ll co m Ge tA he T w w w 14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page iii om The Fundamentals of Hedge Fund Management et Al l.c How to Successfully Launch and Operate a Hedge Fund w w w T h eG DANIEL A STRACHMAN John Wiley & Sons, Inc 12/4/06 9:30 AM Page vi w w w T h eG et Al l.c om 14102_Strachman_3p_ffirs.f.qxp 14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page i w w w T h eG et Al l.c om The Fundamentals of Hedge Fund Management 14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page ii w w w T h eG et Al l.c om Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analysis, as well as much more For a list of available titles, please visit our Web site at www.Wiley Finance.com 14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page iii om The Fundamentals of Hedge Fund Management et Al l.c How to Successfully Launch and Operate a Hedge Fund w w w T h eG DANIEL A STRACHMAN John Wiley & Sons, Inc 14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page iv Copyright © 2007 by Daniel A Strachman All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada l.c om No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750–8400, fax (978) 646–8600, or on the Web at www.copyright com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748–6011, fax (201) 748–6008, or online at http://www.wiley.com/go/permissions eG et Al Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages .T h For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762–2974, outside the United States at (317) 572–3993 or fax (317) 572–4002 w w Wiley also publishes its books in a variety of electronic formats Some content that appears in print may not be available in electronic books For more information about Wiley products, visit our Web site at www.wiley.com Library of Congress Cataloging-in-Publication Data w Strachman, Daniel A., 1971The fundamentals of hedge fund management : how to successfully launch and operate a hedge fund / Daniel A Strachman p cm Includes bibliographical references and index ISBN-13: 978–0-471–74852–6 (cloth) ISBN-10: 0–471–74852–8 (cloth) Hedge funds I Title HG4530.S8368 2007 332.64'5—dc22 2006015453 Printed in the United States of America 10 14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page v “The day is short; the task is great.” om Ethics of the Fathers Chapter II Verse 20 w w w T h eG et Al l.c “Opportunity is missed by most people because it is dressed in overalls and looks like work.” Thomas A Edison 12/4/06 9:30 AM Page vi w w w T h eG et Al l.c om 14102_Strachman_3p_ffirs.f.qxp 14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page vii w w w T h eG et Al l.c om To Felice, Leah, and Jonah 12/4/06 9:34 AM Page 164 w w w T h eG et Al l.c om 14102_Strachman_3p_bgloss.f.qxp 14102_Strachman_3p_bbiblio.f.qxp 12/4/06 9:34 AM Page 165 Bibliography w w w T h eG et Al l.c om Australian Stock Exchange Website Glossary Retrieved August 11, 2006, from http://www.asx.com.au/investor/lmi/how/AbsoluteFundsGlossary.htm Berger & Montague, P.C Client Files Class Action Against Bayou Hedge Fund Entities, Citibank, Hennessee Group, Sterling Stamos Capital Management and Others on Behalf of Bayou Hedge Fund Investors,” Market Wire (November 2005) Retrieved August 11, 2006, from http://findarticles.com/p/articles/ mi_pwwi/is_200511/ai_n15850332 Bernheim, A “Repeal of the Ten Commandments: The Impact on the offshore hedge fund administrations industry.” Retrieved August 11, 2006, from http:// www.hedgefundnews.com/news_n_info/article_detail.php?id=260 Burton, J “SEC proposes tighter ‘softer dollar’ rules: Use of commissions for investment research under fire.” MarketWatch (October 20, 2005) Retrieved August 9, 2006, from http://www.marketwatch.com/News/Story/Story.aspx?guid= %7B373BBC75-B693–457F-B656-A540F21CC034%7D Butler, D S “How to Select an Administrator: Due Diligence: What to Look For—What to Ask.” Delivered at AIMA and Euronext 7th Annual