Firma 2006 Washington Conference Hedge Funds April 12, 2006 Presented by: Anees T. Din Partner

Discussion Topics Definitions Regulatory Environment Structure of Hedge Funds Roles and Responsibilities Core Documents Accounting

Hedge Funds Definitions Pool of money – a group of investors (3-C-1 Structure vs. 3-C-7) Hedge Funds are flow-through entities General Partners – unlimited liability (all partners in an ordinary partnership are GPs) Limited Partners/shareholders capital only (must have one GP to manage the partnership) (the LPs/shareholders do not participate in its management and operation)

Hedge Funds Definitions Onshore vs. Offshore Funds Registered or Not Registered with CFTC (depends on types of securities held) Differences from Registered Investment Companies (can hedge funds be registered?)

Types of Hedge Funds Private Equity Funds Venture Capital and LBO Funds Funds of Funds Commodity Funds Offshore Funds

What Does a Hedge Fund Look Like? Structure of Standard Domestic Fund Investment Advisor LLP Management Co. LLC Domestic Partnership LP 20% Performance Fee Management Fee = 2% Investors/ Limited Partners

What Does a Hedge Fund Look Like? Structure of Stand-Alone Offshore Fund US Investment Manager LLC Offshore Corporate Investment Fund LTD Management Fee = 2% Performance Fee = 20% Investors/ Shareholders Own Shares

What Does A Hedge Fund Look Like? Side-By-Side Structure Performance Fee = 20% Investment Advisor LLP Management Co. LLC Offshore Corporate Investment Fund Domestic Investment Partnership LP Management Fee = 2% Performance Fee = 20% Foreign Investors/ Shareholders Investors/ Limited Partners Note: Fading in use due to economies of scale.

What Does A Hedge Fund Look Like? Structure of Master-Feeder Fund Performance Fee = 20% Investment Advisor LLP Management Co. LLC Management Fee = 2% Offshore Corporate Fund (Feeder) Performance Fee = 20% Hedge Fund Domestic Partnership (Feeder) Investment Partnership (Master) Foreign Investors/ Shareholders Investors Investors/ Limited Partners Note: Private Investments Stay in Feeder Structure

Motivation/Role of Limited Partner or Shareholder Advantages Ability to obtain professional investment management Ability to share in a diversified investment strategy Liability is limited to capital contributions Disadvantages LP interest by itself is not a liquid investment Restrictions on capital withdrawal GP has control over the assets No say in management Potential for style drift

Motivation/Role of General Partner GP Advantage Ability to pool funds for a large number of small investors Ability to diversify by managing large pool of investors Admin partnership as a simple entity Possibly greater earnings through performance fees GP Disadvantage Presumably liable for partnership obligations Ante-up seed capital contributions – minimum 1%, cannot use 20% override Bears the burden of responsibility

Other Roles & Responsibilities Hedge Fund Administration Portfolio systems (why are they important) In-house systems Use of prime broker – provided back office services and also produces portfolio requests Outside systems – fund administrator factors provide back office bookkeeping on securities pricing and partner allocations Use of several brokers

Other Roles & Responsibilities Functions Fund Administration Information the partnership will provide to the prime broker When the partnership has broker dealer affiliate

Other Roles & Responsibilities Parties to Execution and Trade Clearance Use of prime broker – central in custody and clearing of manager’s assets and providing one consolidated statement and 1099 Selection of prime broker Role of prime broker Benefits of operating a broker dealer affiliate Advantages of a prime broker – stock loans on shorts (access to lend to borrow) Interaction between the partnership and the prime broker

Core Documents in Marketing a Hedge Fund Private Placement Memorandum (what is in it?) Investor subscription agreement Investor agreement

Private Placement Memorandum (PPM) Primary sales document used to describe the terms of the offering to prospective investors. It indicates that the ownership interests are offered as a private placement under the exemption from SEC registration The PPM will discuss, among other things: The investment objectives, strategies, and risk factors The general partner/fund manager and any related entities of conflicts of interest

Private Placement Memorandum (PPM) The term of the fund The minimum amount of initial capital contributions When additional capital can be contributed and when new investors can be admitted The fund’s fiscal year Rights of withdraw and cash distributions How profits and losses will allocated

Private Placement Memorandum (PPM) Any regulatory matters Management fees and operating expenses Whether or not fund will employ leverage Financial suitability requirements Reports to investor Subscriptions for interest

Investor Subscription Agreement The subscription agreement is evidence of an investor’s purchase of an interest and obligation to make required capital contributions.

