Peter J. de Marigny
is Portfolio Manager of DITMo® Strategies, an Equity Hedge, Aggressive-Income Objective, Buy/Write Portfolio for an Aggressive-Income Objective used as an Enhanced Cash investment vehicle. Pj is also Head of Risk Alternative Strategies for Newport Beach, CA advisor Renovatio Asset Management.
» View Peter J. de Marigny
Ryan Conner is Principal at HedgeCo Securities. As an experienced industry veteran, Ryan Conner offers his opinions on the hedge fund industry and hedge fund strategies. » View Ryan Conner
Rashida Fleet is involved with consulting and working with managers during the fund launch phase. Her work includes; interviewing managers, collecting information for the HedgeCo database and contributing to the HedgeCo News feed.
» View Rashida Fleet
Tim Seymour is co-founder and managing partner of Red Star Asset Management, as well as Chief Operating Officer of the $116 million Red Star Double Alpha Fund. » View Tim Seymour
Richard Heller Richard Heller is a partner at the New York City law firm of Thompson Hine LLP. His experience is in the formation of private offerings for hedge funds as well as the formation of registered broker-dealers and RIAs.
» View Richard Heller
Cameron Hight, CFA, is an investment industry veteran with experience from both buy and sell-side firms, including CIBC, DLJ, Lehman Brothers and Afton Capital. He is currently the Founder and President of Alpha Theory™, a Portfolio Management Platform designed to give fundamental money managers the ability to create their own repeatable discipline to organize the complex process of portfolio management.
» View Cameron Hight
The Internal Revenue Service (“IRS”) has done taxpayers a favor in Revenue Procedure 2009-41 (“2009 Procedure”) by greatly extending the due date for making retroactive elections for entity classifications (known as the “check-the-box” regime) in cases where the election was missed. In the fund world, this most often occurs in the case of an offshore master fund formed as a company under foreign law, for which an election on IRS Form 8832 for partnership status for U.S. federal income tax rules was missed.
The check-the-box regime is commonly used to convert an offshore company (which would otherwise be classified as a corporation) that is used as a master fund (typically with domestic and offshore feeder funds as its owners) into a partnership for U.S. federal income tax purposes. This removes the classification of the offshore master fund as a Passive Foreign Investment Company (“PFIC”) which may carry disadvantageous tax results for taxable U.S. investors.
The check-the-box flexibility comes with a price. The election must be made timely. Generally, for a newly formed entity, the election needs to be made within 75 days of its formation. For an existing entity, Form 8832 must be filed no more than 75 days before the effective date of the election and no more than 12 months prior to the election’s effective date. In practice, the Form 8832 is filed effective for the first day of the offshore company’s life.
The 2009 Procedure addresses the case where an election’s due date was missed and extends relief afforded in the 2002 guidance. The 2009 Procedure extends the due date for filing Form 8832 for both missed initial entity classifications and change of classification for existing entities, to three years and 75 days of the requested effective date (again, generally, back to the first day of existence of the offshore master fund). To claim the extended due date, the entity must have made all federal tax filings as though it had made a valid election. If no entity level federal tax filings were required, all owners of the entity (such as the feeder funds of a foreign master fund) must have filed federal tax returns consistent with the desired entity classification. An entity that does not meet the new extended date will, however, still have to apply for an IRS letter ruling.
The 2009 Procedure is effective September 28, 2009 and generally applies to all requests for relief pending under the 2002 guidance, as well as requests for relief made after September 28, 2009.
The extended relief under the 2009 Procedure is certainly welcome. However, funds whose financial statements use U.S. GAAP (generally accepted accounting principles) may still be required to report under FIN 48 (Uncertain Tax Positions) the missed election, which is an embarrassment, if nothing else. A structure using an offshore master fund formed under the local limited partnership act, so that the master fund will be classified as a partnership under U.S. federal income tax rules without the need for a Form 8832, eliminates the uncertainties surrounding the check-the-box election.
