© copyright, briggs and morgan, professional association, 2006-2008 hedge funds – maintaining the...

© Copyright, Briggs and Morgan, Professional Association, 2006-2008

Hedge Funds – Maintaining the Private Placement Exemption [Advanced]

2008 NSCP Midwest Membership Meeting

Chicago, IllinoisApril 28, 2008


Disclaimer

• This publication is circulated to bring useful and timely information to our clients and colleagues. The publication is for general information purposes only and is not legal advice. You should not rely on any information or views contained in the publication in evaluating any specific legal issues you may have. Please consult your Briggs and Morgan attorney for specific legal advice. Any U.S. Federal tax advice contained in this communication (whether distributed by mail, email or fax) is not intended or written to be used, and it cannot be used by any person for the purpose of avoiding U.S. Federal tax penalties or for the purpose of promoting, marketing or recommending any entity, investment plan or other transaction. (The foregoing legend has been affixed pursuant to U.S. Treasury Regulations governing tax practice.)


Summary

• Introduction to Hedge Funds• Maintaining Private Placement

Exemption• Marketing


Resources

• Principles and Best Practices for Hedge Fund Investors– Report of the Investors’ Committee to the President’s

Working Group on Financial Markets– April 15, 2008

• Best Practices for the Hedge Fund Industry– Report of the President’s Working Group on Financial

Markets• Alternative Investment Management Association (AIMA)

– AIMA’s Guide to Sound Practices for Hedge Fund Valuation, March 2007

• International Organization of Securities Commissions (“IOSCO”)– Principles for the Valuation of Hedge Fund Portfolios, March

2007• Hedge Fund Working Group – January 28, 2008, Hedge

Fund Standards: Final Report.


What is a Hedge Fund?

• D.C. Circuit: “Entity that holds a pool of securities or other investments that does not register its offerings under the Securities Act, and is not registered under the Investment Company Act.”

• PWG: Pooled investment vehicle (i) not marketed to general public; (ii) investors are limited to high net worth individuals and institutions; (iii) not registered as an investment company; (iv) professional asset manager; (v) investing in liquid portfolio of securities and other assets; (vi) periodic but restricted or limited redemption rights. (MFA, Sound Practices for Hedge Fund Managers, 2007).


Hedge Funds, con’t.

• Alternative investment vehicle– Trades in stock, securities, other

instruments– Free of regulatory constraints

• Originally, designed to reduce market risk through “hedging”– Hedge funds “market” inefficiencies

• No longer market neutral– Often employ “straddles” that bet whether

trading ratio will contract or expand between two securities


Hedge Funds, con’t.

• Wide varieties• Long and short investments in equities,

fixed income securities, currencies, commodities, and their derivatives

• Leveraged• Usually managed through a

combination of long and short positions to limit exposure

• Counterparty risks


Hedge Fund v. Private Equity Fund

• Hedge Fund is NOT a private equity fund• Liquidity

– Hedge fund has more liquidity– Private equity investor is long term

• Hedge fund should have a perpetual life• Hedge fund investor disposes of investment in

a single transaction• Hedge fund has a broader investment

mandate• Private equity funds often look to buy stakes in

companies


Hedge Fund v. Mutual Fund

• Hedge fund is not a mutual fund• Both invest in marketable securities• Both have liquidity• Hedge fund tries to generate positive

returns in all environments– Mutual fund return is compared to

“benchmarks”

• Different in market risk, investors, fees, diversification, leverage and regulation


Differences: Hedge Fund v. Mutual Fund

• Fees– Hedge fund manager charges fee as a fixed

percentage of gain– Mutual fund cannot

• Mutual Funds are registered under ’33 Act– Hedge funds are not registered– Exempt from registration, § 4(2) of the Act

• Most hedge funds exempt from ’40 Act– § 3(c)(1), which excludes funds with 100 or less

investors– § 3(c)(7), which excludes funds with “qualified

purchasers”


