A hedge fund is a common name for a collective investment scheme, designed to pool investors’ money for a specific purpose.
Just to give you a flavor of what we are talking about, here are a few things you could potentially do with an offshore hedge fund:
- Raise $5 million between 30-40 investors to develop a leveraged long term real estate buy-to-let fund aimed at capital gains. The fund manager (you) could choose to take his fee in shares with a view to participating himself in the fund’s profits.
- Raise EUR 1 million from a group of 10 investors who want to participate in the foreign exchange market (forex) with the help of a professional trader, on a quarterly, half-yearly or annual term. The fund manager charges a fee for setting it up.
- Pool investments in a ‘fund of funds.’ Under this arrangement you simply collect the initial capital and then invest it all in one or more professionally managed funds, rather than managing it yourself. This way there is very little risk or work involved, but you can charge a fee and provide greater privacy and asset protection to your investors. You can also allow them access to funds they might not be able to access themselves due to high minimum investments, or restrictions on investors from certain countries like the US, UK or Japan.
An offshore hedge fund is one that is specifically set up established in a tax haven jurisdiction.
Unlike those run in major onshore countries (the USA and UK in particular are major onshore hedge fund centers), offshore hedge funds typically benefit from a ‘light touch’ regulatory approach. This is because they are aimed at experienced or sophisticated investors.
These sophisticated financial professionals are deemed to be capable of assessing their own risks better than regular retail investors, so they need less investor protection.
Professional investors are generally sophisticated individuals who manage their own or their families’ money on a more-or-less full time basis, or regulated financial managers working for others, or in many cases the investors are financial institutions themselves, such as offshore banks.
Offshore hedge funds, at the basic level, are surprisingly simple and cheap to set up. For entrepreneurs who would like to manage other people’s money and charge a fee based on performance, a hedge fund may be the answer. If you think you have a good investment proposal, in a matter of just a few days you can put together a hedge fund offering, and raise the capital needed to continue from the international markets.
Whilst of course financial regulation is a serious matter, and for the largest funds regulation is attractive, necessary and enhances credibility, this report particularly focuses on how you can legally set up and structure an unregulated hedge fund.
Open and Closed End Funds
Hedge funds broadly fall into two categories: open ended funds and closed ended funds. The terminology is used loosely and the definitions of each vary slightly between jurisdictions, but broadly an open ended fund is a typical mutual fund – it has a continuous offering of securities which can be bought and redeemed at the fund’s current net asset value with limited redemption restrictions.
Closed ended funds on the other hand, are private equity and venture capital style funds which tend to have a limited offering period, a time when no new investors can invest and restricted rights to a return of capital and profits before the closure of the fund.
Where the intended asset classes are illiquid investments, for example real estate developments or film finance, then valuation and redemption opportunities are less frequent, so a closed end fund is particularly appropriate – but in principle there is no reason why a closed end fund cannot also be used for liquid investments or even cash equivalents.
Closed end funds, are of course a lot easier to administer and are therefore recommended for ‘newbies.’ You do not have to calculate a net asset value every day and deal with the instability of constant cash flow in and out. Instead, your investors have to commit for a certain period of time, and during that time you can be sure their funds are available to you or your trader. Your accounting could easily be done with an off-the-shelf book-keeping program or probably even just with Excel spreadsheets. For the rest of this report we will focus on Closed End Funds.
A closed end fund, by the way, should not be mistaken with a Closed Fund. Closed funds are mutual funds that have been closed temporarily or permanently to new investors because the fund’s asset base is too large to execute its investing style.
Master Feeder Funds
The master-feeder structure is an important way for asset managers to capture the economies of scale of managing a larger pool of assets all at the same time, while tailoring investment funds to separate market niches. The retail investors putting up the capital invest directly in a ‘feeder’ fund. One or more feeder funds then pool their portfolio within another vehicle – i.e. there are several smaller feeder funds and one master to which they contribute. This is also sometimes called the hub and spoke structure.
You might wish to work with a number of different promoters who go out and market asset management services to investors. These promoters could ‘white label’ the funds, ie put their own name, brand and logo on them, and deal with the onshore compliance issues in their own markets. You would then pool the assets from these feeder funds into one or more master funds.
For a U.S. taxable investor, the master-feeder structure has a particular value. The ownership of shares in what is known as a passive foreign investment company or PFIC can prove to be a very expensive proposition taxwise. An offshore hedge fund may well meet the definition of a PFIC, but a properly structured master fund will not, so the transaction is set up so that the master fund is a partnership for U.S. tax purposes. This makes it an effective insulation between the US based investor and the PFIC feeder.
A Master-Feeder fund structure may be open end, requiring regulation, or closed end which as we have said avoids most regulatory requirements.
Umbrella funds using protected cell companies
Although most offshore hedge funds permit themselves a full range of investments for
maximum flexibility and agility, for practical purposes they typically specialize in a particular area: such as equities, bonds, currencies, particular geographical areas or market sectors.
You might desire additional flexibility, however, to offer investors a choice of portfolio mix. There is a way to allow a choice of asset classes with the option to switch between asset classes at minimal cost. This is where segregated cells within an Umbrella Fund come in handy.
A segregated portfolio company (or SPC), also referred to as a protected cell company, is a special type of company which segregates the assets and liabilities of different classes, or
sometimes series, of shares from each other and from the general assets of the company. A segregated portfolio company is broadly equivalent to the Series LLC that is well-known in the U.S.
Segregated portfolio assets comprise assets representing share capital, retained earnings, capital reserves, share premiums and all other assets attributable to or held within the segregated portfolio.
Only the assets of each segregated portfolio are available to meet liabilities to creditors in respect of that segregated portfolio; where there are liabilities arising from a matter attributable to a particular segregated portfolio, the creditor may only have recourse to the assets within that segregated portfolio.
Under the laws of some jurisdictions where the assets of a segregated portfolio are
inadequate to meet that portfolio’s obligations then a creditor may have recourse to the general assets of the SPC, but not those assets which belong to a different segregated portfolio.
You could arguably achieve the same result by using a whole series of different companies, but the key advantage of the SPC is that it makes administration much easier.
An SPC is a single legal entity, so investors in one portfolio can easily switch to another portfolio
without having to sign new contracts and without affecting their tax positions back home, since the investment is always held within the same company. These ‘sub-funds’ also offer a ‘menu’ from which investors can pick and choose on a pooled basis when they may have no access individually.