If you have any questions concerning this Tax Alert or any related matters, please contact Steven M. Etkind, 212-573-8412 (setkind@sglawyers.com) or Roger D. Lorence, 212-573-8413 (rlorence@sglawyers.com). We welcome your input.
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Hedge fund compensation was already becoming a hot topic of discussion within the industry, and the latest earnings report from Och-Ziff Capital Management Group isn’t likely to quiet the chatter.
The $20.7 billion alternative asset manager reported a second quarter loss that was wider than expected this week, and attributed the shortfall in large part to compensation, including bonuses for top traders. The hedge fund firm reported total compensation expense of $47.6 million, which Och-Ziff will pay at the end of the fourth quarter. Bonus payouts are almost 75% higher than the same period a year ago, and more than double the expectation of Jefferies analyst Daniel Fannon. The differential between Jefferies’ estimates of $22.2 million and the payout reflects “year-to-date investment performance and talent retention,” according to Jefferies.
Indeed, Och-Ziff’s AUM have increased 2% since April 1, 2009, while performance has climbed in all four flagship hedge funds. Och-Ziff’s management fees, however, spiraled 42% from the year-ago period. Fee structures will continue to be a topic of discussion among hedge fund managers and their limited partners throughout 2009, according to Jefferies, although Och-Ziff seems to get a pass: “We believe Och-Ziff’s relative strong performance along with the willingness to provide liquidity to LPs during this period will be a strong bargaining chip in future fee discussions,” Fannon says in the report.
And this time it’s taking private equity and venture capital with it. First, let’s quickly rewind to 2006, when hedge funds throughout the U.S. were completing their ADV and implementing technology to retain their e-mails and documents. At the time, they were anticipating having to register with the SEC under the Investment Advisers Act of 1940. Enter Phil Goldstein of Bulldog Investors, who lives up to the company moniker by suing the SEC and to the surprise of everyone-wins.
The movement to regulate hedge funds lies dormant for several years, until the fall of 2008, when Wachovia and Merrill Lynch are listed for sale on eBay. This time around the government is smarter. They introduce an amendment to the 1940 act called the Private Fund Investment Advisers Registration Act of 2009 and, just to be safe, throw PE and VC firms under the bus along with hedge funds.
The 2009 Act eliminates the private adviser exemption that funds relied on to avoid regulation. It also takes step to ensure that the Phil Goldstein’s of the world don’t reappear by granting the SEC enhanced authority to define terms in the 2009 Act. (Note: Goldstein successfully claimed that the SEC exceeded its rule making authority in 2006.)
Recently, a lot of attention has been given to the Private Fund Investment Advisers Registration Act’s requirement that advisers report their positions, off-balance sheet borrowing and assets under management in an effort to identify systemic risk. There’s less clarity concerning the government’s proclamation that “the SEC should be given expanded authority to promote transparency in disclosures to investors.” Sounds a bit open ended, doesn’t it?
I often hear the terms Capital Introduction and Third Party Marketing used interchangeably. They actually however, represent two different services within the hedge fund asset gathering space.
Capital Introduction is a service usually provided by hedge fund prime brokers. The biggest teams coming from the largest prime brokers, firms like Goldman Sachs & Co., Morgan Stanley, Merrill Lynch, etc. These prime brokers have teams within their ‘prime services’ divisions that will help clients of the firm to find investors suitable for their funds.
How do they introduce investors you may ask? Well, investor introductions are made through occasional capital introduction conferences, road shows, one on one investor meetings, and individual investor conference calls. When done properly, this service can help to raise a fund millions of dollars at no cost to the general partner and no harm to the limited partner.
The real trick here, is finding a firm that actually follows through with what they claim. Many smaller trading firms and ‘mini-primes’ claim they offer capital introduction when in reality all they offer is a list of fund of funds or introductions to third party marketers.
