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The C corporation could be used to structure a hedge fund investment so that investors could not be called upon to invest more than their original 73... In fact, this type of structure i

CHAPTER 5 Hedge Fund Business Models

Although a hedge fund is viewed by an investor as the portfolio of ments that provide a return, it may in fact be composed of two or moreseparate businesses The structure and division of labor of the businessesare not arbitrary The design of the hierarchy creates a limited liability in-vestment for all investors and is tax efficient

invest-TYPES OF BUSINESS UNITS

To understand the typical hedge fund business structures, it is necessary tofirst discuss the building blocks Bear in mind that small variations existfrom state to state in the United States because the individual states autho-rize the creation of business units Fortunately, the rules are similar in moststates; these business structures have been adopted by all or nearly all the

50 states The structures commonly used to create hedge funds are ally available in international locations, as well, although the makeup ofoffshore hedge funds typically combines these business types differently

gener-C gener-Corporation

The most familiar business structure to most people is the C corporation.Most of the large companies in the United States and many of the small andmedium-sized companies are structured as C corporations This type ofstructure is also commonly used in many other countries

The C corporation sells ownership stakes called common stock A Ccorporation can have practically an unlimited number of owners Theseowners can be spread over many classes of common stock plus preferredstock

The C corporation could be used to structure a hedge fund investment

so that investors could not be called upon to invest more than their original

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paid-in investment In fact, this type of structure is usually used for hedgefunds when the funds are located in areas with low or no income taxation.

In the United States, however, the C corporation is seldom used to ture a hedge fund due to the double taxation of investment returns Hedgefund management companies (the actual employees who invest the money)are organized separately from the investment assets and may be structured

struc-as a C corporation

Professional Corporation

The professional corporation is used to structure businesses comprised ofcertain professionals—medical, legal, financial services, architectural,and other professionals The laws governing the professional corporationdiffer from state to state Some state laws might allow a manager tostructure the management company as a professional corporation, ratherthan a C corporation, but it is unlikely that a hedge fund (the investmentassets) would be structured as a professional corporation

Limited Liability Corporation

The limited liability corporation (LLC) is a relatively new business ture; it has been approved in 48 of the 50 states in the United States Itmay be taxed as a corporation or a partnership Nearly all businessesstructured as LLCs elect to be treated as partnerships to receive flow-through tax treatment The LLC structure also allows all investors, in-cluding the fund sponsors and managers, to limit their liability to theircommitted investment

struc-Sole Proprietorship

The sole proprietorship is the default structure an individual ends up with

if no effort is made to structure a business as a partnership or corporation.The owner of the sole proprietorship also retains unlimited liability for theliabilities of the business So, despite a possible tax advantage over a cor-poration, a sole proprietorship is not used in the hedge fund industry

Partnership

There are several variations on the partnership structure The variationsare fairly similar and closely resemble the general partnership in most re-gards In particular, all partnerships (and several other business structures)

are taxed the same as a general partnership A partnership may be createdformally, but a partnership is the default business structure when two ormore individuals or businesses cooperate to create a business A partner-ship receives flow-through tax treatment and may or may not report thebusiness income as self-employment income.

The two most important partnership structures are described next.The differences primarily involve the scope of liability of the investors.General Partnership A general partnership has only one category of part-ners, and there must be at least two partners The general partnership re-ceives flow-through tax treatment, avoiding the double taxation of thereturns All partners are wholly liable for the obligations of the partner-ship For hedge funds, this means that investors could be required to as-sume liabilities beyond their investments in the hedge fund, if the fundloses more than 100 percent of the capital under management

limited partnership) resembles a general partnership, except that oneclass of partners (the general partner or general partners) has unlimitedliability for the obligations of the partnership and a second class of part-ners (the limited partner or limited partners) has no liability for the oblig-ations of the partnership beyond the investment committed to thepartnership A limited partnership must have at least one general partnerand one limited partner

