Hedge funds are investment funds that can undertake a wide range of investment and trading activities. They are open to high net worth individuals and institutions. Hedge funds have more flexibility than mutual funds in their ability to short sell, use leverage, and invest in broader parameters. They are structured as limited partnerships, offshore corporations, or master-feeder funds. Hedge funds typically charge management fees of 1-2% of assets and incentive fees of 20% of profits.

1. Hedge Funds 101
January 16, 2013
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2. Introductions
• Alex Johnson, Partner, Financial Services, Ernst
& Young LLP
• Stan Szczepanik, Vice President, SS&C
GlobeOp
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3. Agenda
• Hedge fund sector overview
• Hedge fund structures
• Key players
• Strategies
• Current industry trends
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4. Hedge fund sector overview
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5. What is a hedge fund?
• An investment fund that can undertake a wide
range of investment and trading activities
• Open to specific types of investors
– Typically institutions, pension plans, high net
worth individuals
• Involvement in short selling and leverage
• Typically open ended – meaning investors can
withdraw capital at regular, specific intervals
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6. Comparison
Mutual funds Hedge funds Private equity funds
► Regulated with SEC ► Less regulation ► Less regulation
► Available to general public ► High net worth investors ► High net worth investors
► No Board of Directors ► No Board of Directors
► Must have Board of Directors (General Partner or (General Partner or
Management) Management)
► Open ended, closed ended, ► Open ended ► Closed ended
unit investment trust
► Classified by investments
(money market fund, ► Classified by investment ► Classified by investment
bonds/fixed income, stock or strategy strategy
equity, hybrid)
► Term – perpetual life ► Term – perpetual life ► Term – limited life
► Investors pay fund expenses ► Expenses borne by fund ► Expenses borne by fund
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7. Types of investors
• High net worth individuals and family offices
• Institutions
• Funds of funds
• Trusts
• Estates
• Endowments and foundations
• Retirement accounts
• Pension funds
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8. Regulatory matters
• Hedge funds are not heavily regulated by the
SEC, this allows them the ability to:
– Short sell
– Invest in more broad investment parameters
– Leverage
• Hedge funds are exempt from registration
under section 3(c)1 or section 3(c)7 of the
Investment Company Act of 1940
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9. Section 3(c)1 funds
• A fund can sell their interests under Regulation D
of the Securities Act of 1933 to avoid registration
with the SEC. To avoid registration under the
Investment Company Act of 1940 a fund can use
the exemption under section 3(c)1.
• A fund will qualify for exemption under 3(c)1 if it:
– Has no more than 100 beneficial interests, no more
than 35 of which are “non-accredited” investors.
– Does not make public offerings of such interests.
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10. Accredited investor
• An “accredited investor” under Section 3(c)1 is
an investor who meets certain net worth and
earnings standards, generally, an individual
who has:
– Net worth in excess of $1 million
– An income of $200,000 (or $300,000 joint with
spouse) in each of the past two years, and can be
reasonably expected to continue such earnings
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11. Section 3(c)7 funds
• A fund can sell their interests under Regulation D
of the Securities Act of 1933 to avoid registration
with the SEC
• To avoid registration under the Investment
Company Act of 1940 a fund can use the
exemption under section 3(c)7
• A fund will qualify for exemption under 3(c)7 if it:
– Has no more than 500 beneficial interests
– Is owned exclusively by “qualified purchasers”
– Does not make public offerings of such interests
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12. Qualified purchasers
• A qualified purchaser is defined under Section
3(c)7:
– Persons who own not less than $5 million in
investments
– Family owned companies that own not less than $5
million in investments
– Certain trusts
– Any other persons such as institutions that own and
invest on a discretionary basis not less than $25
million
in investments
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13. Other regulatory issues
• Investment Adviser Registration – SEC
– Custody rule
• Registration with Commodity Futures Trading
Commission (CFTC)
• Registration with Cayman Islands Monetary
Authority (CIMA)
• Irish stock exchange listing
• New issues
• Anti-money laundering
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14. Overview of the hedge fund structure
Portfolio manager
General partner/managing
member/investment manager
Portfolio of
Investment partnership
investment securities
Investors
Limited partners in the investment
partnership
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15. Fee structures
• Fees in accordance with legal documents
– Management fees
– Incentive (performance) fee/allocation
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16. Management fees
• In accordance with legal documents funds
charge a management fee
• Industry standard has been in the range of 1-
2%
• This fee is designed to cover the cost of
running the business
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17. Incentive (performance) allocation/fee
• Compensation, based on performance, to the
general partner/investment manager for
investment advisory services
• On a domestic partnership it is a reallocation of a
% of the income earned by each limited partner
• Additional considerations
– Hurdle rates
– High water marks
– Crystalization
– Loss carry forward
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18. Tax
General tax concepts
• Book income versus tax income.
