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Hedging the Global
Market Series
Avoiding Excessive Hedge Fund Regulation in a
Post-Recession Era
Series by Jon Terracciano
Topic: Background and
Structure of Hedge Funds
Backgroundand Structure of Hedge Funds
In today’s highly developed and advanced financial environment, the term
“hedge fund” still invokes perceptions of obscurity and ambiguity, even among
the most sophisticated investors. To this day, the term “hedge fund” lacks a
single, universally recognized definition in the financial world, resulting in
various, and sometimes contradicting, definitions of the term. Although not
statutorily defined in the U.S. or abroad, the industry’s generally “accepted
definition is that [hedge funds] are privately offered investment vehicles in
which the contributions of the high net worth participants are pooled and
invested in a portfolio of securities, commodity futures contracts, or other
assets.”
36
36 See, e.g., Staff of the Commission's Division of Investment Management and Office of Compliance Inspections and Examinations, Implications
of the Growth of Hedge Funds: Staff Report to the United States Securities and Exchange Commission viii (2003) [hereinafter SEC 2003 Staff
Report]; Financial Services Authority (United Kingdom), Hedge Funds and the FSA, Discussion Paper 16, at 8 (2002).
37 Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation. Hedge Funds Consistency Index. Feb. 12, 2010, available at
http://www.hedgefund-index.com/s_negi.asp.
37
The term “hedge fund” is believed to have been coined back in 1949, referring
to a private investment fund managed by Alfred Winslow Jones under a
private partnership agreement. In that fund, Mr. Jones employed a strategy of
holding both long and short equity positions to “hedge” the fund portfolio’s
risk against market volatility. Moreover, Mr. Jones pioneered a revolutionary
way of charging a “management fee” to investors. Rather than charging a
percent of assets under management, Jones charged a 20% “performance fee”
equal to the fund’s returns. This strategy has been widely adopted by the
hedge fund industry, where most hedge funds charge a 15-25% performance
fee, in addition to a 2% general management fee based on the total value of
assets held.
38 David A. Vaughn, Selected Definitions of “Hedge Fund.” Comments for the U.S. Securities and Exchange
Commission Roundtable on Hedge Funds. May 14-15, 2003, available at
http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1.
39 Id.
40 Christopher Holt, Performance Fees: As Old as Portfolio Management Itself? Seeking Alpha. Jan 20, 2009
available at http://seekingalpha.com/article/115612-performance-fees-as-old-as-portfolio-management-itself.
41 Id.
3
38
40
6
41
39
Although the fee structure established by Mr. Jones in 1949 is applied by
nearly all hedge funds today, the investing strategy of “hedging” he employed
is not a universal characteristic of the entire industry. As the hedge fund
industry evolved over time, many hedge funds began to utilize different
investment strategies, and some hedge funds even did away with “hedging”
altogether. In addition to, or in place of, “hedging,” many current hedge funds
draw from a pool of over twenty-five investing strategies, such as using
leverage, derivatives, and arbitraging by investing in multiple markets. A fund
need not utilize all these methods to be deemed a “hedge fund,” but must
simply have the capability to engage in them. Today, hedge funds are defined
by their organizational structure and mode of operation, rather than by the
investing or financial strategies they employ. As more and more hedge funds
have taken a purely equitybased approach to investing without applying any of
the aforementioned methods, many “’hedge funds’ are not actually hedged,
and the term has become a misnomer in many cases.”
42 Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000).
Available at http://www.sec.gov/spotlight/hedgefunds/hedgevaughn.htm#footnote_1.
43 JOHN DOWNES AND JORDAN ELLIOTT GOODMAN, BARRON'S, FINANCE & INVESTMENT HANDBOOK 358 (5th ed. 1998). Available at
http://www.sec.gov/spotlight/hedgefunds/hedgevaughn.htm#footnote_1; MANAGED FUNDS ASSOCIATION, HEDGE FUND FAQs 1 (2003)
44 Id.
45 Supra note 18: Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E.
Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1.
46 WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, TESTIMONY CONCERNING INVESTOR PROTECTION
IMPLICATIONS OF HEDGE FUNDS BEFORE THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS, Apr. 10, 2003, available at
http://www.sec.gov/news/testimony/041003tswhd.htm.
