Hflr 0211 - Hedge funds structuring


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How Can Hedge Funds Be Structured to Accommodate Investments in Illiquid Assets?

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Hflr 0211 - Hedge funds structuring

  1. 1. HedgeFund The The definitive source of actionable intelligence on L AW R E P O RT hedge fund law and regulationwww.hflawreport.com Volume 4, Number 4 February 3, 2011Side PocketsHow Can Liquid Hedge Funds Be Structured to Accommodate Investments in Illiquid Assets?By Philippe Simoens, WeaverDuring the past decade, an increasing volume of hedge fund fund structuring and taxation; characteristics and taxationdollars has poured into traditional liquid strategies. As a of marketable securities versus private equity; and structuresresult, market inefficiencies have narrowed or vanished, and employed by liquid funds to accommodate illiquid assetsopportunities for arbitrage – and the alpha it can generate (including side pockets, lock-ups, gates and redemption– have grown fewer and farther between. In response, some suspensions). The article concludes with thoughts onhedge fund managers that traditionally focused on liquid structuring for managers who traditionally have focused onstrategies started investing at least part of their funds’ capital liquid strategies, but who are exploring illiquid opportunities.in private equity and other illiquid securities and assets.However, using liquid fund vehicles to invest in illiquid assets Traditional Liquid Fund Structures and Taxationhas presented a variety of problems, including those relating Domestic hedge funds typically are structured as limitedto: taxation, liquidity, valuation, manager compensation, partnerships. The manager of the fund is often the generalstrategy drift, due diligence, expectations regarding returns partner of the limited partnership, and fund investors areand regulatory scrutiny. While there has been considerable limited partners in the partnership. In a basic fund structure,discussion regarding the convergence of hedge funds and a single domestic limited partnership will collect capital fromprivate equity funds, the experience and aftermath of investors and the manager will invest funds according to thethe credit crisis indicate that the convergence discussion fund’s strategy. See Table 1.should be more refined. Convergence at the fund level isproblematic because illiquids do not fit naturally into a liquidfund. Convergence at the manager level – for example,the same manager managing both private equity funds andhedge funds – is marginally more palatable, but by and large,institutional investors have demonstrated a preference formanagers who stick to their knitting.This article addresses some of the reasons why illiquid assetspresent problems when housed in liquid funds – even liquidfunds purportedly structured to accommodate illiquidinvestments via mechanisms such as side pockets. In thecourse of doing so, this article explains traditional liquid Table 1©2011 The Hedge Fund Law Report. All rights reserved.
  2. 2. HedgeFund The The definitive source of actionable intelligence on L AW R E P O RT hedge fund law and regulationwww.hflawreport.com Volume 4, Number 4 February 3, 2011More complex fund structures achieve scale and leverage via disparate track records (because the performance of the masterpooling arrangements. So-called master-feeder structures pool fund flows through to the feeders); and creating a larger assetfunds from onshore and offshore feeder funds into a master base (by pooling the funds of both feeders in a single master),fund, which is the main trading entity. See Table 2. which can help mitigate counterparty risk concerns and can render the master fund eligible for certain transactions for which the feeders individually may not be eligible. Various types of income can subject the offshore feeder to U.S. taxation. First, U.S. source dividend income paid or allocated to the offshore feeder generally is subject to U.S. tax withholding at a rate of 30 percent. Moreover, many of the jurisdictions in which offshore feeders typically are established do not have treaties with the U.S. that would reduce that 30Table 2 percent withholding rate. In addition, any income earned by the offshore feeder and construed to be derived from aIn a master-feeder structure, gains and losses realized by the U.S. trade or business would be subject to U.S. income tax atmaster