When people define what a hedge fund is, they often focus on a fund’s investment strategy. I think any hedge fund definition should also incorporate structural features that may be present.In this talk, we’ll focus on seven hedge fund features that you may not find in other hedge fund definitions. I’ll provide a brief commentary on each one.
First some basics: A hedge fund is a private investment vehicle that is usually managed by an investment adviser for fees.
Hedge funds are not registered under the Investment Company Act of 1940, the federal statute that governs registered investment funds like mutual funds.
Their interests are sold in the U.S. to high-net worth individuals and institutions pursuant to private placement rules.
In the U.S., hedge funds are often organized as limited partnerships.
Now let’s turn to some not so obvious features that are often present in hedge funds.
These features are embedded in a fund’s legal terms.
1. A hedge fund is an economic bargain.
A hedge fund is an economic bargain.
An investor pays fees and expenses and, in turn, a manager provides investment management services.
Within those broad parameters, fund investment terms are often negotiated between a manager and one or more of its investors.
These negotiated terms can include fund fees, fund reporting obligations and an investor’s liquidity rights to redeem out of a fund.
2. A hedge fund is a contract.
A really big contract with many investor obligations.
How big? In my experience, a hedge fund’s limited partnership agreement can run 40 or 50 pages. A subscription agreement which is also a contract can run 10 or 15 pages taking out the administrative pages.
Add to those 50 or 60 pages of contractual terms a fund’s private placement memorandum that contains terms that have a material impact on manager-investor relations and you can add another 100 pages to the contract pile.
3. A hedge fund is often part of multi-tiered, multi-jurisdictional ecosystem.
The use of the term “hedge fund” in the singular in many cases is only partially descriptive.
An investor may be investing into one fund but often that one fund acts as a “feeder” fund that, in turn, invests into a much larger overall fund structure.
Those fund structures often involve multiple interconnected funds and span multiple international jurisdictions with different rules and regulations than the U.S.
Here’s an example: In this case, a US limited partnership is investing into a Cayman Islands fund that acts as the structure’s overall “master fund” pooling different investment vehicles together.
4. Many hedge funds continuously sell fund interests.
Hedge funds can be continuously open to new investors. These funds are constantly selling their fund interests.
Contrast that with private equity funds that usually have a finite length of time that they are open to new investors.
If you’re an investor in such a hedge fund, how have you accounted for this?
What pressure, for example, is a manager under to change a fund’s investment terms for investors coming into the fund later?
5. Hedge funds are not self-liquidating.
Hedge funds typically are under no obligation to make distributions of fund interest.
The onus is on investors to redeem their interest out of a fund so the ability to monitor a fund’s performance and a manager over the course of an investment becomes critical.
6. Hedge fund structures are not static.
The pressure on a manager to grow overall assets under management means that managers can often form new funds with similar investment objectives and change existing structures to bring in new assets under management.
How are investors interests impacted by these changes?
7. Hedge fund disclosure standards vary.
Hedge fund interests are sold pursuant to selling documents such as private placement memorandums.
Generally, the disclosure standard used is that there should not be “a material misstatement or omission” in these selling documents material to an investor’s decision on whether to invest in a fund or not.
But what one lawyer’s interpretation of this standard is when it comes to actually drafting hedge fund selling documents may be different from another.
Investors and their investment advisers should be cautious when picking up different hedge fund selling documents such as a private placement memorandums and assuming that the disclosure across these different fund products is the same.