By Steven B. Nadel Esq., Seward & Kissel LLP
Friday, July 10, 2009 1:30:12 PM ET
Over the past year, the financial markets have experienced a series of unprecedented events, including the folding or near-folding of various investments banks and the bargain basement sale of some others, multibillion-dollar government bailouts, the collapse of equity values, massive subprime mortgage crisis, and huge Ponzi schemes.
Consequently, like most investments, hedge funds on the whole performed negatively in 2008; however, they nonetheless on average outperformed the broader indices by about 20%. Yet despite such outperformance, not only have there been significant hedge fund redemptions, but it has generally become increasingly challenging for most hedge funds to raise new capital from investors.
In my opinion, hedge fund managers will increase their likelihood for attracting new capital, if they adopt a number of steps designed to produce: (I) better investor/manager alignment of interests; (II) a culture of compliance, and (III) a greater level of investor transparency and education.
(I) Better Investor/Manager Alignment of Interests
There have recently been public statements made by a number of large institutional hedge fund investors questioning what they perceive to be an apparent misalignment of interests between hedge fund managers and their investors. Primarily, these statements have focused on issues with respect to hedge fund liquidity and manager compensation. The following sets forth the primary concerns of these investors and some suggestions as to how a manager might address them:
(a) Liquidity
* Concerns: The primary investor concerns that have been raised relating to liquidity are that some funds have unnecessarily long lock-up or holding periods, and some fund managers shouldn’t have used their gating, suspension or similar powers during the recent market crisis.
* Suggestions: With respect to long lock-ups or holding periods, managers must be sensitive to the paramount importance of liquidity to many investors in the current environment. Liquidity terms should be designed to match portfolio characteristics and also provide stability to the fund. Consequently, if a manager is seeking to establish a long/short publicly traded large cap equity fund, the manager probably should not impose a two year lock up on fund redemptions. Conversely, if a manager’s strategy is less liquid in nature, a longer lock-up is more likely to be warranted. In sum, fund investor liquidity should more closely reflect underlying investment liquidity.
With regard to the usage of gates, suspension provisions and other liquidity management mechanisms, managers (as well as investors) need to be mindful of the fact that a manager owes a fiduciary duty to the fund, including both to its remaining and redeeming investors. If paying out cash to redeeming investors could jeopardize the fund and the remaining investors, the surrounding issues need to be carefully considered. Given the fundamental conflict inherent in such a situation, it is imperative that any such decision not be made lightly, and in fact should be made with the advice of experienced, independent persons such as the fund’s outside directors and, in addition, preferably a specially established fund conflicts board. Once the decision is reached, appropriate guidelines should be adopted and consistently applied on a going forward basis, and then communicated to clients, so that investors can manage their own expectations.
(b) Manager Compensation
* Concerns: Those investors who have identified manager compensation as an issue have focused primarily on management fees that are, in their opinion, too high in some cases, and incentive compensation calculations that, in their view, do not take into account the underlying illiquidity and holding period of certain fund assets.
* Suggestions: The management fee rate currently charged by most hedge fund managers is 2% per annum. The 2% rate came into effect after many decades without any real increase from a 1% annual rate, despite the fact that manager overhead costs have continued to increase from year to year. Given the foregoing, one would think that the 2% rate is thus justifiable, however, some very large managers have been criticized that their management fee constitutes a de facto “profit center.” While some investors are now asking for a lowering of the management fee rate, a better long-term approach, in the author’s opinion, would be for such managers to seek to better educate their clients about the significant costs needed to be borne in today’s market in order to successfully operate a competitive, world-class hedge fund organization, including the extensive costs associated with adopting compliance protocols, attracting and retaining experienced personnel, and establishing state of the art multiple offices and information technology.
