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`Hedge Fund Regulation (2nd Edition)
`Table of Chapters
`Author(s): Scott J Lederman
`Practice Area: Corporate and Securities
`Published: 2012 Supplement Date: May 2015
`PLI Item #: 42542
`
`Terms & Connectors
`Table of Chapters
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`Table of Chapters
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`Hedge Fund Regulation (2nd Edition)
`
`PART I
`Chapter 1
`Chapter 2
`Chapter 3
`PART II
`Chapter 4
`Chapter 5
`Chapter 6
`Chapter 7
`Chapter 8
`Chapter 9
`PART III
`Chapter 10
`Chapter 11
`PART IV
`Chapter 12
`Chapter 13
`Chapter 14
`Chapter 15
`Chapter 16
`Chapter 17
`Chapter 18
`PART V
`Chapter 19
`Chapter 20
`Chapter 21
`Chapter 22
`PART VI
`Chapter 23
`Chapter 24
`Chapter 25
`Chapter 26
`Chapter 27
`Chapter 28
`PART VII
`Chapter 29
`
`Introduction to Hedge Funds
`From Innovation to Industry
`Form Over Substance Hedge Fund Structures
`Rationale for Regulation
`Raising Capital
`Private Placement
`Commodity Pools
`Marketing the Manager
`Marketers
`Anti-Money Laundering Regulations
`Privacy Regulations
`Fund Regulation
`Regulation of Private Investment Companies
`Regulation of Registered Investment Companies
`The Hedge Funds Manager
`Investment Adviser Registration
`Compliance
`Books and Records
`Custody
`Performance Fees
`State Advisory Regulation
`Commodity Pool Operators and Commodity Trading Advisers
`Investor Considerations
`Pensions
`Banks
`Insurance Companies
`Registered Investment Companies
`Market Participation and Portfolio Management
`Broker-Dealer Status and Relationships
`Disclosures of Market Participation
`Systemic Risk Regulation
`Derivatives Markets Participants
`Trading
`Portfolio Management
`Hedge Fund-Related Products
`Structured Products
`
`All Contents Copyright © 1996-2015 Practising Law Institute Continuing Legal Education since 1933
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`Privacy Policy
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`VIRNETX EXHIBIT 2015
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`Page 1 of 39
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`Chapter 2
`
`Form Over Substance:
`Hedge Fund Structures
`
`Hedge Fund Design—The Jones Blueprint
`§ 2:1
`Common Characteristics
`§ 2:2
`§ 2:2.1
`Centralized Management
`§ 2:2.2
`Co-Investment
`§ 2:2.3
`Performance-Based Compensation
`§ 2:2.4
`Limited Liquidity
`§ 2:3
`Domestic Hedge Funds
`§ 2:3.1
`Limited Liability
`§ 2:3.2
`Tax Efficiency
`§ 2:3.3
`Flexible Terms
`[A] Management Fees
`[B] Expense Pass-Throughs
`[C] Performance-Based Allocations
`[C][1]
`High Water Marks
`[C][2]
`Hurdles
`[C][3]
`Regulatory Considerations
`[D]
`Liquidity
`[D][1]
`Portfolio Characteristics
`[D][2]
`Publicly Traded Partnership Status
`[D][3]
`Liquidity Management Tools
`[D][3][a]
`Lock-Ups
`[D][3][b]
`Gates
`[D][3][c]
`Settlement Terms
`[E] Multiple Classes/Flexible Terms
`[E][1]
`Side Pockets
`[E][2]
`New Issues
`[F] Side Letters
`Offshore Hedge Funds
`§ 2:4
`§ 2:4.1
`Non-U.S. Investors
`§ 2:4.2
`U.S. Tax-Exempt Investors
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`2–1
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`§ 2:1
`
`HEDGE FUND REGULATION
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`§ 2:4.3
`
`§ 2:4.4
`§ 2:4.5
`
`U.S. Taxable Investors
`[A] Passive Foreign Investment Company
`[B] Controlled Foreign Corporation
`Selecting an Offshore Entity and Jurisdiction
`Offshore Fund Terms
`[A] Partnership Approach Within a Corporate Structure
`[B] Equalization
`Complex Fund Structures
`§ 2:5
`§ 2:5.1
`Parallel Funds
`§ 2:5.2
`Master-Feeder Structure
`§ 2:5.3
`Mini-Master Fund
`
`Hedge Fund Design—The Jones Blueprint
`§ 2:1
`Although it is convenient to use terms such as “absolute return”
`and “alpha” to identify certain investment vehicles as hedge funds, the
`diversity of strategies pursued by hedge funds, as well as the erosion of
`the distinctions that have historically separated hedge funds from
`more traditional money management, renders unsatisfactory any
`attempt to define hedge funds solely by investment style. Hedge funds
`are, in fact, more readily defined by their form of organization and
`manner of operation, rather than by the substance of their activities in
`the financial markets.
