not act on any of this information without contacting an attorney,
accountant or tax professional.
an Area of Interest:
Starting a Hedge Fund, How Should I Handle My Accounting?
To Choose A CPA Firm For Your Audit, Tax and/or Back-Office Accounting
Accounting Definitions & Issues
Allocations and Issues
Starting a Hedge Fund, How Should I Handle My Accounting?
a new hedge fund is created, the fund must keep detailed accounting
records. The accounting records for the fund will be compiled mainly
from your brokerage statements. Determination of fees(incentive
and management) and other expenses will depend on your partnership
agreement. Along with determining the profit and loss in your partnership,
special attention should be paid to the nature and characteristics
of the limited partners in the fund.
will also want to get audited, your limited partners will demand
it and some marketing agents may not work with you if you're not.
Should A Fund Proceed With Accounting Functions?
functions can be outsourced to back-office accounting operations
firms and CPA firms or the fund can hire an in-house accountant.
advantage in hiring an in-house accountant, for obvious reasons,
is the timeliness of performance data. In-house accountants can
also help you with the analysis of your portfolio, and identifying
exposure in certain areas. An in-house accountant with an audit
and tax background can also ease the burden of the audit and tax
duties that a CPA firm provides by preparing a significant portion
of the work that a CPA firm would normally do. It is important to
hire an individual with a background in investment partnerships,
As a former auditor, I have worked on several funds where the accountant
erroneously prepared the accounting records or missed some compliance
issues because of lack of knowledge of the industry.
and cost saving method to handle your accounting functions is to
outsource it to firm that exclusively provide this service. There
are some firms that can be found on the internet that provide this
To Choose A CPA Firm For Your Audit, Tax and/or Back-Office Accounting
good CPA firm will have knowledgeable staff at all levels. When
seeking services, always ask how many professionals are dedicated
to the hedge fund practice. Find out how many professionals are
in audit and how many are in tax. If a firm only has two or
three professionals dedicated in any of
these areas, then they probably aren't committed in the
area of hedge funds. Try and meet with the seniors involved
in the hedge fund practice area, this group will be the most involved
in completing your work. Make sure to ask complex questions about
your hedge fund's accounting and tax issues to this group, also
test their product knowledge. Meeting with partners is fine, but
remember, when one reaches the level of partner they are only interested
in the sale and some firms may say anything to get your business.
That's why I suggest meeting with the other staff levels, they usually
have to pick up the mess. Also ask to see each department's work
firm should also have several hedge fund clients that can be used
as references. Most firms will provide a list of their clients,
ask if you can contact these clients. Make sure the clients you
contact are utilizing the same services that you are seeking. Some
firms may do a good job at auditing, but they provide poor tax support.
BREAK PERIODS (THE PARTNERSHIP ALLOCATIONS)
heart of hedge fund accounting is the partnership allocations. The
allocations are then broken into sections called break periods.
periods will always occur when a partner withdraws fully or partially,
contributes more capital or a new partner is admitted. The break
period will usually end on the last day of a given month (dictated
by the partnership agreement). The partnership then needs to be
valued on that date and the new capital activity and percentages
will become effective on the following day (the first of the month).
Basically, anything that affects the partnership percentages is
going to result in a break period.
use an example to show a typical break period and the allocation
of the performance for the break period:
is the general partner of Hedge Fund Homepage Partners, L.P., he
has decided to start this partnership. Paul and Gene have also joined
in as limited partners. On 1/1/97 they start the partnership, Phil
contributes $100,000, Paul contributes $500,000, Gene contributes
200,000. The partnership begins trading and has net income from
1/1/97 - 3/31/97 of $50,000, on 4/1/97 they add
a new partner, Linda, she contributes $250,000. This has now resulted
in a 3/31/97 break, with new partnership percentages taking effect
the date of the break period, the revenue and expenses are all accounted
for, the securities are marked to market and a valuation of the
partnership is determined. The net income is $50,000. For
above schedule is a simple example of what is called book allocations.
When a limited partner invests in a hedge fund, it is important
to make sure that the investment partnership is audited by a reputable
accounting firm. Book allocations must adhere to the partnership
agreement. There are other items that will be part of book allocations,
such as, management fees and performance fees, it is important for
an independent auditor to make sure that the hedge fund manager
is adhering to the limited partnership agreement. A hedge fund manager
may interpret the agreement incorrectly, resulting in either an
overcharge or undercharge to the limited partners. So, if you are
investing in a limited partnership you should make to sure to read
the partnership agreement, find out what the management fee is (usually
1% a year) and how the performance fee is determined(usually 20%
of net income)*
fees may have benchmarks and hurdles
percentage and method of calculation depends on your partnership
agreement. the typical fee structure is as follows:
fee is usually charged on 1/1, 4/1, 7/1, 10/1. The partnerships
net asset value is determined on the specified date and is charged
to the partnership. the are instances where some funds do not charge
all the limited partners this fee. Some funds may have relatives
or others who they do not wish to charge. If a fund does not charge
this fee to everyone, a break period will result on the dates that
the management fee is charged. Over a length of time, certain inequities
may result to those who are charged due to the dilution of their
partnership percentages. There will also need to be a separate allocation
of the management fee whenever charged.