Generally, hedge funds charge incentive compensation annually based on realized and unrealized gains. However, since some funds invest in assets that may take a long time to realize due to their illiquid nature or for other reasons, some large investors are of the view that the incentive compensation on such assets should not be charged on an annual basis. There are a number of suggested ways to handle this concern ranging from “side pocketing” such assets into a separate fund account and not charging incentive compensation on such assets until there is a realization event (assuming the fund’s governing documents allow for it), to implementing a private equity fund-like “clawback” mechanism on the incentive compensation and paying back to the investors any overcharging on the incentive compensation derived from the initial unrealized value calculation as compared to the incentive compensation based on the actual realized value calculation. Each of these approaches has drawbacks and advantages. The manager will need to weigh the various approaches carefully taking into account tax, structure, liquidity and other relevant factors.
(II) A Culture of Compliance
Given the concerns that have arisen following the Bernard Madoff and similar scandals, as well as other frequently cited industry issues related to conflicts of interest, personal trading, insider trading, asset valuations and the like, many investors now seem to believe that their money is safer at a large SEC-regulated institution. While history would often seem to dispute this theory, managers should still take these concerns very seriously. The following are a number of suggestions that managers may wish to implement in some fashion in light of the foregoing:
(a) Adopt written compliance procedures. Regardless of whether a manager is SEC-registered or not, it should consider adopting and implementing a set of policies intended to cover the primary areas of concern, e.g., personal trading, gift policies, valuation, insider trading, trade allocations, conflicts of interest and custody of assets. Moreover, someone at the firm should be appointed to monitor compliance with these policies and train firm personnel on a periodic basis.
(b) Conduct a comprehensive compliance review. The manager should also entertain the idea of having an outside legal or compliance expert come in to review the firm’s compliance practices and identify any areas of sensitivity. Once the third-party review is completed, the firm’s internal compliance personnel should discuss the findings with management and make appropriate operational adjustments as needed.
(c) Foster enmeshed independence. The entire firm should operate in a manner designed to eliminate, to the greatest extent possible, conflicts of interest, undue influence, “front running” and similar issues. This may require the creation of “Chinese walls” or other information barriers and restricted/watch lists, as well as overall protocols meant to ensure impartiality and the proper exercise of the manager’s fiduciary duty to its clients.
(III) Greater Investor Transparency and Education
An unfortunate adjective often closely associated with hedge funds and their managers is that they are “secretive.” While this characterization is a bit unfair, given the many filings that managers are often required to make under the Securities Exchange Act of 1934 and other relevant laws and regulations, managers would nevertheless be well served to address this characterization head-on.
Here are a number of suggestions that managers may want to consider:
(a) Regulatory filings. While not obligated in all cases to do so, managers who are making a regulatory filing may wish to notify their investors when such filings occur and identify how those filings may be obtained.
(b) Top position transparency. Subject to limits imposed by the manager to ensure portfolio strategy confidentiality, since managers are already generally required under GAAP to disclose on an annual basis their positions greater than 5%, managers should consider voluntarily providing such information on a more frequent basis (perhaps quarterly).
(c) Exposure transparency. More managers may wish to consider disclosing on a periodic basis their key portfolio exposure information.
(d) Investor education. As already alluded to above, managers must become more consistent in terms of how, when and what they communicate to their investors. Subject of course to confidentiality concerns, many common investor concerns can be easily addressed, if managers take a more proactive approach with their investor base and keep clients apprised of important fund developments in a timely manner.
Conclusion
While there is no panacea to reinvigorating hedge fund investment, and while performance is obviously the main cure, the points raised above are meant to create a long-term shift in manager/investor relations that will strengthen the industry for many years to come.
Steven B. Nadel is a partner in Seward & Kissel’s Investment Management Group who specializes in issues relating to the establishment and ongoing operation of hedge funds. He is also the founding editor of The Private Funds Report, the Group newsletter. He can be reached at nadel@sewkis.com or 212-574-1231.
Story Copyright (c) 1999-2009 HedgeWorld Limited All rights reserved.
This article originally appeared on HedgeWorld.com on July 10, 2009
The Internal Revenue Service issued another notice this week regarding the procedure for late filing of the 2008 Form TD F 90-22.1, “Report of Foreign Bank and Financial Accounts” (FBAR).
