A step foo far into the private arena?
The flow of investment into hedge funds, largely due to the increased allocation to hedge funds from pension funds and institutions, has resulted in capacity issues, with too much money and too few investment opportunities, for investors and hedge fund managers alike. Consequently, investors have had difficulty accessing good hedge fund managers.
The rapid flow of funds into the hedge fund market has been viewed by many fund managers as one of the factors contributing to the downturn in hedge funds
performance, as strategies that rely on niche, specialised trading become effectively swamped by excess capital and identifying unique trading strategies/opportunities becomes more difficult.
As a result there has been a recent trend for hedge funds to expand their investment strategies to areas outside the traditional hedge fund arena in the endeavour to continue to outperform the market.
But what is the traditional hedge fund arena? While hedge funds encompass a wide array of investment strategies, typically they involve strategies that use substantial leverage and derivatives to take advantage of market volatility and arbitrage. The non-traditional strategies that hedge funds have recently begun to invest in have included private equity, reinsurance, money lending and securitisation activities which have been traditionally been the realm of the banking industry.
In the private equity area, hedge fund managers are adopting a
variety of investment strategies. Some managers are adopting a ‘hybrid’ approach by taking larger stakes in businesses which allow them a place on the board of directors so that they can actively participate in management and business decisions to achieve better returns. Other hedge fund managers are ‘buying in’ private equity teams which then establish private equity funds to offer alternative investment strategies to investors.
All investors should undertake appropriate and timely due
diligence before they invest in an alternative asset class such as a hedge fund. The fact that a hedge fund operation pursues different investment strategies by either offering private equity investments or by adopting strategies within its hedge funds that are akin to private equity investment strategies makes careful due diligence even more essential. Highlighted below are a few of the key issues that investors should consider.
q Manager experience Where a hedge fund manager adopts a hybrid approach to private equity investment by taking a sufficient stake in a business to secure a place on the board and a say in management decisions, investors need to be satisfied that the hedge fund manager has the requisite experience to run private equity strategies. Fund managers may have a great track record at running a long/short strategy but this will not necessarily correlate to success in running a private equity fund.
Investors should consider whether the manager has sufficient operational, strategic and financial experience, together with the required industry experience, to make effective changes that add value to the company.
Specific questions investors might want to ask include: Does the manager truly understand an investment’s value drivers, costs and risks? Can the manager model ‘what if’ scenarios? Does the manager have the appropriate financial models?
Where a hedge fund house ‘buys-in’ a team of private equity specialists who then-set up a private equity fund, then the operating model is perhaps more akin to a fund of hedge funds operation. In these circumstances, investors should ask the hedge fund manager questions surrounding their manager research and selection process – for example, how the hedge fund manager determines the risk profile of the private equity manager’s strategies and how the hedge fund manager has assessed the experience of the private equity team, and so on.
q Reporting systems Investors should also ensure that the hedge fund manager has adequate systems in place and the experience to provide information that is required for the investor’s own tax reporting (eg, US K1) or benchmarking requirements, as the information required by investors for private equity investments might be different to that for traditional hedge funds.
For example, private equity may require different valuation methodologies and more information on the underlying investments (charges, taxes, etc) being made available to the investor. Further, can the manager comply with
withholding tax reporting obligations such as the US QI 1441 requirements (which may not be required to the same degree where hedge funds are structured offshore and cannot access treaty rates of withholding tax on dividends and interest)?
From a tax perspective, an investor needs to understand the tax attributes of the investment vehicle and their own tax position vis a vis investment returns, as different types of alternative investments can lead to different tax outcomes for investors.
q Mitigation of withholdings taxes Investors in private equity funds typically expect a structure that minimises tax leakage, whereas to date this has not typically been the case for hedge fund investors. To minimise tax leakage, a private equity vehicle would typically be structured as a tax transparent entity such that income and capital gains retain their nature as they flow through the fund to the investor. In many cases the ultimate investor may be able to obtain a credit for underlying tax paid.
However, a hedge fund is often located in an offshore jurisdiction that cannot access treaty relief on interest and dividends; and because it is often structured as a corporate entity investors are not generally able to claim a credit for underlying taxes either. The hedge fund manager will need to regard the management and mitigation of withholding taxes as being vital to fulfilling investor expectations.
q The ‘trading’ issue Another difference that investors need to be mindful of is the issue of ‘trading’. Private equity funds are not generally regarded as trading for UK tax purposes whereas most hedge funds would generally be regarded as trading. The significance of this issue is that there is a risk that profits attributable to a trading fund arising through the activities of a UK manager may be subject to UK tax unless the UK safe harbour provisions of the investment management exemption (IME) apply.
Investors should ensure the manager can advise whether or not the relevant fund is trading and if so, seek assurance that the UK manager satisfies the requirements of the IME. Investors such as UK pension funds or US tax exempt investors that do not wish to receive trading income should also ensure their investment into the fund is structured appropriately.
q UK transfer pricing rules As capital/loan commitments by investors to private equity funds and hedge funds differ, investors should also ensure that the manager understands the impact of the new UK transfer pricing rules in respect of financing arrangements for private equity investments. Breaches of the rules can deny tax deductions for interest paid by portfolio companies in which the fund invests, which may substantially have an impact on returns, unless the fund can justify that the level of shareholder debt is an amount that would have been provided by an independent third party.
q Lock-up periods and liquidity Investors should also be aware that private equity and hedge funds have typically had different lock-up periods. Lock-up periods for private equity are typically between five-10 years, whereas lock-up periods for hedge funds can vary significantly.
Very successful hedge fund managers may be able to command lock-up periods of three to five years. However, the majority of hedge funds have minimal lock-up periods or no lock-up period at all (with a penalty for early redemption in some cases).
Generally hedge funds that do undertake private equity do so via their hedge fund structures or through bespoke subsidiary entities under their hedge funds (rather than via a typical private equity BVCA LP structure).
A key issue for an investor in a hedge fund that moves into private equity is liquidity. If the hedge fund has monthly or quarterly redemptions how will the hedge fund manager monitor portfolio valuations / yields across the traditional hedge fund portfolio and private equity portfolio and maintain sufficient liquid assets to deal with any investor redemptions. What you do not want as an investor is a hedge fund manager having to liquidate good positions / investments because too high a level of the fund is ‘trapped’ in illiquid private equity.
The differences outlined above, while emphasising the need for careful due diligence by the investor also highlight that investors should be careful not to adopt a formulaic approach to due diligence as different strategies may require different questions of the hedge fund manager.
Elizabeth Stone is tax director and Rebecca McGerty is tax manager with PricewaterhouseCoopers in London