The limited partnership is a good structure for a hedge fund in a able domicile because the structure avoids double taxation of investmentreturns and can create a limited liability for the hedge fund investors Thegeneral partners assume unlimited liability for the obligations of the hedgefund, but, as described in Chapter 5, the general partner can be a businessentity with a limited capital base that effectively removes the general liabil-ity risks

tax-Limited Liability Partnership The limited liability partnership (LLP) is verysimilar to an LLC but is used to organize the professional practices of ac-countants, lawyers, and architects California first created the LLP struc-ture, and to date very few states allow for the LLP structure Although thestructure has flow-through tax status and limited liability, it cannot be usedfor the hedge fund assets because that business unit has few or no employ-ees who are accountants, lawyers, or architects The management companycould arguably be structured as an LLP in some cases, but the LLP is not

an important business model for hedge fund managers

CREATING LIMITED LIABILITY INVESTMENT POOLS

Investors who buy certain types of assets (notably real estate) may borrowmoney that could create a situation where investors must commit addi-tional capital or otherwise repay debt obligation In contrast, when buying

a common stock, bond, or mutual fund, an investor can rely on losing nomore than the committed investment Hedge fund investors would also like

to limit their exposure to their committed capital

Need for Limited Liability

An investor in a common stock has made an equity investment in a ration The corporation may have issued debt in addition to stock Thisdebt creates leverage because the value of the assets is greater than thevalue of the equity In the absence of default, equity holders receive all thegains if the assets rise in value and suffer all of the losses if the assets de-cline in value Assets, however, sometimes decline in value by more thanthe total amount of equity If losses exceed the capital of the corporation,lenders begin to share in the losses because equity holders cannot be re-quired to invest more than their original paid-in investment

corpo-This corporate structure would seem to work well as a structure for alevered pool of investments Structured as a corporation, a hedge fundwould be a limited liability investment that could use leverage, but the in-vestors would never be required to make additional investments, even inthe event of default Further, the borrowings to finance levered hedge fundpositions resemble corporate borrowings

Indeed, the corporation is a common structure to use to organizehedge funds located in low-tax or no-tax domiciles In areas with substan-tial corporate taxation, this structure often results in double taxation of in-vestment returns For this reason, hedge funds organized where theinvestment returns are subject to corporate taxation (certainly, the UnitedStates and Europe) use partnerships or other business structures that passtaxable income through to investors without paying tax as a fund (seeChapter 10) Those partnerships or other limited liability entities mayleave the hedge fund sponsors with considerable liability losses from badinvestment returns in the investment portfolios

Who Bears the Loss in a Hedge Fund Default?

Hedge funds often invest more than their capital in assets and may haveshort positions For either reason, hedge funds may lose more than the cap-ital invested in the fund If a hedge fund loses more than the investors’ cap-

ital, other parties must bear part of the loss, because the fund investors aretreated like equity investors in a corporation They cannot be required to

When hedge funds lose more than 100 percent of their capital, the loss

is shared by the secured and unsecured creditors The secured creditorshave the benefit of collateral, which may greatly reduce the chance of lossdue to the bankruptcy of a hedge fund customer The losses in excess ofpaid-in capital are generally shared by the unsecured creditors and the se-cured creditors (to the extent that their security is insufficient)

Liability of a C Corporation

Figure 5.1 shows the way losses are shared in a C corporation The area ofthe boxes represents the relative size of the assets, liabilities, and equity(also called capital in a hedge fund)

If the assets decline in value, the loss is borne by the equity holders.Just as debt holders do not participate in the rise in asset values, they alsodon’t participate in the losses, as long as there is sufficient equity in thecompany (see Figure 5.2)

If the losses continue, the debt holders may be exposed to risk thatthey will not be completely repaid Figure 5.3 shows how a loss may ex-ceed the equity and result in losses for the debt holders, as well In Figure5.3, losses have exceeded the value of the paid in capital Liability holdersshare in the loss because the equity holders cannot be required to infuse ad-ditional capital and (except in circumstances involving fraud by the equity

FIGURE 5.1 Starting Levels for Asset Values

Equity

holders) can’t be held liable for losses greater than their capital This C poration is bankrupt and the liability holders have effectively become theequity owners of the company.

cor-Limited Partnership

In contrast to a C corporation, the general partners are held liable for theobligations of the partnership Further, all partners remain liable for all theFIGURE 5.2 Balance Sheets after Loss