GAINS & LOSSES
track your realized gains and losses on a break period basis. It
is important for the fund to track gains and losses on a TRADE DATE
basis. Most good prime brokers offer trade date monthly realized
gains and losses reports on a monthly and YTD basis. For audit and
tax purposes, hold on to all your brokerage reports and schedules
prepared by your accountants. For tax purposes, keep track of gains
and losses that are considered short-term and long-term on a monthly
and break period basis. Having the accounting firms recreate this
for you can increase your audit and tax fees.
fee is usually 20% of the net profits of the partnership. Calculation
of the fee is determined by the partnership agreement. The fee is
a reallocation on the book and tax allocations on the income of
the limited partners to the general partner. Incentive fees may
have hurdles, benchmarks, complicated scenarios, etc. There are
also certain SEC rules regarding the incentive fees and Registered
DUE TO WITHDRAWING PARTNER
on how the partnership agreement is structured, when a partner fully
withdraws from a hedge fund, the hedge fund manager will usually
pay the limited partner that is leaving 90-95% of the amount due
to him/her within 10-15 days of the break period. The remaining
5-10% will be paid pending a verification of capital amounts on
the date the partner decides to leave. This 5-10% is usually paid
a certain amount of interest until paid to the withdrawing limited
partner. Please read your partnership agreement (offering memorandum)
to see if this applies to you.
CARRYFORWARDS & HGH WATER MARKS
partnership agreements provide for loss-carryforwards. This protects
the limited partner from being charged an incentive fee on an "up"
year when total cumulative return is a loss. For example, if a limited
partner enters into a partnership on 1/1/96 and has a net
loss of $60,000 for the year, the general partner will
not be entitled to an incentive fee. If in 1997 the limited partner
has a net appreciation for the year of $50,000
the general partner will still not be able to charge an incentive
fee, even though there was a net gain for the year. In addition,
the general partner must make up another $10,000 loss in 1998. This
is a loss carry-forward, the general partner cannot charge an incentive
fee till the limited partners are made whole. Each limited partner
must be tracked individually. Please read your partnership agreement
to see if this pertains to you. A high water mark is similar except
that the manager must recoup lost profits on the limited partner's
funds frequently trade in what are called "Hot Issues".
Hot issues are basically IPOs. When a partnership trades in Hot
Issues, only certain investors are allowed to participate, there
are certain rules that will restrict certain partners. Hot
Issue activity such as profit and loss, interest income and expense,
dividends, etc. must be separated from regular trading activity.
A separate brokerage account must also be maintained for Hot Issues.
If you trade hot issues and you're a hedge fund, your prime broker
will ask you for an "opinion letter", at least they're
required to. This letter is usually prepared by your attorney.
preparing book or tax allocations, one must create a separate allocation
of performance for those who can participate in Hot Issues.
purposes of counting investors, a 3(c) 1 fund must carefully consider
capital contributions made by registered investment companies, 3(c)
1 funds and 3(c) 7 funds. If any of these entities hold more than
10% of the funds capital, the fund will have to count the investors
in the contributing fund as well for purposes of the 99 partner
limit. Fund managers operating a 3(c) 1 fund that wishes to accept
large contributions from these entities should consider starting
a 3(c)7 fund or converting their fund to a 3(c)7. When your accountant
prepares your allocations, a check should be performed at each break
period for limited partners exceeding 10% of the fund's assets.
accounting fees and other fee associated with starting the fund
can be charged through the fund.
fund will normally incur accounting and legal fees throughout it's
life. Fees that are directly related to the fund should be expense
through the fund. Audit and accounting fees should be accrued on
a monthly basis, rather than when paid. If your anticipated audit
and tax fees are $24,000/yr. You should expense $2,000 a month for
accounting and audit expenses.
INCOME/EXPENSES, DIVIDEND INCOME/EXPENSE
characters of income should be recorded when earned and not when
received. Interest should be accrued on a monthly basis based on
interest rates or coupon dates. Dividends should be recorded on
ex-date rather than pay-date.
and large the most complicated area. There are several federal and
state tax issues that a hedge fund must consider when starting a
hedge fund, management company or/and affiliate management company
of a hedge fund. Below you will find some some information on tax
allocations are created to determine the amounts to be reported
on the K-1s. The tax allocations are the area that some of the hedge
fund software manufacturers try to facilitate.
tax purposes your accountants will create a tax allocation of your
partnership. The tax allocations are derived from the book allocations.
The difference between the book allocations and tax allocations
are outlined below:
book allocation purposes, performance need not be broken out by
character of income, for tax purposes all the components that
make up the partnership's performance must be broken out(i.e.;
Interest, dividends, realized long term, realized short tem, etc.).
Unrealized is not taxed.
performance must be broken out by period, by character.
book allocations a general partner can take 20% of the total performance
and reallocate that amount to his/her account. For tax purposes,
the accountant must hit every component of income for the 20%
means that the GP must take 20% of interest income, 20% of
dividends, 20% of realized short term, etc.
results at the end of the tax allocation is every partners share
of each component of income for the tax year net of any performance
fee to be reported on the K-1s
are a couple of methods that accountants use to account for realized
gains for tax purposes (layering, aggregate, etc.).
addition to determining what the character of income for
each partner is for tax purposes, the accountant will review the
partnerships trading activity to determine if there are any tax
adjustments to made. Certain tax laws require these adjustments.
Contact a CPA firm for information on these adjustments.