Saturday, May 26, 2007
The media sometimes vilify “hedge” funds for their secretiveness and elitism and rue the hedge fund industry’s economic power and apparent ability to disrupt the smooth operation of financial markets and national economies. This article seeks to provide readers, who are generally familiar with mutual funds, a basic understanding of the structure and characteristics of “hedge” funds in their regulatory context. The article compares hedge funds with mutual funds and explains that most hedge funds are private investment companies that their promoters design so that they need not register under the Investment Company Act of 1940. Those unregistered funds do not make a public offering of their securities and come in two basic varieties: (i) funds that admit no more than 100 investors (referred to by the applicable exception under the Investment Company Act as section 3c1 funds) and (ii) funds that admit as many as 499 investors (the limit only to avoid registration under the Securities Exchange Act of 1934), all of whom must be qualified purchasers (referred to as section 3c7 funds). Qualified purchasers, in the case of individuals, are people who own at least $5 million in investments. Since 1998, there are registered hedge funds that restrict their investor base to qualified clients, who are, in the case of individuals, people with at least $1.5 million in investments.
The article identifies and explains the two principle reasons for avoiding Investment Company Act registration: (i) incentive fees for investment advisers to the funds and (ii) no restrictions on borrowing to create leverage for the fund. Registered hedge funds may pay incentive fees to their investment advisers but may not borrow except within the narrow three times asset coverage limits applicable to mutual funds. In addition, the article explains the taxation of hedge funds and the need to provide different fund structures for different classes of investors, partnerships that are transparent for tax purposes for taxable U.S. investors and corporations, usually offshore, for tax exempt U.S. investors and non-U.S. investors. Finally, the article briefly comments on the need for additional regulation of hedge funds.
After introducing some history of hedge funds and comparing the liquidity of hedge fund investing with mutual fund investing, part 2 of the article describes the structuring of hedge funds to exempt them from regulation under the Securities Act, the Exchange Act, and the Investment Company Act. Part 3 explains how the exemption of hedge funds from regulation under the Investment Company Act enables the funds’ investment advisers to avoid regulation under the Advisers Act but, more importantly, to remain free from the limitations on the fees the advisers may collect. Part 4 identifies federal income tax rules that contribute to structural choices and result in a mixture of domestic and offshore funds to meet the needs of differing classes of investors. Part 5 discusses hedge fund strategies and the importance of leverage. Part 6 concludes by synthesizing the regulatory frameworks to an understanding of the simple fundamental nature of hedge funds and briefly explores the question of the need for additional regulation of the hedge fund industry.