HEDGE FUNDS:

A BASIC OVERVIEW

DEFINITION: HEDGE FUND

Hedge Fund a lightly regulated investment vehicle that may use a variety of investment techniques and may invest in a vast array of assets to generate higher returns for a certain level of risk when compared to conventional investments.
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HEDGE FUND OVERVIEW

Reduced regulatory oversight Private in nature Often more aggressive investment strategies Absolute-return funds Directional funds Short Selling Leverage Greater investment flexibility Performance fees or incentive allocations Frequently substantial investment by advisers and portfolio managers Tax benefits from funds structure

REDUCED REGULATORY OVERSIGHT

Do not have to register with the U.S. Securities and Exchange Commission (SEC), National Association of Securities Dealers (NASD), or Commodity Futures Trading Commission (CFTC) Some hedge funds nonetheless elect to register with these governing bodies

Registered or not, hedge funds cannot commit fraud, participate in insider trading, or violate other local, state, or federal law

 Private securities offering, i.e. not registered under federal or state securities laws Under current law, cannot be offered or sold to the general public, must be limited to:
Accredited investors individuals with net worth of at least $1 million or an annual income of $200,000 ($300,000 for a married couple) Qualified purchasersindividuals, trust accounts, or institutional funds with at least $5 million in investible assets

PRIVATE IN NATURE

Rationale: people with high net worth generally understand investment risks and returns better than the average person and can afford to lose money if the investment does not work out

AGGRESSIVE INVESTMENT STRATEGIES

Absolute return fundsdesigned to generate steady return regardless of what the market is doing
More appropriate for a conservative investor (wants low risk and willing to give up some return in exchange) Generate bond-like returns (in long run returns higher than bonds, but lower than stocks)

Directional funds funds that dont hedge fully by maintaining exposure to the market, but trying to get higher than expected returns from the amount of risk taken
More appropriate for an aggressive investor (willing to take some risk to gain potentially higher returns) Generate stock-like returns Not as steady as absolute return funds, but over long run returns are higher
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AGGRESSIVE INVESTMENT STRATEGIES (CONTINUED)

Short sellingwhen securities look like they will go down in price, you borrow them from investors who own them and then sell the securities in an attempt to buy them back at lower prices to repay the loans Leverage borrowing money to increase return, relative to the amount of money the fund has
Fund has to repay the loan regardless, so can increase risk Funds may sometimes use leverage for low-risk investment strategies to increase the return without taking on undue risk Key difference between hedge fund and other investments which are not permitted to employ leverage

GREATER INVESTMENT FLEXIBILITY

Portfolio manager may employ a broad array of investment techniques that are not permissible for a tightly regulated investment vehicle Generally not constrained in investment activities by diversification requirements applicable to mutual funds
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PERFORMANCE & MANAGEMENT FEES

Industry standard 2 and 20 arrangement fund manager receives an annual fee of 2% of the assets in the fund and an additional bonus of 20% of the years net profits
May be different percentages, but management fee + bonus is standard Management fee typically mean to cover operating expenses Manager only receives a bonus if the fund makes money Performance fees frequently conditioned with a loss carryforward provision, whereby no fee is paid on profits that replace prior losses

PERFORMANCE & MANAGEMENT FEES (CONTINUED)

Key difference in hedge fund versus other investments (SEC prohibits mutual funds from charging performance fees) Downsides:
After accounting for fees, a hedge funds outsized performance relative to other investments may be reduced If a fund has a negative year, manager has incentive to close the fund and start over instead of foregoing a performance fee while recovering prior losses

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SUBSTANTIAL INVESTMENT BY ADVISERS AND MANAGERS

Managers usually become partners with the investors by making significant investments of their own into the fund or by paying the funds organizational expenses Financial commitment by managers can be important in attracting outside investors, as the fund manager carries the same investment risks as the investors and both groups interests are, therefore, aligned

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TAX BENEFITS
Flow-Through Tax Treatment: Unlike a LP, a corporation is taxed on its profits and its shareholders pay taxes on any dividends they receive double taxation. LPs, however, act as flow through entities and no tax is paid at the entity level. Instead, the LPs members are individually taxed on their allocable share of the entities income, gain, or loss (whether or not distributed or realized). Accordingly, each member receives a report of their allocable share on Internal Revenue Service Form 1040, Schedule K1, and similar state tax forms, issued by the LP.