Equity Loss

FIGURE 5.3 Balance Sheet after Loss Exceeding Capital

Loss

losses up to the total of their net worth regardless of the size of their mitments as partners before the loss.

com-Figures 5.4 to 5.6 shows the balance sheet of a limited partnership.With a limited partnership, the general partners must pay in additionalcapital if losses exceed the paid-in capital Limited partners cannot be re-quired to invest additional capital

FIGURE 5.4 Balance Sheet for Limited Partnership

Limited General Partners Partners

FIGURE 5.5 Limited Partnership Balance Sheet after Loss

Limited General Partners Partners

Loss

Using Two (or More) Business Units to Alter Liability

If a corporation serves as the general partner of a limited partnership, thegeneral partner still has unlimited liability However, the owners of the cor-poration can’t be required to put more money into that business As a re-sult, the ultimate owners of the partnership have liability limited to theircapital investment in the corporation

Figure 5.7 shows the organizational structure of a limited partnershipthat has a corporation as its only general partner The structure may lookunnecessarily complicated It is not necessary if the hedge fund is located in

a low-tax domicile As you will see, structures similar to Figure 5.7 are ical in offshore funds For a domestic fund organized in the United States

typ-or any other country with a substantial ctyp-orptyp-orate income tax, the structure

in Figure 5.7 avoids double taxation of investment returns at least for thelimited partners If the general partner is organized as a limited liabilitycorporation or a subchapter S corporation, the general partner also avoidsdouble taxation of investment returns

Simple Hedge Fund Structure

A simple hedge fund must have a business entity to hold the investmentsplus at least one other business entity to act as manager The manager usu-ally contains all the employees involved with managing, marketing, andoperating the business Figure 5.7 resembles a typical hedge fund organized

FIGURE 5.6 Limited Partnership Balance Sheet after Loss Exceeding Capital

Assets

General Partners Assume Additional Loss

Liabilities

Loss Loss

in the 1990s or earlier in the United States The corporation served as boththe manager and the general partner of the fund Investors invested in thefund as limited partners.

Several variations to the structure in Figure 5.7 have become mon First, fund managers may be organized separately from the businessthat acts as the general partner because a manager may run more thanone fund Each fund is backed by a different general partner, so that thegeneral partnership capital of other funds is protected from the failure ofanother fund Second, with the development of the limited liability struc-ture, the fund may be structured without any general partners Instead,all the investors, including the insiders, invest as shareholders and havelimited liability

com-Who Is Liable?

Hedge funds as a group are less risky than an unlevered investment in mon stocks Some funds do fail because of the risks they have taken, be-cause of failure to effectively control risk, or because of fraud If none ofthe investors in a hedge fund have liability for losses beyond their commit-ted investments, who bears the loss when hedge funds lose more than thepaid-in capital? Refer again to Figure 5.6 If general partners do not make

com-up losses, the decline in value falls on the liability holders

FIGURE 5.7 Basic Structure to Create Limited Liability

A hedge fund has many creditors Broker-dealers are liable on tled trades Financing counterparties generally have collateral to securetheir lending, but rapid changes in asset values can leave secured lendersexposed to default Derivatives counterparties also margin their exposure

unset-to hedge fund default, but the margin may be inadequate If a hedge fundfails, the losses cascade beyond the hedge fund investors

When a hedge fund has investors from many different countries, it isusually efficient to organize the fund in a low-tax or no-tax domicile This

is a tax avoidance strategy but it is not a tax evasion strategy The ence is important By structuring a hedge fund offshore, a French investoravoids paying taxes to the United States but does not avoid paying taxes tothe French government

differ-Figure 5.8 shows a simple structure for an offshore hedge fund Inthis master-feeder structure, a corporation is created in a low-tax or no-

FIGURE 5.8 Offshore Hedge Fund Structure

U.S.-Based Fund

Offshore Fund, Inc.

tax domicile to avoid double taxation of investment returns Some vestors may invest directly in the offshore fund as shareholders This off-shore fund is not controlled by U.S or other securities laws andregulations In order to be accepted as an offshore entity for U.S tax pur-poses, the fund does not accept investments from U.S citizens However,

in-a U.S hedge fund cin-an invest in in-another hedge fund thin-at hin-appens to be in-aforeign asset If constructed carefully, the U.S hedge fund can channelU.S investments into the offshore fund without compromising the off-shore tax status of the main fund Most hedge funds organized today re-semble Figure 5.8

