HEDGE FUNDS: A BASIC OVERVIEW

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.

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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• Tax benefits from fund’s structure

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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 other local, state, or federal law 4

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

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 Not as steady as absolute return funds, but over long run returns are

higher

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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

not permitted to employ leverage7

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

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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 profits that replace prior losses

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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

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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

TAX BENEFITSFlow-Through Tax Treatment:Unlike a LP, a corporation is taxed on its profits and its shareholders pay taxes on any dividends they receive— “double taxation.” LPs, however, act as “flow through” entities and no tax is paid at the entity level. Instead, the LP’s members are individually taxed on their allocable share of the entities’ income, gain, or loss (whether or not distributed or realized). Accordingly, each member receives a report of their allocable share on Internal Revenue Service Form 1040, Schedule K-1, and similar state tax forms, issued by the LP. 12

SAMPLING OF HEDGE FUND STRATEGIES

• Long only• Long/Short• Market Neutral• Short-Bias• Macro• Sector• Convertible Bond and

Convertible Arbitrage• Fixed-Income

Arbitrage

• Credit Funds• Event-driven

Arbitrage• Distressed Securities• Energy Funds• Emerging Markets• Crossover Funds• Managed Futures

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LONG ONLY

• Purchase and sell securities • Does not sell short very often, if at all

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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

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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

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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

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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

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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

SECTOR

• Focuses in particular industries or economic/financial sectors

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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 aggressive or conservative the fund strategy is

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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 amount of leverage to enhance returns

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CREDIT FUNDS

• Extends credit to various companies

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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

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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

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 issued in a reorganization on a when issued basis

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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

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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

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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

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

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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 new clients 31

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

Limited Partnership

General Partner

Prime Broker

Limited Partner

Limited Partner

Limited Partner

- Custody- Reporting- Settlement- Other services

Portfolio Transactions

Invest

Manage (and frequently invest in) the fund

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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

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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

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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

Maintaining the customary financial and accounting books and records for the fund

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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• Exercise financial controls

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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-advisory agreements, etc.

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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

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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

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 some jurisdictions.

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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 INDEPENDENT TAX ADVISER.

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