Taxpayers should make every attempt to file timely, as reports filed late need to be filed in duplicate. The original is to be filed according to the instructions on the form, along with a statement explaining why the FBAR is late. A second copy must be sent to a different IRS Offshore Identification Unit (noted below), which is affiliated with the current IRS voluntary disclosure program. A copy of the taxpayer’s 2008 tax return needs to accompany duplicate FBARs filed with the Offshore Identification Unit.
Both filings must be submitted on or before September 23, 2009, to ensure the minimization of penalties. For income tax returns due after September 23, 2009, a copy of the 2008 return need not accompany the FBAR. Please note: Though acceptable, this alternative process — involving the Offshore Identification Unit and filing the form with a copy of the return — could result in a higher level of scrutiny.
Fund of hedge fund managers, investing across many hedge funds to provide diversification to clients, are changing the way they allocate capital. These managers, many of whom never thought they would see the day when high-flying funds run by the industry’s best-of-breed talent were torpedoed, have in the worst cases been forced to liquidate their own funds.
Now those that remain are increasingly being scrutinized by investors. So it’s no longer just the brand-name hedge funds that win out. Indeed, it’s the emerging hedge fund manager talent that shows promise of greater returns, while hedge funds with fewer assets under management offer something else fund of fund managers long for — the ability to adapt quickly.
The herd mentality that is often subscribed to by investors once led the fund of hedge fund manager pack to the largest of investment firms run by household name managers. The reason, says Brad Balter, managing partner at hedge fund advisory Balter Capital Management, is twofold. “Use the biggest names and if something goes wrong you can point to the fact that there are other smart investors in there. Secondly, the largest allocators feel that if they are going to allocate $50 million to $100 million at a clip, only the bigger hedge funds can absorb it. The reality is, that argument is flawed and creates a negative selection bias,” Balter says.
Hedge funds, private investment vehicles that manage pools of capital for wealthy investors, tend to follow a life cycle that is defined early.
For instance, Paul Tudor Jones, who runs a $7 billion global hedge fund, delivered 70% returns nearly a decade ago. Jones has yet to repeat that performance (although his funds are up this year), but his investors remain fixated on that one-time event. “The establishment likes to believe that just because someone is managing $10 billion it must be the right place to invest your money, and if someone is managing $100 million it isn’t the right place to invest your money. As a methodology for hedge fund investing, that type of thinking is flawed,” Balter says
Anthony Scaramucci, managing partner at SkyBridge Capital, provides seed capital to emerging hedge fund talent. He says once successful, the market tends to reward fund managers with an increase in assets, and that’s when priorities begin to change. The general partner in a fund that oversees $50 million to $200 million is very focused on growing assets and performance. But once the fund reaches $10 billion in AUM and the GP is collecting 1.5% in management fees, they tend to start “hugging the index,” or maintaining performance so as to not over-promise on returns Scaramucci says.
“You’ve got a bigger asset base now and you don’t want to do anything to upset the apple cart that could lead to dramatically negative performance,” he says.
And according to Balter, asset size “kills” and can constrain a hedge fund strategy. “When hedge funds get too large, they are no longer a hedge fund. They’re not nimble enough and the incentives for the portfolio manager are just not there,” he says.
Balter points to Raptor Global, Cantillon Capital and Pequot Capital, all of which have either closed down, transferred funds or liquidated. “For whatever reason, all of these were placed on the top allocation list for big allocators time and time again,” Balter says.
In addition to the large fund blowups, there are other factors driving fund of fund managers into the arms of new talent. For instance, fund managers have become “very concerned” about investing in large hedge fund firms with legacy positions, Scaramucci says. “If you’re invested in a fixed-income fund, oftentimes you’re worried about what illiquid securities the manager is holding and where they’re marking the security,” he says. “They must rely on third-party brokers to determine whether or not it’s an accurate price.”