Investor Forum, September 25, 2002 Retrieved August 11, 2006, from http://www customhousegroup.com/How%20to%20Select%20Admin.htm Cantrell, A “Bayou Founder, CFO Plead Guilty to Fraud,” CNN (September 29, 2005) Retrieved August 11, 2006, from http://money.cnn.com/2005/09/29/ markets/bayou/index.htm ———— “Hedge funds launch, close in record numbers” (March 2006) Retrieved August 8, 2006, from http://money.cnn.com/2006/03/01/markets/hedgefund _stats/index.htm Cartine, M “Unrelated Business Taxable Income.” BISYS Alternative Investment Services (Fall 2006) Das, N., R Kish, D L Muething, and L W Traylor “An Overview of the Hedge Fund Industry.” Martindale Center for the Study of Private Enterprise, Lehigh University 2002 Series Retrieved August 11, 2006, from http://www.lehigh edu/~incntr/publications/2002_series_1.pdf Eisinger, J “A David toppled hedge fund rule, but was Goliath really so bad?” Wall Street Journal (July 28, 2006), C1 E-zine Articles “History of Texas Hold’em.” Retrieved August 8, 2006, from http://ezinearticles.com/?History-of-Texas-Hold-em&id=205439 Felsenstein, S., J Telpner, and B Chavez Greenberg Traurig Alert: “New NASD Rule 2790 Revises Retrictions on the Purchase and Sales of Initial Public Offerings” 165 14102_Strachman_3p_bbiblio.f.qxp 12/4/06 9:34 AM Page 166 166 Bibliography w w w T h eG et Al l.c om (January 2004) Retrieved August 11, 2006, from http://www.gtlaw.com/pub/ alerts/2004/felsensteins_01.pdf FBI History: Famous Case: Willie Sutton Retrieved August 11, 2006, from http://www.fbi.gov/libref/historic/famcases/sutton/sutton.htm Frontline: Betting on the Market Pros: Peter Lynch Retrieved August 11, 2006, from http://www.pbs.org/wgbh/pages/frontline/shows/betting/pros/lynch.html Fund Investors, LLC “Hedge Fund Accounting Basics.” Copyright 2001–2006 Retrieved August 11, 2006, from http://www.hedgefundcenter.com/wrapper cfm?article_type=basics GPO Access: United States Code, 2000 Edition Title 15, Chapter 2D, Subchapter 1, Sec 80a-2 Retrieved August 8, 2006, from http://frwebgate.access.gpo gov/cgi-bin/getdoc.cgi?dbname=browse_usc&docid=Cite:+15USC80a-2 HR 3162: Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA Patriot Act) Act of 2001 (Enrolled as Agreed to or Passed by Both House and Senate) Sections 326 & 352 Retrieved August 11, 2006, from http://thomas.loc.gov/cgi-bin/query/ D?c107:4:./temp/~c1076T6dS4 PFPC Worldwide Inc “Global Hedge Funds: Maze—Navigate the maze of opportunities.” Copyright 2004 Retrieved August 11, 2006, from http://www.pfpc com/pdfs/BRO_Hedge_Fund.pdf Royal Vegas Poker “The History of Poker.” Retrieved August 8, 2006, from http://www.royalvegaspoker.com/history-of-Poker.asp?BTag=ad_157206 Stead, D (ed.) “Up Front: For Hedge Funds, Some Sweet Deals” (May 8, 2006) Retrieved August 11, 2006, from Frontline—Betting on the Market—Pros Peter Lynch: http://www.pbs.org/wgbh/pages/frontline/shows/betting/pros/lynch.html Strachman, D Getting Started in Hedge Funds, Second Ed (Hoboken, N.J.: John Wiley & Sons, Inc., 2005.) Strachman, D Julian Robertson: A Tiger in the Land of Bulls and Bears (New York: John Wiley & Sons, Inc., 2004.) Texas MBD Hedge Fund Organization: McCombs School of Business Website Glossary of Terms Retrieved August 11, 2006, from http://www.mccombs.utexas edu/students/MBAHFO/glossary.asp#H Thackray, J “Whatever happened to the hedge funds?” Institutional Investor (1977 May): 70–73 United States District Court, District of Connecticut, Civil Action No.