Securities investment partnerships, often referred to as hedge funds,* offer a means for investors to have their funds professionally managed by some of the hottest stock-pickers in the country. For the highly successful money manager, the financial rewards may be considerably more than could be achieved as a stock broker with full discretionary authority over accounts or as an investment advisor managing separate accounts.

Although their origins go back many decades, hedge funds first became popular in the 1960s. As with any pooled fund, such as collective trust accounts and mutual funds, investors enjoy greater portfolio diversification than available to them individually while at the same time gaining access to professional, full-time portfolio managers. To the observer, hedge funds may not appear much different from public funds, which are widely advertised; however, there are significant differences. Pooled funds are normally managed by investment companies, bank trust departments, pension funds, and insurance companies. Absent establishing a bank or insurance company, a fund manager normally may only commingle funds in an investment company registered with the SEC in accordance with the provisions of the Investment Company Act of 1940, as amended (1940 Act). In addition, securities offered to the public by a regulated investment company must be registered in accordance with the Securities Act of 1933, as amended (1933 Act), as well as state securities commissions, where required, commonly referred to as "Blue Sky" filings.

Management Investment Companies

Management investment companies fall into two categories for 1940 Act purposes. First, the open-end management investment company, known as a mutual fund, issues redeemable securities that are continuously offered and must be redeemable on a daily basis at net asset value per share. The other management investment company, the closed-end fund, issues a non-redeemable security, normally sold to the public in an initial public offering with subsequent liquidity achieved by secondary market trading via a listing on a national stock exchange. However, closed-end funds normally trade at a discount from net asset value in the secondary market. Both open- and closed-end funds registered with the SEC are subject to the rigorous regulatory provisions of the 1940 Act, including prohibitions against affiliated transactions, strict recordkeeping and periodic reporting rules, strict adherence to stated investment objectives and policies, specific capital structure requirements, including limits on leverage, custodial and fidelity bonding requirements, and submission of certain matters to shareholders (which require proxy solicitation in accordance with SEC regulations).

Hedge Funds

In contrast, hedge funds operate largely outside SEC regulation and oversight. To be sure, they are subject to the anti-fraud provisions of the securities laws and the same rules relating to insider trading, reporting of securities holdings in excess of certain thresholds, the provisions of the Investment Advisers Act of 1940, as amended (Adviser's Act), and Blue Sky requirements where applicable. But in most other respects, they must only comply with the appropriate SEC requirements for private placements. Where the manager of a hedge fund happens to be subject to the Advisers Act, because of his other activities (such as management of individual clients' funds), there are some additional strictures (such as custodial and recordkeeping requirements); but they still can operate largely unfettered by regulation. This allows the fund manager to have more freedom over trading strategies.

The organizer-manager of a hedge fund stands to earn substantial financial rewards depending on his success in portfolio management. Typical compensation arrangements call for the following:

* A management fee (usually 1%) based on the fund's net assets, i.e., partners' equity; and

* A performance reallocation (usually 20%) based on appreciation of net assets, determined on an individual investor basis.

The management fee is calculated and paid monthly or quarterly, depending on the provisions of the limited partnership agreement. The performance reallocation is usually calculated annually, which nullifies the effects of interim fluctuations in market value.

Example: A fund had 25% appreciation in net assets for the first half of the year and 10% depreciation for the second half of the year, leaving the portfolio with an overall appreciation of 12 1/2% (125% x 90%) - 100% for the entire year. The 20% performance reallocation would be applied to the 12 1/2%, thereby crediting the organizer-manager with 2 1/2%. If the performance reallocation were done more often than annually, the organizer-manager would have been credited for 5% (25% x 20%) for the first six months, but would not have to return anything for the second period's decline.

This points out a key element that exists with most funds: a high water mark. Fund managers only get a performance reallocation to the extent fund performance exceeds the previously realized high point or is in excess of some other index, e.g., a 4% annually compounded return. Absent this benchmark, the organizer-manager could get performance reallocations on amounts that merely represent recoupment of prior year losses.

Organizer-managers usually come from the ranks of stock brokers or investment advisors with many individually managed client accounts. The administrative ease in handling a fund versus individual accounts and the financial incentives are a great attraction.

The Support Team

To get started, the organizer-manager must assemble a support team:

Securities attorney (with emphasis on 1940 Act and Advisers Act experience)--To prepare confidential private placement offering memorandum and limited partnership agreement and advise on securities, tax, and ERISA matters.

Certified Public Accountant--To setup accounting system and procedures; review limited partnership agreement for provisions having financial significance; conduct annual audit of financial statements; prepare partnership tax return and Forms K-1; advise on operational and regulatory matters.

Primer broker-dealer--To maintain custody of assets; assist in the correct execution of securities trades; generate periodic reports to assist in portfolio appraisals; and acumulate information for financial and income tax reporting purposes.

Regulatory Concerns

Generally, an investment company is required to register with the SEC under the 1940 Act if one of the following is true:

* More than 40% of its assets are in the form of "investment securities," and its outstanding securities are beneficially owned by more than 100 persons (including the number of beneficial security holders of a company owning 10% or more of the voting securities of the investment company).

