Hedge Fund Investors course phần 4 doc

CHAPTER 5 Hedge Fund Business Models A lthough a hedge fund is viewed by an investor as the portfolio of invest- ments that provide a return, it may in fact be composed of two or more separate businesses. The structure and division of labor of the businesses are not arbitrary. The design of the hierarchy creates a limited liability in- vestment for all investors and is tax efficient. TYPES OF BUSINESS UNITS To understand the typical hedge fund business structures, it is necessary to first discuss the building blocks. Bear in mind that small variations exist from state to state in the United States because the individual states autho- rize the creation of business units. Fortunately, the rules are similar in most states; these business structures have been adopted by all or nearly all the 50 states. The structures commonly used to create hedge funds are gener- ally available in international locations, as well, although the makeup of offshore hedge funds typically combines these business types differently. C Corporation The most familiar business structure to most people is the C corporation. Most of the large companies in the United States and many of the small and medium-sized companies are structured as C corporations. This type of structure is also commonly used in many other countries. The C corporation sells ownership stakes called common stock. A C corporation can have practically an unlimited number of owners. These owners can be spread over many classes of common stock plus preferred stock. The C corporation could be used to structure a hedge fund investment so that investors could not be called upon to invest more than their original 73 ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 73 paid-in investment. In fact, this type of structure is usually used for hedge funds when the funds are located in areas with low or no income taxation. In the United States, however, the C corporation is seldom used to struc- ture a hedge fund due to the double taxation of investment returns. Hedge fund management companies (the actual employees who invest the money) are organized separately from the investment assets and may be structured as a C corporation. Professional Corporation The professional corporation is used to structure businesses comprised of certain professionals—medical, legal, financial services, architectural, and other professionals. The laws governing the professional corporation differ from state to state. Some state laws might allow a manager to structure the management company as a professional corporation, rather than a C corporation, but it is unlikely that a hedge fund (the investment assets) would be structured as a professional corporation. Limited Liability Corporation The limited liability corporation (LLC) is a relatively new business struc- ture; it has been approved in 48 of the 50 states in the United States. It may be taxed as a corporation or a partnership. Nearly all businesses structured as LLCs elect to be treated as partnerships to receive flow- through tax treatment. The LLC structure also allows all investors, in- cluding the fund sponsors and managers, to limit their liability to their committed investment. Sole Proprietorship The sole proprietorship is the default structure an individual ends up with if no effort is made to structure a business as a partnership or corporation. The owner of the sole proprietorship also retains unlimited liability for the liabilities of the business. So, despite a possible tax advantage over a cor- poration, a sole proprietorship is not used in the hedge fund industry. Partnership There are several variations on the partnership structure. The variations are fairly similar and closely resemble the general partnership in most re- gards. In particular, all partnerships (and several other business structures) 74 HEDGE FUND COURSE ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 74 are taxed the same as a general partnership. A partnership may be created formally, but a partnership is the default business structure when two or more individuals or businesses cooperate to create a business. A partner- ship receives flow-through tax treatment and may or may not report the business income as self-employment income. The two most important partnership structures are described next. The differences primarily involve the scope of liability of the investors. General Partnership A general partnership has only one category of part- ners, and there must be at least two partners. The general partnership re- ceives flow-through tax treatment, avoiding the double taxation of the returns. All partners are wholly liable for the obligations of the partner- ship. For hedge funds, this means that investors could be required to as- sume liabilities beyond their investments in the hedge fund, if the fund loses more than 100 percent of the capital under management. General-Limited Partnership A general-limited partnership (also called limited partnership) resembles a general partnership, except that one class of partners (the general partner or general partners) has unlimited liability for the obligations of the partnership and a second class of part- ners (the limited partner or limited partners) has no liability for the oblig- ations of the partnership beyond the