`Indeed, while many modern hedge funds bear very limited resem-
`blance to the original Jones hedge fund, if one compares their portfolios
`and means of generating returns, many of the structural and operational
`traits of today’s hedge funds can trace their lineage directly back to
`Jones. As reported by Carol Loomis in 1966, the Jones hedge fund was
`organized as a privately placed, unregistered fund and was originally
`structured as a general partnership.1 It was subsequently converted into
`a limited partnership in 1952 to accommodate outside investors. The
`partnership afforded its investors only limited liquidity, as it permitted
`capital contributions into and withdrawals from the fund at the end of
`each fiscal year. In addition, the general partners of the fund received as
`compensation 20% of any realized profits (after deduction of realized
`losses) generated on the fund’s capital. Also of note was the fact that the
`general partners had agreed to keep all of their investment funds in the
`partnership. Loomis also described a fairly centralized and streamlined
`decision-making process on the part of the fund’s portfolio managers
`when it came to implementing investment decisions.
`
`1.
`
`Loomis, The Jones Nobody Keeps Up With, FORTUNE, Apr. 1966, at 237.
`
`2–2
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`

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`Form Over Substance: Hedge Fund Structures
`
`§ 2:2.4
`
`Common Characteristics
`§ 2:2
`The structural approach taken by Jones has largely been followed by
`hedge fund managers to the present day. In surveying today’s hedge
`funds, one finds four traits that characterized the Jones fund that are
`commonly found in most current funds and the firms that manage them.
`
`Centralized Management
`§ 2:2.1
`Hedge funds are managed by a hedge fund advisory firm. That firm
`may be run by an individual portfolio manager or a team of managers,
`but the firm makes all decisions regarding the hedge fund’s investment
`activities. The hedge fund itself is organized as a limited liability entity
`whose partners, members, or shareholders are passive investors with
`little or no voting rights.
`
`Co-Investment
`§ 2:2.2
`Hedge fund managers usually invest a significant portion of their own
`liquid net worth in their hedge funds alongside of the fund’s other
`investors. This is often a major distinction from mutual fund managers,
`and provides investors some measure of comfort in that the manager is
`“eating his own cooking,” thereby helping to align the interest of the
`manager with that of the investor. Indeed, most sophisticated investors
`in hedge funds will insist upon such co-investment as a prerequisite to
`investing their own money with the manager.
`
`Performance-Based Compensation
`§ 2:2.3
`Perhaps the trait most often focused upon is that of performance-
`based compensation. While hedge fund managers generally receive a
`periodic asset-based management fee of 1% or 2% per annum, and may
`also pass through to investors certain other costs, it is the assessment
`of performance-based fees or profit allocations, pursuant to which the
`manager receives a percentage (often but not exclusively 20%) of the
`annual profits generated for the hedge fund, that has been a significant
`distinguishing characteristic from traditional money management.
`This is a major factor behind the ability of hedge funds to attract a
`steady stream of talented traders and portfolio managers.
`
`Limited Liquidity
`§ 2:2.4
`The fourth defining characteristic is the limited liquidity of hedge
`funds. This does not mean that the underlying investment portfolios
`of hedge funds are necessarily illiquid. Most hedge funds pursue their
`strategies in securities that are traded in broad liquid markets. The
`limited liquidity in question relates instead to the ability of investors
`to either add to or withdraw from the hedge funds in which they
`
`2–3
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`§ 2:3
`
`HEDGE FUND REGULATION
`
`invest. Hedge funds often accept capital only at the beginning of calendar
`months and, if they determine that they may be reaching levels of assets
`under management that exceed their ability to effectively deploy such
`capital, may temporarily close themselves to new investor contributions.
