Evolution in Hedge Fund Structures

Special situations

Originally published in the April 2009 issue

2009 marks the 150th anniversary of the publication of On the Origin of Species by Charles Darwin. It is also an appropriate time to reflect on the genesis and development of hedge fund structures, especially where they invest in illiquid assets. The legal structures of hedge funds, and the performance fees charged by their managers, have taken a different evolutionary path from those used in private equity funds, in recognition of the different types of investment activities and underlying assets.

This article examines whether, as hedge funds move further into the special situations field, and given the current political and regulatory climate, they would be better served in copying their private equity counterparts.

Traditionally, hedge funds have carried out short term trading activities where profits are recycled, and have charged annual performance fees based on the increase in the NAV of funds under management. Because the underlying investments are liquid, investors are themselves entitled to come in and out of the fund (at NAV) at periodic intervals throughout its life.

Where a fund with a UK based investment manager pursues a trading strategy, it has to be structured to fall within the investment manager exemption(IME) to avoid the risk of the fund’s profits being subject to UK tax. One of the conditions for the IME essentially requires that the annual promote (performance fee) has to be recognised in the UK as a fee each year where it is ultimately subject to employment income tax and NICs when paid out to executives. These features have resulted in hedge funds with UK based investment managers typically being established as companies based in tax havens, such as the Cayman Islands.

By contrast, private equity funds have typically been structured as (tax transparent) limited partnerships. This, and the fact that they invest in illiquid assets, has three immediate consequences.

First, because the assets are difficult to value, the performance fee (“carried interest”) is only paid on a cash basis, i.e. no performance fee is paid until investors have themselves been repaid their original investment, often with an additional performance hurdle. In the UK, carried interest is typically paid on a “fund as a whole” rather than a “deal by deal” basis.

Second, because the underlying assets are illiquid, after an initial 9-12 month period during which further investors are allowed to be admitted at cost (plus interest), no further investors are admitted to the fund, and the only agreed way for an investor to exit prior to the end of the life of the fund is to find a purchaser for its interest.

Third, because the fund is investing and not trading, where it has a UK investment manager, it does not need to rely on the IME to avoid UK tax on the profits of the fund. This (combined with a tax transparent structure) allows the carried interest to be delivered not as a fee, but as a share of the underlying profits of the fund, including capital gains realised on the disposal of investments.

This and other factors can give rise to lower effective rates of tax for private equity executives in relation to their carried interest. These rates are available to hedge fund executives whose funds invest rather than trade. The distinction between delivering promote in the form of a (capital gains based) profit share as opposed to a fee will be increased if the proposed increases in UK higher rate income tax (to 45%) and NIC rates (by 0.5%) are implemented in 2011.

More diverse asset classes
Hedge funds are now investing in more diverse asset classes, often acquiring illiquid assets as longer term investments. Where the fund has a UK based investment manager, the fact that it is investing and not trading means that it does not need to satisfy the IME. This and the fact that more of its profits are likely to be in the form of capital gains increases the potential advantages for both the investors and the executives of a tax transparent (limited partnership) fund structure. Therefore, while limited partnerships have been the vehicle of choice for private equity funds for some time, they are now increasingly being used as the vehicle for hedge funds investing (as opposed to trading) in other asset classes.

Additionally, as the nature of the assets invested in becomes more illiquid, it can make the typical hedge fund economic terms outlined above less appropriate, and those more usually found in private equity funds more suitable. Securing long term commitments from investors provides the fund with more security enabling it to pursue longer term investment strategies to fruition.

Furthermore, in the current climate, the private equity model of rewarding performance over the life of the fund based on actual realisations rather than annually based on increases in NAV might be seen as more appropriate, particularly given the additional difficulties and potential conflicts of interests in valuing illiquid assets in fluctuating markets.

There may be other advantages of hedge funds adopting more private equity type terms and structures. First, the regulatory environment on both sides of the Atlantic is becoming more hostile to typical hedge fund structures. Both the EU and US are proposing tighter regulation of hedge funds and a crack down on tax havens. It is quite possible that private equity structures might escape the worst of these measures.

Certainly, while the scope of recently proposed legislation in the US and the proposed regulatory framework in the EU is uncertain, the aim is very much at the hedge fund, rather than private equity, industry as demonstrated by the name of the “Hedge Fund Transparency Act” in the US, the recent pronouncement from the EU finance ministers in Berlin and, in the UK, the report of Lord Turner, the Chairman of the Financial Services Authority. This coupled with the current negative political climate in relation to the perceived short termism of the bonus culture in much of the financial world suggests that the private equity model may well be in the ascendant.

Finally, a UK managed hedge fund does not need to adopt a purely longer term investing strategy to access the benefits of a limited partnership structure. For funds which both invest and trade, a hybrid structure can be set up with the investments being made by a master limited partnership and the trades by a tax haven subsidiary of the partnership, and the benefits outlined above can still be achieved.

It was Herbert Spencer, the English polymath, who coined the phrase “survival of the fittest” although it is Darwin who will be best remembered for it. In the fund management industry, those funds that evolve structures to suit the assets they invest in and adapt their terms to ensure the interests of the manager and their investors are aligned, may find themselves better placed to succeed in the new regulatory climate.

Stephen Sims is a partner in the Investment Funds and Financial Services Group at Macfarlanes LLP where he advises fund managers and investors on the structuring, establishment and operation of private funds and their incentive arrangements.

Damien Crossley is a partner in the Corporate Tax Group at Macfarlanes LLP where he advises on the establishment of private equity and similar funds and related co-investment and carried interest arrangements and on the structuring of pan-European investment transactions.