NY Metro Hedgefund Law & News

Beware the Small Business and Work Opportunity Act of 2007

OK - this one isn't law yet. It's a bill pending in the Senate introduced on 1/22/07.

One (of a host of items)  basic effect, if passed, will be to cap annual non-qualified income tax deferral to the lesser of (i) average of last 5 years compensation or (ii) $1 Million. Yes, there is a provision adjusting in the case where there is not 5 years of compensation.

This will set the hedge fund manager world on its ear if passed. Successful hedge fund managers who are generally sufficiently well advised to navigate the infamous Sec. 409A of the Internal Revenue Code - another nightmare of tax complexity - are accustomed to deferring way, way over $1 M per year. So this bill is not going to make them happy campers - if it becomes law.

The slated effective date is now (i.e. for tax years beginning in 2007). Folks who've overcooked their 2007 deferral election will apparently be allowed to remedy it down to the mere $1 M.

So us legal types will be keeping our eye on it. Currently the bill (S. 349) is on the Senate legislative calendar. The rumor mill says that this one has "legs". We shall see.

GAIM Day 3

Last day of GAIM today.

Lots of activity in the AM but late afternoon sessions were cancelled. Not so nice for the tail end speakers. Of course, the rule of thumb is that you don't want to be speaking toward the tail end of any conference. Still cancellation before the scheduled time? Plus the workmen for the venue were tearing the joint down when conferences were still scheduled. So....all kinda weird.

So anyhow from today's notes:

Big funds - trouble with returns (too low).

Asia Pacific - why go there:

• values from inefficient markets
• far less sell side analytical coverage - takes pressure off interim short term earnings
• no Reg FD
• not correlated to US
• even easing up on shorting restrictions

Wilbur Ross - Sort of the King of Distressed

• heavy due diligence process before they go in
• lots of foolish $$ in the distressed biz
• low defaults are masking overbought conditions
• sees default doubling or tripling in 2007 and again in 2008
• sees all time hi in Chapt XI in 2009

Predictions/comments re Hedge Fund Regulation:

• general sense the regulators don't know really how to do the job
• admiration expressed for UK approach to regulation
• expects that some type of risk reporting will emerge, e.g. a leverage metric, a liquidity metric
• more calls for regulation seen as forthcoming in 2007

There was a whole session devoted to increased correlations of hedge fund returns with broader market returns. Some of the factors giving rise to this were deemed as structural (long term) and others as cyclical (short term). For now this is a bit of an issue for the industry.

There was a session on some of the big brokerages making hedge funds available for their customers. Sounds like very early days for all of them - and it really sounds like quasi-mutual funds.

One theme that does arise - the big hedge funds are not interested in "small" retail investors - read that as a $5M order or less.

There were a few legal type topics discussed in the afternoon sessions. I am going to defer discussion of some of them.

There was however a very interesting discussion of fees. The bottom line is that the standard 2/20 is probably pretty negotiable.

A few fee pricing drivers are worth noting:

• quant/black box stuff which sort of runs itself get lower fees
• active alpha producing strategies call for higher fees
• side letters - a big investor can cut a deal for a lower fee than other investors through a side letter - however, this scares the lawyers (like me!!)
• lock ins call for lower fees than more liquid situations

Creative fee structures:

• lower fee (or no fee) for beta - this is a little controversial since beta is often arrived at synthetically through derivatives - which require some skill/capacity to set up
• higher fee for alpha - issues here will focus around metrics - i.e. how do you know its alpha (Sharpe ratios? Information return? etc.)

All in all an interesting day and a good (if not without flaws) conference.

GAIM Day 2

Here's todays report (from my notes). Heard today:

Bonds don't have tail events (c.f. Enron)

Go for brick (brazil, russia, india, china) - cynics say brick is finished.

Hedge fund replication is a crock.

Need to know how to pay for alpha/exotic beta. Don't pay for garden variety beta.

US stocks and bonds vastly overvalued.

A few niches FOFs (funds of funds) are looking at: reinsurance, "bricks" (see above), commodities, private equity, direct lending, the activists.