`Conversely, hedge funds typically limit the ability of investors to with-
`draw capital or redeem from a fund, so that investors may only be able to
`exit annually, semi-annually, quarterly or monthly, upon tendering a
`certain amount of advance notice to the fund. This differs markedly from
`mutual funds, which offer daily liquidity to their investors.
`In forming a hedge fund, the legal form of the fund entity, its
`jurisdiction of organization, and the terms by which it will operate
`must be selected. Generally, a significant driver in making these deter-
`minations is the nature of the investors who will capitalize the fund. In
`the broadest sense, hedge funds can be divided between those organized
`in the United States and those organized offshore. The structure of both
`domestic and offshore hedge funds, as well as of the firms that manage
`them, is driven largely by two overriding factors: the desire to limit
`liability and to operate in a tax-efficient manner.
`
`Domestic Hedge Funds
`§ 2:3
`Domestically, a hedge fund operation, in its most basic format,
`consists of the fund itself and the investment advisory firm that
`manages the fund. Most domestic hedge funds are organized as limited
`partnerships under state law, as this legal structure affords flexibility
`and enables the fund to meet both objectives of limited liability and tax
`efficiency. An alternative structure, which is of more recent vintage
`and was not available at the time that Jones launched his fund, but
`which also achieves these ends, is the limited liability company. While
`the various states have statutes pursuant to which limited partner-
`ships and limited liability companies are organized and operated, the
`most popular jurisdiction for organization is Delaware, as its statutes
`are considered among the most flexible and its case law the most
`developed, affording both relative administrative ease and a high
`degree of legal certainty with respect to the manner in which these
`entities are operated. Corporate entities also limit liability by limiting
`their shareholders’ liability to their investment in the corporation’s
`shares; however, as is discussed below, they are not as attractive from a
`tax perspective in the domestic context.
`
`Limited Liability
`§ 2:3.1
`A limited partnership consists of at least one general partner and
`one or more limited partners. The hedge fund management firm
`serves as the general partner of the partnership while the fund’s
`investors comprise its limited partners. A limited partnership limits
`
`2–4
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`

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`Form Over Substance: Hedge Fund Structures
`
`§ 2:3.1
`
`the liability of its limited partners to the extent of their capital account
`in the partnership.2 The balance of the capital account at any point in
`time reflects initial and subsequent contributions of cash or property
`to the partnership, increased by any gains and decreased by any losses
`or distributions. The general partner remains liable for all debts and
`obligations of the partnership.3 Consequently, the general partner is
`itself usually organized as a limited liability entity, generally, either a
`limited partnership, limited liability company, or Subchapter S cor-
`poration.4 A limited liability company, in contrast to a limited partner-
`ship, affords all of its members, including the hedge fund manager
`who serves as the managing member, with limited liability comparable
`to that of a limited partner.5 While it is prudent to operate or invest in
`a hedge fund through a vehicle providing limited liability, its impor-
`tance is magnified to the extent that the hedge fund employs leverage
`in its strategy, since, as was discussed in the previous chapter, leverage
`can serve to magnify losses which, in the absence of limited liability,
`can expose investors to losses far in excess of their invested capital.
`The basic structure of a domestic hedge fund is depicted below.
`
`2.
`3.
`4.
`
`5.
`
`See, e.g., DEL. CODE ANN. tit. 6, § 17 303.
`See, e.g., DEL. CODE ANN. tit. 6, § 17 403.
`If the general partner of the hedge fund limited partnership is itself a
`limited partnership, it will also have its own general partner which will
`also be organized as a limited liability entity such as a limited liability
`company or a Subchapter S corporation.
`See, e.g., DEL. CODE ANN. tit. 6, § 18 303.
`
`2–5
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`§ 2:3.2
`
`HEDGE FUND REGULATION
`
`Tax Efficiency
`§ 2:3.2
`The use of partnerships and limited liability companies also afford
`several important tax benefits that render them preferable over other
`legal entities that are available in organizing domestic hedge funds and
`their managers. Of particular importance is the fact that, unlike a
`standard corporation that under Subchapter C of the Internal Revenue
`Code is taxed on its profits and whose shareholders pay a further tax
`on dividends when distributed, a partnership or limited liability
`company avoids this “double taxation” as neither incurs an entity-
`level tax. The fund’s partners or members are taxed currently on their
`allocable share of such entities’ income, gain or loss, whether or not
`distributed, and receive a report of their allocable share on Internal
`Revenue Service Form 1040, Schedule K-1, and similar state tax forms,
`issued by the fund.6 As most hedge funds reinvest their income rather
`than make periodic distributions to their investors, hedge fund in-
`vestors typically must meet their hedge fund related tax obligations
`from other financial sources, or withdraw capital, pursuant to the
`withdrawal terms of the fund, in advance of the due dates for their tax
`payments.
