Regulation of hedge funds. 68 good questions, nicely answered!

What happens if all the criteria for integration are met?

the two funds will be treated as a single 3c1 fund for purposes of determining whether the 100-owner limit is exceeded. Especially important for the 10% look through test. Easier to reach the 10% if two funds are integrated.

What are the characteristics of the section 3c7 exemption?

1. only qualified purchasers, 2. no ipo's, 3. no limit on number of owners.

What are qualified purchasers? (5)

1. individual $5 mio in investments

2. family entity; $ 5 mio in investments and not formed for the specific purpose

3. trust; not formed for the specific purpose and each trustee and each contributor is a qp

4. other entities; greater than $ 25 mio in investments and not formed for the specific purpose

5. entity exclusively owned by qp's

* knowledgeable employees excluded.

What are the key elements of rule 506?

1. rule 502b information delivery requirements

2. limit sales to not more than 35 non-accredited investors

3. take steps to restrict resales of any of its securities sold in reliance on the rule 506 safe harbor

4. not employ any advertising or general solicitation in offering to sell securities

5. file a notice with the SEC on Form D within 15 days of the first sale.

Which tests are applicable to determine whether there is general solicitation or advertising?

a. two step analysis -> is the communication a general solicitation or advertisement and is it being used to offer or sell a security?

b. facts and circumstances test.

c. the issuer must have had a substantive relationship with the prospective investor prior to soliciting the investor: should be extensive enough to enable the issuer to evaluate the financial circumstances and investment sophistication of the person solicited.

What are the criteria under rule 506c?

1. all purchasers of securities in such offering are accredited investors

2. all terms and conditions of rule 501 and 502 are satisfied and

3. the issuer takes reasonable steps to verify that all purchasers of the securities are accredited investors.

Which two methods can be used to verify accredited investor status?

1. principles based approach

2. non-exclusive list of methods to verify status of natural person investors

What tests are in the non exclusive list?

Net income test, net worth test, third party verification and pre-existing relationship.

What is the 'bad actor' rule?

Rule 506 prohibit an issuer from relying on rule 506 if the issuer or certain persons affiliated with the issuer (covered persons) have had certain types of legal violations with US federal, state or regulatory authorities.

What happens if the disqualifying event occurs before the effective date of the amendments?

Prominent disclosure to investors required.

Who are covered persons according to the bad actor rule?

the issuer, any director or executive officer of the issuer participating in the securities offering (more than incidental involvement), holders of at least 20% of the issuer's voting equity securities, calculated on the basis of voting power, investment managers of issuers that are funds and promoters connected with the issuer in any capacity at the time of the sale of securities and placement agents and other solicitors.

What are disqualifying events according to rule 506(d)?

criminal convictions within 10 years before the sale of securities or 5 years in case of the issuer and its predecessors and affiliated issuers,

court orders, judgement or decrees entered within five years before the sale of securities in the offering.

Certain final orders from specified state or federal regulators

SEC disciplinary orders

SEC cease and desist orders

Suspension or expulsion of a covered person from membership in a securities SRO or from association with a member of an SRO.

Certain SEC refusal or stop orders

Certain US postal service false representation orders

What are the exceptions to rule 506(d)?

If the issuer can establish that it did not know and, in the exercise of reasonable care, could not have known that a disqualifying event existed because of the presence or participation of another covered person.

Who can grant waivers of the disqualification from relying on rule 506(d)?

The SEC's Director of its Division of Corporation Finance

When will disqualification not apply?

If, before a sale is made under rule 506, the court or regulator that issued an order or judgment that constitutes a disqualifying event advises in writing that disqualification from relying on rule 506 should not arise as a consequence.

What other documents are involved in an offering?

Marketing materials

form ADV part 2A

Name some topics which are covered in the offering memo.

Disclaimers

investor suitability

fund structure

risk factors

management

conflicts of interest.

What are examples of side letter requests?

Reduced management fees and/or performance allocations

Reporting about positions, valuation and material adverse events

Accelerated withdrawal rights

Limitations on distributions in-kind and side pockets

Capacity rights

Approval or notice for change of service providers

Most favored nations

Name 9 examples of possible conflicts of interest.

1. Management of other funds and accounts

2. Not devote full time to management

3. Affiliated businesses

4. Allocation of investment opportunities

5. Trade aggregation

6. Trading for personal account

7. Serve on board of directors

8. Responsible for valuing securities

9. Affiliated transactions.

What is in the subscription agreement?

What investor

3c1 look through

AML representations

Not relying on manager of rund for advice

not subscribing pursuant to advertisement

acknowledgement of withdrawal limitations

What are the exemptions from registration under the investment advisers act?

Private adviser exemption 203(b)(3) --> fewer than 15 clients during preceding 12 months, does not advise registered investment companies or BDC's and does not hold itself out generally to the public as investment adviser.

When must an investment adviser register? And when may he do that?

