Hedge Funds

What is a hedge fund?

A hedge fund is a term commonly used for an investment company, or pooled investment fund, that is not registered with the SEC as a mutual fund. In order to offer and investment fund without registering with the SEC, a fund must limit its investors to accredited investors.  The rule governing private hedge funds is Regulation D of the Securities Act of 1933.

What is a Reg D Fund?

Regulation D of the Securities Act of 1933 governs the public offering of securities. Certain types of funds are exempt from registration under the Securities Act if they meet criteria for offerings. Reg D funds, or hedge funds, can only be offered to investors that are 1) accredited, or 2) qualified, as those two definitions are defined in the Securities Act.

What is the definition of an accredited investor?

To be an accredited investor, a person must have a net worth of more than $1million, excluding personal residence, or an annual income exceeding $200,000, or $300,000 for joint income, for the last two years with expectation of earning the same or higher income in the current year. The income test cannot be satisfied by showing one year of an individual’s income and the next two years of joint income with a spouse. The exception to this rule is when a person is married within the period of conducting a test.

What is a qualified purchaser under Reg D?

Qualified purchasers are institutional or very sophisticated investors because of the level of assets for which they are responsible or their professional experience and expertise. The asset level depends upon the type of institution, but all qualifications number in the $millions of assets under the Qualified Purchaser’s direction.

Is there a difference between a hedge fund and a private fund?

Many people and industry publications refer to all private non-registered investment funds as hedge funds. A narrower definition of a true hedge fund would be a portfolio that limits its exposure to market volatility by executing “hedge” strategies. Examples might be having a portion of the portfolio short and able to benefit when the markets decline, and a portion of the portfolio long and benefiting when the markets increase in value.

Many private funds are “long only” or invest in assets and hold those assets and securities, and only benefit when the asset increases in value. It is difficult to have a short position in a real estate private fund, for instance, although it is not impossible.

Where are private or hedge funds registered?

Most private or hedge funds established in the United States are either Limited Partnerships (“LP”) or Limited Liability Company (“LLC”).  A domestic private fund is often set up as a Delaware LP or Delaware LLC.

Many firms choose to set up a private or hedge fund offshore in a tax advantaged jurisdiction, like the Cayman Islands, British Virgin Islands, Bermuda or other favorable jurisdiction.

Are offshore hedge funds tax advantaged for US investors?

No. That is not the primary reason a fund would establish offshore. An offshore jurisdiction primarily benefits non-US investors, or retirement plan or other assets that have restrictions on investing in US based private funds.

What is a private placement memorandum?

A private placement memorandum is a document, much like a mutual fund prospectus, that outlines the investment goals and objectives for the hedge fund, and the risks to an investor from investing in that fund. The expected fees and expenses are disclosed, and relevant tax and other information is included to fully inform an investor on what is being purchased.

What expenses are involved in operating a hedge fund?

Expenses for operating a private fund are much less than a registered mutual fund. The basic expenses are 1) portfolio management or investment advisory fee; 2) fund accounting, participant recordkeeping and compliance; 3) custody and trading expenses; and 4) audit fees for annual financial statement and K-1 shareholder reporting.

Startup expenses are generally less than $50,000, and annual operating expenses other than the portfolio management fee are approximately $50,000 for a small fund and increase as the hedge fund increases in total assets.

When is a hedge fund a better option for an investment advisor than registered mutual fund?

If there are a limited number of investors that want to invest in a new fund, and most of those investors are either accredited or qualified as those terms are defined under Regulation D, then the lower expenses associated with operating a private fund are a major advantage.

Another example is when the investment advisor wants to include a performance fee as part of the advisor’s compensation. Performance fees are much more flexible in a hedge fund than in a registered mutual fund.