Secondly, fund of hedge fund performance was certainly not unscathed by the financial market tremors, and with plenty of cash sidelined, fund managers are asking their clients for another chance. “They are saying, ‘I know we hurt you last year, but we have a new and improved group of smaller managers. We have a research team dedicated to uncovering new gems and funds off the beaten path. I can find smaller emerging managers to bring into the portfolio, where there is no index hugging,’” Scaramucci says.
Andrew Schneider, managing partner at HedgeCo, says the firm has assisted in various hedge fund startups recently in multiple strategies ranging from options and futures to distressed real estate and exchange traded funds.
For instance, HedgeCo helped emerging fund manager Stephen Hinel and treasurer Stephen Cutler launch an equity fund dubbed the StrongCap Fund, which seeks to raise $15 million by year’s end, and Gary Chandler to start the 12% Distressed Realty Fund, which will refrain from collecting management fees until the fund reaches its 12% hurdle rate for returns.
Schneider says in addition to investing in emerging talent, fund of hedge funds are beginning to join in the separately managed account (SMA) movement. “I don’t think strategies are changing as much as the way fund of hedge funds are investing,” Schneider says. “They used to put money into single-strategy funds and not worry about lock-up periods. Now, for example, we’re doing a launch of a $1.5 billion fund of hedge funds that is made up entirely of SMAs, which in essence gives them daily transparency and liquidity.” Schneider says.
Cogo Wolf Asset Management, a multi-asset alternative investment firm, launched a new fund of hedge funds in June.
The fund, dubbed the Cogo Wolf Trimaran Liquidity Fund, is named after the three-hulled sailboat. The fund’s three-pronged investment “hulls” comprise investing in: ultra-liquid strategies, such as managed futures; debt-related instruments, including distressed debt; and ETFs. The fund is void of any lock-up periods and offers monthly liquidity with 10 days notice. “The goal is to create something that as a whole is less correlated to the underlying equity markets and also within each hull to have low or no correlation to each other,” says Christopher Wolf, co-CIO and managing partner at Cogo Wolf. “We’re certainly looking for nimble, prudent and hungry managers. That said, you often find them in the smaller category of emerging managers.” Wolf adds that the firm plays close attention to infrastructure risk.
“Do they have people on board who know how to run and operate a business? They don’t need to have a five-year history running their own fund, but at the same time there needs to be sufficient evidence they know what they’re doing and can make money,” he says.
(c) 2009 Investment Dealers’ Digest and SourceMedia, Inc. All Rights Reserved.
Metrostudy successfully predicted changes in home prices and sales just before the downturn in the housing market. Bradley Hunter explains how robust indicators can be used by hedge funds to quantify the current status of local housing markets, helping them to make informed decisions.
By Bradley Hunter
Chief Economist/National Director of Consulting
Metrostudy
While the media often refers to national statistics when referring to the current downturn in the housing industry, those with investment portfolios particularly sensitive to the housing cycle know there is no “U.S. Housing Market.” Rather, hundreds (or thousands) of housing markets are rolled into national totals for purposes of recognizing trends or quantifying an upswing or a downturn. These totals, however, can obscure vital differences among markets. For example, San Francisco’s housing cycle has been radically different from Raleigh-Durham’s, and its current trajectory and outlook are also distinct.
Common to local housing markets, even in markets where there was no “boom,” like Raleigh, is a universal theme — a dearth of home buying, but there are some early signs that the market is turning the corner now that homes are affordable again.
Even consumers who still have a good job and good income are being deterred from buying a home. I attribute this to what I call the four “Fs”– fear, financing, falling home prices, and failure to sell an existing home.
Governmental entities have failed to arrest the decline in home prices and foreclosures because they have not been able to change consumer psychology nor overcome the problem of negative equity. Lowering interest rates, offering tax credits to people buying homes and raising conforming loan limits were measures taken to encourage people to buy, but they have not been powerful enough to overcome the four Fs.