9
42
43
44
45
46
Although the investing tactics of hedge funds may have morphed over the last
sixty years, the management and investor structure has primarily remained
the same, much like the original fee structures. U.S. hedge funds are normally
organized as limited liability partnerships (“LLP’s”) or limited liability
corporations (“LLC’s”), whereby the fund manager serves as the general
partner (“GP”) and the investors constitute limited partners (“LP’s”). Subject
to the limited partnership agreement and the fiduciary duties that apply under
both LLP’s and LLC’s, the general partner (fund manager) in an LLP has near-
plenary control over the hedge fund’s investing activities, notably the overall
strategy and debt structure being the two primary responsibilities. As such,
under an LLP the general partner will have unlimited liability for any
outstanding debts or obligations in situations where the hedge fund cannot
fulfill them. Moreover, a hedge fund may pass tax liabilities directly on to
investors, known as “flow through” tax treatment. Since the investors are
LP’s, making them passive investors with no direct control over managing the
fund’s portfolio, they benefit by only being held liable for losses to the degree
of their investment in sharing in the gains, losses, and income of the fund. But
on the downside, the LP investors in both LLP’s and LLC’s are afforded only
marginal rights and protection.
47 Shartsis Friese, LLP, U.S. Regulation of Hedge Funds 88 (2005); Gerald T. Lins, Hedge Fund Organization, in Hedge Fund Strategies: A Global Outlook
98, 98 (Brian R. Bruce ed., 2002); Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J.,
1997, at 18, available at http://www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf; Jacob Preiserowicz,
Note, The New Regulatory Regime for Hedge Funds: Has the SEC Gone Down the Wrong Path?, 11 Fordham J. Corp. & Fin. L. 807, 812 (2006).
48 Id. at 90-92.
49 Id.
50 Id.
51 Id.
47
48
49
51
50
52
In comparison, when a hedge fund is organized as an LLC, tax liabilities flow
through to investors, in addition to the hedge fund directly incurring tax expenses,
known as “double taxation.” Hence, structuring the hedge fund as an LLP is more
favorable in terms of tax liabilities, but an LLC provides one or managing members
limited liability where an LLP imposes unlimited liability upon the GP fund manager.
Regardless, the fund manager(s) under either an LLP or LLC are faced with fiduciary
duties to their members in conducting operations and investing for the fund.
Similar to most other LLP’s and LLC’s in the U.S., hedge funds usually file as an
organization in the State of Delaware. Delaware has several distinct benefits
tailored to hedge funds, found nowhere else in the United States. First, Delaware
provides the most favorable state tax treatment to hedge funds. Second, the
Delaware Revised Uniform Limited Partnership Act (DRULPA) is renown for its
lenient and “flexible” LP statutes. Third, Delaware allows “side letters,” which
permit hedge fund managers to make supplementary agreements with LP’s so that
they confer additional benefits to specific investors who are preferred over other
LP’s. From these unique benefits, it is clear why so many hedge funds prefer to
file in Delaware rather than any other state in the U.S..
53 Id.
54 Id.
55 Id.
56 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http://www.hedgefundworld.com/documents/Delawarerev.pdf.
57 Id.
58 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at
http://www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf.
59 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http://www.hedgefundworld.com/documents/Delawarerev.pdf.
60 Id.
61 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res.J., 1997, at 18, available at
http://www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf.
53
54
55
56
57
58
59
60
61
The most widespread form of hedge funds that are seen today are organized
under a “master-feeder” organization. The “master” fund is formed as a
partnership, usually in a “tax haven” where it is a foreign resident. In
addition, there are two “feeders,” one being U.S. domestic feeder for
American taxable investors and another feeder for foreign investors or
American investors who are tax exempt. The foreign “feeder” is typically
organized as a corporation in a “tax haven,” whereas the U.S. domestic
“feeder” is an LLP where income, gains losses, and deductions from investing
“flow through” to LP investors. Moreover, there is only one portfolio and one
investment vehicle that the fund manager must operate, and income is
allocated to investors based on the amounts of their investments.
62 Martin A. Sullivan and Lee A. Sheppard, Offshore Explorations: Caribbean Hedge Funds, Part I," Tax Notes, Jan. 7, 2008, p. 95 available at
http://www.tax.com/taxcom/features.nsf/Articles/35244A221EDD1BF7852573D00071118E?OpenDocument.
