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Saturday, 20th April 2024 |
| An introduction to hedge funds |
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| Key characteristics |
Key characteristics
Hedge funds by their nature defy comprehensive definition. The term ‘Hedge fund’ is used to describe an investment vehicle, which has some of the following characteristics:
• Employs a broad spectrum of strategies and techniques in the investment of a variety of investment instruments.
• Has the ability to sell short and use leverage to increase returns while using insurance/hedging to decrease its exposure to market risks.
• Has a positive absolute return objective.
• Has a limited number of investors.
• The hedge fund manager (hereinafter the ‘manager’) invests in the fund and receives an incentive fee based on profits and not the size of the fund.
• Utilises the services of a prime broker.
In the past, there has been and still is a misconception that hedge funds are volatile and speculative investment programmes that seek phenomenal returns and employ leverage extensively. Although true for some funds, modern hedge funds while riskier than managed portfolios of equities and bonds, typically hedge their position and employ leverage modestly.
Brief history
Hedge funds are not a recent development but have existed for over 50 years. First developed by an Australian named Alfred W. Jones in 1940 to manage risk by selling short, their great performances were highlighted in an article in Fortune Magazine by Carol Loomis where the phrase ‘hedge fund’ was coined. Hedge funds drifted out of fashion until 1986 when press attention was paid to Julian Robertson’s Tiger Fund, which achieved an annual return of 43 per cent during its first six years. The two most famous hedge funds are (i) George Soros’ Quantum Fund, and (ii) Long Term Capital Management (which collapsed while leveraged at up to 600 per cent and had to be rescued by the US Federal Reserve. This collapse is widely blamed for the popular misconception of hedge funds alluded to earlier).
Jurisdiction
Traditionally, hedge funds have been established in offshore jurisdictions like the Cayman Islands as they can be established quickly, are tax efficient and effectively unregulated giving maximum commercial freedom to the manager.
It has always been possible to establish funds in Ireland, which possess some of the characteristics of hedge funds mentioned above. However, as the requirements imposed by the Central Bank on trustees were incompatible with the commercial requirements of the prime broker, very few funds have been established in Ireland until recently. The prime broker normally takes possession and custody of all the assets as collateral against the provision of financing facilities and utilises the assets of the fund as if they are its own including the rehypothecation of those assets to third parties. This was irreconcilable with the Central Bank’s rules, which required that all of the assets of a fund be entrusted to the trustee for safe keeping. Following extensive lobbying by members of the industry, the Central Bank issued a letter to A & L Goodbody in September, 1998 (the contents of which subsequently became draft Guidance Note 2/00) setting out the requirements for the appointment of a prime broker which led to the birth of the Irish hedge fund Industry.
Choice of legal vehicle
Hedge funds in Ireland are typically constituted in the form of either a unit trust or an investment company with variable capital (in either case as a single fund or as an umbrella fund). The umbrella structure typically results in it being easier, quicker and cheaper to launch future sub-funds as it obviates the need to establish a separate vehicle for each sub-fund.
Documentation
The main documentation required to establish a hedge fund is the same as that required for traditional funds together with the following documents:
• Prime brokerage agreement: typically entered into between the fund, the prime broker and the trustee
• Sub-custodian agreement: this agreement is entered into between the trustee and the prime broker in order to satisfy the requirements of Guidance Note 2/00 as discussed below.
The 2 major players
• Manager: Hedge funds in aiming for positive returns, regardless of the state of the markets, rely on the skill and expertise of the manager more than conventional funds. The most important factor for a potential investor in a hedge fund is the strategy which the manager proposes to employ. There are as many strategies as there are types of hedge fund and the strategy that is used gives the hedge fund its unique characteristics.
Some strategies include fixed income arbitrage, convertible arbitrage, long-short equity, global/macro and sector specific to name a few. The key for managers is to develop and use particular investment strategies and style which utilise all of their experience and expertise and are suited to the current market.
• Prime broker: Draft Guidance Note 2/00 states that the Central Bank will permit a Fund to appoint a prime broker provided that the assets which the prime broker may utilise for its own purpose does not exceed the level of the fund’s indebtedness to the prime broker, the investment positions are marked to market daily and the arrangements incorporate a legally enforceable right of set-off. The prime broker can only hold assets of the fund in excess of the prescribed limit if it is appointed as sub-custodian and holds the excess assets in a segregated account in the name of the trustee.
Usually, the prime broker is appointed by the trustee as a sub-custodian (in order that the prime broker may take a charge over all of the assets of the fund). In our experience, the establishment of this relationship often causes the most delays in setting up a fund. The two main reasons for this are that (i) it often takes some time for work to be carried out on the systems used by the two entities to ensure that they are compatible from a logistical point of view and (ii) the trustee and the prime broker usually disagree on the extent to which the prime broker as sub-custodian should accept responsibility for its actions and those of an entity appointed by it as sub- sub-custodian. The reconciliation of the trustee’s responsibility for safekeeping of the assets, its watchdog role and the role carried out by the prime broker in extending credit and taking custody of the assets of the hedge fund as sub-custodian, often require protracted negotiation and drafting.
The future
To date, approximately 25 hedge funds not including the sub-funds of these hedge funds have been established in Ireland. A substantial return with low correlation to traditional assets and an incentive fee based on performance means that hedge funds, in the current difficult market conditions are here to stay. Although hedge funds will continue to be popular in unregulated jurisdictions, a regulated hedge fund established in Ireland is a highly marketable product, which the funds industry can exploit. This may be even more so if the recent trend of increased interest in hedge funds from institutional investors continues, as these traditionally conservative investors may be more comfortable investing in a regulated jurisdiction. |
Barry McGrath is an associate with A&L Goodbody Solicitors. (Peter O’Leary, assistant solicitor with A&L Goodbody Solicitors assisted in the preparation of this article).
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| Article appeared in the March 2002 issue.
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