Some years ago, we had launched a "’40 Act" fund (more specifically a Registered Investment Company, or "RIC" under the SEC’s 1940 Act). This RIC is a fund of hedge funds targeted only to accredited investors, yet allowing for unlimited investors with initial minimum investment amounts far below the typical $1mm+ required by other funds. The first product launched in the early naughts when expanding investor access to hedge funds through traditional retail channels was deemed to be its primary raison d’être. This market of moderately HNW clients looking only a dip a toe into the hedge fund waters proved a reasonable opportunity. Investors were happy with the reduced minimums as well as the fact that this fund had elected to provide 1099 tax reporting, as opposed to K-1s. This was also an important selling point of the fund. 1099s are distributed to investors in January following year-end as opposed to K-1s which get distributed anywhere from February (highly optimistic) to as late as in the summer months, which can be frustrating to investors and their accountants.

All well and good so far, yet despite the simplification of the Form 1099 from an investor’s viewpoint, it poses additional challenges for the fund. Subchapter M of the IRS Code spells out certain needs for a Registered Investment Company, the largest challenges for a fund of hedge funds (or even stand-alone hedge funds) being:

• Quarterly asset diversification testing, and
• Annual distribution of fund profits (else face an excise tax).

The quarterly asset diversification test, while conceptually mechanically simple, requires all underlying managers to divulge their positions on a quarterly basis. The test is made to ensure compliance with the IRS Code’s Subchapter M rule which compels that the RIC fund hold no more than 5% of its assets in a given investment.¹ There are some other concentration tests as well, but this 5% rule is a challenge as it creates the need for the RIC to aggregate all of its investments on a look-through basis.

Outbound portfolio dissemination is not always favorably viewed by hedge fund managers, particularly the smaller ones who may have a policy of non-disclosure, or who otherwise wouldn’t be compelled to disclose (e.g. 13-D filings). This leads generally to a business decision by the underlying manager as to whether to change their stance. In our funds, we have eased the pain somewhat through processes whereby portfolios are transmitted on a confidential basis to a third party service provider to receive portfolios. However, not all hedge funds become converts, which somewhat narrows the investment opportunity set, and could provide some tracking error versus a similar non-registered fund.

The second hurdle comes from the need to determine effectively before the end of December as to what dividend to declare. Simply stated, the IRS Code says that a RIC needs to distribute 98% of its annual income during the calendar year. This requires receipt of reasonably good taxable income estimates early in December from all of the RIC’s underlying fund mangers and aggregation of these amounts. Then a safety margin gets built in, (fingers get crossed), and a dividend gets declared in the final days of the year. In our fund, our investors elect to reinvest the year-end dividend, so fortunately there’s no additional cash movements required. The downside to missing this estimate is a 4% excise tax impounded against any upside variance.

What makes this process work effectively is active communication with the underlying hedge funds to get the best possible data possible. In the following year, a measurement is made on a retrospective basis, as to where the estimates used in compiling the RIC’s dividend compare relative to the actual full year taxable results. Given the volatility of the latter portion of most Decembers (flash crashes aside), it’s impossible to have all mangers be spot-on. Yet given normal distribution patterns, hopefully the late variances to the downside offset those to the upside, and thus an excise tax is avoided.

Challenges aside, we happily still see robust interest from investors for a registered product with 1099 reporting.

^{1 More technically, the 5% restriction is made as to "issuer", which means that all securities of a given company (i.e. equities, bonds, options ) are aggregated together to make the test.}

-Matthew Jenal, Senior Advisor, CADOGAN MANAGEMENT, LLC 

In the ever-expanding area of operational due diligence, a major focus is given to the operational integrity and risk controls of a hedge fund’s service providers. Of specific concern are those firms with direct access and control of a fund’s assets: administrators and custodians. Some level of risk-management comfort is given by a certification of the service provider’s processes by an SAS 70 audit by an independent audit firm. Coming in June 2011, the current SAS 70 examination guidelines will be superseded by Statement on Standards for Attestation Engagements 16, or simply SSAE 16.

Currently, successful completion of a SAS 70 audit represents that a service organization has been through an in-depth audit of their control objectives and control activities, which often include controls over information technology and related processes. In my fund-of-funds firm, we seek this certification from not only our fund’s service providers but also of those for the underlying funds that we invest in. One technical hitch that can arise in getting access to the SAS 70 reports for the external hedge funds’ service providers arises from the fact that the reports are not meant to be distributed beyond the service provider’s direct clients and their auditors. Not a huge hurdle if you can rely upon a representation of the SAS 70 audit, but there’s an increasing the need to see and verify, which may be solved by a disclosure option under the new SSAE 16.

SSAE 16 highly similar to its SAS 70 predecessor again seeks to have the service organization demonstrate the establishment of control objectives and effectively designed control activities. (As part of the migration from GAAP to IFRS, it has complies with the new international service organization reporting standard – ISAE 3402, for the accounting technicians). SSAE 16 will have three reporting levels, identified as SOCs (Service Organization Controls), two of which can enable external distribution of results. Between the migration to international standards and ability for greater dissemination of reports, one can forecast an increase in demand for these audits.

As the demand for attestation as to service provider controls increases, a greater burden increases on the smaller service providers to have audits of their processes and controls. Many operational due diligence personnel are somewhat wary of firms of small scale, as perceived enterprise risk for these firms are higher. For these small firms, an SSAE 16 examination may be a business imperative.

Matthew Jenal, Senior Advisor, CADOGAN MANAGEMENT, LLC

Executive Board Member, HFBOA

Just back from attending the GAIM Ops Cayman conference and there were a couple of interesting observations. While the purpose of this posting is not to provide a review of the conference, in general, attendance was up over the prior year and the mood was generally brighter, with more speakers saying that they were optimistic about the future of the hedge fund industry. 

Comments of note were as follows. One speaker said that some funds that had gated their investors or suspended redemptions entirely were getting feedback from investors that they were pleased with the results of those actions. Many strategies that were mauled in 2008 rebounded strongly in 2009 and had investors redeemed when they wanted to, they would have locked in losses at what is viewed as the low point of the cycle. Quite a change from the uproar that originally greeted the notice of gating/suspension. 

The mania of managed accounts appears to be tapering off. While there are still some investors that will only invest through a managed account, many investors are comfortable with the traditional fund structure-especially when they learn about the additional costs and administrative complexities associated with managed accounts. 

Another observation was that many hedge fund CFOs may be struggling with the implementation of FIN 48. In addition to the technical issues inherent in FIN 48, historically, hedge fund CFOs have been stronger on the accounting side than on the tax side. Most hedge funds are structured as pass thru entities and pay no tax (exceptions are withholding and transaction taxes) so the issues tended to be more focused on tax matters at the individual level (ordinary vs. capital, trader vs. investor, etc.). FIN 48 will force hedge fund CFOs to focus more on international tax issues and potential liabilities associated with structured products.

Sincerely,

-George Roeck
 Managing Director & Chief Financial Officer/Chief Compliance Officer, Agamas Capital Management, LP
and Member of HFBOA Board of Directors