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Firma 2006 Washington Conference

Hedge FundsApril 12, 2006

Presented by: Anees T. Din Partner

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Discussion Topics

• Definitions• Regulatory Environment• Structure of Hedge Funds• Roles and Responsibilities• Core Documents• Accounting

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Hedge Funds

Definitions• Pool of money – a group of investors (3-C-1

Structure vs. 3-C-7)• Hedge Funds are flow-through entities• General Partners – unlimited liability (all

partners in an ordinary partnership are GPs)• Limited Partners/shareholders capital only

(must have one GP to manage the partnership) (the LPs/shareholders do not participate in its management and operation)

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Hedge Funds

Definitions• Onshore vs. Offshore Funds• Registered or Not Registered with

CFTC (depends on types of securities held)

• Differences from Registered Investment Companies (can hedge funds be registered?)

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Types of Hedge Funds

• Private Equity Funds• Venture Capital and LBO Funds• Funds of Funds• Commodity Funds• Offshore Funds

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What Does a Hedge Fund Look Like?

Structure of Standard Domestic Fund

Investment Advisor LLP

Management Co. LLC

DomesticPartnership LP

Investors/LimitedPartners

20% Performance Fee

Management Fee = 2%

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What Does a Hedge Fund Look Like?

Structure of Stand-Alone Offshore Fund

US Investment Manager LLC

Offshore Corporate

Investment Fund LTD

Investors/Shareholders

Management Fee = 2%

Performance Fee = 20%

Own Shares

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What Does A Hedge Fund Look Like?

Investment Advisor LLP

Management Co. LLC

DomesticInvestment

Partnership LP

Investors/LimitedPartners

Side-By-Side Structure

OffshoreCorporate

InvestmentFund

ForeignInvestors/

Shareholders

Performance Fee = 20%

Management Fee = 2%

Performance Fee = 20%

Note: Fading in use due to economies of scale.

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What Does A Hedge Fund Look Like?

Investment Advisor LLP

Management Co. LLC

DomesticPartnership

(Feeder)

Investors/LimitedPartners

Structure of Master-Feeder Fund

OffshoreCorporate

Fund(Feeder)

ForeignInvestors/

Shareholders

Performance Fee = 20%

Management Fee = 2%Performance

Fee = 20%

Note: Private Investments Stay in Feeder Structure

InvestmentPartnership

(Master)

Hedge Fund

Investors

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Motivation/Role of Limited Partner or Shareholder

Advantages1. Ability to obtain

professional investment management

2. Ability to share in a diversified investment strategy

3. Liability is limited to capital contributions

Disadvantages1. LP interest by itself is

not a liquid investment

2. Restrictions on capital withdrawal

3. GP has control over the assets

4. No say in management

5. Potential for style drift

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Motivation/Role of General Partner

GP Advantage1. Ability to pool funds

for a large number of small investors

2. Ability to diversify by managing large pool of investors

3. Admin partnership as a simple entity

4. Possibly greater earnings through performance fees

GP Disadvantage1. Presumably liable

for partnership obligations

2. Ante-up seed capital contributions – minimum 1%, cannot use 20% override

3. Bears the burden of responsibility

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Other Roles & Responsibilities

Hedge Fund Administration • Portfolio systems (why are they important)• In-house systems• Use of prime broker – provided back office

services and also produces portfolio requests

• Outside systems – fund administrator factors provide back office bookkeeping on securities pricing and partner allocations

• Use of several brokers

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Other Roles & Responsibilities

Functions Fund Administration • Information the partnership will

provide to the prime broker• When the partnership has broker

dealer affiliate

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Other Roles & ResponsibilitiesParties to Execution and Trade Clearance• Use of prime broker – central in custody and

clearing of manager’s assets and providing one consolidated statement and 1099

• Selection of prime broker• Role of prime broker• Benefits of operating a broker dealer affiliate• Advantages of a prime broker – stock loans on

shorts (access to lend to borrow)• Interaction between the partnership and the

prime broker

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Core Documents in Marketing a Hedge Fund

• Private Placement Memorandum (what is in it?)