63 Id.
64 Id.
65 Id.
66 Id.
63
64
65
62
66
The other, less popular hedge fund structure is known as the “side-by-side”
fund. There, U.S. taxable investors form an LLP and have a separate
investment vehicle than that of the nontaxable U.S. investors and foreign
investors. Though more costly to operate, the “side-by-side” structure
prevents the U.S. taxable investors from adding trade costs to the foreign and
nontaxable U.S. fund while the U.S. domestic fund addresses U.S. tax
liabilities.
67 Id.
68 Id.
69 Id.
67
68
69
For hedge funds that operate offshore, the “master-feeder” structure is
preferred because it “provides anonymity to investors, blocks exempt investors
from being considered owners of certain kinds of assets, and avoids putting
foreign investors directly in a U.S. trade or business that generates effectively
connected income.” American and international investors alike are both
enticed off safer, domestic land, into these murky tax havens, which are still
skeptically viewed by many industry experts. As we will discuss later, privacy,
tax breaks, and higher returns on investment are the three main factors that
attract investors to loosely regulated tax havens with limited investor
protection.
70 Id.
71 http://online.wsj.com/article/SB124588728596150643.html. (stating that, “Hedge-fund assets in offshore tax havens such as the Cayman Islands
and Bermuda represent more than two-thirds of the roughly $1.3 trillion industry, according to Hedge Fund Research Inc. Of those offshore assets,
industry insiders estimate, between $400 billion and $500 billion belongs to U.S. investors, with tax-exempt foundations, endowments and pension
funds accounting for about half of that. Investors from outside the U.S. make up the rest.”)
72 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper,Mar. 14, 2008) available at http://
ssrn.com/abstract=967788). (Stating that due to “the tax advantage, offshore investors may collect higher illiquidity premium when their investment
has the same level of share illiquidity as the investment of onshore investors. Our results may help explaining why the growth rate has been much
higher in offshore funds than in onshore funds (26.4 vs. 15.0 percent per year from 2000 to 2004).”).
70
71
72
Upcoming from Jon Terracciano
Stay Tuned for: CURRENT LEGISLATION GOVERNING HEDGE
FUNDS
Jon Terracciano Website

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Jon Terracciano - Background and Structure of Hedge Funds

  • 1. Hedging the Global Market Series Avoiding Excessive Hedge Fund Regulation in a Post-Recession Era Series by Jon Terracciano Topic: Background and Structure of Hedge Funds
  • 2. Backgroundand Structure of Hedge Funds In today’s highly developed and advanced financial environment, the term “hedge fund” still invokes perceptions of obscurity and ambiguity, even among the most sophisticated investors. To this day, the term “hedge fund” lacks a single, universally recognized definition in the financial world, resulting in various, and sometimes contradicting, definitions of the term. Although not statutorily defined in the U.S. or abroad, the industry’s generally “accepted definition is that [hedge funds] are privately offered investment vehicles in which the contributions of the high net worth participants are pooled and invested in a portfolio of securities, commodity futures contracts, or other assets.” 36 36 See, e.g., Staff of the Commission's Division of Investment Management and Office of Compliance Inspections and Examinations, Implications of the Growth of Hedge Funds: Staff Report to the United States Securities and Exchange Commission viii (2003) [hereinafter SEC 2003 Staff Report]; Financial Services Authority (United Kingdom), Hedge Funds and the FSA, Discussion Paper 16, at 8 (2002). 37 Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation. Hedge Funds Consistency Index. Feb. 12, 2010, available at http://www.hedgefund-index.com/s_negi.asp. 37
  • 3. The term “hedge fund” is believed to have been coined back in 1949, referring to a private investment fund managed by Alfred Winslow Jones under a private partnership agreement. In that fund, Mr. Jones employed a strategy of holding both long and short equity positions to “hedge” the fund portfolio’s risk against market volatility. Moreover, Mr. Jones pioneered a revolutionary way of charging a “management fee” to investors. Rather than charging a percent of assets under management, Jones charged a 20% “performance fee” equal to the fund’s returns. This strategy has been widely adopted by the hedge fund industry, where most hedge funds charge a 15-25% performance fee, in addition to a 2% general management fee based on the total value of assets held. 38 David A. Vaughn, Selected Definitions of “Hedge Fund.” Comments for the U.S. Securities and Exchange Commission Roundtable on Hedge Funds. May 14-15, 2003, available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 39 Id. 40 Christopher Holt, Performance Fees: As Old as Portfolio Management Itself? Seeking Alpha. Jan 20, 2009 available at http://seekingalpha.com/article/115612-performance-fees-as-old-as-portfolio-management-itself. 41 Id. 3 38 40 6 41 39
