The law firm's investment management practice represents a full range of U.S. domestic and non-U.S. clients
in all aspects of their organization and operations. Our clients include start-up investment managers/advisers and
investment funds, seasoned private equity and venture capital professionals and established/industry-recognized investment companies and institutions.
2. DEFINITION: HEDGE FUND
• Hedge Fund – a lightly regulated
investment vehicle that may use a variety
of investment techniques and may invest
in a vast array of assets to generate higher
returns for a certain level of risk when
compared to conventional investments.
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3. HEDGE FUND OVERVIEW
• Reduced regulatory oversight
• Private in nature
• Often more aggressive investment strategies
Absolute-return funds
Directional funds
Short Selling
Leverage
• Greater investment flexibility
• Performance fees or incentive allocations
• Frequently substantial investment by advisers and
portfolio managers
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• Tax benefits from fund’s structure
4. REDUCED REGULATORY
OVERSIGHT
• Do not have to register with the U.S. Securities
and Exchange Commission (SEC), National
Association of Securities Dealers (NASD), or
Commodity Futures Trading Commission (CFTC)
• Some hedge funds nonetheless elect to register
with these governing bodies
• Registered or not, hedge funds cannot commit
fraud, participate in insider trading, or violate 4
other local, state, or federal law
5. PRIVATE IN NATURE
• Private securities offering, i.e. not registered
under federal or state securities laws
• Under current law, cannot be offered or sold to
the general public, must be limited to:
Accredited investors– individuals with net worth of at least $1
million or an annual income of $200,000 ($300,000 for a
married couple)
Qualified purchasers—individuals, trust accounts, or
institutional funds with at least $5 million in investible assets
• Rationale: people with high net worth generally
understand investment risks and returns better
than the average person and can afford to lose
money if the investment does not work out 5
6. AGGRESSIVE INVESTMENT
STRATEGIES
• Absolute return funds—designed to generate
steady return regardless of what the market is
doing
More appropriate for a conservative investor (wants low risk and
willing to give up some return in exchange)
Generate bond-like returns (in long run returns higher than bonds,
but lower than stocks)
• Directional funds– funds that don’t hedge fully by
maintaining exposure to the market, but trying to
get higher than expected returns from the amount
of risk taken
More appropriate for an aggressive investor (willing to take some
risk to gain potentially higher returns)
Generate stock-like returns 6
Not as steady as absolute return funds, but over long run returns are
higher
7. AGGRESSIVE INVESTMENT
STRATEGIES (CONTINUED)
• Short selling–when securities look like they will
go down in price, you “borrow” them from
investors who own them and then sell the
securities in an attempt to buy them back at
lower prices to repay the loans
• Leverage– borrowing money to increase return,
relative to the amount of money the fund has
Fund has to repay the loan regardless, so can increase risk
Funds may sometimes use leverage for low-risk investment strategies to
increase the return without taking on undue risk
Key difference between hedge fund and other investments which are 7
not permitted to employ leverage
8. GREATER INVESTMENT
FLEXIBILITY
• Portfolio manager may employ a broad
array of investment techniques that are
not permissible for a tightly regulated
investment vehicle
• Generally not constrained in investment
activities by diversification requirements
applicable to mutual funds
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9. PERFORMANCE & MANAGEMENT
FEES
• “Industry standard” 2 and 20 arrangement– fund
manager receives an annual fee of 2% of the
assets in the fund and an additional bonus of
20% of the year’s net profits
May be different percentages, but management fee +
bonus is standard
Management fee typically mean to cover operating
expenses
Manager only receives a bonus if the fund makes
money
Performance fees frequently conditioned with a loss
carryforward provision, whereby no fee is paid on 9
profits that replace prior losses
10. PERFORMANCE & MANAGEMENT
FEES (CONTINUED)
• Key difference in hedge fund versus other
investments (SEC prohibits mutual funds from
charging performance fees)
• Downsides:
After accounting for fees, a hedge fund’s outsized
performance relative to other investments may be