Alpha, alpha, alpha - catch it if you can.

Pensions and endowments - looking to hedge funds for alpha.

Risk budgeting is replacing asset allocation.

Decompse your risk.

Spain is dipping its toes into hedge funds - seems not really ready yet - unions are big market drivers.

The new Fair Value measurement rules - hedge fund folks you need to learn what Level 1, 2 and 3 assets are. Avoid Level 3 if you can. Effective for fiscal years beginning after 11/15/2007.

Structured credit - incomprehensible.

New fund looking for seed capital? If you can't miss and will let us run you we might be able to do business.

The rouble is going through the roof vs. don't trust anything in Russia.

And now a few editorial comments:

Not to knock it - lots of smart people - but invariably the best money managers go to the big big money investors.

Thus, your average Joe millionaire (soon to be Joe $2.5M sans house) probably will in fact do best being extremely cautious in dealing with hedge funds.

The big investors ($1B and up) are maybe putting up to 15% of their portfolios into this and they are getting the cream of the managers. There are niches for small investors of course  (outside of FOFs) but it's going to be in very risky stuff with unproven managers.

However, if you start small - 5% of your portfolio (this is $125K if you are worth $2.5M liquid) in, for example, a good FOF you just might get some alpha or at least exotic beta for your management fee.

Caveat: I am not an investment adviser. This is a free non-professional (as to investment advice) blog. I hope to entertain my readers and pass along some of what I heard today. Any enlightenment given is purely coincidental. My opinions in today's blog are purely those of a private investor.

GAIM Day 1

Well Day 1 of the GAIM USA Hedge Fund Conference is history.

From my notes:

Buy corn, fertilizer, aluminum.

Short Coke, Pepsi - they are going to pay more for aluminum cans.

Non-Japan Asia - a big buy.

Likely best 2007 strategy (by audience vote) equity long/short.

Forget mirroring of hedge fund strategies.

Activist funds deal pain to inept old fogey boards and management.

State pension plans looking for alpa from hedge funds - maybe 15% of portfolio.

Event driven to rock as deal cycle just starting to really kick into gear - abroad even more so than US.

Global Macro/CTA - our day will come.

We can make you money in Vietnam.

China, China, China!!!

We've got the metrics on risk measurement.

US Stocks no good - gotta go foreign.

Japan banks ready to move up.

REITS way way way overpriced.

Oils gotta move up.

In short - loads of fun.

Stay tuned for Day 2.

GAIM Conference

Next week is the GAIM USA 2007 hedge fund conference in Boca Raton, Florida. This is generally regarded as "the" big annual industry meeting.

Yours truly will be in attendance at the 3 day event and certainly hopes that  it will live up to its reputation. Lots of fund managers are slated to be there presumably presenting their latest investment ideas and stratagems. So that should be interesting - although of course I don't expect anything of a proprietary nature will be formally disclosed.

However, being a legal and regulatory sort (and not a money manager) I will especially be interested in such topics to be discussed as model industry regulations, the latest trends in hedge fund fee structures, and dispute resolution for those cases when things do go sour. These are sort of "hot" regulatory topics in the industry.

In my upcoming blogs, with full respect given to any confidential "off the record" matters, I hope to discuss some of what I have learned at the conference.

In the meantime, while at the conference, I might even do a video upload to You Tube of me with a spot on my sense of each days events  from my hotel room in Boca. (Hmm "boca" = "mouth", "raton" = "mouse" - there's meaning in that somewhere.)

Anyhow, it should be exciting (for me anyhow :)).

US Taxes to Offshore Funds on Credit Derivatives?

An interesting Article  * appeared in today's WSJ dealing with the uncertain tax consequences to offshore funds purchasing credit swap derivatives in the secondary markets. At stake is whether non-US investors in the funds, or in some cases the funds themselves, are liable for US taxes on any profits from the transactions.