fund are allocated to the various feeder funds. Those graduated rates. Also, such “trade or business” income may begains and losses in turn are allocated to the investors in the subject to U.S. branch profits tax, also at a rate of 30 percent.feeder funds. In sum, much of the income earned by an offshore feeder from a U.S. trade or business would be taxed at a combinedThe domestic feeder fund in a master-feeder structure is rate of 55 percent. This punitive tax rate may apply, forusually organized as a limited partnership; most foreign feeder example, to investments by non-U.S. persons in certain U.S.funds in such structures are organized in a low tax jurisdiction real estate and certain U.S. source debt. See “Implications ofand treated as corporations for U.S. tax purposes; and Recent IRS Memorandum on Loan Origination Activitiesmost master funds are organized as corporations in low tax for Offshore Hedge Funds that Invest in U.S. Debt,” Thejurisdictions, but “check the box” for partnership treatment Hedge Funds Law Report, Vol. 2, No. 41 (Oct. 15, 2009);for U.S. tax purposes. This structure enables flow-through tax “IRS Rules that Long Position in a Swap Referencing atreatment for U.S. taxable investors in the domestic feeder;avoids passive foreign investment company tax issues; and Broad-Based US Real Property Index is Not a US Real“blocks” unrelated business taxable income for U.S. tax- Property Interest for FIRPTA Purposes,” The Hedge Fundsexempt investors in the offshore feeder. In addition, a master Law Report, Vol. 1, No. 15 (Jul. 8, 2008). However, infeeder structure offers practical advantages, such as: executing certain circumstances, non-U.S. investors may use a debtall trades in a single vehicle and avoiding difficult allocation holding structure, which may enable them to benefit from thequestions; providing a single derivatives counterparty; avoiding U.S. source interest income tax exemption regime.©2011 The Hedge Fund Law Report. All rights reserved.
  3. 3. HedgeFund The The definitive source of actionable intelligence on L AW R E P O RT hedge fund law and regulationwww.hflawreport.com Volume 4, Number 4 February 3, 2011 Characteristics and Taxation of Marketable Investments by Liquid Hedge Funds in Illiquid Assets Securities versus Private Equity Despite the differing characteristics detailed in Table 3 andMarketable securities and private equity and similar illiquid the differing tax consequences detailed in Table 4, over theassets have different features and characteristics. Table 3 past decade, liquid hedge funds collectively have increasedillustrates various characteristics of marketable securities their stake in private equity and other illiquid assets. Liquidversus private equity. Various of these characteristics are hedge funds have been able to do so in cases where theirdifficult to reconcile within a single liquid hedge fund. governing documents include mechanisms enabling them to invest a discrete percentage of assets in illiquid investments. Those mechanisms prominently include side pockets, but also include gates, lock-ups, and redemption suspensions. Side Pockets Side pockets generally are segregated accounts into which a manager of an otherwise reasonably liquid hedge fund can place an illiquid investment representing, as of the date of investment, a designated percentage of net asset value. See “Secondary Buyers of Private Equity Fund Interests are Looking at Assets in Hedge Fund Side Pockets,” The Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).Table 3 Side pockets generally can be used in two circumstances. First, an asset can be purchased by a hedge fund with theTable 4 contrasts various tax features of marketable securities intent at the time of investment of placing the asset in a sideversus private equity, based on investor type. pocket. Second, assets can be transferred to a side pocket in order to prevent redemptions. While the line between these two uses is sometimes blurry, the former use is significantly more palatable to investors than the latter; and in the latter incarnation, side pockets are merely one name used to refer to a group of vehicles designed to retain assets and prevent redemptions, often contrary to the expressed preferences of investors. See “Steel Partners’ Restructuring and Redemption Plan: Precedent or Anomaly?,” The Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).Table 4©2011 The Hedge Fund Law Report. All rights reserved.