• Investor subscription agreement• Investor agreement

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Private Placement Memorandum (PPM)

Primary sales document used to describe the terms of the offering to prospective investors. It indicates that the ownership interests are offered as a private placement under the exemption from SEC registration

The PPM will discuss, among other things: 1. The investment objectives, strategies, and risk factors2. The general partner/fund manager and

any related entities of conflicts of interest

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Private Placement Memorandum (PPM)

3. The term of the fund4. The minimum amount of initial

capital contributions5. When additional capital can be

contributed and when new investors can be admitted

6. The fund’s fiscal year7. Rights of withdraw and cash

distributions8. How profits and losses will allocated

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Private Placement Memorandum (PPM)

9. Any regulatory matters10.Management fees and operating

expenses11.Whether or not fund will employ

leverage12.Financial suitability requirements13.Reports to investor14.Subscriptions for interest

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Investor Subscription Agreement

The subscription agreement is evidence of an investor’s purchase of an interest and obligation to make required capital contributions.

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Investor Agreement

The investor agreement is a cornerstone document defining business purpose and rights and obligations of the entity. The agreement controls the relationship between the fund manager and the investors. It will also address certain responsibilities such as record keeping, who the auditors will be, who will be responsible for tax returns and K-1 preparation, if any.

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Investor Agreement

The major areas of the agreement that have a bearing on accounting and financial reporting are: • Investment structure (Master Feeder, Side by Side, Stand Alones) • Capital contributions and withdrawals• Fees and allocation of profits to investment advisor (deferral programs) • Allocation of profit and loss to investors

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Investor Agreement

• Determination of profit and loss• Audits, financial statements,

accounting principles, and reports to investors

• Record keeping

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Critical Hedge Fund Issues

• Securities valuation• Economic allocation• Reporting to investors• Footnotes• Allocations• Tax issues• Other

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Securities Valuation

• US GAAP defined AICPA Audit Guide for Investment Companies

• Trade date valuation• Valuing the portfolio at market value or

fair value• Valuation issues

Illiquid securities Restricted positions Market blockage Fund of Fund investments Emerging market positions Derivatives Investment valued solely by investment

advisor

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Securities Valuation

• Valuation of securities sold under agreements to repurchase and securities purchased under agreement to resell are valued at contract amount, not market value

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Economic Allocations & Investors’ Capital Account

• Capital contributions and withdrawals• Determination of profit and loss• Allocation of profit and loss to

investors in interim accounting periods (Breaks)

• Management fees and performance fees – when are they calculated and paid, high water marks, claw backs

• Special allocations for hot issues• Side pockets

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Reporting to Investors

• Financial Statements consist of: • Statement of Financial Condition• Condensed Schedule of Investments• State of Income• Statement of Cash Flows or Statement

of Changes in Net Assets – FASB 95 If entity uses leverage, prepare statement

of cash flows, otherwise no leverage is used then prepare a statement of net assets

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Reporting to Investors

• Statement of Changes in Partnership Capital (note: shows incentive fees paid to GP)

• Applicable Footnotes and Disclosures under GAAP

• Financial highlights• Other Reporting to Investors – Rates of

Return (AIMR Performance)• Individual Investor “Capital” Schedules

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Footnotes

• Organization Discusses the structure, general business of

the partnership and the state trading strategy

• Significant Accounting Policies such as: Trade date accounting Method of valuing portfolio investments

• Related party transactions • Transaction subsequent to date of

financial statements Post year end capital contributions and

withdrawals Other significant events

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Footnotes

• Management and incentive fee• Partnership shareholder equity • Risk management and derivatives

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Financial Instrument Disclosures• This FASB is still active, despite new

guidelines from FASB 133 project on “Derivatives and Hedging”

• FAS 133 Disclosure – A derivative financial instrument is: Futures contract Forward contact Swap Options Other financial instruments with similar

characteristics (such as interest rate caps or loans and fixed rate loan commitments and possible variable note loan commitments and other variable rate financial instruments (all similar to options): forward interest rate agreements, interest rate collars, commitment to purchase stocks or bonds (all similar to forward contracts)

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Allocations – Layering Method