reduced
If a fund has a negative year, manager has incentive to
close the fund and start over instead of foregoing a
performance fee while recovering prior losses
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11. SUBSTANTIAL INVESTMENT BY
ADVISERS AND MANAGERS
• Managers usually become partners with the
investors by making significant investments of
their own into the fund or by paying the fund’s
organizational expenses
• Financial commitment by managers can be
important in attracting outside investors, as the
fund manager carries the same investment risks
as the investors and both groups’ interests are,
therefore, aligned 11
12. TAX BENEFITS
Flow-Through Tax Treatment:
Unlike a LP, a corporation is taxed on its profits
and its shareholders pay taxes on any dividends
they receive— “double taxation.” LPs, however,
act as “flow through” entities and no tax is paid at
the entity level. Instead, the LP’s members are
individually taxed on their allocable share of the
entities’ income, gain, or loss (whether or not
distributed or realized). Accordingly, each member
receives a report of their allocable share on
Internal Revenue Service Form 1040, Schedule
K-1, and similar state tax forms, issued by the LP. 12
13. SAMPLING OF HEDGE FUND
STRATEGIES
• Long only • Credit Funds
• Long/Short • Event-driven
• Market Neutral Arbitrage
• Short-Bias • Distressed Securities
• Macro • Energy Funds
• Sector • Emerging Markets
• Convertible Bond and • Crossover Funds
Convertible Arbitrage • Managed Futures
• Fixed-Income
Arbitrage 13
14. LONG ONLY
• Purchase and sell securities
• Does not sell short very often, if at all
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15. LONG/SHORT
• Take both long and short positions in securities
• Seeks to benefit from fund manager’s view on
undervalued/overvalued assets in the market
instead of directional movements in the market
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16. MARKET NEUTRAL
• Similar to long/short strategy
• Seeks to eliminate or minimize impact of the
market on the fund’s return
Relies almost entirely on portfolio manager’s
investment analysis
• Various techniques:
Take offsetting positions in same security
Take long and short positions in same types of
securities
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17. MARKET NEUTRAL
(CONTINUED)
• Different ways to be neutral:
Beta Neutral fund has same level of overall market
risk in long and short positions
Dollar neutral fund has same overall dollar amounts
committed to long and short positions
Sector neutral fund has same dollar amounts
committed to long and short positions within each
sector or industry
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18. SHORT-BIAS
• Invests primarily in short positions, focusing on
identifying overvalued stocks to sell short
Selling stocks short
Buying put options
Selling stock index futures
• Almost always net short the market
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19. MACRO
• Seeks returns in major changes in global
economic or financial trends
• May use a high degree of leverage
• Relatively volatile
• May take positions in several types of
instruments
Securities
Currencies
Commodities
Derivatives 19
20. SECTOR
• Focuses in particular industries or
economic/financial sectors
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21. CONVERTIBLE BOND AND
CONVERTIBLE ARBITRAGE
• Invests in convertible bonds (bonds that can be
converted into the issuer’s stock at a certain
price)
• Provides a degree of exposure to equities with
controlled risks
Aims to generate profits while protecting itself from risks
• Often take positions in both convertible bonds
and underlying equity of a company
May separate convertible bonds into constituent debt and equity
parts, keeping some portions and selling others
May purchase distressed convertible bonds or use credit
derivatives to protect against credit risk, depending on how 21
aggressive or conservative the fund strategy is
22. FIXED INCOME ARBITRAGE
• Seeks to take advantage of price inefficiencies
between debt instruments (mortgage-backed
securities, corporate, and government bonds,
and interest rate derivatives)
Cross credit arbitrage simultaneous long and short positions in
debt securities of different issuers to profit from differences in
their credit quality
Capital structure or balance sheet arbitrage simultaneous long
and short positions in debt securities of the same issuer
Convergence trades designed to produce profits as perceived
inefficient prices converge over time
• Because of small profit potential on each
