Tuesday, October 9, 2018

Investment Funds Primer: Different Hedge Fund Structures. Part I of Many

As our investment fund practice expands, we have decided to post a series of blogs relating to the basics of hedge fund and private equity fund structuring issues and considerations.

What is a hedge fund?

Hedge funds are often unfairly confused with hedging. “Hedging” is the practice of attempting to reduce risk (similar to getting an insurance), but the goal of most hedge funds is to maximize return on investment. Hedge funds are also often confused with private equity funds. Hedge funds generally invest in publicly traded securities and derivative instruments. Their portfolios can be marked to market. Investors can at any time invest into the funds as well as redeem their interests (subject to limitations, of course). Some hedge funds do invest a portion of their assets in illiquid securities though “side pockets,” but those are less common. Private equity funds, on the other hand, invest in securities of private companies, and therefore are much less liquid. They place significant restrictions on the investors’ ability to invest (only during the subscription period) and exit the fund (mostly only at the expiration of the fund’s term that can be as long as ten years).

Hedge fund structures

Single domestic fund. A stand-along domestic fund is typically a Delaware limited partnership or a Delaware limited liability company. The investors become its members, and the investment managers acts as the fund’s manager or general partner. If the fund is set up as an LLC, the manager receives limited liability protection as a manager of the company, whereas if the fund is set up as an LP, it does not. Therefore, to limit personal liability of the investment manager, it is important to establish a separate investment management entity as an LLC.

In cases where the investment manager will manage only one fund, the investment manager may also act as a general partner of the LP / manager of the LLC. Alternatively, the investment manager may act through its own entity advising various funds. In such case, it becomes necessary for the fund to enter into an investment management contract with the investment manager, in addition to having it or another entity be the general partner / manager of the fund.

Fund of funds. These structures have recently become very popular. Funds of funds are investment vehicles that, instead of investing into securities or other assets, invest into other hedge funds, private equity funds, or other type of funds. Some funds invest across a broad spectrum of assets, including hedge funds, private equity funds, venture capital funds, and real estate funds. Funds of funds provide for maximum diversification of investment and therefore spearing of the risk, as each “portfolio” fund itself invests in multiple assets or securities. It is also easier to invest into funds of funds, as the investment manager can rely on the due diligence done by the managers of the portfolio funds. Further, investing into funds of funds allows investors access to those funds that have high minimum investment amount, thus excluding smaller investors. Note that investing into funds of funds may be more expensive, since the fund of funds’ management fee is layered on top of the management fees of each portfolio fund. It is of course possible for the funds of funds to make direct investments into the underlying funds’ securities in addition to the underlying funds themselves.

Parallel funds. Parallel funds typically involve an onshore fund and an offshore fund that invest directly into the underlying portfolio of assets. The onshore fund has a general partner that itself is a pass-through entity for U.S. federal income tax purposes. The onshore fund pays management fees to the management company and makes an incentive allocation to the general partner. The offshore fund will also pay management fees to the management company, but will also pay an incentive fee to it. Such management company is typically an affiliate of the general partner. Recent tax changes (2008) disallowed the management company to defer the time of the receipt of the incentive fee from the offshore fund, and therefore some offshore funds have created mini-master funds descried below.

The parallel fund structure allows funds to invest differently in the underlying portfolio due to tax or regulatory considerations, although the objective is for the underlying portfolios to be identical.

Master-feeder funds. In a master-feeder structure, each of the onshore and the offshore feeder funds hold an interest in an entity that is treated as a partnership for U.S. federal income tax purposes, the master fund. The master fund invests into the underlying portfolio of assets. Investors in the onshore and the offshore feeders participate in exactly the same investments, and have the same compensation arrangements for the fund managers. In some master-feeder funds, the master fund makes an incentive allocation to its general partner or managing member and pays the management fee to the management company. It is also possible that each of the feeder funds pays a management fee to the management company, and the onshore feeder makes an incentive allocation to its general partner, whereas the offshore fund pays an incentive fee to a management company that is an affiliate of the general partner of the onshore fund.  However, as we mentioned above, this structure is no longer common.

Frequency of redemption requests at the feeder fund level must correspond to the frequency allowed by the master fund, since the money is invested by the master fund and the feeder would need to redeem some of its interest in the master fund in order to meet the redemption request at the feeder fund level.

Typically, the master fund would have a limited number of partners: only the general partner, the onshore feeder, and the offshore feeder.

Parallel funds with mini-master. In this structure, the onshore fund has the same structure as in the parallel funds structure described above. The offshore fund structure, however, has changes. Since it will be treated as a corporation for U.S. federal income tax purposes, it cannot make incentive allocations. So instead it pays an incentive fee to the management company. Due to the elimination of deferral fee arrangements in 2008, some investment managers have modified this by adding a mini-master structure.

In the mini-master structure, the offshore fund is the sole limited partner in a partnership (mini-master) and the general partner of the mini-master is the same as the general partner of the onshore fund or its affiliate. This allows the offshore fund to make incentive allocation to its general partner.

Of course, these are the most basic structures, and in real life, they are much more complicated.  But we thought we would start our fund blog series with the basics.

In the next blog post, we will describe the types of investors that invest into such funds, and the legal considerations involved in dealing with different types of investors. In the later blog posts, we will describe how to set up funds (again, from the legal perspective), and what laws and regulations apply to the funds and the fund managers.

This article is not legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors Arina Shulga or Kristina Subbotina.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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