• Every fund should have an established process for
monitoring tax character.
• Some examples are:
– Capital gains – those which are generated by capital assets.
Can be long term or short term. Generally, most financial
instruments held by a security investment or trading
partnership will be capital assets.
– Ordinary income – taxed at a higher rate than capital gains.
In investment partnerships this generally includes interest
and dividends.
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19. Hedge fund legal structures
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20. Domestic partnership structure
General partner
Domestic entity
Investment
20%
Incentive allocation
$$ Manager
Domestic entity
Domestic
Limited
1%
Partnership Management
Fee
$$
Limited partners
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21. Offshore corporate structure
Investment manager
1% Management fee
20% Incentive fee
Offshore corporation
$$
Shareholders
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22. Master-feeder structure
General partner
Domestic entity Investment manager
1% 1% Management fee
20%
Management 20% Incentive fee
Incentive allocation
fee
Domestic
limited Offshore corporation
partnership
$$
$$
Offshore limited
Shareholders
Limited partners Partnership OR
corporation
Invest/trade in securities
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23. Mini master-feeder structure
General
Limited partners Offshore feeder
partner
Limited partners
$$
Shareholders
20%
Incentive allocation
Investment manager
Domestic 1% Management fee
Limited partnership (master)
Invest/trade
in securities
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24. Master feeder vs Parallel structure
• Advantages of master • Advantages of Parallel
feeder structure structure
– Single portfolio to manage – – More tailored to individual
improves order placement investors
– Offer different deal terms or – Could use different year ends
tax structures to different so all incentive fees not in
investor groups one cycle
– Identical returns (assuming – No tax conflicts (US taxable
no withholding issues) vs. non tax sensitive)
– Offer to more than 100 – Have full advantage of US
investors treaty network for US
– Easier to administer partnership and investor
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25. Fund of funds structure (domestic)
Invests/trades in Invests/trades in
securities securities
Domestic investee Domestic investee
limited limited
partnership partnership
Other limited partners Other limited partners
LP Interest
General partner Fund of funds
Investment Manager
Domestic entity (Domestic limited
partnership)
Incentive $$ 1%
allocation Management fee
Limited partners of the
Fund of funds LP
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26. Advantages/disadvantages of fund of
funds structure
• Advantages • Disadvantages
– Diversification – Higher fee structures (fees
– Accessibility to underlying taken by the investment
funds/investment manager manager of the fund of funds
– Generally lower minimum and the underlying funds)
investment amounts – Less transparency to the
portfolios of the underlying
funds
– Less liquidity
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27. Key players
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28. Key players
Prime broker/custodian/counterparties
Attorney and Hedge fund and Administrators
independent auditor Investment Manager
Investors
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29. Prime
broker/custodian/counterparties
• Prime broker: a special group of services that many
brokerages give to special clients. The services
provided are securities lending, leveraged trade
executions, and cash management, among other
things. A prime broker can also be a custodian.
• Custodian: a financial institution that has the legal
responsibility for a customer’s securities.
• Counterparty: the other party that participates in a
financial transaction. Every transaction must have one
in order for the transaction to go through.
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30. Administrator
• Maintain primary books and records
• Compute periodic NAVs and prepare reports to investors
• Maintain shareholder register and supporting documents and accept
subscriptions/pay redemptions (transfer agency work)
• Liaise with regulators and handle filings
• Liaise with auditors, tax professionals and similar
• Often provide directors and officers for the fund (offshore) & may offer
other services (banking, custody, valuation)
• Often have a “SSAE 16” Report for Service Organizations (SSAE 16)
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31. Legal documents
• Regardless of the “physical structures,” the
legal structure is created through agreements
and documentation:
– LP/LLC Agreements
– Private placement memorandum
– Subscription booklets/agreements
– Articles of incorporation/memorandum and
articles of Association (offshore only)
– Investment management agreement
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32. Legal documents (cont.)
