Equitable Distribution and Hedge Funds

Hedge Fund Structure

In order to understand the way a hedge fund operates, and ultimately to determine the value of the hedge fund management entities, it is important to understand the structure of a typical hedge fund. The term “hedge fund,” broadly defined, refers to a structure of at least three companies: 1) the Management Company (or investment manager), which manages investors' assets together with 2) the General Partner (or GP), and 3) the Fund, itself. There may also be one or more offshore funds for non'U.S.-based investors or U.S. tax-exempt investors, and the hedge fund may also have separate “managed accounts” for large investors.

In a typical hedge fund, capital is raised from accredited investors, as defined in the Securities Act of 1933. These investors usually have similar investment objectives, and the Fund's investment objectives, along with the types of securities in which the Fund will invest, should be set forth in the Fund's offering documents (i.e., a Confidential Private Placement Memorandum and/or Subscription Agreement).

Provided the prospective investor agrees with a fund's investment objectives, as set forth in the agreements mentioned above, the investor will subscribe to the Fund and commit a certain amount of capital to the Fund. A capital account is then created for each investor, in order to track the performance of each investor's capital (i.e., for bookkeeping and fee-charging purposes), and the capital of several investors is pooled into a Fund, which for a typical domestic fund is organized as a Limited Partnership (or LP). The hedge fund's General Partner also has an interest, and therefore, a capital account, in the LP. The LP typically enters into an investment management agreement with the Management Company, which defines the roles of the Management Company and the GP, and gives the Management Company the authority to manage the Fund's assets on a discretionary basis.

If the subject company hedge fund is attempting to attract offshore or tax-exempt investors, it may also establish an offshore fund. An offshore fund may give rise to deferred fees, which present additional issues for a valuator.

A hedge fund's principal or principals typically keep a large portion of their own net worth in the Fund itself to assure investors that they have confidence in their ability to manage the Fund's assets effectively. The fair market value of a principal's direct investment in the Fund(s) will be reflected in monthly capital account statements issued by the hedge fund's third party administrator. The value of the principal's capital account is separate from the value of the operations of the hedge fund.

Management of the Fund and Structure of Fees Charged

The Management Company and the GP manage the assets pooled in the Fund. The Management Company's staff makes investment decisions regarding the allocation of the Fund's assets. In many hedge-fund structures, control over the day-to-day operations is concentrated among one, or at most, a few investment professionals. In other words, the hedge fund's founder(s)/principal(s) make most of the investment decisions.

The Management Company charges investors a base management fee of 1% to 2% of AUM. This base management fee is charged on the amount of capital in each investor's capital account, and will be charged regardless of whether or not the capital account appreciates in value.

In addition, as defined in the hedge fund's offering documents, the GP of the Fund is entitled to receive a performance fee of (usually) up to 20% of the appreciation in an investor's capital account in a given year, subject to high watermark provisions. In many hedge fund structures, the sole role of the GP is to collect the incentive fee income.

A “high watermark” refers to the highest value of the assets that each partner's capital account has reached, exclusive of additional capital contributions. The following is a simple example of a high watermark: Suppose I contributed $100 of capital to a fund. My beginning capital account balance for the year would be $100. During Year 1, my capital account grows to $120, after base management fees are charged. The GP is entitled to receive a 20% incentive or performance fee, based on the $20 appreciation in the account in Year 1. Thus, in Year 1, the GP is paid an incentive fee of $4 ($20 appreciation x 20%), and my beginning capital for Year 2 is now $116.

Now, let us assume that in Year 2, as a result of poor market performance and bad investment decisions, the value of my capital account at the end of Year 2 fell to $105. In Year 2, I will still be charged the base management fee (charged regardless of performance), but I will not pay an incentive fee to the GP, because my return on investment was negative in Year 2. Thus, the high watermark for my investment is $116, and as a result, my capital account will not be charged incentive fees until the value of my account eclipses the $116 high watermark set in Year 1. The above example illustrates the unpredictability, volatility and high risk associated with the incentive fee income stream.

In next month's issue, we will discuss several methods for valuing hedge funds.

Steven Cusumano is a senior associate in the forensic accounting and business valuation firm of Klein Liebman & Gresen, LLC (KLG). He assists attorneys, judges, accountants, and business owners in forensic accounting, business valuation and litigation support matters. Contact him at [email protected]. KLG website: www.goKLG.com. This article also appeared in The Matrimonial Strategist, an ALM sister publication of this newsletter.

Over the past two decades, notwithstanding the recent economic downturn, the alternative investment industry has grown at a rapid pace, in terms of dollars flowing into the funds from investors, and the overall number of funds. Many former portfolio managers and managing directors of large investment banks have left their former institutions to establish hedge funds and other alternative investment outfits. These professionals are lured by lower levels of regulation and the ability to earn higher levels of income at an alternative investment firm than at a traditional investment bank.