Advantages of not registering

• By not registering as investment company– Avoids leverage constraints on open ended fund– Avoids § 18(f) limits fund in issuing senior securities– Avoids §§ 12(a)(i) and (3) limitation on short selling

and margin

• Portfolio manager did not register as an Advisor under the Advisors Act of 1940– § 203(b)(3) exempts a manager with less than 15

clients• Each hedge fund is a client

– Carry can be charged under the Advisor’s Act for “qualified client[s]”


SEC Release IA-2333

• SEC endeavored to amend Rules to require “look through” hedge fund to count all the investors

• Required portfolio manager to register as an advisor under the Advisor’s Act

• June 23, 2006 D.C. Circuit reversed finding that the term “client” of a manager could not include an investor in hedge fund

• December 13, 2006: SEC proposed new anti-fraud rules that would prohibit making of false of misleading statements. Applies to all portfolio managers

• Effective on September 13, 2007: Rule 206(4)-8


Rule 206(4)-8

• Applies to both registered and unregistered Investment Advisers

• Applies to pooled investment vehicles exempt from ’40 Act §§ 3(c)(1) or 3(c)(7)

• Does not matter whether malfeasance occurs when selling, offering or redeeming

– Includes RFP process• Rule prohibits advisers from

– Making false or misleading statements to investors or prospective investors in hedge funds and other pooled investment vehicles

– Otherwise defraud these investors • “Rule clarifies that an adviser’s duty to refrain from fraudulent

conduct under the federal securities laws extends to the relationship with the ultimate investors [in the fund]”

– Commission may bring enforcement actions against investment advisors who defraud investors in those pooled investment vehicles

• Intent is to prohibit all fraud, without proving scienter• No private right of action


Fund Structures

• Structures of Hedge Funds– Single Entity– Master-Feeder– Parallel– Multi-Manager

• Single Entity– Partnership or Limited Liability Company– Manager or GP receives a carried interest

• Fixed percentage of the net gains of the fund• However, must be alert to effective carried interest

– May have two entities that manage the fund• Divide between the manager and the portfolio manager• Reduces tax burden


Master-Feeder Funds

• Taxable investors, tax-exempt investors and foreign investors

• Foreign feeder is a holding company– Tax-exempt and foreign investors make contribution

here

• Organized in low-tax jurisdiction as a corporation for tax purposes

• Avoids Unrelated Business Taxable Income• But, will be subject to federal tax if it engages

in a United States trade or business– If it “trades” or “invests”, exempt

• Acts to increase after tax returns to feeder and its shareholders


Parallel Funds

• Mirrors the Master-Feeder• Two members of a hedge fund complex

populated by same investors• Parallel entity is created in a low-tax

jurisdiction• Invests in tandem with on-shore fund


Fund of Funds

• Invests in different hedge funds• Gives exposure to different market

segments– Investor may not have time or qualifications

to diversify


Types of Funds

• Arbitrage Funds– Errors in market price– Often long and short positions in same stock

• Profit based upon whether profit exceeds loss

• Distressed Securities Funds– Invests in debt securities of bankrupt,

insolvent or troubled company– Participates in restructuring– Takes over company by controlling debt

• Futures Funds– Futures market


Types of Funds

• Event Funds– Anticipates certain corporate events, often spin-offs– Short one stock and purchased other– Sandell Asset Management

• Opportunistic Funds– Broad discretion to manager

• Macro Funds– Invests based upon macro events– Short or long asset classes

• Market Timing Funds


Investors

• Individuals• Public companies• Tax-exempt investors; e.g., Pension

Funds– Issue of fiduciary responsibility– UBTI issues

• Foreign Investors– Tax issues


Private Placement

• § 4(2) of the Securities Act– Secrecy

• Reg. D– Accredited investors

• Sophisticated investors• No general solicitations

– Adverse tax issues:• Market Rules (no violations)• Secondary Market Rule (includes redemption)

– See, Fortress Investment Group Holdings Registration Statement

• Limited transferability of interests• State regulation


Disclosure

• Private Placement Memorandum– Effort to achieve disclosure required by Registration

Statement

• Although exempt from registration, still subject to anti-fraud provisions

• Disclosure may be governed by– Securities Act of 1933– Securities Exchange Act of 1934– Investment Company Act of 1940– Investment Advisors Act of 1940– State statutes


