An Accountant's Guide to the Major Legal Issues Affecting Hedge Funds

By Nadel, Steven B. | The CPA Journal, October 1998 | Go to article overview

An Accountant's Guide to the Major Legal Issues Affecting Hedge Funds


Nadel, Steven B., The CPA Journal


According to a recent survey, there currently exist over 3,000 hedge funds managing in excess of $200 billion of investors' capital (see Exhibit). As such, many accountants, both in the public sector and at private companies, are being exposed to this growing practice area and are being asked to provide guidance to hedge fund investors and hedge fund managers. Since today's accountants are often expected to give more than just accounting advice, they may be required to be conversant in the relevant hedge fund legal issues.

Hedge Fund Investors: Major Legal Issues

What are hedge funds and how do they differ from mutual funds? While there is no precise definition, a hedge fund can best be described as an investment vehicle (typically in the form of a limited partnership or an offshore corporation), privately offered to a limited number of qualified investors, that is permitted to engage in virtually all types of securities-related investments, as well as utilize leverage and hedging techniques. Hedge funds are not registered with the Securities and Exchange Commission (SEC) as investment companies (because they either restrict their ownership to no more than 100 beneficial owners or are offered exclusively to certain qualified purchasers), nor are their managers usually required to be registered as investment advisers with the SEC. Furthermore, because hedge funds are often limited in both the number and types of investors they permit, the minimum initial subscription set by the hedge fund manager will frequently be at least $250,000 (subject to the manager's discretion).

Unlike mutual funds, which are heavily marketed to the general public and restricted in their investment methods by SEC regulations, hedge funds are not publicly traded, cannot publicly advertise, and are not subject to the same level of regulatory constraint. Moreover, hedge funds generally limit the frequency of capital contributions and withdrawals (usually no more frequently than quarterly), whereas mutual funds must permit transactions on a daily basis (with relatively low minimum initial contributions). Finally, hedge fund managers are typically paid a fee based upon assets under management, as well as an incentive fee or allocation in the form of a percentage (usually 20%) of actual net profits generated (generally after recouping all losses that have been carried forward from prior fiscal periods); by contrast, mutual fund managers generally do not receive any form of compensation tied to the return they generate for investors but rather receive a management fee based solely upon assets under management.

Hedge Fund Managers: Major Legal Issues

Concerns about investors, structure, locale, and strategy. Hedge fund managers may seek to raise capital from U.S. taxable and tax-exempt investors, as well as non-U.S. investors. Factors that may affect this mix include the fund's investment strategy and its suitability for potential investors: the regulatory implications of admitting certain investors into the fund; and, in the case of an offshore fund, whether the fund is to be listed on an exchange. Hedge funds are free to engage in a myriad of investment strategies, some of which may not be well suited to certain categories of investors. For example, the fund's investment strategy may entail too much risk for a given investor, involve an area in which a prospective investor is not permitted or authorized to invest, (e.g., hot issues of securities may not be allocated to certain restricted persons under the rules of the National Association of Securities Dealers), or create negative tax consequences for the investor, e.g., U.S. taxexempt investors may incur unrelated business taxable income (UBTI) if a U.S. hedge fund employs leverage, and non-LT.S. investors in a U.S. hedge fund may be sub ject to certain U.S. withholding and possible U.S. estate tax requirements. Besides investor suitability, the admission of certain investors may result in undue regulatory burdens for the fund and its manager, e. …

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