Last year proved to be another break-through year for structuring fund-linked investment products in the U.S. Guidance from the Securities Exchange Commission, along with historic U.S. pension fund reforms, allowed dealers to structure closed-end fund-of-funds platforms that offer both institutional and retail investors leveraged access to single-manager hedge funds. Investment inflows in the U.S. reached several hundred million U.S. dollars in 2006 alone, as investors continued to seek alpha across alternative asset classes and in the fund space in particular.
The SEC issued a no-action letter to a fund manager (July 10, 2006) that expanded prior guidance when structuring hedge fund-linked investments for pension plans, foundations and other tax-exempt investors. The fund manager sought approval for a multi-tiered structure that provides fund access to U.S. tax-exempt institutional investors and non-U.S. investors, but also to U.S. retail investors who meet the "accredited investor" threshold. Separately, the SEC has proposed raising the "accredited investor" threshold from USD1,000,000 net worth to USD2,500,000.
The fund manager proposed the following three-tiered, master-feeder structure (see chart 1):
* a U.S.-organized closed-end investment company, the "Top Tier Fund", registered under the Investment Company Act of 1940 to publicly offer registered securities in the U.S.
* an offshore feeder fund, in this case a Cayman limited duration company, funded by the Top Tier Fund ("Cayman Feeder")
* a U.S.-organized closed-end investment company ("Onshore Master") funded by the Cayman Feeder with a mandate to invest in a portfolio of unaffiliated, onshore and offshore hedge funds
The SEC approved the proposed structure, which provides a number of significant structuring advantages.
First, the structure addresses the tax consequences to tax-exempt clients of investing directly into the Onshore Master. The issue stems from the use of leverage by hedge funds.
Under U.S. tax law, tax-exempt entities generally may not engage in ordinary business activities which are unrelated to their basic portfolio management functions. Clearly, tax-exempt entities would have an unfair advantage if they could generate tax-free revenues while competing against regular, taxable operating companies. The Internal Revenue Service discourages this conduct by levying a tax on any income derived from such ordinary business activities. This income is referred to as "unrelated business taxable income" or "UBTI".
One type of ordinary business activity is the use of borrowed money, for example, when a company obtains bank financing for capital expenditures or other common corporate purposes. While tax-exempt entities typically do not use leverage when investing in a fund, the fund itself often will. The use of leverage by the fund is attributable to the tax-exempt investor due to its status as a partner in the pass-through investment fund vehicle. To address this concern, the structure places a "blocker corporation" between the Onshore Master and the Top Tier Fund.
The use of a corporation, rather than a partnership, essentially converts the leveraged partnership returns, which would be taxable as UBTI, into dividend income from a corporation. Tax-exempt entities are permitted to invest in equities in managing their portfolios and any resulting dividend income is exempt from tax. Similarly, the dividend income received from the Cayman Feeder does constitute UBTI and is not taxable income for tax-exempt entities.
Offering By Cayman Feeder
The use of a "blocker corporation" in this type of structure has been previously blessed by the SEC and the IRS. This structure, however, is unique in that the SEC permitted the Cayman Feeder itself to offer securities via Regulation S to offshore investors simultaneously with a registered public offering by the Top Tier Fund. Regulation S is a widely used safe-harbor under U.S. securities law that allows U.S. issuers to sell securities to non-U.S. investors without the burden of SEC registration and disclosure requirements.
The SEC required the Cayman Feeder to conduct its offering entirely separate from the U.S. offering. The Cayman Feeder's offering could not have any connection with the U.S., could not use any U.S. brokers or advisors or have any telephone or other communications in the U.S. Assuming the fund manager maintained these transactional barriers, the SEC concluded that it would not view the Cayman Feeder's offering as part of the Top Tier Fund's registered U.S. offering
Hedge Funds For Retail
The SEC guidance also highlights the increasing ability to offer single-manager hedge funds to accredited investors. The hedge funds included in the fund-of-funds platform are generally only available to "qualified purchasers," or individuals with at least USD5 million in net worth. The fund-of-funds platform, however, allows accredited investors, who would otherwise be unable to invest directly into these funds, to invest indirectly through the platform. While the platform requires initial investments of at least USD100,000, another structure has sold Top Tier Fund interests in as little as USD25,000 denominations. Moreover, these retail investors are able to access the hedge funds on a levered basis. Under the securities laws, the balance sheet of a registered 40 Act fund may include up to 33% leverage, or USD3 of assets for each USD1 of debt.
Notwithstanding the fund manager's ability to access accredited investors, the structure is not overly burdened with providing extensive disclosure on the underlying hedge funds. The fund-of-fund's offering documentation only identifies the specific underlying funds, the size of the initial investment by the Onshore Master and performance to date. The fund manager is required to provide quarterly reporting of existing fund positions.
Pension Plan Investments
As discussed above, the fund-of-funds platform is specifically designed to accommodate retirement plans and other tax-exempt investors in a tax-efficient manner. Another benefit of this fund-of-funds platform is that, due to its status as a registered 40 Act company, it is eligible for investments from employee benefit plans subject to the Employee Retirement Income Security Act of 1974 ("ERISA"). Traditional hedge funds and other private investment companies, however, generally face substantial restrictions in accepting ERISA funds. President Bush signed into law sweeping amendments to ERISA.
The most important amendment to ERISA now permits a hedge fund to accept a larger portion of retirement plan investments without subjecting the fund to ERISA regulation. Hedge funds and other private investment companies generally conduct their activities to avoid triggering ERISA oversight. ERISA imposes extensive restrictions on investment activities and various fiduciary duties and responsibilities on funds, among other regulations.
Prior to the ERISA amendments, a pension fund could invest in a total of up to 25% of a class of equity interests in a fund without triggering ERISA oversight. For example, assume a hedge fund issues a USD100 million class of limited partnership interests, and USD24 million interests are purchased by a state retirement plan. Because the retirement plan's investment at the time of purchase is less than 25% of that class of limited partnership interests, the hedge fund would not be subject to ERISA regulation. However, if the retirement plan purchased USD26 million in limited partnership interests, all USD100 million of the hedge fund's class of limited partnership interests would be deemed "plan assets" for ERISA purposes, and the hedge fund would be subject to ERISA regulation.
The amendments to ERISA do not increase the 25% limit to 50%, as some members of Congress wanted. Instead, the revised definition of a retirement plan, or "benefit plan investor," now excludes state, local and other government plans. Accordingly, state and local pension plans are now able to invest in more than 25% of the equity of a hedge fund without triggering ERISA. Given that the U.S. public retirement plans oversee approximately USD2.5 trillion in assets, the hedge fund community should expect to see marked increases in funds from this newly available pool of capital.
This week's Learning Curve was written byMatthew Kerfoot,a structurer inHSBC's global structured fund products group in New York.