments• Many managers whose funds invest in securities are registered as investment advisers with the SEC under the U.S. Investment Advisers Act of 1940 (Advisers Act) or under state law, although there are some exemptions to registration 33
  • 34. PRIME BROKER• Provides general manager with centralized custody, clearing and settlement, execution of portfolio transactions, reporting, financing, securities loans and borrowing, record keeping, access to securities offerings, marketing to new investors, and other services from one source• Even though prime broker holds all the fund’s assets, manager can still trade with a variety of broker dealers– similar to a bank custodial account 34
  • 35. ADMINISTRATOR• General administration for LPs and LLCs:  Monthly calculation of the net asset value of the fund  Maintaining capital accounts for fund participants  Tracking deposit and payment of funds as fund’s designated custodians  Facilitating, upon instructions from fund, the payment of fees and expenses of service providers and fund management  Maintaining the customary financial and accounting books and records of the fund• General administration for offshore corporations:  Day to day administration, reporting, and business of the fund  Determining and notifying fund management of net asset values of fund overall, each class, each series of each class, and the relevant net asset values per share– as well as the issue and redemption price of shares and number of shares in issue  Tracking deposit and payment of funds as fund’s designated custodians  Preparing letters for a director’s signature or facilitating the authorization of payments of fees and expenses of service providers and fund management 35  Maintaining the customary financial and accounting books and records for the fund
  • 36. ADMINISTRATOR (CONTINUED)• Document review• Subscription processing for domestic funds• Share registry for offshore corporations• Provide portfolio details with monthly brokerage statements, performance reports, investors reports, underlying managers reports,• Maintain records for fund accounting and cash activity• Audits and tax preparatory work• Administrative records 36• Exercise financial controls
  • 37. LEGAL COUNSEL• Provide advice concerning appropriate structures and entity creation• Draft offering documents, partnership/membership agreements, and subscription agreements• Register investment advisor with the Securities and Exchange Commission or one or more state securities division(s), including drafting of Form ADV, and/or commodity pool operator registration with the National Futures Association, as necessary• Provide tax advice, including treatment of ERISA plans and other tax-exempt investors• Submit Regulation D, Rule 506 Form D and blue sky filings with applicable state securities divisions• Draft related documents, such as side letter agreements, sub- 37 advisory agreements, etc.
  • 38. AUDITORS• Provide investors with independently audited annual financial statements• Various jurisdictions require periodic audited financial statements• Providing audited statements can be an easier way for the fund manager to comply with certain custody requirements under the Advisers Act 38
  • 39. SUMMING IT UP• Private in nature with limited regulatory oversight• May use a variety of aggressive investment techniques• Objective is to generate higher return on investments for the amount of risk taken compared to conventional investments• Usually set up at a Limited Partnership or Limited Liability Company• Involves a team consisting of the fund manager, investors, prime broker, administrator, auditors, and legal counsel 39
  • 40. DISCLAIMER• This presentation was made for informational purposes only.• Malik Law Group LLC is not providing legal advice to any user.• Malik Law Group LLC is not providing tax advice. This presentation is subject to the Circular 230 Notice on the next slide.• This presentation does not establish an attorney-client relationship between Malik Law Group LLC and the user.• Any discussion herein is not a substitute for seeking actual legal advice from a licensed attorney with knowledge of the rules and regulations governing the industry.• Malik Law Group LLC makes no representations, guarantees, or warranties as to the accuracy, completeness, currency, or suitability of the information provided via this presentation.• This presentation may be considered “attorney advising” in 40 some jurisdictions.
  • 41. DISCLAIMER–CIRCULAR 230 NOTICE• CIRCULAR 230 NOTICE. THE FOLLOWING NOTICE IS BASED ON THE U.S. TREASURY REGULATIONS GOVERNING PRACTICE BEFORE THE U.S. INTERNAL REVENUE SERVICE: (1) ANY U.S. FEDERAL TAX ADVICE CONTAINED HEREIN, INCLUDING ANY OPINION OF COUNSEL REFERRED TO HEREIN, IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING U.S. FEDERAL TAX PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER; (2) ANY SUCH ADVICE IS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS DESCRIBED HEREIN (OR IN ANY SUCH OPINION OF COUNSEL); AND (3) EACH TAXPAYER SHOULD SEEK ADVICE BASED ON THE TAXPAYER’S PARTICULAR CIRCUMSTANCES FROM AN 41 INDEPENDENT TAX ADVISER.