investment, the fund often uses a significant 22
amount of leverage to enhance returns
24. EVENT-DRIVEN ARBITRAGE
• Seeks to profit from price differences of
securities involved in announced corporate
events (ex., mergers, acquisitions, restructuring)
• Major risks:
Possibility of transaction failing to be completed
Difficulty and expense in borrowing shares to sell short
Lack of mergers or other transaction critical to the
strategy
• To protect against risks, fund diversifies risk
across many sectors and transactions 24
25. DISTRESSED SECURITIES
• Sometimes referred to as “Vulture Funds”
• Investing in distressed securities, seeking to
profit from special opportunities
Bonds, loans, trade claims, receivables, or equity of
companies in severe economic distress, possibly facing
bankruptcy, reorganization/restructuring or
recapitalizations
• Often limit investor withdrawals by imposing a
lock-up period because the lengthy amount of
time it takes to turn a profit on these securities
and the fund’s holdings illiquid nature 25
26. DISTRESSED SECURITIES
(CONTINUED)
• “Second lien loans” direct loans to struggling
companies, taking short positions in the company
stock or playing an active role in any workout of the
company
• “Orphan equities” acquire restructured equity in
companies which trade at discounted rates since
analysts and markets don’t follow them
• “Loan to own” when holding substantial amounts
of distressed securities, may end up owning the
company if it becomes insolvent
• “When issued basis” trade securities about to be 26
issued in a reorganization on a when issued basis
27. ENERGY FUNDS
• Focus on various aspects of green technology
and resource industries
Commodities
• Crude oil, natural gas, coal
Green technologies
• Emission and carbon trading
• Renewable energy
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28. EMERGING MARKETS
• Investing in equities or fixed income securities of
corporate or sovereign issuers in emerging
markets
• High risk/ High return
Greater potential for significant price appreciation
Increased Illiquidity
Increased Volatility
Foreign laws and regulations governing trading can
add significant risks and costs
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29. CROSSOVER FUNDS
• Seeking opportunities in other’s fields
(convergence)
• Hybrid between hedge fund and private equity
fund
Seeks to profit by holding publicly traded and private
securities
• Greater investment flexibility, broader range of
potential investment opportunities
• Frequently longer lock-up periods than other
types of hedge funds 29
30. MANAGED FUTURES
• Futures and options on futures contracts
• Generally is considered a commodity pool by the
CFTC
• Commodity pool adviser and any trading
advisors must be registered, absent an
exemption
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31. HEDGE FUND STRUCTURE
• Fund Manager– may do all trading and research
himself or hire a staff to give him advice:
Traders– execute buy-sell decisions, operating in real time
Analysts –make projections about future value of securities
• Fund Administrator
• Investors
• Legal Counsel – help navigate regulations,
registration obligations, exemptions and
compliance responsibilities
• Other Consultants – advise investors, monitor
fund performance, and market fund managers to
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new clients
32. HEDGE FUND STRUCTURE
(CONTINUED)
• Usually structured as Limited Partnership (but could also be an
LLC)
General partner—controls the fund
Limited partners– invest in the fund Portfolio
Transactions
Manage (and frequently
General invest in) the fund
Partner
Limited - Custody
Partnership - Reporting
- Settlement
- Other services
Limited
Partner
Invest
Limited Prime Broker
Limited Partner 32
Partner
33. FUND MANAGER/ GENERAL
PARTNER
• Responsible for the overall management of the
fund’s assets and portfolio investments
• Many managers whose funds invest in securities
are registered as investment advisers with the
SEC under the U.S. Investment Advisers Act of
1940 (Advisers Act) or under state law, although
there are some exemptions to registration
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34. PRIME BROKER
• Provides general manager with centralized
custody, clearing and settlement, execution of
portfolio transactions, reporting, financing,
securities loans and borrowing, record keeping,
access to securities offerings, marketing to new
investors, and other services from one source
• Even though prime broker holds all the fund’s
assets, manager can still trade with a variety of
broker dealers– similar to a bank custodial