  • 4. Although the fee structure established by Mr. Jones in 1949 is applied by nearly all hedge funds today, the investing strategy of “hedging” he employed is not a universal characteristic of the entire industry. As the hedge fund industry evolved over time, many hedge funds began to utilize different investment strategies, and some hedge funds even did away with “hedging” altogether. In addition to, or in place of, “hedging,” many current hedge funds draw from a pool of over twenty-five investing strategies, such as using leverage, derivatives, and arbitraging by investing in multiple markets. A fund need not utilize all these methods to be deemed a “hedge fund,” but must simply have the capability to engage in them. Today, hedge funds are defined by their organizational structure and mode of operation, rather than by the investing or financial strategies they employ. As more and more hedge funds have taken a purely equitybased approach to investing without applying any of the aforementioned methods, many “’hedge funds’ are not actually hedged, and the term has become a misnomer in many cases.” 42 Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedgevaughn.htm#footnote_1. 43 JOHN DOWNES AND JORDAN ELLIOTT GOODMAN, BARRON'S, FINANCE & INVESTMENT HANDBOOK 358 (5th ed. 1998). Available at http://www.sec.gov/spotlight/hedgefunds/hedgevaughn.htm#footnote_1; MANAGED FUNDS ASSOCIATION, HEDGE FUND FAQs 1 (2003) 44 Id. 45 Supra note 18: Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 46 WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, TESTIMONY CONCERNING INVESTOR PROTECTION IMPLICATIONS OF HEDGE FUNDS BEFORE THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS, Apr. 10, 2003, available at http://www.sec.gov/news/testimony/041003tswhd.htm. 9 42 43 44 45 46
  • 5. Although the investing tactics of hedge funds may have morphed over the last sixty years, the management and investor structure has primarily remained the same, much like the original fee structures. U.S. hedge funds are normally organized as limited liability partnerships (“LLP’s”) or limited liability corporations (“LLC’s”), whereby the fund manager serves as the general partner (“GP”) and the investors constitute limited partners (“LP’s”). Subject to the limited partnership agreement and the fiduciary duties that apply under both LLP’s and LLC’s, the general partner (fund manager) in an LLP has near- plenary control over the hedge fund’s investing activities, notably the overall strategy and debt structure being the two primary responsibilities. As such, under an LLP the general partner will have unlimited liability for any outstanding debts or obligations in situations where the hedge fund cannot fulfill them. Moreover, a hedge fund may pass tax liabilities directly on to investors, known as “flow through” tax treatment. Since the investors are LP’s, making them passive investors with no direct control over managing the fund’s portfolio, they benefit by only being held liable for losses to the degree of their investment in sharing in the gains, losses, and income of the fund. But on the downside, the LP investors in both LLP’s and LLC’s are afforded only marginal rights and protection. 47 Shartsis Friese, LLP, U.S. Regulation of Hedge Funds 88 (2005); Gerald T. Lins, Hedge Fund Organization, in Hedge Fund Strategies: A Global Outlook 98, 98 (Brian R. Bruce ed., 2002); Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http://www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf; Jacob Preiserowicz, Note, The New Regulatory Regime for Hedge Funds: Has the SEC Gone Down the Wrong Path?, 11 Fordham J. Corp. & Fin. L. 807, 812 (2006). 48 Id. at 90-92. 49 Id. 50 Id. 51 Id. 47 48 49 51 50 52