–Class Action Complaint 305CV176 Retrieved August 11, 2006, from http://securities stanford.edu/1035/BHFE05_01/20051117_f01c_0501762.pdf United States General Accounting Office “Testimony before the subcommittee on government efficiency and financial management, Committee on Government Reform, House of Representatives: Securities and Exchange Commission— Preliminary observations on SEC’s spending and strategic planning” (July 23, 2003) Retrieved August 8, 2006, from http://www.gao.gov/new.items/d03969t pdf United States Securities and Exchange Commission, 17 CFR Part 230–Releases No 33–8041; File No S7–23–01 “Defining the Term ‘Qualified Purchaser’ under 14102_Strachman_3p_bbiblio.f.qxp 12/4/06 9:34 AM Page 167 167 Bibliography w w w T h eG et Al l.c om the Securities Act of 1933.” Retrieved August 11, 2006, from http://www.sec gov/rules/proposed/33–8041.htm United States Securities and Exchange Commission “Accredited investors” (July 2000) Retrieved August 8, 2006, from http://www.sec.gov/answers/accred.htm United States Securities and Exchange Commission “Implications of the growth of hedge funds: Staff report to the United States Securities and Exchange Commission” (September 2003) Retrieved August 8, 2006, from http://www.sec.gov/ news/studies/hedgefunds0903.pdf University of Cincinnati College of Law Security Lawyer’s Deskbook “The Investment Company Act of 1940.” Retrieved August 17, 2006, from http://www.law uc.edu/CCL/InvCoAct/sec3.html Van Hedge Fund Advisors International, LLC “Size of Hedge Fund Universe.” Retrieved from http://www.hedgefund.com/abouthfs/universe/universe.htm 12/4/06 9:34 AM Page 168 w w w T h eG et Al l.c om 14102_Strachman_3p_bbiblio.f.qxp 14102_Strachman_3p_bindex.f.qxp 12/4/06 9:34 AM Page 169 Index Al l.c om Aggressiveness, 99–103 Akin, Gump, Strauss, Hauer, & Feld, 150 Algorithms, usage, 105 Allocations, basis, 62 Alpha, definition, 159 Alter ego charges, 43 Alternative assets, definition, 159 Anchin, Block & Anchin LLP, 153 Annual rate of return, definition, 159 Anti-money laundering (AML), 47–52 issues, 48 laws, 66 needs, 65 performing, 41–42 programs, establishment, 47 Arbitrage, definition, 160 Arnold & Porter LLP, 150 Articles of incorporation, 41 As Nas, 10 Assets access, 72 data points, 74 Assets under management, definition, 160 Auditors, usage, 18, 31 Audits fees, 124 frequency, 14 process, 60–61 Average annual return (annualized rate of return), definition, 160 Average monthly return, definition, 160 Average rate of return, definition, 160 A.W Jones & Company, w w w T h eG et Absolute-return fund, definition, 159 Absolute return strategy, 5–6 Accountants, 30–33 comfort level, 56 hiring, 112 importance, fund manager perspective, 26 list, 153–154 review See Documents switching, 54 trust, 54 Accounting See Hedge funds fees, disbursement, 67 Accredited investor, definition, 159 Action plan, 133–134 Administrative staff, need, 66 Administrators, 33–34, 64–67, 114 See also Hedge funds communication, 22 cost savings, 66 definition, 159 due diligence, 68–70 hiring, 112 independent electronic price feed, availability, 70 in-house responsibilities, performing, 65 list, 152–153 review See Documents services, providing, 53 standard agreement, counsel review, 69 technology, availability, 70 usage, 18, 34 Advent Geneva, 107 After-tax performance results, 61 Aggregate method, usage, 62 169 14102_Strachman_3p_bindex.f.qxp 12/4/06 9:34 AM Page 170 170 Index setup, 114–115 sustainability phase, 71 BVI See British Virgin Islands Al l.c om California Public Employees’ Retirement System (CalPERS), 88 Capital account, 60 calls, 57 decision, 133–134 inflows, 30, 33 introduction, 30 needs, 133 outflows, 33 raising, 84, 93–94, 100 Carried interest, clawbacks, 57 Cartine, Maury, 80 Cayman Islands Monetary Authority, 50 tax-haven jurisdiction, 38, 49 Certified Public Accountant (CPA) credentials, 85 Certified Public Accountant (CPA) firms, 32–33 CFTC See Commodity Futures Trading Commission Charitable organization, exempt status (government challenge), 79–80 Check-the-box mentality, 15 Citigroup Global Prime Brokerage, 149 Clearing, definition, 160 Client servicing, providing, 65–66 Cobb & Eisenberg LLC, 150 COBRA, usage, 110 Cohen, Steven A., 109 Coleman, Epstein, Berlin & Company LLP, 153 Commodity Futures Trading Commission (CFTC), 48 cash deposit, requirement, 81 Commodity Trading Advisor (CTA), definition, 