United States: Global Hedge Funds Reach into the Billions

Tremont Capital Management’s TASS Research recently released data that showed 2003 was a record year for in- flows into hedge funds, in particular due to increasing interest from institutional investors. By December 31, 2003, $72.2 billion was invested in hedge fund strategies, leaving the size of the global hedge fund industry at the end of 2003 at $750 billion. The European hedge fund industry has recently seen significant investor interest from larger pension funds. Hermes Investment Management Limited, the manager of the United Kingdom’s largest retirement fund — the British Telecoms pension fund — recently announced plans to allocate £500 million in up to 40 hedge funds, managed by both London- and U.S.-based investment managers.

In the United States, the Massachusetts state pension plan recently allocated $1.6 billion for its first foray into hedge funds. Massachusetts State Treasurer Tim Cahill commented: "Year after year, sophisticated endowments such as Harvard and Yale have demonstrated that hedge funds are a way to get value, especially when markets are down."

Following a U.S. Securities and Exchange Commission (SEC) staff report on hedge fund regulation issued in September 2003, five SEC commissioners convened on July 14, 2004, to determine the next step. The report’s main recommendation was that investment managers of hedge funds should be obliged to register with the SEC. But in a rare display of policy division, the proposal was passed after a reportedly heated meeting by the commissioners on a 3:2 vote, with Republican commissioners Cynthia Glassman and Paul Atkins dissenting. Critics of the proposals say the SEC lacks proper funding and should not be concentrating on an area traditionally reserved for sophisticated investors. U.S.-based investment managers will not be the only ones affected. European-based investment managers of hedge funds who target U.S. investors will need advice on whether they need a SEC registration in addition to their local registrations, such as regulation by the UK Financial Services Authority. The proposal does not apply to the venture capital industry.

A hedge fund or a fund of hedge funds must be structured to enable not only the investment manager to implement the fund’s investment objective, policy and methodology, but also to ensure the target investors regard the structure chosen as tax efficient. Hedge funds will typically be "open-ended," meaning investors can buy their investment from the fund and sell it back to the fund regularly, usually at net-asset value. Two vehicles of choice for hedge funds are the corporate and the limited partnership. UK and continental European investors often invest in shares allowing them the potentiality to roll-up income and capital gains, tax free, at the level of fund. U.S. tax-exempts also prefer the opacity offered by a corporation enabling them to avoid tax on unrelated business taxable income (UBTI), for example, if the fund uses leverage.

Concerns of European and U.S. tax-exempts and U.S. taxpayers can be met through the use of integrated fund structures. This is where master feeder terminology becomes relevant. Master feeder funds can comprise, say, a limited partnership and a corporate limited partner (a one-legged structure) or a master fund that holds the investments into which self-standing limited partnership and corporate vehicles feed (a two-legged structure). Integrated structures cost more to establish and, where a manager wants to access the U.S. market, it may be worthwhile to canvass key U.S. potential tax-paying investors to see whether they would be willing to invest in a corporation having made the qualified electing fund election. 

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