`The federal tax status of an entity is governed by the U.S. Treasury ’s
`“check-the-box” regulations, which list a number of domestic organi-
`zations that are always classified as corporations, and also provides
`that certain entities are, by default, classified as a partnership for
`federal tax purposes unless they elect to be treated as an association
`taxable as a corporation. A domestic entity with two or more members
`that is a limited partnership or limited liability company under state
`law is automatically treated as a partnership for tax purposes.7
`States and localities that impose income taxes generally do not
`impose an entity-level tax on partnerships and limited liability
`companies. However, some states and localities do impose an entity-
`level income tax or, in some cases, an annual tax per member on
`limited liability companies, and such levies need to be considered
`when determining where to organize and operate the fund and its
`manager.
`Domestic hedge funds organized as partnerships and limited liabil-
`ity companies also provide another advantage over a corporation,
`namely that the items of taxable income generated by such funds
`retain their tax character when allocated to the funds’ partners or
`members. Since certain categories of income, such as long-term capital
`gains (securities held for more than one year) and certain qualifying
`
`6.
`7.
`
`I.R.C. §§ 701, 702(a), 706(a).
`See Treas. Reg. § 301.7701 3(a). But see discussion in chapter 4 regarding
`publicly traded partnership status.
`
`2–6
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`

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`Form Over Substance: Hedge Fund Structures
`
`§ 2:3.3
`
`dividend income, are taxed more favorably (currently at a maximum
`rate of 15%) than ordinary income (currently taxed at a maximum rate
`of 35%), the retention of character enables certain hedge fund investors
`to receive the more favorable tax treatment on their own tax returns.
`This contrasts to corporations, where the tax rate imposed at the
`entity level does not differentiate between long-term capital gains and
`ordinary income and where dividends distributed to shareholders are
`deemed ordinary income to the recipient, regardless of the character of
`the income that gave rise to the dividend, except in the case of
`qualified dividends.
`A Subchapter S corporation is a corporation that elects special tax
`status under Subchapter S of the Internal Revenue Code. Although
`such status permits partnership-like tax treatment by avoiding an
`entity-level tax and permitting tax character to pass through to share-
`holders, S corporations are not well suited for hedge funds when
`compared to partnerships or limited liability companies. An S corpora-
`tion is limited to no more than 100 shareholders who may not be
`nonresident aliens and who generally must be natural persons.8
`Moreover, it may issue only one class of stock, which generally
`requires allocations of taxable income and loss to its shareholders on
`a pro rata basis based on their shareholdings. Partnerships and limited
`liability companies, in contrast, have far greater flexibility to specially
`allocate income and loss. In addition, some state and local taxing
`authorities impose entity-level taxes on such corporations.
`
`Flexible Terms
`§ 2:3.3
`Yet another benefit of organizing a domestic hedge fund as a
`partnership or limited liability company is the flexibility that these
`entities afford in structuring the economic relationship between the
`hedge fund manager and its investors. As mentioned above, the
`limited partnership agreement or limited liability company operating
`agreement of most hedge funds is infused with Jones-inspired terms,
`which have been refined and modified over time. Subject to the
`manager ’s fiduciary and disclosure obligations, these terms can be
`tailored and adjusted for different groups of investors within the fund.
`
`[A] Management Fees
`Most domestic hedge funds compensate their manager with both
`an asset-based management fee and a performance-based profits
`allocation. The management fee is designed to compensate the
`manager for the overall management and administration of the hedge
`fund. It is typically set at a percentage of the net asset value, or NAV, of
`
`8.
`
`I.R.C. § 1361(b).
`
`2–7
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`

`
`§ 2:3.3
`
`HEDGE FUND REGULATION
`
`assets under management and often falls between 1% and 2% per
`annum. It can be assessed monthly or quarterly, and can be computed
`in advance of a given period, in arrears following the close of a period,
`or based on an average of assets under management during the period.