• Each partner’s share of unrealized gain or loss with respect to a particular security is separately tracked through the date of opposition

• Realized gains and losses are allocated to partners to reflect the unrealized gain or loss for that partner for the security sold

• Layering methodology produces the most exact results

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Allocations – Aggregate Method

• Realized gains and losses are aggregated and allocated to the partners assuming that opening unrealized items are realized first

• Does not specifically account for a partner’s share of unrealized appreciation or depreciation by security

• Any reasonable method can be used

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Allocations – Aggregate Method

The regulation provides two approaches:

1. The character of the realized gain and losses must be determined

2. The character of the income must be allocated to the partners so that the tax attributes of each item are preserved; be determined under consistent approach and not be determined with a view of reducing the partners aggregated tax liability

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Allocations – Aggregate Method

Other issues using an aggregate method

1. The character of the realized gains and losses must be determined

2. The character of the income must be allocated to the partners so that the tax attributes of each item are preserved; to be determined under consistent approach and not to be determined with a view of reducing the partners aggregate tax liability

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Tax Issues

• Generally not relevant for offshore traders

• Classification as either trader or investor fund

• Deferral programs• Transaction reporting to the IRS

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Fund Classification

Fund may be classified as either Investor of Trader Fund

Classification significant for passive loss purpose, investments interest expenses limitation, two percent rule on miscellaneous itemized deductions, three percent rule on itemized deduction and limitation of New York State itemized deductions

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Investor Fund

1. Investors are not engaged in a trade or business regardless of extensiveness of activities

2. Investors seek long-term approach3. Investors profit primarily from capital

appreciation, dividends, and interest4. Expenses of investors are subject to 2%

limitation5. Income of investors constitutes

“portfolio income” for purposes of passive loss limitation

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Trader Fund

1. Traders are engaged in the trade or business of buying and selling securities

2. Traders do not hold inventorya. Traders realize capital gain or loss from sale of

securities 3. Traders seek profits from short-term price

swingsa. Profits derived mainly from frequent and

substantial trading activitiesb. Not profit primarily from dividends, interest or

long-term appreciation 4. Income from activity as trader is not

classified as “passive” for purposes of passive loss limitations

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Other Accounting Issues

• Hurdle Rate: Only above this level can the fund charge performance fee

• Water marks: If fund drops below water mark, cannot charge performance fee until it gets back to the watermark level

• Carry forward of high water marks of inclusion of hurdle rte return provisions to reward investors who reinvest proceeds from failed fund of the manager

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Other Accounting Issues

• Clawback Account: 50% of incentive allocation (if any) is credited to capital account of General Partner and 50% is credited to claw back account

• Carry forward of high water marks and inclusion of hurdle rate provisions

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Anees T. Din, CPA – Partner Practice StrengthsMr. Din possesses over 20 years of experience in providing auditing, accounting, and consulting services in the financial services industry to such clients as Gabelli Funds and Skudder/Dreman Value Funds. He has extensive experience in domestic and foreign investment partnerships, registered investment advisors, broker/dealer audits, and public companies in the time-sharing industry. He actively solicits new business with service providers in the financial services industry. Industry Expertise

Financial Services Real Estate (Time Shares)NASD Registered Public Companies Technology

Licenses and Accreditations Certified Public Accountant, New York

 AffiliationsAmerican Institute of Certified Public AccountantsNew York State Society of Certified Public Accountants, Stockbrokerage CommitteeSecurities Industry Association, Internal Audit Group, Executive Committee Member and Education Committee 

EducationBBA, City University of New York, Bernard Baruch CollegeMBA in Investments and Finance, University of Pennsylvania, Wharton Graduate DivisionAdvanced Education Diploma in Leadership and Management – Columbia University

 Consultancy Assignments and Speeches

Consultant to Fidelity Investments on Hedge FundsSpeaker on hedge funds at the SIA annual conferenceSpeaker on hedge funds at SIA Educational Committee seminar

 Recent AchievementsAdjunct Professor, Pace University (graded for various accounting professors)Adjunct Professor, Baruch College (taught financial and cost accounting courses)