* It is offering or proposing to offer its securities to the public and is in the business of investing or reinvesting in securities.

Although a hedge fund may intend to be treated as a private unregulated partnership, it may inadvertently become subject to the 1940 Act by crossing one of the above thresholds. For example, if a partnership consisting of 50 partners were to acquire a 25% ownership interest in a hedge fund, the 50 partners would be counted with the hedge fund's direct owners, and if the combined number exceeded 100, the hedge fund would be required to register with the SEC.

The second criterion noted above, dealing with a public offering, underscores the need to issue interests pursuant to a confidential private placement offering memorandum pursuant to the exemption granted under Regulation D of the 1933 Act. Only Rule 506 of Regulation D may be relied upon by an investment company seeking to sell securities in a private placement. That regulation allows for an unlimited number of accredited investors and a maximum of 35 non-accredited investors. When dovetailed with the 1940 Act, a hedge fund may have no more than 100 investors (joint tenants and tenants by the entireties must be counted separately), as defined, of which no more than 35 may be non-accredited. If the hedge fund is seeking performance-based compensation and the fund manager is a registered adviser under the Advisers Act, the Advisers Act requires that only investors with a net worth of at least $1,000,000 or making an investment of at least $500,000 will be qualified. The offering document should disclose matters similar to that found in a mutual fund registration statement including, but not limited to, a discussion of investment objectives, risk factors, regulation, use of proceeds, background on management, tax discussion, and limited partnership agreement.

If a hedge fund intends to have employee benefit plans as investors, it should be aware that the ERISA rules are invoked when 25% or more of the hedge fund's ownership interests are held by employee benefit plans, e.g., pension and profit-sharing plans and IRAs. The ERISA rules subject hedge fund management to a higher fiduciary standard and may require a less aggressive trading strategy than was otherwise planned.

Hedge fund managers and their advisors should also be aware of the income tax rules, some of which may cause tax-exempt entities to be subject to unrelated business taxable income ("UBTI") when leverage is employed or the partnership is treated as a publicly trade partnership which will subject the partnership to taxation as a corporation and cut off flow-through tax benefits.

Entity Selection

A limited partnership is the entity of choice for a hedge fund. In such a partnership, the organizer-manager is the general partner either individually or acting through a corporation. This form offers limited liability to "outside" investors and conveniently accommodates the allocations/reallocations that typically occur with these entities. Also, limited partnerships may not be subject to state income taxation or may be subject to tax at a reduced rate. Contrast these advantages with the drawbacks that result from selecting another form of organization:

General partnership. All partners have joint and several liability, regardless of whether they are active in management.

S Corporation. Limited to 35 investors and one class of stock, as defined. The one class of stock limit may preclude allocations/reallocations of profits.

C Corporation. Subject to two levels of taxation; once at the corporate level and, when income is distributed, again at the shareholder level.

Another possible form for operating a hedge fund is a limited liability company. Legislatures in an increasing number of states, most recently Connecticut and New Jersey, are recognizing this form of business entity, which has the flexibility of a partnership with the limited liability characteristics of a general corporation. As more states pass the necessary legislation, the LLC could become the entity of choice for hedge funds in the future. Note, however, an LLC may be subject to state income tax.

In selecting the limited partnership form, the selection should be respected for income tax purposes. Treasury Regulation 301.7701-2 specifies four basic corporate characteristics that distinguish a corporation from a partnership. These corporate characteristics are 1) continuity of life, 2) centralized management, 3) limited liability, and 4) free transferability of interests. The treasury regulations provide that an unincorporated organization, such as a limited partnership, will not be classified as an association taxable as a corporation unless it has more corporate characteristics than noncorporate characteristics. These regulations have been interpreted to require that an organization possess at least three of the four listed characteristics in order to be classified as an association taxable as a corporation.

The practical implications call for a limited partnership agreement that specifies a limited term (say 20 years); take necessary action to make certain the general partner(s) is not deemed to have limited liability; and only permit transfer of partners' interest with the general partner's approval. A further requirement is the general partner must always maintain at least a 1% interest in partners' capital. Where the general partner is a corporation, additional net worth requirements may have to be met.

Specialized Accounting and Reporting Matters

The AICPA Audit and Accounting Guide, Audits of Investment Companies, should be consulted by hedge fund management and their independent CPAs. Written primarily from the standpoint of registered investment companies, most of its accounting guidance is also applicable to hedge funds. GAAP for these entities require the accrual basis of accounting and the carrying of portfolio position at fair value. Some of the detailed requirements are:

* Basis of recording securities transactions. Trade-date basis with securities valuation as follows:

If traded on an exchange or in the over-the-counter market, at the last sale price or a combination of bid and asked prices, as applicable; if not traded, then management is to make a "good faith" determination of fair value. (See SEC Codification of Financial Reporting Policies, Section 404.)

* Dividends on portfolio securities. Recorded as of the "ex-dividend" date.

