What is a Hedge Fund?
For my first post, I thought I would discuss the what makes a fund a "hedge fund" and the two main regulations that hedge funds rely on in order to be excluded from the Investment Company Act of 1940 ("ICA").
Interestingly, "hedge fund" is not defined statutorily. Historically a hedge fund was defined by what it was not, which is a registered fund under the ICA (aka a mutual fund). "The term 'hedge fund' refers generally to a privately offered investment vehicle that pools the contributions of its investors in order to invest in a variety of asset classes, such as securities, futures contracts, options, bonds, and currencies."[i] This closely resembles a mutual fund, however, it is privately offered and tends to operate outside of ICA registration. More recently, the SEC promulgated form PF, which is a reporting regime for private funds. If a fund meets the required thresholds, the form needs to filled out and reported. I will do a more detailed post on Form PF later. This form, however, is not the same as reporting under the ICA.
Under Section 3(a)(1), an investment company means any issuer which:
(A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing reinvesting, or trading in securities;
(B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificates outstanding; or
(C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis.
Typically, any company considered a "hedge fund" will fall within 3(a)(1)(A). Therefore, in order to stay outside of regulation the fund must rely on an exclusion or exemption from the definition of investment company. To do this, hedge funds typically rely on Section 3(c)(1) or Section 3(c)(7) of the ICA.
Section 3(c) states, "Notwithstanding subsection (a), none of the following persons is an investment company within the meaning of this title:
(1) Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer....
(7)(A) Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities.
Qualified purchaser is defined in Section 2(a)(51)(A) as any person who owns not less than $5,000,000 in investments or any company that owns not less than $5,000,000 in investments.
Therefore, a company will remain outside the definition of investment company if, without a public offering, it's outstanding securities are owned by less than 100 persons or all of its outstanding securities are owned solely by qualified purchasers.
More and more funds are choosing to operate as a 3(c)(7) company due to the unlimited amount of investors in their fund and the ability to charge a performance fee (this will be discussed in a future post). Most private fund managers, however, do meet the definition of investment adviser under the Investment Advisers Act of 1940 ("IAA") and do have to register themselves.
I am going to try to keep changing up the size of my blogs. I didn't want to keep them extraordinarily long so this will do for now. In a later post I will be going into the charging of performance fees and other aspects of operating outside the ICA.
Please feel free to leave any comments. All feedback is appreciated.
[i] THE
SECRETARY OF THE TREASURY, THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE
SYSTEM, THE SECURITIES AND EXCHANGE COMMISSION, A REPORT TO CONGRESS IN
ACCORDANCE WITH § 356(c) OF THE USA PATRIOT ACT OF 2001 (2002).