• Other significant agreements
– Brokerage and custody agreement – sets forth the commission rates and the
terms and conditions of other services provided to the fund.
– Investment advisor agreement – sets forth the fee structure and terms and
conditions of operations between the fund and the investment adviser.
– Administration agreement – sets forth the fee structure, administrative
responsibilities and the terms and conditions of operations between the fund
and the administrator. Specifies the administrator’s liability to the fund.
– Master netting agreement – provides for the exercise of rights (such
as, netting, set-off, liquidation, termination, acceleration or closing out)
under, or in connection with, one or more qualifying transactions.
– ISDA master agreement – allows parties to aggregate amounts owed by each
other under all the transactions covered by the agreement and replace them
with a single net amount payable by one party to the other.
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33. Independent auditor
• Responsible for issuing an opinion over the financial
statements of the hedge funds that are issued to investors
• Generally an audit is required as part of the funds’ legal
documents
• Independent examination of the books and records of the
funds
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34. Strategies
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35. Hedge fund strategies
• Long/short • Special situations (event
• High yield/distressed driven)
• Emerging markets • Private equity
• Fund of funds • Statistical arbitrage
• Macro (global macro) • Convertible arbitrage
• Multi strategy
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36. Current industry trends
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37. Current industry trends
• Relationship between the investor and the
hedge fund
• Registration of investment advisers (“RIAS”)
with SEC
• Registration of master funds w/ CIMA
• CFTC
• Form PF
• FATCA
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38. Current industry trends (cont.)
• Relationship between the investor and the hedge fund
– Fee structures
– Transparency
– Liquidity
– Fund raising
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39. Current industry trends (cont.)
• Advisor registration with the SEC
– Presence exams
• Focus, risk-based examinations
• Examination covers marketing, portfolio management, conflicts of interest, safety
of client assets and valuation
– Inquiries of auditors of the underlying funds
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40. Current industry trends (cont.)
• Registration of master funds with CIMA
– New and existing master funds in open-ended master/feeder structures are
required to register with CIMA to bring the Cayman regime in line with
practice adopted in other jurisdictions
– Existing master funds were required to register by March 31, 2012
– Eligible master funds:
• Issue equity interests redeemable at option of investor
• Have more than one investor
• Have one or more feeder funds registered with CIMA
– Consequences
• Fund pays annual fee to CIMA
• Required to file audited financial statements signed off by a Cayman-approved
auditor and a FAR form
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41. Current industry trends (cont.)
• On February 9, 2012 CFTC issued several rules adopting significant
revisions to regulations involving Commodity Pool Operators (“CPOs”)and
Commodity Trading Advisors (“CTAs”):
– Rescind rule 4.13(a)(4) (effective 4/24/12), which contained a broad
exemption from most of the requirements of the Commodity Exchange Act
(“CEA”) (an exemption that many private fund advisors relied upon to avoid
registration)
– Major alterations to Rule 4.5 which was relied on heavily for registered
investment companies to claim exemption
– Adopt new data collection forms for CPOs and CTAs
– Requires persons relying on exemptions in Rule 4.5, 4.13 and 4.14 to reaffirm
annually
– Kept exemption 4.13(a)(3) (“de minims” futures activity rule) in place
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42. Current industry trends (cont.)
• Form PF
– Form PF requires registered investment advisers to
report an unprecedented amount of portfolio
information on managed private funds
• Data from multiple sources, certified, aggregated, and
reported
– Regulatory Assets Under Management (“RAUM”) used
to determine whether the adviser and private funds
meet certain filing thresholds
– Regulators will move from a high-level understanding
of businesses to a detailed understanding and will
apply increased scrutiny
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43. Current industry trends (cont.)
• FATCA
– FATCA is a US tax law designed to prevent US
taxpayers from avoiding US tax on their income by
investing in the US through non-US financial
institutions and offshore investment vehicles.
– FATCA was enacted on March 18, 2010
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