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Law at the Speed of Business

Private Funds - An Overview.

Introduction

A hedge fund is an investment vehicle that pools private capital and invests in securities and other instruments. The name comes from the fact that many, but not all, hedge funds use leverage as part of their investment strategies. Some examples of leverage include obtaining financing, purchasing on margin, selling short, entering into repurchase agreements or acquiring derivative or synthetic instruments.

Hedge funds, depending on their investment strategies, hold a range of investments in their portfolios. Some hedge funds invest solely in stocks and other equity-linked securities; others invest in debt securities, convertible securities or distressed debt; still others invest in foreign currencies, futures and forward contracts, swaps and a range of other financial instruments. Within any of these categories, a hedge fund may hold multiple long and short positions in securities of the same issuer or in highly-correlated securities of different issuers. Depending upon the type of hedge fund, the success of an investment strategy may depend less on the direction of the equity or debt markets as a whole and more on the changes in the relative values of the various long and short positions in the fund's portfolio. In other hedge funds, the success of a strategy may depend upon the ability of the portfolio manager to identify and exploit pricing anomalies in the market.   

Characteristics of Hedge Funds

Some key characteristics of hedge funds are that they:

• Operate so as not to be subject to regulatory requirements for registered investment companies under the Investment Company Act of 1940 (Investment Company Act) many of which are intended to protect retail investors;

• Are privately offered under an exemption from registration under the Securities Act of 1933 (Securities Act);

• Primarily invest in liquid assets;

• Are “open-end funds” in that they permit investors to subscribe and redeem at regular intervals (typically quarterly or monthly) at prices that reflect the then-current valuation of the fund's assets;

• Calculate incentive or performance-based fees on increases in the valuation of the fund's assets;

• Do not seek to raise a specific amount of capital (although minimum investment amounts are common);

• Do not have single dominant investment strategy, although many seek to obtain returns that are not correlated to equity, debt or other market returns and instead seek to obtain an “absolute return” in a variety of market environments;

• Often are organized by portfolio managers that also maintain a substantial equity investment in the fund, and so share in the increases and decreases in the valuation of the fund portfolio with other investors; and

• Only disclose holdings and other trading data with investors to the extent agreed as part of the investment, with no public disclosures required.

Alternatives to Hedge Funds

Other Private Funds

The term “private funds” refers to all funds that operate so as not to be subject to regulatory requirements under the Investment Company Act, and are privately offered under an exemption from registration under the Securities Act. The following are some common private funds that are not hedge funds.

Private Equity Funds

• Primarily invest in illiquid assets;

• Generally are formed with the intent of funding specific investments, often with a set amount of capital being subscribed for and requiring that investors make capital commitments on a single or a limited number of closing dates;

• Require investments for a set period of years or until a trigger event occurs; and

• Generally purchase large positions in growth-stage companies or use capital structuring techniques to acquire mature companies that the fund views as inefficiently capitalized or operated.

Real Estate Funds

Real Estate Funds are generally similar in form to private equity funds but invest specifically in real estate assets, usually for development purposes.  

Commodity Pools

While many hedge funds invest in both securities and commodities, commodity pools only invest in futures, forwards and options in the commodities markets (including agricultural commodities, petroleum products, metals, currencies, interest rate securities and securities indices).

Separate Managed Accounts

Some investment managers manage their clients’ funds through individual accounts rather than through investing in pooled investment entities.

Managed accounts allow managers to individualize each client's portfolio. Because the brokerage account typically is in the client's name, a managed account allows the client greater access to information about the account and the composition of the portfolio.

On the other hand, because managed accounts do not pool the assets of several investors, managed accounts generally have smaller amounts of capital to invest and may not have access to certain investment opportunities that larger pooled investment entities may have.  

Registered Investment Companies

Funds that are registered investment companies under the Investment Company Act also may be referred to as “retail funds” because the funds must be offered and operated in a manner appropriate for retail, rather than institutional or high net worth individual, investors.  

Mutual Funds

Open-end retail funds, commonly referred to as mutual funds, are pooled investment vehicles that generally continuously offer shares to the public. Open-end retail funds issue redeemable securities, which means that except in extraordinary circumstances, on shareholder demand a mutual fund must redeem the shares at net asset value and pay redemption proceeds within the requisite time period.

As opposed to hedge funds, mutual funds are subject to specific regulations regarding, among other things:

• Leverage – limiting the amount to which a mutual fund's investments may be subject to leverage;

• Investment concentration – limiting how much can be invested in any one investment;

• Liquidity – requiring a certain amount of liquidity in the investments;

• Redemption – requiring that the fund's shares are redeemable at all times;

• Conflicts of interest – requiring that there be no actual or potential conflict of interest among the various service providers to a mutual fund;

• Specific disclosures regarding fund management, investments, fees, expenses and performance; and

• Pricing – there are specific rules on how the net asset value of the mutual fund's investments are calculated.