  4. 4. HedgeFund The The definitive source of actionable intelligence on L AW R E P O RT hedge fund law and regulationwww.hflawreport.com Volume 4, Number 4 February 3, 2011The SEC has expressed concern regarding the use by hedge A less frequently cited rationale is to protect a run on thefund managers of side pockets. In particular, the SEC has bank and an unraveling of the fund and managementevidenced that concern by bringing a civil fraud action against business. This latter, manager-perspective rationale appearsa hedge fund manager that allegedly used a “side pocket” to to run contrary to the creative destruction ethos of the hedgemisrepresent the value of its funds to investors. See “SEC fund industry, engendered significant apprehension amongBrings Civil Securities Fraud Action Against Principals of investors during the credit crisis and caused a rethinkingHedge Fund Palisades Master Fund, Alleging Fraud, Self- and renegotiation of hedge fund terms post-crisis. See, e.g.,Dealing, Misuse of Fund Assets and Use of a ‘Side Pocket’ to “CalPERS Special Review Foreshadows Seismic Shift inMisrepresent the Fund’s Value to Its Investors,” The Hedge Business Arrangements among Public Pension Funds,Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010). Hedge Fund Managers and Placement Agents,” The Hedge Fund Report, Vol. 4, No. 1 (Jan. 7, 2011); “Single InvestorGates Hedge Funds Offer the Benefits of Managed Accounts and Additional Tax and Other Advantages for Hedge FundGenerally, gates are mechanisms that limit the percentage Managers and Investors,” The Hedge Fund Report, Vol. 3,of net assets of a hedge fund that may be paid out inredemptions on any given redemption date. Gates may No. 16 (Apr. 23, 2010); “How Can Hedge Fund Managersbe broadly grouped into two categories: fund-level gates Structure Managed Accounts to Remain Outside theand investor-level gates. (A third category – “hybrid gates” Purview of the Amended Custody Rule’s Surprise– will be discussed in a forthcoming issue of The Hedge Examination Requirement?,” The Hedge Fund Report, Vol.Fund Law Report.) Generally, a fund-level gate may be 3, No. 5 (Feb. 4, 2010).triggered (usually in the manager’s discretion) if the aggregateredemption requests on any redemption date exceed a certain Lock-Upspercentage of the hedge fund’s net assets, usually between A lock-up generally refers to the period following investments10 and 25 percent. Use of a gate permits the manager to during which an investor may not redeem from the hedgereduce aggregate redemption requests pro rata such that fund. Following the lock-up period, investors generally maythe total redemptions on that redemption date equal the redeem periodically. See “Soft Lock-Ups Help Hedge Fundgate threshold, e.g., that 10 to 25 percent. To the extent Managers Reconcile the Goals of Stable Capital and Investorredemptions exceed that threshold, they are carried forward to Liquidity,” The Hedge Fund Report, Vol. 3, No. 45 (Nov. 19,the next scheduled redemption date. 2010).Investor-level gates operate similarly, but the relevant Redemption Suspensionsthresholds are measured per investor capital account ratherthan fund-wide. In either case, the most frequently cited Hedge fund documents generally provide that the managerrationale for the use of gates is to protect remaining investors may suspend redemptions in designated circumstances. Anfrom winding up with a less liquid or lower quality portfolio. interesting recurring issue arises when an investor submits a©2011 The Hedge Fund Law Report. All rights reserved.
