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Risk, Regulation and Organizational Structure. Hedge Fund Investing Risks.

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Presentation on theme: "Risk, Regulation and Organizational Structure. Hedge Fund Investing Risks."— Presentation transcript:

1 Risk, Regulation and Organizational Structure

2 Hedge Fund Investing Risks

3 Risks Many hedge funds managers are inherently more comfortable taking risks compared to non-hedge fund managers and are willing to consider a much broader array of investment alternatives In addition, hedge funds frequently use derivatives, which sometimes carry risks that are problematic to analyze and value However, derivatives can also mitigate risk, if used properly Systemic risk relates to the possibility that many financial institutions fail simultaneously in response to a single major event Hedge funds can create systemic risk in two ways the failure of several large hedge funds at the same time could create contagion across many classes of financial assets as the failing funds are required to unwind their investment positions at fire sale prices hedge funds can create large losses for the banks that lend to them if collateral is inadequate or valuation methodologies are inaccurate

4 Leverage Most, but not all, hedge funds use leverage, including off-balance sheet leverage associated with derivatives, to increase their returns Leverage works well when returns are positive, but it backfires when returns are negative Assuming a hedge fund borrows $70 after receiving $30 from investors and a $100 investment is made with the total proceeds, if the investment increases by 10%, investors gain 33%, but if the investment declines by 10%, investors suffer a loss of 33% A large proportion of hedge fund leverage is collateralized by assets and so, although notional leverage amounts can be very large, marginal leverage (uncollateralized by assets) is much smaller

5 Leverage

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7 Short Selling Many hedge funds sell securities short as a way to express a bearish view This short selling action creates a theoretically limitless exposure if the shorted security increases in value A long position in a security has a loss potential that is limited by the value of the security, but there is no such limit in a short position However, short sale positions that are hedges against a long holding are considered risk mitigators, rather than risk augmenters

8 Regulation U.S. hedge funds have historically been able to rely on the “private adviser exemption” to reporting under the Investment Advisers Act of 1940 (’40 Act), as long as a hedge fund adviser “has fewer than fifteen clients and neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser” to a registered investment company Since nearly all hedge fund advisers manage fewer than fifteen separate hedge funds, they are were not compelled to register under the ’40 Act As a result, U.S. hedge funds were not subject to as much direct oversight from financial regulators, compared to mutual funds and most other investment managers who are not exempt from the ’40 Act However, banks (the principal counterparties to hedge funds in trading and lending transactions) are highly regulated and therefore “indirect” regulation (including the U.S. Fed’s Reg T limitations on margin) applied to hedge funds

9 Regulation Hedge funds are sold through private placement offerings, which means that funds cannot be offered or advertised to the general public, and are normally offered under Regulation D of the Securities Act of 1933 This process basically limits hedge fund offerings to accredited investors An accredited investor is an individual with a minimum net worth of $1.5 million or, alternatively, a minimum income of $200,000 in each of the previous two years and a reasonable expectation of reaching the same income level in the current year The Dodd-Frank Act passed during 2010 requires all hedge fund advisers that manage more than $150 million to register with the SEC, maintain and share with the SEC extensive records about their investment and business practices, hire a chief compliance officer to design and monitor a compliance program, and be subject to periodic SEC examinations and inspections

10 Regulations (2) Regulations are designed to protect “little guys” Over regulations may induce risk taking Remember Bernie Madorff? “More related” does not mean “less risky” Take a look at page 189 to 191 of Jaeger’s book

11 Organizational Structure

12 Hedge funds usually organize as a limited partnership for U.S.-based taxable investors The general partner of the limited partnership is usually the hedge fund investment manager and investors are limited partners Offshore investors that are non-U.S. entities and U.S. entities that do not pay taxes (such as pension funds) invest through a separate offshore vehicle Both onshore and offshore funds usually invest in a master feeder fund, which then co-invests in a master fund, which is managed by the hedge fund investment manager This structure creates optimal tax and regulatory advantages for both onshore and offshore investors, while enabling the investment manager to manage all invested funds together If organized properly, this structure enables taxable investors to avoid paying taxes twice, and also enables tax-exempt investors to participate in the same investment management pool as taxable investors

13 Domicile Many hedge funds are registered offshore, principally in the Cayman Islands, British Virgin Islands and Bermuda Onshore hedge fund registrations are principally in the U.S. (65%-mostly in Delaware) and in Europe (31%) The domicile chosen depends on the tax and regulatory environment of the fund’s investors By creating an offshore domicile, the fund can avoid paying taxes on the increase in the value of its portfolio However, investors in the fund will still pay individual taxes on any profit realized in their investment with the fund and the hedge fund manager will pay taxes on management fees

14 Open-Ended Partnership Hedge funds typically operate as open-ended partnerships An open-ended fund is able to periodically issue additional partnership interests or shares directly to new investors at a price that is equal to NAV/share or interest Investors are able to redeem their interests or shares at the prevailing NAV/share or interest on the date of redemption Shares or interests in open-ended funds are typically not traded Profits associated with these shares or interests are usually not distributed to investors before redemption By contrast, a closed-end fund distributes profits to shareholders and allows shares to be traded

15 Delivery systems of Hedge Funds (Chapter 12 Jaeger) Limited partnership Limited liability company An offshore company (see page 188, Jaeger) Tax haven countries, like Bermuda, British Virgin Islands, the Cayman Islands. Funds need pay various administrative fees. Taxable investors typically A commodity pool Futures pools (page ) A specialized separated account

16 Mutual funds vs Limited Partnerships Mutual funds are companies A private investment partnership is not a company but a business arrangement based on the distinction between a general partner and a limited partner. The partners do not own shares in a company; they own a fractional interest General partner runs the business and bears unlimited liability for anything that might go wrong Limited partners bear limited liabilities

17 Further differences in these two (1) Liquidity: mutual fund investors have access to daily liquidity, while hedge funds don’t provide this access. They offer quarterly or even annual liquidity Number of investors: mutual funds are designed to serve a large number of small investors; hedge funds (limited partnerships) are designed to serve a small number of large investors Marketing: mutual funds are allowed to market to the general public while limited partnerships are not Investments: restrictive to mutual funds, not to HFs Turnover: short short run for MFs, repealed in 1998 (page 185)

18 Further Differences (II) Distributions: MF: all taxes are paid by the investors. MFs must distribute to their investors 95% of its income and realized capital gains. No such requirements for HFs Custody: MFs are required to hold their assets in a segregated account at a bank. HF assets may be held in a brokerage account. Investment management fees: MFs cannot charge a percent of profits fee. Fulcrum fee is allowed (page 186). 1-and-20 for HFs Governance: MFs must have a board of directors while limited partnership are not subject to any governance rule. HFs could have advisory boards, while it does not hold fiduciary responsibilities


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