Hedge funds can have various types of fund structures, including open-end funds, closed-end funds, and separate accounts. Hedge funds have no direct investment opportunities per se, as is found with private equity, real estate, and hard assets where there is an ability to directly invest in portfolio companies and properties. In terms of open-end fund structures for hedge funds, there are several subgroupings, including commingled private partnerships,1 registered investment companies (RICs), and separate accounts. There are closed-end hedge fund of funds products that are publicly listed primarily in Europe and exchange-traded hedge fund indexes in the United States. However, closed-end hedge funds do not yet represent a significant portion of capital invested in hedge funds.
Hedge fund private partnerships and separate accounts can be domiciled onshore in the United States or in an offshore tax haven such as the Cayman Islands or the British Virgin Islands. Nontaxable investors in the United States take advantage of offshore funds and separate accounts. For instance, endowments, foundations, and ERISA (Employee Retirement Income Security Act of 1974) corporate pension plans that are subject to unrelated business taxable income (UBTI) liabilities utilize offshore funds. Offshore tax havens also are suitable for non-U.S. investors seeking safe harbor from their domestic tax laws. Whether onshore or offshore, the difference between commingled funds and separate accounts lies in the fact that separate accounts typically are reserved for the largest investors that commit more than $25 million to a hedge fund.
For commingled hedge funds, although initial cash flow subscriptions can be completely accomplished over a short time frame, redemptions may be less predictable. Redemptions depend on initial lockups, quarterly redemption periods, the ability for the manager to gate redemptions if large numbers of investors seek to redeem, and holdbacks of a small portion of capital upon final redemption until the completion of the fund's annual audit. In comparison, a separate account is dedicated to the beneficial interest of only one investor. Furthermore, the investment manager serves in a discretionary role as the effective agent in the management of investments in the separate account, but the investor also has direct authority over the account as the beneficiary. The benefit of the separate account structure is that the investor often is allowed to make immediate cash contributions or withdrawals from the account, in accordance with an investment management agreement with the hedge fund manager. Thus, separate accounts in hedge funds have among the most flexible and predictable cash flow considerations for the range of alternative investments.
Open-end hedge funds that are RICs are also quite liquid and subscriptions to and redemptions from them tend to be quite facile. Nevertheless, the managers of these funds often make it a practice to erect redemption windows that may require initial lockups and advance notice periods prior to redemption. The structure of RICs, which in many respects mirror traditional mutual funds, is such that they can offer liquid terms to investors. However, the underlying strategies of the hedge funds and the securities that they hold can cause the managers to create constraints to redemption. Therefore, in the area of RICs for hedge funds, cash flows into and out of the funds are fairly predictable but often may require some planning.
Hedge funds with long lockup periods reside in the middle of the spectrum for open-end versus closed-end funds, in terms of liquidity and degree of aggravation associated with cash flow planning. For example, hedge funds with lockup periods of three years, although they are technically open-end funds, might be considered hybrid funds that lie somewhere between true closed-end and open-end funds. Consider a hedge fund with a three-year rolling lockup and redemption periods only up to 20 percent of the investor's assets in any one quarterly period thereafter. This construct is the equivalent of a closed-end fund, particularly if the illustrated fund does not have a cleanup provision. Without a cleanup provision, the 20 percent quarterly redemption limitation is perpetual, such that the investor ad infinitum would be able to redeem only 20 percent of its total investment each quarter, not based on the total value of the investment when the initial redemption process began. Even with a cleanup provision, such as a straight-line 20 percent quarterly redemption based on the total amount of investment when redemption was initiated, this example of an open-end fund would only return the investor's total capital in four and one-quarter years. Many investors who may be enticed into investing in long-lockup hedge funds because of fee discounts may not be fully cognizant of the illiquid nature of these investments. The timing of cash flows out of these investments has the propensity to underachieve the cash flow expectations of investors. A rigorous read of the placement documents for these types of funds and the creation of a detailed cash flow and liquidity matrix by the investor in order to track cash redemption privileges from these investments are required. Without such an approach, an investor with a generous allocation to these types of funds is vulnerable to finding a significant cash flow shortfall that affects the ability to rebalance in future years. An inability to effect rebalancing of a portfolio at a minimum will be an embarrassment to the investor, if not a significant missed opportunity to capture or avoid movements in asset classes.
As far as closed-end funds are concerned, examples are few in the realm of hedge funds, but the area is growing as managers of open-end hedge funds seek sources of permanent capital. An early example of a hybrid closed-end hedge fund is structured products. These devices offer investors tax advantages, the ability to leverage hedge fund returns, and a form of insurance on invested principal. In return, the investor enters into often a five-year investment term, with the caveat that the invested capital is returned early to the investor in the event that the underlying hedge fund generates losses of a certain magnitude. Therefore, although the cash inflows into this type of investment are predictable, the cash outflows from the investment have a chance of surprising the investor. Unplanned cash outflows are likely to occur at disadvantageous times, such as in the face of a loss. This would be unfortunate if the investor believes that ultimately the value of the investment will recover.
Two other examples of closed-end hedge funds are public listings of hedge fund organizations and the classic closed-end fund public offerings. In the former case, an investor in these shares benefits from an investment in the management company that operates the hedge fund, rather than as an investor in the related fund. However, there is a linkage between these two opportunities through the performance fee that is paid to the manager of the hedge fund. Strong returns in the hedge fund cause a performance fee that will be paid to the hedge fund manager. Therefore, the buyer of shares in the management company experiences an alignment of benefits with the investors in the underlying hedge fund. Additionally, the investor in the management company benefits from the stability of the management fee paid to the management company and perhaps some sort of related dividend pass-through to common shareholders. This example yields very predictable timing of cash outflows to the investor, but much more proportionally because of the ability to liquidate an investment in the public markets than an ability to capture dividends. Another variation on this investment is private equity seed funds that invest in hedge funds. Although the lockups for these funds are long, the cash flow from the ownership share in the management and performance fees of the underlying hedge funds typically is paid in regular dividends back to the limited partners in these funds, thereby providing predictable interim-period cash flow.
In the case of the traditional closed-end fund public listing of hedge funds of funds, there are instances of this structure primarily in Europe as well as hedge fund indexes listed in the United States. This form of classic closed-end fund enables good secondary market liquidity for the purchasers of these funds. Therefore, cash flows out of the investment are predictable. Interim-period cash flows likely would be nonexistent, but predictable in that sense. The benefit for a hedge fund manager from this structure is access to permanent capital. However, this benefit comes with the vulnerability of being replaced as manager upon a vote by shareholders. The benefit for an investor in this type of fund is complete liquidity, predicable cash flow for portfolio rebalancing, and ostensibly strong corporate governance pertaining to the public listing status of the closed-end fund.
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