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SAMPLING OF HEDGE FUND STRATEGIES

Long only Long/Short Market Neutral Short-Bias Macro Sector Convertible Bond and Convertible Arbitrage Fixed-Income Arbitrage Credit Funds Event-driven Arbitrage Distressed Securities Energy Funds Emerging Markets Crossover Funds Managed Futures
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LONG ONLY
Purchase and sell securities Does not sell short very often, if at all

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LONG/SHORT
Take both long and short positions in securities Seeks to benefit from fund managers view on undervalued/overvalued assets in the market instead of directional movements in the market

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MARKET NEUTRAL
Similar to long/short strategy Seeks to eliminate or minimize impact of the market on the funds return
Relies almost entirely investment analysis on portfolio managers

Various techniques:
Take offsetting positions in same security Take long and short positions in same types of securities
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MARKET NEUTRAL (CONTINUED)

Different ways to be neutral:
Beta Neutral fund has same level of overall market risk in long and short positions Dollar neutral fund has same overall dollar amounts committed to long and short positions Sector neutral fund has same dollar amounts committed to long and short positions within each sector or industry

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SHORT-BIAS
Invests primarily in short positions, focusing on identifying overvalued stocks to sell short
Selling stocks short Buying put options Selling stock index futures

Almost always net short the market

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MACRO
Seeks returns in major changes in global economic or financial trends May use a high degree of leverage Relatively volatile May take positions in several types of instruments
Securities Currencies Commodities Derivatives

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SECTOR
Focuses in particular economic/financial sectors industries or

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CONVERTIBLE BOND AND CONVERTIBLE ARBITRAGE

Invests in convertible bonds (bonds that can be converted into the issuers stock at a certain price) Provides a degree of exposure to equities with controlled risks
Aims to generate profits while protecting itself from risks

Often take positions in both convertible bonds and underlying equity of a company
May separate convertible bonds into constituent debt and equity parts, keeping some portions and selling others May purchase distressed convertible bonds or use credit derivatives to protect against credit risk, depending on how aggressive or conservative the fund strategy is

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FIXED INCOME ARBITRAGE

Seeks to take advantage of price inefficiencies between debt instruments (mortgage-backed securities, corporate, and government bonds, and interest rate derivatives)
Cross credit arbitrage simultaneous long and short positions in debt securities of different issuers to profit from differences in their credit quality Capital structure or balance sheet arbitrage simultaneous long and short positions in debt securities of the same issuer Convergence trades designed to produce profits as perceived inefficient prices converge over time

Because of small profit potential on each investment, the fund often uses a significant amount of leverage to enhance returns

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CREDIT FUNDS
Extends credit to various companies

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EVENT-DRIVEN ARBITRAGE
Seeks to profit from price differences of securities involved in announced corporate events (ex., mergers, acquisitions, restructuring) Major risks:
Possibility of transaction failing to be completed Difficulty and expense in borrowing shares to sell short Lack of mergers or other transaction critical to the strategy

To protect against risks, fund diversifies risk across many sectors and transactions

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DISTRESSED SECURITIES
Sometimes referred to as Vulture Funds Investing in distressed securities, seeking to profit from special opportunities
Bonds, loans, trade claims, receivables, or equity of companies in severe economic distress, possibly facing bankruptcy, reorganization/restructuring or recapitalizations

Often limit investor withdrawals by imposing a lock-up period because the lengthy amount of time it takes to turn a profit on these securities and the funds holdings illiquid nature

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DISTRESSED SECURITIES (CONTINUED)

Second lien loans direct loans to struggling companies, taking short positions in the company stock or playing an active role in any workout of the company Orphan equities acquire restructured equity in companies which trade at discounted rates since analysts and markets dont follow them Loan to own when holding substantial amounts of distressed securities, may end up owning the company if it becomes insolvent When issued basis trade securities about to be issued in a reorganization on a when issued basis

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ENERGY FUNDS
Focus on various aspects of green technology and resource industries
Commodities
Crude oil, natural gas, coal

Green technologies
Emission and carbon trading Renewable energy

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EMERGING MARKETS
Investing in equities or fixed income securities of corporate or sovereign issuers in emerging markets High risk/ High return
Greater potential for significant price appreciation Increased Illiquidity Increased Volatility Foreign laws and regulations governing trading can add significant risks and costs
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CROSSOVER FUNDS
Seeking opportunities in others fields (convergence) Hybrid between hedge fund and private equity fund
Seeks to profit by holding publicly traded and private securities

Greater investment flexibility, broader range of potential investment opportunities Frequently longer lock-up periods than other types of hedge funds

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MANAGED FUTURES
Futures and options on futures contracts Generally is considered a commodity pool by the CFTC Commodity pool adviser and any trading advisors must be registered, absent an exemption

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HEDGE FUND STRUCTURE

Fund Manager may do all trading and research himself or hire a staff to give him advice:
Traders execute buy-sell decisions, operating in real time Analysts make projections about future value of securities

Fund Administrator Investors Legal Counsel help navigate regulations, registration obligations, exemptions and compliance responsibilities Other Consultants advise investors, monitor fund performance, and market fund managers to new clients