`Where a management fee is assessed, the manager generally is
`responsible for paying the overhead in running the fund, including
`rent, phones, computers, and salaries of its personnel acting on behalf
`of the fund. The fund typically pays for investment expenses arising
`from the management of the fund’s portfolio, including brokerage
`commissions and research costs.
`
`[B] Expense Pass-Throughs
`Some funds have implemented expense pass-through arrangements
`that entitle the manager to pass through to the fund and its investors
`some of its operating expenses, in addition to charging a management
`fee.9 In a few notable instances, certain prominent hedge funds employ
`an expense pass-through in lieu of a fixed management fee. In all such
`instances, the investor should understand the level of such expenses as
`a percentage of NAV in order to compare them to more standard asset-
`based management fees. The costs of organizing the fund are typically
`paid by the fund. The Internal Revenue Code permits a partnership to
`deduct in the first year of operation $5,000 of organizational expenses,
`reduced (but not below zero) by the amount by which such organiza-
`tional expenses exceed $50,000, and the remainder may be deducted
`ratably over its first 180 months of operation.10 Many hedge funds
`pass these costs on to investors over a sixty-month period.11
`The deductibility of certain expenses allocated to the partners of a
`partnership or members of a limited liability company will depend on
`whether the hedge fund is deemed a “trader” or an “investor” under
`the Internal Revenue Code. The status of the fund is a question of fact
`and turns on whether the fund is deemed to be engaged in a trade or
`business pursuant to I.R.C. section 162, in which case it will be a
`trader. The courts and the IRS have generally looked at certain factors
`to ascertain if the fund is engaged in a trade or business, including
`whether the fund engages in frequent, short-term trading and whether
`
`9.
`
`10.
`11.
`
`Wood, Expenses Are Another Way to Hike Fees, ABSOLUTE RETURN,
`Dec. 2004 Jan. 2005, at 17.
`I.R.C. § 709(b).
`Generally Accepted Accounting Principles (GAAP) do not permit such
`amortization. However, most funds will still amortize these costs, so as not
`to unfairly burden initial investors. Where such costs are deemed material
`in nature, the fund must disclose in its financials that GAAP is not being
`adhered to with respect to the treatment of organizational expenses.
`See also discussion of potential implications under the Custody Rule,
`chapter 15, at n.21.
`
`2–8
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`

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`Form Over Substance: Hedge Fund Structures
`
`§ 2:3.3
`
`income tends to be short-term capital gains from the sale of securities
`as opposed to interest and dividend income that is more representative
`of an investor. Trader status renders expenses trade or business
`expenses that are fully deductible by an individual partner or member
`to whom they are allocated. Certain expenses of a fund that is deemed
`an investor will be deductible by an individual partner or member only
`to the extent they exceed 2% of such partner ’s or member ’s adjusted
`gross income.12 In addition, when combined with an individual
`taxpayer ’s deductions for certain other items, they are subject to a
`further reduction generally equal to 3% of the taxpayer ’s adjusted gross
`income over a certain threshold amount.13
`
`[C] Performance-Based Allocations
`The performance-based element of manager compensation is
`intended to reward the manager for successfully generating positive
`returns on the fund’s investment portfolio. As noted above, it is a key
`distinguishing characteristic of the hedge fund, and a primary driver
`in the attractiveness of these vehicles from a portfolio manager ’s
`perspective. In the original Jones fund, the manager received 20% of
`any realized profits over realized losses.14 Today, 20% remains the
`industry “standard,” although there are managers who receive signifi-
`cantly more. However, it is typically based on both realized and
`unrealized profits in excess of losses, net of the management fee,
`and is generally assessed at the end of the calendar year.
`The manager of a domestic hedge fund will generally structure the
`performance-based compensation as an allocation of the fund’s in-
`come to the manager ’s partnership or limited liability company capital
`account, rather than as a fee.15 In the domestic setting, performance
`allocations are typically assessed on an investor-by-investor basis,
`rather than on a fund-wide basis. Allocations can afford both the
`manager and the fund’s investors certain tax advantages. The income
`so allocated to the manager retains the tax character it had inside the
`
`12.
`13.
`14.
`15.
`
`I.R.C. § 67.
`I.R.C. § 68.
`Loomis, The Jones Nobody Keeps Up With, FORTUNE, Apr. 1966.
