Securities Investment Partnerships

By Levy, Gregory M.; Del Raso, Joseph V. | The CPA Journal, September 1993 | Go to article overview

Securities Investment Partnerships


Levy, Gregory M., Del Raso, Joseph V., The CPA Journal


Securities investment partnerships, often referred to as hedge funds* offer a means for investors to have their funds professionally managed by some of the honest stock-pickers in the count. For the highly successful money manager. the financial rewards may be considerably more than could be achieved as a stock broker with full discretionary authority over accounts or as an investment advisor managing separate accounts.

Although their origins go back many decades, hedge funds first became popular in the 1960s. As with any pooled fund, such as collective trust accounts and mutual funds, investors enjoy greater portfolio diversification than available to them individually while at the same time gaining access to professionally full-time portfolio managers. To the observer, hedge funds may not appear much different from public funds, which are widely advertised; however, there are significant differences. Pooled funds are normally managed by investment companies, bank trust departments, pension funds, and insurance companies. Absent establishing a bank or insurance company, a fund manager normally may only commingle funds in an investment company registered with the SEC in accordance with the provisions of the Investment Company Act of 1940, as amended (1940 Act). In addition, securities offered to the public by a regulated investment company must be registered in accordance with the Securities Act of 1933, as amended (1933 Act), as well as state securities commissions, where required, commonly referred to as "Blue Sky" filings.

MANAGEMENT INVESTMENT COMPANIES

Management investment companies fall into two categories for 1940 Act purposes. First, the open-end management investment company, known as a mutual fund, issues redeemable securities that are continuously offered and must be redeemable on a daily basis at net asset value per share. The other management investment company, the closed-end fund, issues a non-redeemable security, normally sold to the public in an initial public offering with subsequent liquidity achieved by secondary market trading via a listing on a national stock exchange. However, closed-end funds normally trade at a discount from net asset value in the secondary market. Both open-and closed-end funds registered with the SEC are subject to the rigorous regulatory provisions of the 1940 Act, including prohibitions against affiliated transactions, strict recordkeeping and periodic reporting rules, strict adherence to stated investment objectives and policies, specific capital structure requirements, including limits on leverage, custodial and fidelity bonding requirements, and submission of certain matters to shareholders (which require proxy solicitation in accordance with SEC regulations).

HEDGE FUNDS

In contrast, hedge funds operate largely outside SEC regulation and oversight. To be sure, they are subject to the anti-fraud provisions of the securities laws and the same rules relating to insider trading, reporting of securities holdings in excess of certain thresholds, the provisions of the Investment Advisers Act of 1940, as amended (Adviser's Act), and Blue Sky requirements where applicable. But in most other respects, they must only comply with the appropriate SEC requirements for private placements. Where the manager of a hedge fund happens to be subject to the Advisers Act, because of his other activities (such as management of individual clients' funds), there are some additional strictures (such as custodial and recordkeeping requirements); but they still can operate largely unfettered by regulation. This allows the fund manager to have more freedom over trading strategies.

The organizer-manager of a hedge fund stands to earn substantial financial rewards depending on his success in portfolio management. Typical compensation arrangements call for the following:

* A management fee (usually 1%) based on the fund's net assets, i.e., partners equity; and

* A performance reallocation (usually 20 based on appreciation of net assets. …

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