160 Communication importance, 84 openness, 119 process, 94 w w w T h eG et Back office functions, importance, 104 tools, usage, 104–106 Back-test, definition, 160 Bank of America Securities LLC, 149 Bank of Butterfield/Butterfield Fund Services, 152 Bankruptcy, 56 Banks/custodians, 114 Barclays Capital Prime Services, 149 Bayou hedge fund case, class action suit, 43 BDO Seidman LLP, 153 Bear market, 131 definition, 160 Bear Stearns Securities, 108, 149 Berger & Montague PC, 43 Berkshire Hathaway, annual reports (examination), 34 Bermuda, tax-haven jurisdiction, 38, 49 Bibliography, 165–167 Big Four (accounting firms), 31 BISYS Alternative Investment Services, 80, 152 Bloomberg, development, 104 Blue-sky provisions, 46 BNY Alternative Investment Services, 152 Bookbinder, Richard, 18, 31, 96 Bookkeeper, usage, 112 Boxes, checking, 88–90 Break period, 60–61 British Virgin Islands (BVI), tax-haven jurisdiction, 38, 49 Brokerage firms, 11 Brokers, 114 Buffett, Warren, 34, 131 Bull market, 131 definition, 160 Burch, Robert, Business bricks-and-mortar, 132 decisions, 126–127 plan, 105 development, 92 happy medium, 117 problems, 120 14102_Strachman_3p_bindex.f.qxp 12/4/06 9:34 AM Page 171 171 Index om l.c Earnings allocation, 61 return, difference, 78 Economic interest See Hedge funds Egos importance, 132–133 satisfaction, 124–125 Eisner LLP, 154 Employee Retirement Income Security Act (ERISA), 71, 73–78 money, manager responsibility, 74–75 plans, 75–77 Entrepreneurs, 93–95 decisions, 126–127 difficulty, 93 experience, 18 number, increase, 12 stress, 118 Entrepreneurship, issue, 14 Equalization adjustment approach, 64 Equalization/depreciation deposit approach, 64 Equalization shares approach, 64 Ernst & Young, 154 Execution services, 27 Expected revenue, estimate, 122 Expenses, allocation, 62 Exposure, definition, 160 w w w T h eG et Data access, 115 Data collection, 96 Data points, 88–90 See also Assets Davis Graham & Stubbs LLP, 151 Day trading, reinvention, 128 Debt-financed real estate, 80 Debt finance property rules, expansion, 81 Dechert LLP, 151 Deloitte & Touche, 154 De minimis exception, 59 Derivatives, definition, 160 Designated investments, 57 Directors fees, disbursement, 67 meetings, conducting, 67 Distressed debt, 80 Diversification See Investment amount, 76 definition, 160 Dividends, payment (disbursement), 67 Dix Hills Partners, 29 Documents See Partnership; Subscription document accountant review, 54 lawyer objections, 26–27 administrator review, lawyer objections, 26–27 completion costs See Hedge funds drafting, 26 logging, 115 setting, 59–60 usage, 38, 114 Domestic nontaxable investors, 39 Drawdown, definition, 160 Due diligence, 16, 20 See also Administrators definition, 160 level, 97 performing, 86 process, 18, 66, 75, 102 See also Service providers issues, 76 thoroughness, 86 Duties, roles (definition), 121–123 Al Company accounts, auditing, 67 stocks, sales (solicitation), 67 Cook, Peter, 29 Corporate records/books, maintenance, 67 Credit Suisse, 149 CTA See Commodity Trading Advisor Custodian, definition, 160 Cuttone & Company, 149 Fair value, definition, 160 Family-owned organization, Fee reduction, requirement, 100 Fidelity Prime Services, 149 Fiduciaries, 76 Financial commitments, 138 Financial decisions, making, 118–119 Financial pressures See Hedge funds ...14102_Strachman_3p_ffirs.f.qxp 12/4/06 9:30 AM Page iii om The Fundamentals of Hedge Fund Management et Al l.c How to Successfully Launch and Operate a Hedge Fund w w w T h eG DANIEL A STRACHMAN John... job as a new manager about to launch a fund is to make sure that you are ready, willing, and able to deal with everything that the market and investors throw at you and that you are prepared... investments and hedge funds are going to become smaller and smaller Hedge funds are not going to disappear because people understand the value of creating a portfolio that is hedged against market volatility