`Under I.R.C. § 707(a) and its related legislative history, the fact (1) that the
`performance based compensation is contingent on positive performance of
`the hedge fund’s portfolio rather than calculated based on the amount of
`investment management services provided, (2) that the hedge fund man
`ager, as the fund’s general partner or managing member, acts in that
`capacity for the duration of the fund, rather than for a discrete period and
`(3) that the allocation is generally made annually, rather than more
`frequently as services are performed, should result in the performance
`allocation being respected as such, rather than being treated as a fee for tax
`purposes. See TAGGART & BIONDO, HEDGE FUNDS: A COMPREHENSIVE TAX
`PLANNING GUIDE, 44 46 (1996).
`
`2–9
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`§ 2:3.3
`
`HEDGE FUND REGULATION
`
`fund, thereby affording the manager capital gains treatment to the
`extent the allocation includes such gains. In contrast, a fee would be
`treated entirely as a “guaranteed payment” to the manager, taxable as
`ordinary income.16 Moreover, while the profit allocation is computed
`on both realized and unrealized gains and losses, only realized gains
`included in the allocation will be subject to taxation when the
`allocation is made to the manager.17 Investors may also benefit from
`a performance allocation, as the allocation will reduce their share of
`the fund’s allocable gain dollar for dollar, while a fee will be treated as
`an ordinary expense of the fund and may be subject to limits on its
`deductibility to some investors.18
`
`[C][1] High Water Marks
`Performance-based allocations are typically subject to what is
`referred to in the industry as a “high water mark.” This requires the
`manager to make up for prior years’ losses before becoming entitled to a
`current year performance allocation. The high water mark concept in the
`domestic context is often implemented by tracking gains and losses on an
`investor-by-investor basis. Thus, if an investor invests $100,000 in a
`hedge fund that has a 20% performance fee, and, in its first year of
`operation, the fund loses money so that the investor ’s capital account
`declines to $80,000, no performance allocation would be assessed for that
`year. In order to assess a performance fee in the following year, the capital
`account would have to appreciate enough so as to exceed its prior high
`water mark (in this example, $100,000), and then, only the amount that
`exceeded the high water mark would be subject to a performance
`allocation. Thus, if at the end of the second year, the capital account
`stood at $110,000, net of the management fee or expense pass-through,
`the hedge fund manager would receive a performance allocation or fee of
`$2,000 (20% of the $10,000 over the high water mark).
`In recent years, some of the larger and more established hedge funds
`have replaced the standard high water mark with a modified approach.
`The primary rationale behind this change in terms is to better enable
`the manager to retain key talent in the wake of a loss year. As the
`preceding discussion indicates, once a hedge fund has incurred a loss,
`
`16.
`17.
`
`18.
`
`I.R.C. § 707(c).
`If the performance based compensation includes an allocation of unreal
`ized gains, that portion of the allocation will not generate tax unless the
`securities to which such gains are associated are disposed of, or the
`manager withdraws the allocated amount from its capital account. In
`contrast, if performance compensation is structured as a fee, it is included
`in income (even if it is based upon unrealized income) when the manager ’s
`right to receive it is fixed and determinable or received, depending on
`whether the manager is an accrual or cash basis taxpayer.
`I.R.C. §§ 67, 68.
`
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`Form Over Substance: Hedge Fund Structures
`
`§ 2:3.3
`
`it must, under the traditional high water mark concept, generate
`profits that recoup that loss before the manager can receive a perfor-
`mance allocation. Where a fund is under its high water mark, senior
`employees of the fund’s management firm may become concerned that
`their overall compensation in the coming year or years may decline as
`the manager will not earn any performance-related revenues until
`prior losses are made up. This concern may increase the likelihood
`that they will seek employment at competing firms that are not
`encumbered by an existing loss carry forward.
`In order to enable the hedge fund manager to address this concern,
`some have amended their fund’s terms to permit the earning of some
`portion of performance compensation notwithstanding the existence
`of a loss carry forward. One approach permits the manager to receive a
`lower performance allocation (for example, 10% instead of 20%) until
`the prior loss plus some additional amount has been recouped through
`future positive investment performance. Another approach is to adjust
`the high water mark after some period of time so as to allow the
`manager to begin receiving performance allocations, even though it
`was unable to earn its way back over the preexisting high water mark.