  • 6. In comparison, when a hedge fund is organized as an LLC, tax liabilities flow through to investors, in addition to the hedge fund directly incurring tax expenses, known as “double taxation.” Hence, structuring the hedge fund as an LLP is more favorable in terms of tax liabilities, but an LLC provides one or managing members limited liability where an LLP imposes unlimited liability upon the GP fund manager. Regardless, the fund manager(s) under either an LLP or LLC are faced with fiduciary duties to their members in conducting operations and investing for the fund. Similar to most other LLP’s and LLC’s in the U.S., hedge funds usually file as an organization in the State of Delaware. Delaware has several distinct benefits tailored to hedge funds, found nowhere else in the United States. First, Delaware provides the most favorable state tax treatment to hedge funds. Second, the Delaware Revised Uniform Limited Partnership Act (DRULPA) is renown for its lenient and “flexible” LP statutes. Third, Delaware allows “side letters,” which permit hedge fund managers to make supplementary agreements with LP’s so that they confer additional benefits to specific investors who are preferred over other LP’s. From these unique benefits, it is clear why so many hedge funds prefer to file in Delaware rather than any other state in the U.S.. 53 Id. 54 Id. 55 Id. 56 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http://www.hedgefundworld.com/documents/Delawarerev.pdf. 57 Id. 58 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http://www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 59 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http://www.hedgefundworld.com/documents/Delawarerev.pdf. 60 Id. 61 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res.J., 1997, at 18, available at http://www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 53 54 55 56 57 58 59 60 61
  • 7. The most widespread form of hedge funds that are seen today are organized under a “master-feeder” organization. The “master” fund is formed as a partnership, usually in a “tax haven” where it is a foreign resident. In addition, there are two “feeders,” one being U.S. domestic feeder for American taxable investors and another feeder for foreign investors or American investors who are tax exempt. The foreign “feeder” is typically organized as a corporation in a “tax haven,” whereas the U.S. domestic “feeder” is an LLP where income, gains losses, and deductions from investing “flow through” to LP investors. Moreover, there is only one portfolio and one investment vehicle that the fund manager must operate, and income is allocated to investors based on the amounts of their investments. 62 Martin A. Sullivan and Lee A. Sheppard, Offshore Explorations: Caribbean Hedge Funds, Part I," Tax Notes, Jan. 7, 2008, p. 95 available at http://www.tax.com/taxcom/features.nsf/Articles/35244A221EDD1BF7852573D00071118E?OpenDocument. 63 Id. 64 Id. 65 Id. 66 Id. 63 64 65 62 66
  • 8. The other, less popular hedge fund structure is known as the “side-by-side” fund. There, U.S. taxable investors form an LLP and have a separate investment vehicle than that of the nontaxable U.S. investors and foreign investors. Though more costly to operate, the “side-by-side” structure prevents the U.S. taxable investors from adding trade costs to the foreign and nontaxable U.S. fund while the U.S. domestic fund addresses U.S. tax liabilities. 67 Id. 68 Id. 69 Id. 67 68 69
  • 9. For hedge funds that operate offshore, the “master-feeder” structure is preferred because it “provides anonymity to investors, blocks exempt investors from being considered owners of certain kinds of assets, and avoids putting foreign investors directly in a U.S. trade or business that generates effectively connected income.” American and international investors alike are both enticed off safer, domestic land, into these murky tax havens, which are still skeptically viewed by many industry experts. As we will discuss later, privacy, tax breaks, and higher returns on investment are the three main factors that attract investors to loosely regulated tax havens with limited investor protection. 70 Id. 71 http://online.wsj.com/article/SB124588728596150643.html. (stating that, “Hedge-fund assets in offshore tax havens such as the Cayman Islands and Bermuda represent more than two-thirds of the roughly $1.3 trillion industry, according to Hedge Fund Research Inc. Of those offshore assets, industry insiders estimate, between $400 billion and $500 billion belongs to U.S. investors, with tax-exempt foundations, endowments and pension funds accounting for about half of that. Investors from outside the U.S. make up the rest.”) 72 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper,Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). (Stating that due to “the tax advantage, offshore investors may collect higher illiquidity premium when their investment has the same level of share illiquidity as the investment of onshore investors. Our results may help explaining why the growth rate has been much higher in offshore funds than in onshore funds (26.4 vs. 15.0 percent per year from 2000 to 2004).”). 70 71 72
  • 10. Upcoming from Jon Terracciano Stay Tuned for: CURRENT LEGISLATION GOVERNING HEDGE FUNDS Jon Terracciano Website