Master-Feeder versus Mirror Funds

The master-feeder fund is also sometimes called a spoke and hub fund.Before this structure was developed, hedge fund sponsors frequently cre-ated separate funds in the host country and offshore (mirror funds; seeFigure 5.9) The manager ran each fund so that each pool contained thesame positions, adjusted proportionally to the size of the fund Maintain-ing a mirror fund is very difficult because every flow into either fund re-quires the manager to rebalance all the investments in both funds

FIGURE 5.9 Mirror Hedge Fund Structure

U.S.-Based Fund

Offshore Fund, Inc.

Futures positions and over-the-counter derivatives are very difficult to balance The rebalancing process is time-consuming and creates the op-portunity for the performances of the funds to diverge.

re-QUESTIONS AND PROBLEMS

5.1 Why is a C corporation not a good choice for the business structure

of a hedge fund in the United States?

domiciled in a tax-free haven?

5.3 With a C corporation, who suffers a loss when the value of the assetsdecline below the value of the liabilities?

5.4 With a general-limited partnership, who suffers a loss when the value

of assets decline below the value of the liabilities?

5.5 What is a flow-through tax entity?

5.6 Explain how a general partner can create a limited liability ment in a partnership

invest-5.7 What is the advantage of setting up a business as the general partner

of a general-limited partnership?

protec-tion against liability above the capital committed to a business?

act as the manager and another unit to act as general partner of ahedge fund?

5.10 What is the main objective of a mirrored hedge fund structure?5.11 Why would a fund sponsor seek to get similar returns in the domesticand offshore mirrored funds?

5.12 Why is a corporate structure often used for an offshore fund, instead

of a limited partnership?

5.13 What advantage does a master-feeder structure have over a mirroredstructure for a fund sponsor needing both a U.S and an offshorefund?

5.14 Why would anyone set up a mirrored structure, given the advantages

of a master-feeder structure?

5.15 What is the correct domicile for setting up a business in the UnitedStates?

5.16 What is the best domicile for an offshore fund?

5.17 What is the key advantage of administering a hedge fund offshore?

1 In reality, the commitments can be more complicated due to contractual tions For example, venture capital funds generally receive commitments to make additional capital contributions These commitments may be enforceable

obliga-in the event of bankruptcy Also, some partnerships require the partners to sign commitments to put in additional money These commitments act to strengthen the creditworthiness of the business.

CHAPTER 6 Hedge Fund Leverage

Over the centuries, many societies have frowned on borrowing money It’snot hard to find evidence of this displeasure in religion and literature In

Shakespeare’s Hamlet, Polonius advises his son to “neither a borrower nor

a lender be.” Islam retains the prohibition against interest rates Outside ofthe financial community (especially broker-dealers, hedge funds, and fu-tures traders), modern society fears selling an asset short (selling an assetwith the intent of repurchasing at a lower price in the future) and re-proaches those carrying short positions Yet borrowing to buy assets hasbecome much more acceptable Corporations rely on debt Consumers fi-nance houses with mortgages Credit cards give individuals the ability toborrow on demand

BACKGROUND ON LEVERING SECURITIES POSITIONS

Securities regulations have historically limited the ability of regulated vestment companies (mutual funds, common trusts, etc.) to borrow money

in-to buy assets or sell securities short While some of these restrictions havebeen relaxed over the past several decades, hedge funds sidestep the limita-tions by organizing in ways that exempt the pools from borrowing restric-tions (see Chapter 8) Certain strategies require no borrowing or shortselling to produce attractive returns; these funds may use none of the tech-niques described here Many hedge funds, however, either borrow cash tocarry positions, sell securities short, or invest in derivative securities thatcreate the same effect in their portfolios In the past, some hedge funds havecarried positions more than a hundred times their capital After the collapse

of Long-Term Capital Management, counterparties began to limit the ity of hedge funds to carry positions so far in excess of their capital.1Hedgefunds that primarily invest common stocks (more than half the hedge fundassets) rarely carry positions more than about twice their capital

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