* Interest income. Accrued evenly over the period the instrument is held.

* Financial statements. A hedge fund's basic financial statements consist of a statement of financial condition, statement of income, statement of changes in partners' capital, and statement of changes in net assets. The statement of cash flows does not have to be presented when, according to FASB Statement No. 102, all the following conditions are met:

* During the period, substantially all of the enterprise's investments were highly liquid (for example, marketable securities and other assets for which a market is readily available);

* Substantially all of the enterprise's investments are carried at market value;

* The enterprise had little or no debt, based on average debt outstanding during the period, in relation to average total assets; and

* The enterprise provides a statement of changes in net assets.

As noted above, GAAP for investment companies requires all portfolio investments be carried at fair value, and this treatment is explicitly permitted by FASB Statement No. 12 (see paragraph 14). This treatment is continued under FASB Statement No. 115, which supercedes Statement No. 12 Statement No. 115 is effective for fiscal years beginning after December 15, 1993. The resultant unrealized gains/losses are reported in the statement of income as a component of net income. The equity method is inapplicable to investment companies, except where the investment provides facilities or services for long-term operating purposes.

A hedge fund ordinarily allocates net income/loss among its partners based upon their respective partners' capital balances at the beginning of each fiscal period. Where those balances remain unchanged, only one allocation would be required for the entire fiscal year. Consider, however, that many hedge funds, especially start-ups, allow partners to invest more frequently than annually, and partners are often allowed to withdraw some or all of their capital at other than a year-end. In these cases, referred to as "break periods", a determination of net income/loss must be made and an allocation performed for every period where the sharing ratios changed. In essence, a single fiscal year is divided into discrete shorter periods. This concept is illustrated in Exhibit 1.

Income Tax Issues

A hedge fund's securities investing activities, coupled with the limited partnership form, subject it to distinctive income tax rules; primary among these are:

* Trader versus investor classification;

* Allocation of realized gains/losses; and

* Applicability of the passive loss rules.

A hedge fund is ordinarily treated as a trader or investor, and not as a dealer, with respect to its securities and commodities transactions. A trader or investor buys and sells securities and commodities for its own account. On the other hand, a dealer purchases securities or commodities for resale to customers rather than for investment or speculation. In most cases, gains or losses realized by a trader or investor from the sale of securities and commodities are capital gains or losses.

The classification of trader versus investor is subjective and should be based on all pertinent factors. A trader is characterized by frequent purchases/sales of securities and the holding of positions for a short time period to profit from temporary market fluctuations. Conversely, an investor seeks long-term capital appreciation and dividend income from its holdings. Although both types would report realized gains and losses as capital (long- or short-term, depending on holding period), there is disparate treatment of expenses.

As to management fees and other "operating" expenses, a trader reports them as "trade or business" deductions; an investor reports them separately to its partners. In the latter case, they are deductible subject to the 2% limitation that applies to miscellaneous itemized deductions.

As to interest expense allocable to the general partner, a trader would report this item as a "trade or business" deduction; an investor reports it as investment interest expense. Interest expense allocable to limited partners would be treated as investment interest expense in all cases.

Allocation of Gains and Losses

The allocation of realized gains/losses from securities transactions requires special attention. Hedge funds often hold a securities position open over a period that spans more than one fiscal period (or break period). During that span of time, the partners' sharing ratios may have changed. Since tax law generally requires that the gains/losses are only reportable in the period when realized, it may not be proper to allocate realized gains/losses among partners based solely on current year sharing ratios. A frequent practice is to allocate realized gains/losses using the same sharing ratios that were used to allocate the unrealized gain/loss over the period the security was held. This concept is illustrated in Exhibit 2. This approach is termed layering, and in practice requires a computer program developed for this purpose. Other approaches, based on 1) "first-in, first-out" reversals of unrealized gains/losses and 2) percentage of partners' capital, may yield reasonable results depending on a hedge fund's trading style.

Investors in limited partnerships are concerned with the application of the passive loss rules and how they affect the deductibility of losses, if any, that may be reported by an investee. The IRC contains rules designed to prevent the use of losses from tax shelters to offset compensation and portfolio-type income such as interest and dividends. For income tax purposes, a hedge fund's activities do not constitute a passive activity. Accordingly, a hedge fund's income may not be offset against losses from passive activities (including tax shelter losses).

A hedge fund as herein defined files a partnership income tax return and uses a Form K-1 to apprise each partner of his or her distributive share of the fund's results. Because of this "flow-through" of results, it is helpful to apprise investors of their preliminary share of results so they can consider this when preparing their personal income tax projections to comply with the estimated tax rules and for other purposes.

* The AICPA Audit and Accounting Guide, Audits of Investment Companies, defines a hedge fund as "An investment company seeking to minimize market risks by holding securities believed likely to increase in value and at the same time being short in securities believed likely to decrease in value. The only objective is capital appreciation." Although the term thus applies only to funds employing a certain trading style, in practice the term is often used for any securities investment partnership, notwithstanding its trading approach or portfolio composition, and is used here for convenience.