February 24, 2006
By: Soncia Coleman, Associate Legislative Analyst
You asked for an explanation of hedge funds.
There is no statutory or regulatory definition of the term “hedge fund.” They are generally characterized by their common structure and investment strategies, both of which are directly related to their lack of regulation. Like mutual funds, hedge funds pool investors' money to be invested by portfolio managers. However, they are typically organized as limited partnerships, with the portfolio manager/general partner investing a significant amount of capital in the fund. Hedge funds typically require substantial minimum investments and require individual investors to be wealthy and financially sophisticated in order to invest.
With the exception of anti-fraud regulations, hedge funds are generally exempt from regulation by the Securities and Exchange Commission (SEC) or any other entity. Specifically, hedge funds are not required to register with the SEC as investment companies under the Investment Company Act of 1940. Hedge funds are also not required to register their securities offerings under the Securities Act of 1933. In the past, hedge fund advisers were not required to register under the Investment Advisers Act of 1940. However, in December of 2004, the SEC issued a final rule and rule amendments requiring certain hedge fund managers to register as investment advisers under the act.
This lack of regulation allows hedge funds to employ a wide range of investment strategies. Hedge funds, in contrast to mutual funds, may purchase derivative investments and use “financial leverage” and “short positions,” although they are not limited to these methods. However, the type and number of investors are limited in order for the hedge funds to remain exempt from the regulations. Although the SEC notes that there has been a growth in the hedge fund market in recent years, it is difficult to produce an exact figure as the funds are not required to be registered (although some do so voluntarily). However, a recent American Bar Association article estimates that there are currently more than 8000 hedge funds that manage up to $1 trillion in capital.
According to the SEC, hedge funds were originally designed to invest in equity securities and use leverage and short-selling to “hedge” the portfolio's exposure to movements of the equity market. However, hedge fund advisers presently utilize a wide variety of investment strategies. The term “hedge fund” is more reflective of the fact that the funds, unlike other investment products like mutual funds, have the ability to utilize these strategies.
HEDGE FUND STRUCTURE
Most hedge funds are set up as limited partnerships, with the portfolio manager acting as a general partner and the investors acting as limited partners. The managers cannot raise funds through public offerings of securities. Instead, they offer securities in private offerings to limited partners who provide the necessary additional capital. Investors must usually contribute a significant minimum investment. (Portfolio managers usually have a significant personal investment in hedge funds as well.) Hedge funds typically charge an asset management fee of 1-2%, plus a “performance fee” of 20% of the profits.
Type and Number of Investors
In order for hedge funds to be free from federal regulation, the number and types of investors must be limited to comply with exemptions to existing securities laws. A hedge fund will not have to register its interests under the 1933 Securities Act, register as an investment company under the Investment Company Act of 1940, or comply with reporting requirements of the Securities Act of 1934, if it limits the number and types of investors.
Since hedge fund interests are considered securities under the Securities Act of 1933, they would ordinarily be subject to SEC registration requirements. However, the 1993 Act provides an exception to the registration requirements if the interests are not sold in a “public offering.” Pursuant to Regulation D under the 1933 Act, offers and sales of securities by an issuer that satisfy certain conditions are deemed to be transactions not involving any public offering (and therefore, exempt from registration requirements.) To meet the commonly used “safe harbor” in Regulation D, hedge funds may sell their interests to an unlimited number of “accredited investors.” This term includes a number of entities and (1) a natural person who has individual net worth, or joint net worth with the person's spouse, that exceeds $1 million at the time of the purchase; (2) a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; and (3) an officer of the company selling the securities. It should be noted that Regulation D allows an issuer to sell its interests to a limited number of non-accredited investors (35) if they have sufficient financial knowledge. However, most funds choose to accept only accredited investors.
Under the Investment Company Act, an issuer (1) whose outstanding securities are beneficially owned by 100 or fewer persons and (2) who does not plan to make public offerings is not required to register as an investment company. There is also a “sophisticated investor” exclusion from the Investment Company Act registration requirements. Issuers are exempt from registering under the act if (1) their outstanding securities are owned by “qualified purchasers” and (2) they do not make a public offering of securities. A qualified purchaser is also known as a “super-accredited investor” and is defined as an individual who owns $5 million worth of investments and certain entities that own $25 million of investments.
As a result of all of these rules, hedge funds are typically arranged as a partnership of 100 “accredited investors” or a partnership of up to 500 “qualified purchasers” (or “super-accredited investors”).
FUNDS OF HEDGE FUNDS
Hedge funds should be distinguished from “funds of hedge funds”. A fund of hedge funds is an investment company that invests in hedge funds rather than investing in individual securities. Some funds of hedge funds register their securities with the SEC. These funds must provide investors with a prospectus and file certain reports with the SEC. Many
of these funds have lower investment minimums than typical hedge funds. It should be noted that investors in a fund of funds will have to pay the fees of the underlying hedge funds, as well as the fees of the fund of funds.