Must: AUM > 30 mio and greater than 15 clients

May: AUM > 25 mio

What is the definition of a client under rule 203b31 of investment advisers act

a natural person and a corporation, partnership, LLC, trust or other legal organization to which investment advice is provided based on its investment objectives rather than the individual investment objectives of the owners.

What does §205-3 advisers act prohibit?

Investment advisers from receiving compensation on the basis of a share of capital appreciation.

What are qualified clients?

investors i) with a net worth of 2 mio (excl. primary residence) , or ii) that has >1 mio under management with the investment adviser.

What are the basic Registered Investment Adviser requirements?

Form ADV part 1A, 2A, 2B

Appoint a Chief Compliance Officer

Adopt a code of ethics

Maintain compliance policies and procedures

Foster a culture of compliance

What includes the information disclosed in Form ADV part 1A?

regulatory assets under management

number of employees

number and types of clients

other business activities

information about private funds

custody arrangements

disciplinary information

identity of direct and indirect owners

What is disclosed in from ADV part 2A?

material changes

description of advisory business

fees and compensation

types of advisory clients

methods of analysis and risks

other financial industry activities and affiliations

code of ethics

brokerage practices

review of accounts

proxy voting

Which advisers are subject to limited reporting requirements?

Advisers to only VC funds

private fund advisers < 150m RAUM

What does the Code of Ethics have to include at a minimum?

standards of business conduct that are required of supervised persons, which must reflect fiduciary obligations;

Provisions requiring supervised persons to comply with Federal securities laws

Provisions that require acces persons to report, and the IA to review, their personal securities transactions and holdings periodically;

Provisions requiring any supervised persons to report violations of the Code; and

Provisions requiring the IA to provide each supervised person with a Code and written acknowledgment of receipt.

What is a supervised person?

any partner, officer, director or employee of any investment adviser or other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser.

What is an acces person?

any supervised person who has access to nonpublic information regarding any clients' purchase or sale of securities, or nonpublic information regarding the portfolio holdings of any reportable fund, or is involved in making securities recommendations to clients.

If providing investment advice is primary business, all directors/officers/partners are presumed to be acces persons.

What is required for acces persons?

Annual holdings report

quarterly transactions report

Pre-approval for epos and limited offerings.

What is not required in the content of a code of ethics?

pre-approval of most securities transactions

restrictions on IPOs

provision of duplicate brokerage statements.

restrictions on gifts and entertainment

restrictions on outside activities and boards.

What are the compliance procedures under the Advisers Act?

Adopt and implement written policies and procedures reasonably designed to prevent violation by the adviser and its supervised persons of the Advisers Act and the rules thereunder.

review at least annually the adequacy of the policies and procedures and the effectiveness of their implementation.

designate an individual responsible for administering the policies and procedures; a chief compliance officer.

What should compliance policies and procedures address at minimum?

portfolio management processes

trading practices

proprietary trading of the adviser

personal trading by supervised persons

the accuracy of disclosures

safeguarding of client assets from conversion or inappropriate use by advisory personnel,

etc.

Explain the roadmap for developing compliance programs.

1. Conduct an inventory of compliance and regulatory obligations

2. Understand the investment adviser's business, including identification of risks and conflicts of interest;

3. Identify gaps: match existing compliance policies and procedures with compliance obligations and business demands and risks

4. Assess effectiveness of existing compliance policies and procedures

5. Enhance existing policies and procedures and develop new policies and procedures with input of personnel

6. Implement policies and procedures, including training, monitoring and testing.

7. Engage third party to independently test policies and procedures.

8. CCO's annual review and report on effectiveness of policies and procedures.

What's included in the annual compliance review by the Chief Compliance Officer? (3)

1. the dates during which the review was conducted

2. the steps taken during the review

3. any changes made to the manual as a result of the review.

7 tips for successful compliance programs...

1. off the shelf is not sufficient

2. compliance manual should be user-friendly and in plain english

3. emphasis on procedures and responsibilities, including testing and documentation

4. Establishment of committees

5. ccl needs adequate resources and support

6. monitor and test functionality of key controls on an ongoing basis

7. regular training and buy-in of personnel.

When is an adviser deemed to have custody of client assets?

If it has actual possession of client funds or securities, has the ability to withdraw assets from a client's account, including having authorization to withdraw advisory fees directly from a client's custodial account or has legal ownership of, or access to, the client's funds or securities.

What are the 3 basic conditions designed tos safeguard client assets?

1. maintain client assets with a qualified custodian

2. provide notice to clients about the qualified custodian

3. arrange for delivery of quarterly account statements by such custodian.

What does pay to play mean?

An investment adviser cannot receive compensation from a governmental entity for two years after the IA or any of its covered associates makes a political contribution to an official of the government entity.

What are the fundamental services of a broker?

Execution

clear and settle trades

custody of securities

consolidated reporting

What are the key terms in prime brokerage agreements?

