The following is a broad summary of the rules governing hedge funds. It is not intended as legal, investment or operating advice of any kind. Readers must consult their own legal, financial and tax advisers regarding these matters. As with all investments, the investor is ultimately responsible for evaluating the appropriateness of the vehicle relative to his or her own circumstances.
Domestic Hedge Funds
A domestic hedge fund is an unregistered investment company that is formed in and open to US investors. Most hedge funds are structured as limited partnerships. A general partner serves as investment adviser with overall responsibility management and operations. The general partner typically receives an advisory fee (1% of net assets) performance fee (annual or quarterly), which is a percentage (usually 20%) of the fund's net capital appreciation. Unlike registered funds, the general partner may not be registered with the SEC. Because hedge funds are unregistered, they can use securities and strategies that are either prohibited or restricted in registered funds. Short sales, arbitrage and other kinds of hedging are commonly used in greater proportions than in regulated funds. For this reason, hedge funds are often referred as "alternative" or "non-traditional" investments.
Hedge funds maintain their exemption from securities and mutual fund registration by limiting the number of investors and requiring that they be experienced investors with significantly high net worth (see sidebar). Hedge funds are organized as "3(c)(1)" or "3(c)(7)" funds, referring to exemptions from mutual fund registration. Funds organized as 3(c)(1) funds are limited to 99 "accredited" investors. Section 3(c)(7) funds may have up to 499 "qualified" investors, but the net worth requirement is higher. Both types of funds must take care to avoid a "look-through" in certain circumstances to the underlying investors if an entity owns more than 10% of the fund. This is important because the look-through may cause a fund to exceed the number of permitted investors. Also, if a look-through is required all participants must be qualified to invest. Entities must be already in existence and investing before they invest in a hedge fund. Hedge fund operators must also keep in mind that funds can be "integrated" for mutual fund registration purposes if they have identical investment objectives, so that the SEC could consider two 3(c)(1) funds with 60 investors each to be one fund that is actually required to register. 3(c)(1) and 3(c)(7) funds can't be aggregated.
Offshore Hedge Funds
Offshore hedge funds are unregistered pooled investment funds domiciled outside the US (i.e., "offshore") and open only to non-US investors or, occasionally, US tax-exempt "accredited" investors. Offshore hedge funds are usually structured as corporations. Like domestic hedge funds, they are not subject to portfolio management restrictions that may apply to registered funds. Generally, the number of investors is not restricted. Many offshore hedge funds are formed in international tax havens such as Bermuda or the Cayman Islands, which offer privacy as well as tax advantages. It is important to keep in mind that the domicile of a hedge fund is not an indication of its quality.
An Accredited Investor is defined to include:
An individual whose net worth, or joint net worth with spouse, exceeds $1 million or whose income exceeded $200,000 in each of the preceding two years (or exceeded $300,000 together with spouse) and who reasonably expects to reach the same level of income in the current year, and Corporations, partnerships, trusts or foundations whose total assets exceed $5 million.
A Qualified Investor is defined to include:
Natural persons and certain family-owned companies, partnerships, trusts or similar entities, and certain other types of trusts, that own at least $5 million in investments; Entities that, in the aggregate, own and invest on a discretionary basis at least $25 million in investments, and "Knowledgeable employees" associated with a 3(c)(7) fund.
Alice Schulman is a contributing editor to Hedgefundcenter.com. She has over ten years' experience in managing administration, client service and compliance for investment advisors and funds. Contact her at [email protected]