  5. 5. HedgeFund The The definitive source of actionable intelligence on L AW R E P O RT hedge fund law and regulationwww.hflawreport.com Volume 4, Number 4 February 3, 2011redemption notice, the redemption notice expires, then the can give rise to such trade or business taxation. The mostmanager suspends redemptions. In such a case, especially notable example is real estate. Offshore hedge funds thatfor offshore funds, does the investor become a creditor of invest in U.S. real estate are subject to a level of taxation thatthe fund with the power to petition for a winding up of the in all but the rosiest of scenarios can eviscerate the returns onfund? A recent judgment of the Judicial Committee of the investment. While it may be possible to circumvent some ofPrivy Council in Culross Global SPC Limited v Strategic these adverse tax consequences via derivatives, this tax regimeTurnaround Master Partnership Limited addressed this has dramatically diminished investment by offshore funds inquestion, and provided helpful and authoritative guidance U.S. real estate.about how provisions in a hedge fund’s governing documentsaddressing redemptions and suspensions of redemptions Liquidityshould be interpreted. The judgment also provided guidanceon how to determine which of the various documents One of the more problematic issues presented by illiquidconstituting the investment agreement between a fund and assets in liquid funds is the liquidity mismatch. That is,its investor should take priority if the documents contain investors are often promised monthly, quarterly or annualinconsistent provisions. See “Strategic Turnaround liquidity, but illiquid assets require years for the realizationJudgment Provides Welcome Guidance for the Hedge of investment goals. While the mechanisms describedFund Industry on the Suspension of Redemptions,” The above – side pockets, gates and the like – give managers theHedge Fund Report, Vol. 4, No. 3 (Jan. 21, 2011). contractual authority to manage redemptions in the interest of realizing long-term value in illiquids, they often cannot Challenges Posed by Illiquid Investments in mitigate the practical mismatch of expectations between Liquid Funds managers of funds that are primarily liquid, and investors who have expectations that the majority of their assets will beEven in the presence of the foregoing mechanisms used predominantly liquid. See “How Can Hedge Fund of Fundsindividually or jointly to accommodate illiquid investments Managers Manage a ‘Liquidity Mismatch’ Between Theirin liquid funds, such investments still are fraught withinvestment and operational challenges. Those challenges, Funds and Underlying Hedge Funds?,” The Hedge Fundas enumerated above, relate to taxation, liquidity, valuation, Law Report, Vol. 2, No. 40 (Oct. 7, 2009).manager compensation, strategy drift, due diligence,expectations regarding returns and regulatory scrutiny. Each Valuationof these concerns is described in more detail below. The valuation problem here is easy to identify and hard to remedy: many assets in liquid funds are comparativelyTaxation easy to value because they are traded in liquid markets withAs discussed above, offshore funds that are construed as discoverable prices. By contrast, illiquid assets are hard toengaged in a U.S. trade or business may be subject to punitive value because there are few or no bids for them. In suchtaxation. Investments by liquid hedge funds in illiquid assets circumstances, valuation is often vested in the discretion©2011 The Hedge Fund Law Report. All rights reserved.
  6. 6. HedgeFund The The definitive source of actionable intelligence on L AW R E P O RT hedge fund law and regulationwww.hflawreport.com Volume 4, Number 4 February 3, 2011of the manager, and from time to time, such discretion and the value of the liquid fund decreases, the proportion ofis exercised (or allegedly exercised) in a manner that is net assets comprised by assets in the side pocket may increasearguably inconsistent with the interests of investors. See, to a percentage well beyond the percentage of net assetse.g., “SEC and Connecticut Banking Commissioner Bring comprised by such assets at the time of purchase. In thisCivil Fraud Charges Against Stephen M. Hicks and the manner, an investor who bought into a liquid fund may windSouthridge Hedge Fund Investment Advisers He Controls, up holding a fund that is primarily comprised of illiquid assetsClaiming that They Defrauded Investors by Failing to – especially if other investors redeem from the liquid poolFollow Stated Investment Policies, Overstating the Fund’s or are granted preferential liquidity and redemption rights.Asset Values and Misappropriating Fund Property,” The See “To What Extent is a Hedge Fund Bound, LegallyHedge Fund Law Report, Vol. 3, No. 43 (Nov. 5, 2010). and Practically, by its Strategy as Stated in its Governing Documents and at Marketing Meetings?,” The Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).Manager CompensationHedge fund managers traditionally have been compensated Due Diligenceby collecting 2 percent of net assets under management asa management fee, and 20 percent of fund gains annually From an investment team and