Demand v. lock up

collateral requirements

cross-collateral/cross default

no obligation to clear and settle

events of default

rehypothecation

What are soft dollar arrangements?

a term generally used in the asset management and securities industries to describe the research or other benefits provided to an asset manager by a broker-dealer as a result of commissions generated from financial transaction executed by the broker-dealer for client accounts or funds managed by the asset manager.

What are eligible brokerage and research services?

Furnishes advice, either directly or through publications or writings, as to the value of securities etc.

Furnishes analysis and reports concerning issuers, industries, securities, economic factors and trends.

Effects securities transactions and performs functions incidental thereto or required in connection therewith by rules of the SEC or SRO.

What is the safe harbor created by §28(e) of the SEA?

Research obtained with soft dollars generated by the partnership may be used by the investment manager to service accounts other than the partnership. Where a product or service obtained with soft dollars provides both research and non-research assistance to the investment manager, it will make a reasonable allocation of the cost which may be paid for with soft dollars.

What are the regulatory filing obligations?

- Form 13F

- Schedules 13D and 13G

- Section 16 Reporting

- Form SLT

Form D and Blue Sky filings

- Foreign regulatory filings

Form PF

Which IA's are required to report on Form PF?

IA's managing private funds with RAUM of at least $150m.

Name 6 types of private funds.

- hedge funds

- private equity funds

- hybrid funds

- real estate funds

- venture capital funds

- single transaction funds

What are the characteristics of a private fund?

1933 Act - Reg. D

Investment company act - 3c1 and 3c7

investment advisers act - exemption VC funds

similar structure objectives: limit liability of management and investors, tax efficiency, management flexibility to manage portfolio.

What are the differences between hedge funds and private funds regarding types of investments made?

HF : typically publicly traded, easy to value and held for shorter term

PF: typically privately held securities, difficult to value and held for longer term.

What are the differences between hedge funds and private funds regarding capital raising?

HF: continuously raising capital; contributions made at NAV

PF: limited offering period. investors admitted based on cost of investments plus interest charge.

What are the differences between hedge funds and private funds regarding timing of capital contributions?

HF: entire investment contributed at closing

PF: capital is drawn over time, typically on 10 days notice and must be invested during a specified investment period.

What are the differences between hedge funds and private funds regarding management fees?

HF: 1% to 2% of NAV per year

PF: 1% to 2% annually. Based on capital commitment during investment period and then based on cost of remaining investments thereafter.

What are the differences between hedge funds and private funds regarding performance compensation?

HF: 20% performance allocation made annually to GP on realized and unrealized profits, subject to a high watermark

PF: 20% carry made based on distributions through waterfall, subject to clawback. only based on realized gains.

What are the differences between hedge funds and private funds regarding withdrawal rights?

HF: often initial lock-up period with quarterly or annual thereafter. No withdrawal rights for side pockets

PF: no rights to withdraw. distributions made as investments are sold. could be 7 year puls time horizon.

What are the differences between hedge funds and private equity funds regarding investor advisory committee?

HF: typically none

PF: common, primarily to resolve issues relating to conflicts of interest and valuation. largest investors.

What are the differences between hedge funds and private equity funds regarding management of other funds and accounts?

HF: typically no restrictions

PE: Exclusivity: no new funds until investment period expires or at least 75% of capital deployed.

What should be included in a hedge funds best practices?

disclosure

valuation

risk management

business operations

compliance and conflicts of interest

How can an integrated valuation framework be formed?

- formation of valuation committee

- use of knowledgeable and qualified internal personnel and external resources.

-

What are the elements of valuation policies?

- designated internal and external persons responsible for valuation

identify sources of prices

establish internal documentation procedures

illiquid and side pocketed securities

fair valuing securities

What are the categories of risk?

- liquidity

leverage

market

counterparts credit (Lehman)

operation - sufficient infrastructure to manage and mitigate operational risks;

other risks - key person, reputation

What should be taken into consideration for a hedge funds' trading and business operations?

counterparties

cash, margin and collateral management

selection and monitoring of key service providers

core infrastructure and operational procedures

core accounting processes

disaster recovery/business continuity

What is key for handling conflicts of interest?

having a process for identifying and addressing them

What are the different types of conflicts of interest?

- between manager and funds: proprietary trading, valuation, allocation of expenses, soft dollars and selection of service providers

- between one fund and other funds managed by the same manager: allocation of investment opportunities

- between employees and the fund: personal trading, outside business activities, receipt of gifts

-between investors: side letters

What are the implications of ERISA for hedge funds?

If investments by benefit plan investors equal or exceed 25% of any class of equity interest of a hedge fund the fund becomes a plan asset vehicle and the investment manager could be a fiduciary of the investing plans.

When does a hedge fund only want to exceed the 25% test?

If the investment manager is a Qualified Plan Asset Manager. However, still subject to heightened fiduciary standards and certain prohibited transactions.

Regulation of hedge funds

68 important questions on Regulation of hedge funds