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HEDGE FUND STRUCTURE (CONTINUED)

Usually structured as Limited Partnership (but could also be an LLC)
General partnercontrols the fund Limited partners invest in the fund
General Partner Manage (and frequently invest in) the fund Limited Partnership Limited Partner Limited Partner Limited Partner
- Custody - Reporting - Settlement - Other services

Portfolio Transactions

Invest Prime Broker 32

FUND MANAGER/ GENERAL PARTNER

Responsible for the overall management of the funds assets and portfolio investments Many managers whose funds invest in securities are registered as investment advisers with the SEC under the U.S. Investment Advisers Act of 1940 (Advisers Act) or under state law, although there are some exemptions to registration

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PRIME BROKER
Provides general manager with centralized custody, clearing and settlement, execution of portfolio transactions, reporting, financing, securities loans and borrowing, record keeping, access to securities offerings, marketing to new investors, and other services from one source Even though prime broker holds all the funds assets, manager can still trade with a variety of broker dealers similar to a bank custodial account
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ADMINISTRATOR
General administration for LPs and LLCs:
Monthly calculation of the net asset value of the fund Maintaining capital accounts for fund participants Tracking deposit and payment of funds as funds designated custodians Facilitating, upon instructions from fund, the payment of fees and expenses of service providers and fund management Maintaining the customary financial and accounting books and records of the fund

General administration for offshore corporations:

Day to day administration, reporting, and business of the fund Determining and notifying fund management of net asset values of fund overall, each class, each series of each class, and the relevant net asset values per share as well as the issue and redemption price of shares and number of shares in issue Tracking deposit and payment of funds as funds designated custodians Preparing letters for a directors signature or facilitating the authorization of payments of fees and expenses of service providers and fund management Maintaining the customary financial and accounting books and records for the fund

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ADMINISTRATOR (CONTINUED)
Document review Subscription processing for domestic funds Share registry for offshore corporations Provide portfolio details with monthly brokerage statements, performance reports, investors reports, underlying managers reports, Maintain records for fund accounting and cash activity Audits and tax preparatory work Administrative records Exercise financial controls

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LEGAL COUNSEL
Provide advice concerning appropriate structures and entity creation Draft offering documents, partnership/membership agreements, and subscription agreements Register investment advisor with the Securities and Exchange Commission or one or more state securities division(s), including drafting of Form ADV, and/or commodity pool operator registration with the National Futures Association, as necessary Provide tax advice, including treatment of ERISA plans and other tax-exempt investors Submit Regulation D, Rule 506 Form D and blue sky filings with applicable state securities divisions Draft related documents, such as side letter agreements, subadvisory agreements, etc.

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AUDITORS
Provide investors with independently audited annual financial statements Various jurisdictions require periodic audited financial statements Providing audited statements can be an easier way for the fund manager to comply with certain custody requirements under the Advisers Act
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SUMMING IT UP
Private in nature with limited regulatory oversight May use a variety of aggressive investment techniques Objective is to generate higher return on investments for the amount of risk taken compared to conventional investments Usually set up at a Limited Partnership or Limited Liability Company Involves a team consisting of the fund manager, investors, prime broker, administrator, auditors, and legal counsel

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DISCLAIMER
This presentation was made for informational purposes only. Malik Law Group LLC is not providing legal advice to any user. Malik Law Group LLC is not providing tax advice. This presentation is subject to the Circular 230 Notice on the next slide. This presentation does not establish an attorney-client relationship between Malik Law Group LLC and the user. Any discussion herein is not a substitute for seeking actual legal advice from a licensed attorney with knowledge of the rules and regulations governing the industry. Malik Law Group LLC makes no representations, guarantees, or warranties as to the accuracy, completeness, currency, or suitability of the information provided via this presentation. This presentation may be considered attorney advising in some jurisdictions.

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DISCLAIMERCIRCULAR 230 NOTICE

CIRCULAR 230 NOTICE. THE FOLLOWING NOTICE IS BASED ON THE U.S. TREASURY REGULATIONS GOVERNING PRACTICE BEFORE THE U.S. INTERNAL REVENUE SERVICE: (1) ANY U.S. FEDERAL TAX ADVICE CONTAINED HEREIN, INCLUDING ANY OPINION OF COUNSEL REFERRED TO HEREIN, IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY ANY TAXPAYER FOR THE PURPOSE OF AVOIDING U.S. FEDERAL TAX PENALTIES THAT MAY BE IMPOSED ON THE TAXPAYER; (2) ANY SUCH ADVICE IS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS DESCRIBED HEREIN (OR IN ANY SUCH OPINION OF COUNSEL); AND (3) EACH TAXPAYER SHOULD SEEK ADVICE BASED ON THE TAXPAYERS PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISER.

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