investment committed to the partnership. A limited partnership must have at least one general partner and one limited partner. The limited partnership is a good structure for a hedge fund in a tax- able domicile because the structure avoids double taxation of investment returns and can create a limited liability for the hedge fund investors. The general partners assume unlimited liability for the obligations of the hedge fund, but, as described in Chapter 5, the general partner can be a business entity with a limited capital base that effectively removes the general liabil- ity risks. Limited Liability Partnership The limited liability partnership (LLP) is very similar to an LLC but is used to organize the professional practices of ac- countants, lawyers, and architects. California first created the LLP struc- ture, and to date very few states allow for the LLP structure. Although the structure has flow-through tax status and limited liability, it cannot be used for the hedge fund assets because that business unit has few or no employ- ees who are accountants, lawyers, or architects. The management company could arguably be structured as an LLP in some cases, but the LLP is not an important business model for hedge fund managers. Hedge Fund Business Models 75 ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 75 CREATING LIMITED LIABILITY INVESTMENT POOLS Investors who buy certain types of assets (notably real estate) may borrow money that could create a situation where investors must commit addi- tional capital or otherwise repay debt obligation. In contrast, when buying a common stock, bond, or mutual fund, an investor can rely on losing no more than the committed investment. Hedge fund investors would also like to limit their exposure to their committed capital. Need for Limited Liability An investor in a common stock has made an equity investment in a corpo- ration. The corporation may have issued debt in addition to stock. This debt creates leverage because the value of the assets is greater than the value of the equity. In the absence of default, equity holders receive all the gains if the assets rise in value and suffer all of the losses if the assets de- cline in value. Assets, however, sometimes decline in value by more than the total amount of equity. If losses exceed the capital of the corporation, lenders begin to share in the losses because equity holders cannot be re- quired to invest more than their original paid-in investment. This corporate structure would seem to work well as a structure for a levered pool of investments. Structured as a corporation, a hedge fund would be a limited liability investment that could use leverage, but the in- vestors would never be required to make additional investments, even in the event of default. Further, the borrowings to finance levered hedge fund positions resemble corporate borrowings. Indeed, the corporation is a common structure to use to organize hedge funds located in low-tax or no-tax domiciles. In areas with substan- tial corporate taxation, this structure often results in double taxation of in- vestment returns. For this reason, hedge funds organized where the investment returns are subject to corporate taxation (certainly, the United States and Europe) use partnerships or other business structures that pass taxable income through to investors without paying tax as a fund (see Chapter 10). Those partnerships or other limited liability entities may leave the hedge fund sponsors with considerable liability losses from bad investment returns in the investment portfolios. Who Bears the Loss in a Hedge Fund Default? Hedge funds often invest more than their capital in assets and may have short positions. For either reason, hedge funds may lose more than the cap- ital invested in the fund. If a hedge fund loses more than the investors’ cap- 76 HEDGE FUND COURSE ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 76 ital, other parties must bear part of the loss, because the fund investors are treated like equity investors in a corporation. They cannot be required to invest more money beyond their committed amount. 1 When hedge funds lose more than 100 percent of their capital, the loss is shared by the secured and unsecured creditors. The secured creditors have the benefit of collateral, which may greatly reduce the chance of loss due to the bankruptcy of a hedge fund customer. The losses in excess of paid-in capital are generally shared by the unsecured creditors and the se- cured creditors (to the extent that their security is insufficient). Liability of a C Corporation Figure 5.1 shows the way losses are shared in a C corporation. The area of the boxes represents the relative size of the assets, liabilities, and equity (also called capital in a hedge fund). If the assets decline in value, the loss is borne by the equity holders. Just as debt holders do not participate in the rise in asset values, they also don’t participate in the losses, as long as there is sufficient equity in the company (see Figure 5.2). If the losses continue, the debt holders may be exposed to risk that they will not be completely repaid. Figure 5.3 shows how a loss may ex- ceed the equity and result in losses for the debt holders, as well. In Figure 5.3, losses have exceeded the value of the paid in capital. Liability