This is an area of extreme tax law technical difficulty (kind of like a double diamond ski trail). Technically, and to simplify greatly at the risk of some inaccuracy, the issue is whether such offshore hedge funds can (i) avail themselves of the Code Section 862(b)(2) safe harbor from US taxation (for non-US persons) by characterizing credit swap derivative transactions as trades in a security  or (ii) whether the bogeyman of Reg 1.864-4(c)(5) steps in to make such transactions a US taxable event as the conduct of a US lending business by the hedge funds. A lot of complex case law is also out there on this issue which also helps to make this area technically tough going indeed.

However, even after I considered what I had learned of the "law", my knee jerk reaction was to wonder how, as a matter of fact, the purchase of a credit swap on  secondary markets could be anything other than a securities trade by the offshore hedge fund. It turns out that I needed to learn (or relearn) a little bit about how credit markets function in this day and age.

The old days when your friendly banker made you a loan (e.g your home mortgage) and then held on to it for 30 years to collect as you repaid over time are long gone. Your friendly banker doesn't hold your paper for (likely) more than a day or two after closing. Instead, it gets bundled off (with a bunch of other loans) into a security which is sold by your friendly banker into  secondary credit markets.

Financial institution loans to big borrowers (like public companies) often work the same way. In fact, from day one before the loan is even made there may well be a loan syndicate consisting of  a lead lender and a number of other financial institutions. Eventually (hopefully) terms are agreed upon, the  loan closes, and thereafter the syndicate may unload a lot (or all) of the loan paper in the "secondary market" to purchasers via loan swap agreements. Often, very big players (read purchasers) in this secondary market are offshore hedge funds.

Put differently, in home mortgages and corporate loans, banks don't really lend any more. So where does this leave the answer to the  question, for example, of who is originating the loan or at least for whom is the loan being originated?

Arguably, in many cases, the answer is the hedge funds who are sucking up the paper in the secondary markets.

It may be, for example, that the hedge fund is on a banking syndicate's "speed dial" because it is a "regular" in the secondary market and stands ready to buy loans that the syndicate wants to unload quickly. Some hedge funds (at least historically) have been alleged to do as many as 5 of these deals a month - and likely not for pocket change.

Stated in broad terms, in such cases, the banker and syndicates can be viewed as shilling these loans for the hedge funds. If so, that may well put the offshore funds involved into taxable territory on these transactions - i.e. for being in the lending business.

Indeed, I have read that - in 2005 - 20% of the secondary market for credit derivatives was hedge funds. So,  it would seem beyond peradventure that the syndicates are designing these loans and their derivatives with hedge funds in mind. Hedge funds are also regular players in the markets for collateralized debt obligations which are derivatives backed by credit derivatives.

There is more, much more, that can be mentioned if not endorsed. For example, nasty things have been written about incestuous relationships between banks and hedge funds. There are even things said (nothing I have seen substantiated) about possible abuse (e.g for arbitrage) of insider information the funds get from being "creditors" via the swap arrangements. 

Certainly,  I would be surprised to see if a rule is made extending "securities" treatment (and hence a pass from US tax) to all of these credit derivative transactions engaged in by offshore funds. However, anything can happen. In the meantime, this is going to be an area where uncertainty rules.

*My thanks to the author of WSJ article who was kind enough to direct me to some of her source material. Any mistakes in this post are mine not hers.

New SEC Proposals - The Blogosphere Starts to Speak

Already (besides me) the blogosphere is starting to speak on the SEC proposed accredited investor definition change for hedge fund investors and proposed hedge fund anti-fraud rules.

Have a look at two such comments - to my mind each pretty well written: Fintag (you'll have to scroll down a bit on "his" (I assume) page to get to to the article) and Rossputin. Catchy names.

Throw into the mix as my broadside of the day - a what's the protection anyhow in a global economy where your average American mere millionaire can perhaps do this "exotic" hedge fund stuff offshore or abroad where he/she is not "protected"? Are we simply going to lose more of our financial business to abroad from over regulation?

The inquiring mind wants to know.

Technorati Profile

SEC Hedge Fund Proposed Rule Release re Fraud and Accredited Investors

The SEC has released its full text (click to get it and likely an accompanying headache) on the proposed hedge fund rules regarding fraud and changes to accredited investor standards. The accredited investor standards change is likely to draw most of the attention - although there is kind of a nasty non-scienter catch (you don't have to "know" you are misleading investors) to the anti-fraud rules.