account
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35. ADMINISTRATOR
• General administration for LPs and LLCs:
Monthly calculation of the net asset value of the fund
Maintaining capital accounts for fund participants
Tracking deposit and payment of funds as fund’s designated
custodians
Facilitating, upon instructions from fund, the payment of fees and
expenses of service providers and fund management
Maintaining the customary financial and accounting books and
records of the fund
• General administration for offshore corporations:
Day to day administration, reporting, and business of the fund
Determining and notifying fund management of net asset values of
fund overall, each class, each series of each class, and the relevant
net asset values per share– as well as the issue and redemption price
of shares and number of shares in issue
Tracking deposit and payment of funds as fund’s designated
custodians
Preparing letters for a director’s signature or facilitating the
authorization of payments of fees and expenses of service providers
and fund management 35
Maintaining the customary financial and accounting books and
records for the fund
36. ADMINISTRATOR
(CONTINUED)
• Document review
• Subscription processing for domestic funds
• Share registry for offshore corporations
• Provide portfolio details with monthly brokerage
statements, performance reports, investors reports,
underlying managers reports,
• Maintain records for fund accounting and cash
activity
• Audits and tax preparatory work
• Administrative records 36
• Exercise financial controls
37. LEGAL COUNSEL
• Provide advice concerning appropriate structures and entity
creation
• Draft offering documents, partnership/membership
agreements, and subscription agreements
• Register investment advisor with the Securities and Exchange
Commission or one or more state securities division(s),
including drafting of Form ADV, and/or commodity pool
operator registration with the National Futures Association, as
necessary
• Provide tax advice, including treatment of ERISA plans and
other tax-exempt investors
• Submit Regulation D, Rule 506 Form D and blue sky filings with
applicable state securities divisions
• Draft related documents, such as side letter agreements, sub- 37
advisory agreements, etc.
38. AUDITORS
• Provide investors with independently audited
annual financial statements
• Various jurisdictions require periodic audited
financial statements
• Providing audited statements can be an easier
way for the fund manager to comply with certain
custody requirements under the Advisers Act
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39. SUMMING IT UP
• Private in nature with limited regulatory oversight
• May use a variety of aggressive investment
techniques
• Objective is to generate higher return on
investments for the amount of risk taken compared
to conventional investments
• Usually set up at a Limited Partnership or Limited
Liability Company
• Involves a team consisting of the fund manager,
investors, prime broker, administrator, auditors, and
legal counsel 39
40. DISCLAIMER
• This presentation was made for informational purposes only.
• Malik Law Group LLC is not providing legal advice to any user.
• Malik Law Group LLC is not providing tax advice. This
presentation is subject to the Circular 230 Notice on the next
slide.
• This presentation does not establish an attorney-client
relationship between Malik Law Group LLC and the user.
• Any discussion herein is not a substitute for seeking actual
legal advice from a licensed attorney with knowledge of the
rules and regulations governing the industry.
• Malik Law Group LLC makes no representations, guarantees,
or warranties as to the accuracy, completeness, currency, or
suitability of the information provided via this presentation.
• This presentation may be considered “attorney advising” in 40
some jurisdictions.
41. DISCLAIMER–CIRCULAR 230
NOTICE
• CIRCULAR 230 NOTICE. THE FOLLOWING NOTICE IS BASED ON
THE U.S. TREASURY REGULATIONS GOVERNING PRACTICE
BEFORE THE U.S. INTERNAL REVENUE SERVICE: (1) ANY U.S.
FEDERAL TAX ADVICE CONTAINED HEREIN, INCLUDING ANY
OPINION OF COUNSEL REFERRED TO HEREIN, IS NOT
INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED,
BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING U.S.
FEDERAL TAX PENALTIES THAT MAY BE IMPOSED ON THE
TAXPAYER; (2) ANY SUCH ADVICE IS WRITTEN TO SUPPORT
THE PROMOTION OR MARKETING OF THE TRANSACTIONS
DESCRIBED HEREIN (OR IN ANY SUCH OPINION OF COUNSEL);
AND (3) EACH TAXPAYER SHOULD SEEK ADVICE BASED ON THE
TAXPAYER’S PARTICULAR CIRCUMSTANCES FROM AN 41
INDEPENDENT TAX ADVISER.