holders share in the loss because the equity holders cannot be required to infuse ad- ditional capital and (except in circumstances involving fraud by the equity Hedge Fund Business Models 77 FIGURE 5.1 Starting Levels for Asset Values Assets Liabilities Equity ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 77 holders) can’t be held liable for losses greater than their capital. This C cor- poration is bankrupt and the liability holders have effectively become the equity owners of the company. Limited Partnership In contrast to a C corporation, the general partners are held liable for the obligations of the partnership. Further, all partners remain liable for all the 78 HEDGE FUND COURSE FIGURE 5.2 Balance Sheets after Loss Assets Liabilities Equity Loss FIGURE 5.3 Balance Sheet after Loss Exceeding Capital Loss Assets Liabilities ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 78 losses up to the total of their net worth regardless of the size of their com- mitments as partners before the loss. Figures 5.4 to 5.6 shows the balance sheet of a limited partnership. With a limited partnership, the general partners must pay in additional capital if losses exceed the paid-in capital. Limited partners cannot be re- quired to invest additional capital. Hedge Fund Business Models 79 FIGURE 5.4 Balance Sheet for Limited Partnership Assets Liabilities Limited General Partners Partners FIGURE 5.5 Limited Partnership Balance Sheet after Loss Assets Liabilities Limited General Partners Partners Loss ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 79 Using Two (or More) Business Units to Alter Liability If a corporation serves as the general partner of a limited partnership, the general partner still has unlimited liability. However, the owners of the cor- poration can’t be required to put more money into that business. As a re- sult, the ultimate owners of the partnership have liability limited to their capital investment in the corporation. Figure 5.7 shows the organizational structure of a limited partnership that has a corporation as its only general partner. The structure may look unnecessarily complicated. It is not necessary if the hedge fund is located in a low-tax domicile. As you will see, structures similar to Figure 5.7 are typ- ical in offshore funds. For a domestic fund organized in the United States or any other country with a substantial corporate income tax, the structure in Figure 5.7 avoids double taxation of investment returns at least for the limited partners. If the general partner is organized as a limited liability corporation or a subchapter S corporation, the general partner also avoids double taxation of investment returns. Simple Hedge Fund Structure A simple hedge fund must have a business entity to hold the investments plus at least one other business entity to act as manager. The manager usu- ally contains all the employees involved with managing, marketing, and operating the business. Figure 5.7 resembles a typical hedge fund organized 80 HEDGE FUND COURSE FIGURE 5.6 Limited Partnership Balance Sheet after Loss Exceeding Capital Assets General Partners Assume Additional Loss Liabilities Loss Loss ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 80 in the 1990s or earlier in the United States. The corporation served as both the manager and the general partner of the fund. Investors invested in the fund as limited partners. Several variations to the structure in Figure 5.7 have become com- mon. First, fund managers may be organized separately from the business that acts as the general partner because a manager may run more than one fund. Each fund is backed by a different general partner, so that the general partnership capital of other funds is protected from the failure of another fund. Second, with the development of the limited liability struc- ture, the fund may be structured without any general partners. Instead, all the investors, including the insiders, invest as shareholders and have limited liability. Who Is Liable? Hedge funds as a group are less risky than an unlevered investment in com- mon stocks. Some funds do fail because of the risks they have taken, be- cause of failure to effectively control risk, or because of fraud. If none of the investors in a hedge fund have liability for losses beyond their commit- ted investments, who bears the loss when hedge funds lose more than the paid-in capital? Refer again to Figure 5.6. If general partners do not make up losses, the decline in value falls on the liability holders. Hedge Fund Business Models 81 FIGURE 5.7 Basic Structure to Create Limited Liability XYC, Inc. Hedge Fund L.P. Liability Legend: Limited Unlimited Corporation Owners General Partner Limited Partners ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 81 A hedge fund has many creditors. Broker-dealers are liable on unset- tled trades. Financing counterparties generally have collateral to secure their lending, but rapid changes in asset values can leave secured lenders exposed to default. Derivatives counterparties also margin their exposure to hedge fund default, but the margin may be inadequate. If a hedge fund fails, the losses cascade beyond the hedge fund investors. When a hedge fund has investors from many different countries, it is usually efficient to organize the fund in a low-tax or no-tax domicile. This is a tax avoidance strategy but it is not a tax evasion strategy. The differ- ence is important. By structuring a hedge fund offshore, a French investor avoids paying taxes to the United States but does not avoid paying taxes to the French government. Figure 5.8 shows a simple structure for an offshore hedge fund. In this master-feeder structure, a corporation is created in a low-tax or no- 82 HEDGE FUND COURSE FIGURE 5.8 Offshore Hedge Fund Structure U.S Based Fund Domestic Investors Offshore Investors Offshore Fund, Inc. ccc_mccrary_ch05_73-86.qxd 10/6/04 1:42 PM Page 82 [...]