by HFBOA
2. October 2010 02:14
Some years ago, we had launched a "’40 Act" fund (more specifically a Registered Investment Company, or "RIC" under the SEC’s 1940 Act). This RIC is a fund of hedge funds targeted only to accredited investors, yet allowing for unlimited investors with initial minimum investment amounts far below the typical $1mm+ required by other funds. The first product launched in the early naughts when expanding investor access to hedge funds through traditional retail channels was deemed to be its primary raison d’être. This market of moderately HNW clients looking only a dip a toe into the hedge fund waters proved a reasonable opportunity. Investors were happy with the reduced minimums as well as the fact that this fund had elected to provide 1099 tax reporting, as opposed to K-1s. This was also an important selling point of the fund. 1099s are distributed to investors in January following year-end as opposed to K-1s which get distributed anywhere from February (highly optimistic) to as late as in the summer months, which can be frustrating to investors and their accountants.
All well and good so far, yet despite the simplification of the Form 1099 from an investor’s viewpoint, it poses additional challenges for the fund. Subchapter M of the IRS Code spells out certain needs for a Registered Investment Company, the largest challenges for a fund of hedge funds (or even stand-alone hedge funds) being:
The quarterly asset diversification test, while conceptually mechanically simple, requires all underlying managers to divulge their positions on a quarterly basis. The test is made to ensure compliance with the IRS Code’s Subchapter M rule which compels that the RIC fund hold no more than 5% of its assets in a given investment.1 There are some other concentration tests as well, but this 5% rule is a challenge as it creates the need for the RIC to aggregate all of its investments on a look-through basis.
Outbound portfolio dissemination is not always favorably viewed by hedge fund managers, particularly the smaller ones who may have a policy of non-disclosure, or who otherwise wouldn’t be compelled to disclose (e.g. 13-D filings). This leads generally to a business decision by the underlying manager as to whether to change their stance. In our funds, we have eased the pain somewhat through processes whereby portfolios are transmitted on a confidential basis to a third party service provider to receive portfolios. However, not all hedge funds become converts, which somewhat narrows the investment opportunity set, and could provide some tracking error versus a similar non-registered fund.
The second hurdle comes from the need to determine effectively before the end of December as to what dividend to declare. Simply stated, the IRS Code says that a RIC needs to distribute 98% of its annual income during the calendar year. This requires receipt of reasonably good taxable income estimates early in December from all of the RIC’s underlying fund mangers and aggregation of these amounts. Then a safety margin gets built in, (fingers get crossed), and a dividend gets declared in the final days of the year. In our fund, our investors elect to reinvest the year-end dividend, so fortunately there’s no additional cash movements required. The downside to missing this estimate is a 4% excise tax impounded against any upside variance.
What makes this process work effectively is active communication with the underlying hedge funds to get the best possible data possible. In the following year, a measurement is made on a retrospective basis, as to where the estimates used in compiling the RIC’s dividend compare relative to the actual full year taxable results. Given the volatility of the latter portion of most Decembers (flash crashes aside), it’s impossible to have all mangers be spot-on. Yet given normal distribution patterns, hopefully the late variances to the downside offset those to the upside, and thus an excise tax is avoided.
Challenges aside, we happily still see robust interest from investors for a registered product with 1099 reporting.
1 More technically, the 5% restriction is made as to "issuer", which means that all securities of a given company (i.e. equities, bonds, options ) are aggregated together to make the test.
-Matthew Jenal, Senior Advisor, CADOGAN MANAGEMENT, LLC