`
`[C][2] Hurdles
`In addition to the high water mark concept, some funds include an
`additional requirement to be met before the manager may receive the
`incentive allocation. This generally comes in the form of a “hurdle rate,”
`which requires the fund’s performance to exceed a certain minimum
`rate of return. Hurdle rates can be structured in a number of ways. Some
`are calculated on an annual basis with each year ’s return measured
`against the hurdle applicable to that particular year. Others can be
`cumulative in nature. Moreover, hurdles can be set at a fixed rate or can
`be tied to a variable rate. For example, hurdles can be calculated based on
`an interest rate or a published index, depending on the nature of the
`hedge fund portfolio to which they are to be applied. Hurdles can also be
`distinguished by the amount of profits the manager is entitled to share
`in once the hurdle is surpassed. A “hard hurdle” is one where the
`incentive allocation applies only to the portion of the fund’s return in
`excess of the hurdle rate. In contrast, a “soft hurdle” entitles the
`manager to receive an incentive allocation on all profits in a given
`year, so long as the hurdle rate has been exceeded.
`
`[C][3] Regulatory Considerations
`While the foregoing describes the business and contractual concepts
`underlying performance allocations, such allocations must also be
`implemented in compliance with applicable securities regulations. As
`is discussed in greater detail in chapter 12, hedge fund managers are
`investment advisers as defined under both federal and state securities
`
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`§ 2:3.3
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`HEDGE FUND REGULATION
`
`statutes. As such, they must register under either the federal or state
`regulatory regime for investment advisers unless an exemption from
`registration is available. Section 205(a)(1) of the Investment Advisers
`Act of 1940 (the “Advisers Act”) contains a general prohibition against
`performance-based compensation that states that “[No] investment
`adviser registered or required to be registered with the Commission
`shall enter into, extend, or renew any investment advisory contract, or
`in any way perform any investment advisory contract entered into,
`extended, or renewed on or after the effective date of this title, if such
`contract (1) provides for compensation to the investment adviser on the
`basis of a share of capital gains upon or capital appreciation of the funds
`or any portion of the funds of the client.”19 This prohibition was
`included in the Advisers Act to protect advisory clients as perfor-
`mance-based compensation is viewed as having the potential to
`encourage advisers to take undue risks with client capital in order to
`increase advisory fees. Section 205 excepts from the performance fee
`prohibition advisory contracts with funds that are exempted from the
`definition of “investment company” in the Investment Company Act by
`section 3(c)(7)20 of that statute as well as contracts with persons who are
`not residents of the United States.21
`The SEC is also authorized, pursuant to section 205(e) of the Advisers
`Act, to except from the prohibition any advisory contract if the contract
`is with persons that the SEC determines are not in need of the
`protections of the prohibition on the basis of factors including financial
`sophistication, net worth, knowledge of and experience in financial
`matters, and the amount of assets under management.22 Rule 205-3,23
`adopted pursuant to the SEC’s authority under section 205(e), provides
`relief to advisers by permitting them to charge performance-based fees to
`“Qualified Clients.” A Qualified Client must be either:
`• A natural person24 or a company that the manager reasonably
`believes, immediately prior to entering into the performance-
`based management arrangement, has a net worth of more
`than $2 million or is a “Qualified Purchaser” as defined in
`section 2(a)(51)(A) of the Investment Company Act of 1940 (the
`“Investment Company Act”)25 at the time they enter into the
`arrangement;
`
`19.
`20.
`21.
`22.
`23.
`24.
`
`25.
`
`15 U.S.C. § 80b 5(a)(1).
`For a discussion, see infra chapter 10.
`15 U.S.C. § 80b 5(b)(4) and (b)(5).
`15 U.S.C. § 80b 5(e).
`17 C.F.R. § 275.205 3.
`The calculation of the net worth of a natural person can include assets held
`jointly with a spouse.
`See infra section 10:3.1.
`
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`Form Over Substance: Hedge Fund Structures
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`§ 2:3.3
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`• A natural person or a company that, immediately after entering
`into the performance-based management arrangement, has at
`least $1 million under management with the manager; or
`• A natural person who falls within certain categories of the
`management or employees of the manager.26
`The dollar-amount tests contained in the definition of Qualified
`Client were most recently adjusted in July 2011 and will be adjusted
`by SEC order for inflation (rounded to the nearest multiple of
`$100,000) every five years thereafter.27
`Hedge funds generally fall outside of the regulatory purview of
`the Investment Comp