Hedge funds now comprise a large portion of the alternative investment industry, and in connection with equitable distribution statutes, the valuation of a hedge fund management company and General Partner are becoming more important. Determining the proper value to ascribe to these interests is complex, and as will be discussed below, matrimonial attorneys should be aware that the value of an individual's interest in a hedge fund is often greater than just the value of his or her capital account. Additionally, given the turbulent economy, and specifically the volatility in the financial markets over the last three-plus years, hedge fund valuation presents several challenges in the field of business valuation for the purposes of equitable distribution.

Valuing an individual's interest in a hedge fund management company and/or general partnership is different from valuing an interest in an operating company, a professional corporation, or even an investment management company. The main challenge for valuators is the fact that hedge fund managers earn income two ways: from base management fees (typically 1% to 2% of assets under management, or AUM) and incentive fees, which are based on the performance of the assets in the fund (typically around 10% to 20% of the appreciation, subject to certain hurdle rates and a high watermark).

Hedge Fund Structure

In order to understand the way a hedge fund operates, and ultimately to determine the value of the hedge fund management entities, it is important to understand the structure of a typical hedge fund. The term “hedge fund,” broadly defined, refers to a structure of at least three companies: 1) the Management Company (or investment manager), which manages investors' assets together with 2) the General Partner (or GP), and 3) the Fund, itself. There may also be one or more offshore funds for non'U.S.-based investors or U.S. tax-exempt investors, and the hedge fund may also have separate “managed accounts” for large investors.

In a typical hedge fund, capital is raised from accredited investors, as defined in the Securities Act of 1933. These investors usually have similar investment objectives, and the Fund's investment objectives, along with the types of securities in which the Fund will invest, should be set forth in the Fund's offering documents (i.e., a Confidential Private Placement Memorandum and/or Subscription Agreement).

Provided the prospective investor agrees with a fund's investment objectives, as set forth in the agreements mentioned above, the investor will subscribe to the Fund and commit a certain amount of capital to the Fund. A capital account is then created for each investor, in order to track the performance of each investor's capital (i.e., for bookkeeping and fee-charging purposes), and the capital of several investors is pooled into a Fund, which for a typical domestic fund is organized as a Limited Partnership (or LP). The hedge fund's General Partner also has an interest, and therefore, a capital account, in the LP. The LP typically enters into an investment management agreement with the Management Company, which defines the roles of the Management Company and the GP, and gives the Management Company the authority to manage the Fund's assets on a discretionary basis.

If the subject company hedge fund is attempting to attract offshore or tax-exempt investors, it may also establish an offshore fund. An offshore fund may give rise to deferred fees, which present additional issues for a valuator.

A hedge fund's principal or principals typically keep a large portion of their own net worth in the Fund itself to assure investors that they have confidence in their ability to manage the Fund's assets effectively. The fair market value of a principal's direct investment in the Fund(s) will be reflected in monthly capital account statements issued by the hedge fund's third party administrator. The value of the principal's capital account is separate from the value of the operations of the hedge fund.

Management of the Fund and Structure of Fees Charged

The Management Company and the GP manage the assets pooled in the Fund. The Management Company's staff makes investment decisions regarding the allocation of the Fund's assets. In many hedge-fund structures, control over the day-to-day operations is concentrated among one, or at most, a few investment professionals. In other words, the hedge fund's founder(s)/principal(s) make most of the investment decisions.

The Management Company charges investors a base management fee of 1% to 2% of AUM. This base management fee is charged on the amount of capital in each investor's capital account, and will be charged regardless of whether or not the capital account appreciates in value.

In addition, as defined in the hedge fund's offering documents, the GP of the Fund is entitled to receive a performance fee of (usually) up to 20% of the appreciation in an investor's capital account in a given year, subject to high watermark provisions. In many hedge fund structures, the sole role of the GP is to collect the incentive fee income.

A “high watermark” refers to the highest value of the assets that each partner's capital account has reached, exclusive of additional capital contributions. The following is a simple example of a high watermark: Suppose I contributed $100 of capital to a fund. My beginning capital account balance for the year would be $100. During Year 1, my capital account grows to $120, after base management fees are charged. The GP is entitled to receive a 20% incentive or performance fee, based on the $20 appreciation in the account in Year 1. Thus, in Year 1, the GP is paid an incentive fee of $4 ($20 appreciation x 20%), and my beginning capital for Year 2 is now $116.

Now, let us assume that in Year 2, as a result of poor market performance and bad investment decisions, the value of my capital account at the end of Year 2 fell to $105. In Year 2, I will still be charged the base management fee (charged regardless of performance), but I will not pay an incentive fee to the GP, because my return on investment was negative in Year 2. Thus, the high watermark for my investment is $116, and as a result, my capital account will not be charged incentive fees until the value of my account eclipses the $116 high watermark set in Year 1. The above example illustrates the unpredictability, volatility and high risk associated with the incentive fee income stream.

In next month's issue, we will discuss several methods for valuing hedge funds.

Steven Cusumano is a senior associate in the forensic accounting and business valuation firm of Klein Liebman & Gresen, LLC (KLG). He assists attorneys, judges, accountants, and business owners in forensic accounting, business valuation and litigation support matters. Contact him at [email protected]. KLG website: www.goKLG.com. This article also appeared in The Matrimonial Strategist, an ALM sister publication of this newsletter.