Disclosure

• PPM• Annual audited financial statements• Performance information• Investor communications• Guidelines for disclosing conflicts of

interest• Qualifications of fund investors• Disclosure to counterparties


PPM—General

• Investment philosophy, strategies, products, risks

• Made in advance of the offer to subscribe

• New investments: supplement when a material shcnage has occurred– Review at least annually– Updated PPM should be provided to all fund

investors


PPM—Specific

• Legal structure• Objectives and strategies• Management• Terms• Withdrawal or redemption rights• Fees• Trade allocation policies• Liability and indemnification of Mgr• Information framework• Valuation framework: GAAP and NAV• Third parties• Valuation policy and oversight• Methodologies• Side Pocket arrangements


PPM—Specific, con’t.

• Risks– Incentive fee– Key personnel– Lack of assurance of success– Strategies– Valuation– Liquidity and restrictions on withdrawal– Leverage and margin– Broker and other counterparty risk– Foreign investments– Regulatory ovesight (or lack thereof)– Conflict of interest

• Other– Tax, regulatory and other– Third Party Administrators– Prime Brokers


Trading

• Limited• Accredited Investors• QIBs


Ongoing Informatioin

• Updated material information• Risk Reports• Performance related financial

information• Investment Related Financial

Information – FAS 157– GAAP


FAS 157

• Fair value is market-based measurement– Value based upon highest and best use for the asset

or liability– Principal market be used to determine fair value (if

such a market exists)• Principal market = largest volume and activity

• Three tier valuation hierarchy– Tier I – quoted price on active market– Tier II – Market observable inputs used to price– Tier II – Significant unobservable inputs needed to

determine fair value• Additional financial statement disclosure to be included

here


FAS 157, con’t

• Discounts can no longer taken when valuing a large block of securities– Securities must be valued at quoted price

• Single broker quote in a non-liquid security may fall within Tier II if the broker will trade at such price– Indicative price, then Tier III

• Fund of funds are required to determine whether NAVs provided by underlying funds are “fair value”– If underlying fund has limited liquidity, should a

discount be taken?


FINRA

• Rule 2210(d) – Content Standards– Member communications with the public shall be

based on principles of fair dealing and good faith, must be fair and balance, and must provide a sound basis for evaluating the facts…. No member may omit any material fact or qualification, if the omission, in the light of the context of the material presented would cause the communication to be misleading.

• No false, exaggerated, unwarranted or misleading statements or claims– No distributioni of statement that the member knows

or who has reason to know is false or misleading


FINRA

• Legend – only in event that such placement would not inhibit investor’s understanding

• No prediction of performance– May use hypothetical illustration of

mathematical performance, provided that it does not predict performance of the proposed strategy

• No testimonials unless the person making it has the experience and knowledge


FINRA – Altegris Investments & Risk Disclosure

• Speculative Nature• Leverage• Loss of Investment• Lack of Diversification• Lack of Liquidity• Limited Transferability• Volatility• Foreign Exchanges• Fees• Incorporated Risk Disclosure: It is insufficient

to refer to an accompanying offering document for risk disclosure information


FINRA -- Performance

• Realated Performance– Rule 2210 generally prohibits use of related performance.

May not publish or distribute sales materials containing any performance information other than the actual performance of the offered fund

• Related Performance: performance of other funds or accounts managed by the advisors, clone funds or funds or accounts that preceded or were converted into the advertised hedge fund

• However, FINRA member may use sales material that include related performance information for funds exempt from registration under Section 3(c)(7) of Investment Company act if the investors are “qualified purchasers” under Section 2(a)(51). – Still fall under Rule 2210 – communications must be

fair and balanced


FINRA -- Performance

• Can’t use target returns unless the member provides a “sound basis” for the returns– UBS Financial Services violated 2210(d)(1)

(A) and 2110 because presentations did not include substantial basis for evaluation

• Substantial basis – No guidance. – So, evaluate if meet and risk if do not meet


FINRA – Project Returns

• Rule 2210(d)(1)(D) prohibits use of projected returns

• Citigroup Global Markets• Can’t use hypotheticals and back-

testing because could use actual returns.

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