In case you've been on Mars lately (or have better things to do) the accredited investor standard is to be lifted from $1M in net worth (including home equity) or $200K income ($300K with spouse) as specified to adding an additional (sorry if I am being redundant but not if the SEC is) requirement of $2.5M in net worth exclusive of home equity.

In turn (using somewhat dated numbers) this-  per the SEC - will reduce the % of the US population qualifying as accredited investors from 8.4% of US households to 1.3% of US households.

The chief persons likely to quake in their boots at the new accredited investor rules are entrepreneurial (read "small") hedge funds who fear that they won't be able to recruit new investors meeting the much elevated $2.5 M net worth (ex home equity) standards of the new rules. Worse, for funds relying on the accredited investor standards, their old accredited investors might not be able to invest more capital in the funds if the investors don't meet the new accredited investor standards. Apparently, the rules at least are not retroactive, so old investors who don't meet the new standards don't have to be ignominiously booted out of such funds as being mere millionaires.

Before full panic sets in perhaps a few calming  (and hopefully relatively user friendly) if admittedly preliminary thoughts are in order.

1. The new rules are not final. There is to be an extensive public comment period lasting until March 9, 2007. It would be surprising if those comments did not result in at least some changes to the proposed rules - hopefully with some "relief" to entrepreneurial advisers. The SEC, for example, seems open in the name of an exclusion for "venture capital" funds to giving a "pass" from the new accredited investor standards to funds that will lock up investor capital for a stated minimum period (e.g. 2 years).

2. Provided heightened disclosure and other requirements of Reg D are met, hedge funds are still going to be able to accept up to 35 non-accredited investors (i.e. persons who don't have to meet for federal standards any minimum net worth or minimum income requirements) and still be within the non-registration safe harbor of Reg D.

3. For the truly bold funds (which often equates to the truly small) a reliance on the Section 4(2) (non-public offerings) registration exemption of the US Securities Act without the comfort of the safe harbor of Reg D may be a "risk" worth taking. For such funds, provided state law registration exemptions can at least arguably be obtained in the states where their individual investors reside, the $2.5M federal minimum net worth standard will not be a show stopper.

Stay tuned as there will be more - much more - on this forthcoming from all quarters. However, for now, I would not proclaim the small hedge fund dead.

Happy 2007.

On to Kurtosis

Kurtosis describes the shape of a random variable’s probability density function. Consider the three curves shown in the chart below (click the chart to expand it into a pop up).

The chart illustrates the notion of kurtosis. The red curve has the highest kurtosis. It is the most peaked at the center and has wider tails. The blue curve is in the middle. The green curve has the least kurtosis. It is flatter at the center and has the narrowest tails.

Incidentally, one can’t tell from looking at the chart which curve has the highest or lowest standard deviation*. The red line is more peaked at the center, which might lead one to believe that it has a lower standard deviation. It has fatter tails, which might lead one to believe that it has a higher standard deviation. If the effect of the peakedness exactly offsets that of the fat tails (or vice versa in the case of the green line), each curve will have the same standard deviation.

A normal random variable (the blue curve) has a kurtosis of 3 irrespective of its mean or standard deviation. If a random variable’s kurtosis is greater than 3 (the red curve), it is said to be leptokurtic. If its kurtosis is less than 3 (the green curve), it is said to be platykurtic. Leptokurtosis is associated with densities that are simultaneously “peaked” and have “fat tails.” Platykurtosis is associated with densities that are simultaneously less peaked and have thinner tails.

What does this mean to a hedge fund investor? Well it means that a fund with high kurtosis (i.e. 3+ and therefore, leptokutic) has exhibited more frequent behavior at the extremes (the "tails") than a fund with a lower kurtosis.

If you want to see a relatively accessible discussion of kurtosis and (from my prior blog entry) skew I suggest you look at this working paper by Harry M Katt entitled "Integrating Hedge Funds into the Traditional Portfolio".

*"Standard deviation" is a very traditional portfolio risk measure which will be discussed in a future blog.