... stocks required 94 HEDGE FUND COURSE maintenance margin of 35 percent, the fund would get a margin call if the value of the positions fell below $1,538 ,46 1. 54 The remaining value of the margin is $538 ,46 1. 54 after subtracting the $1 million loan balance from the total value This margin exactly equals 35 percent of the position If the value of the position fell below $1,538 ,46 1. 54, the hedge fund would need... Offshore Investors U.S.-Based Fund Offshore Fund, Inc FIGURE 5.9 Mirror Hedge Fund Structure 84 HEDGE FUND COURSE Futures positions and over-the-counter derivatives are very difficult to rebalance The rebalancing process is time-consuming and creates the opportunity for the performances of the funds to diverge QUESTIONS AND PROBLEMS 5.1 5.2 5.3 5 .4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5. 14 5.15 5.16... another hedge fund that happens to be a foreign asset If constructed carefully, the U.S hedge fund can channel U.S investments into the offshore fund without compromising the offshore tax status of the main fund Most hedge funds organized today resemble Figure 5.8 Master-Feeder versus Mirror Funds The master-feeder fund is also sometimes called a spoke and hub fund Before this structure was developed, hedge. .. quarter of 1 percent or less The hedge fund may be able to set a repo balance as high as $1,022 ,43 7.50 ($1,025,000 × 99.75%) Also, financing rates are somewhat lower for bonds, especially for Treasury and agency bonds Assuming the fund can borrow money at 4. 5 percent, interest on this repo for a week would equal $8 94. 63 ($1,022 ,43 7.50 × 4. 5% × 7/360) In practice, the hedge fund would finance a significantly... investment in a conventional asset plus funding of that position Swaps, therefore, create leverage for a hedge fund, often requiring little or no capital LIMITS ON HEDGE FUND LEVERAGE Margin requirements limit the amount of leverage hedge funds can create with futures, options, or margin loans Initial Margin Hedge funds face many limits on leverage they can employ Most investors know Regulation T or at least... an outright short position Finally, a hedge fund may use leverage because trading is more efficient when structured as derivatives transactions For example, it is not very easy to store electricity, so hedge funds that want to trade electricity use energy derivatives These derivatives create leverage Hedge Fund Leverage 89 WAYS HEDGE FUNDS CREATE LEVERAGE Hedge funds can create leverage in a variety... volatile hedge funds are the funds following arbitrage strategies These funds also have the highest leverage of all hedge fund investment styles A highly levered, well-hedged portfolio has other risks that are not easy to measure with standard measures of risk These risks, including the risk of losing financing capacity, are discussed in Chapter 11, which deals with risk management 102 HEDGE FUND COURSE. .. leverage in this hedge fund? 6.3 A hedge fund is reviewing a stock or bond It appears that the asset should have a return equal to 3 percent The fund can borrow or lend the security at the rate of 5 percent Why might a hedge fund use leverage with this instrument? 6 .4 One fund holds assets equal to its capital and is using no margin or other techniques to create leverage A second fund has no long positions... Loan = (1 – Maintain%) × Margin (6.3) Maintain% × Loan = Margin (1 − Maintain%) (6 .4) The maintenance margin imposes a limitation on the amount of leverage available to a hedge fund if the hedge fund holds assets subject to margin requirements and if the hedge fund must observe the requirements (many offshore hedge funds bypass margin requirements by financing positions with dealers or subsidiaries... capital), or more Hedge funds are structured so that individual investors cannot lose more than 100 percent of their capital, so potential losses on the portfolio that exceed 100 percent don’t necessarily affect hedge fund investors However, the use of leverage may increase the probability of a loss of a certain magnitude Investors are concerned about the impact leverage has on 97 Hedge Fund Leverage the . If a hedge fund loses more than the investors cap- 76 HEDGE FUND COURSE ccc_mccrary_ch05_73-86.qxd 10/6/ 04 1 :42 PM Page 76 ital, other parties must bear part of the loss, because the fund investors. margin their exposure to hedge fund default, but the margin may be inadequate. If a hedge fund fails, the losses cascade beyond the hedge fund investors. When a hedge fund has investors from many. domicile for an offshore fund? 5.17 What is the key advantage of administering a hedge fund offshore? 84 HEDGE FUND COURSE ccc_mccrary_ch05_73-86.qxd 10/6/ 04 1 :42 PM Page 84 NOTES 1. In reality,