operational perspective,as an incentive allocation. Private equity managers, on the many hedge fund managers with a competency in liquidother hand, traditionally have been compensated through a investing are not set up, in terms of personnel and process,“waterfall” that provides for incentive-based compensation as to adequately evaluate investments in illiquid assets. Whiledistributions are made, for example: (1) a full return of capital certain aspects of investing in, for example, public equity andcalled and not yet returned; (2) a preferred return to investors, private equity are similar, in many ways, the two categoriesusually of 8 or 7 percent; (3) a general partner “catch up”; and of investing are very different disciplines with very different(4) an 80/20 split between investors and the general partner skill sets. A good public equity investor is not necessarily aor manager. While hybrid funds have sought to combine good private equity investor, and vice versa. On talent in thethe typical hedge fund “2 and 20” structure and the private hedge fund industry generally, see The Hedge Fund Lawequity “waterfall” structure, doing so involves considerable Report’s recent three-part series on movement of talent fromlegal, accounting and operational legwork, and the level of proprietary trading desks to hedge fund managers.complexity that is inconsistent with the current investor tastefor simplicity. Expectations Regarding Returns Similar to the foregoing point, managers with a traditionalStrategy Drift competency in liquid investing may not be ideally situatedMost side pocket provisions in hedge fund documents to predict the timing and level of fund returns from illiquidare drafted to limit the amount of fund assets that may assets. Faulty predictions in this regard may lead to chargesbe allocated to a side pocket as of the time of investment. from investors or regulators of misrepresentation, and, atHowever, especially if assets in side pockets are carried at cost worst, to claims of breach of fiduciary duty.©2011 The Hedge Fund Law Report. All rights reserved.
  7. 7. HedgeFund The The definitive source of actionable intelligence on L AW R E P O RT hedge fund law and regulationwww.hflawreport.com Volume 4, Number 4 February 3, 2011Regulatory Scrutiny private equity fund managers of discrete investment skill sets and teams, see “Key Legal Considerations in ConnectionAs indicated, the SEC and other regulators have brought with the Movement of Talent from Proprietary Tradingenforcement actions relating to side pockets, valuation, Desks to Start-Up or Existing Hedge Fund Managers:disclosure and other issues raised by illiquid assets in The Talent Perspective (Part One of Three),” The Hedgeotherwise liquid hedge funds. Fund Law Report, Vol. 3, No. 49 (Dec. 17, 2010). Managers with legacy side pockets and those launching new hedge Structuring Recommendations funds with side pocket provisions are encouraged to discloseStructuring decisions for a traditionally liquid manager clearly to investors the circumstances under which assets will be put into and removed from side pockets; how assets incontemplating investments in illiquid assets are invariably side pockets will be valued; and the frequency with whichcomplex and highly fact-specific, but at least a few broad valuations will be assessed, conducted and disclosed.principles can be extracted from the foregoing discussionand observation of current practice: hedge fund managerswould be well advised to hew close to their traditional skill Philippe Simoens is a Senior Manager in Tax and Strategic Businesssets in investing, and to structure funds with terms that Services for Weaver, an independent certified public accounting firm.accommodate those traditional skills, especially in terms Philippe’s practice emphasizes corporation and partnership tax planningof liquidity. For example, if a fund manager has a skill in and compliance, and he has experience in international, multistateequity long/short investing, that manager may be able tooffer a hedge fund with reasonably frequent liquidity. See and local tax compliance matters. In terms of industries, Philippe“Certain Hedge Funds are Using Enhanced Investor concentrates on the hedge fund and financial services industries, as wellLiquidity as a Marketing Tool,” The Hedge Fund Law as the manufacturing and distribution sectors. Within the hedge fundReport, Vol. 2, No. 22 (Jun. 3, 2009). In those relatively and financial services industries, Philippe’s engagements have focusedrare circumstances where a manager has or acquires skill sets on taxation of financial products and trading strategies; reporting toin both liquid and illiquid investing, that manager may be foreign, tax-exempt investors and ERISA plan investors; and federalbest served by pursuing those separate strategies in separate and multistate tax compliance for new and established alternativevehicles, as opposed to pursuing the separate strategies in the investment entities, funds of funds, onshore and offshore master-feedersame vehicle. On acquisitions by hedge fund managers and groups, investment advisory entities and financial institutions.©2011 The Hedge Fund Law Report. All rights reserved.