Investor Agreement The investor agreement is a cornerstone document defining business purpose and rights and obligations of the entity. The agreement controls the relationship between the fund manager and the investors. It will also address certain responsibilities such as record keeping, who the auditors will be, who will be responsible for tax returns and K-1 preparation, if any.

Investor Agreement The major areas of the agreement that have a bearing on accounting and financial reporting are: Investment structure (Master Feeder, Side by Side, Stand Alones) Capital contributions and withdrawals Fees and allocation of profits to investment advisor (deferral programs) Allocation of profit and loss to investors

Investor Agreement Determination of profit and loss Audits, financial statements, accounting principles, and reports to investors Record keeping

Critical Hedge Fund Issues Securities valuation Economic allocation Reporting to investors Footnotes Allocations Tax issues Other

Securities Valuation US GAAP defined AICPA Audit Guide for Investment Companies Trade date valuation Valuing the portfolio at market value or fair value Valuation issues Illiquid securities Restricted positions Market blockage Fund of Fund investments Emerging market positions Derivatives Investment valued solely by investment advisor

Securities Valuation Valuation of securities sold under agreements to repurchase and securities purchased under agreement to resell are valued at contract amount, not market value

Economic Allocations & Investors’ Capital Account Capital contributions and withdrawals Determination of profit and loss Allocation of profit and loss to investors in interim accounting periods (Breaks) Management fees and performance fees – when are they calculated and paid, high water marks, claw backs Special allocations for hot issues Side pockets

Reporting to Investors Financial Statements consist of: Statement of Financial Condition Condensed Schedule of Investments State of Income Statement of Cash Flows or Statement of Changes in Net Assets – FASB 95 If entity uses leverage, prepare statement of cash flows, otherwise no leverage is used then prepare a statement of net assets

Reporting to Investors Statement of Changes in Partnership Capital (note: shows incentive fees paid to GP) Applicable Footnotes and Disclosures under GAAP Financial highlights Other Reporting to Investors – Rates of Return (AIMR Performance) Individual Investor “Capital” Schedules

Footnotes Organization Significant Accounting Policies such as: Discusses the structure, general business of the partnership and the state trading strategy Significant Accounting Policies such as: Trade date accounting Method of valuing portfolio investments Related party transactions Transaction subsequent to date of financial statements Post year end capital contributions and withdrawals Other significant events

Footnotes Management and incentive fee Partnership shareholder equity Risk management and derivatives

Financial Instrument Disclosures This FASB is still active, despite new guidelines from FASB 133 project on “Derivatives and Hedging” FAS 133 Disclosure – A derivative financial instrument is: Futures contract Forward contact Swap Options Other financial instruments with similar characteristics (such as interest rate caps or loans and fixed rate loan commitments and possible variable note loan commitments and other variable rate financial instruments (all similar to options): forward interest rate agreements, interest rate collars, commitment to purchase stocks or bonds (all similar to forward contracts)

Allocations – Layering Method Each partner’s share of unrealized gain or loss with respect to a particular security is separately tracked through the date of opposition Realized gains and losses are allocated to partners to reflect the unrealized gain or loss for that partner for the security sold Layering methodology produces the most exact results

Allocations – Aggregate Method Realized gains and losses are aggregated and allocated to the partners assuming that opening unrealized items are realized first Does not specifically account for a partner’s share of unrealized appreciation or depreciation by security Any reasonable method can be used

Allocations – Aggregate Method The regulation provides two approaches: The character of the realized gain and losses must be determined The character of the income must be allocated to the partners so that the tax attributes of each item are preserved; be determined under consistent approach and not be determined with a view of reducing the partners aggregated tax liability

Allocations – Aggregate Method Other issues using an aggregate method The character of the realized gains and losses must be determined The character of the income must be allocated to the partners so that the tax attributes of each item are preserved; to be determined under consistent approach and not to be determined with a view of reducing the partners aggregate tax liability

Tax Issues Generally not relevant for offshore traders Classification as either trader or investor fund Deferral programs Transaction reporting to the IRS

Fund Classification Fund may be classified as either Investor of Trader Fund Classification significant for passive loss purpose, investments interest expenses limitation, two percent rule on miscellaneous itemized deductions, three percent rule on itemized deduction and limitation of New York State itemized deductions

Investor Fund Investors are not engaged in a trade or business regardless of extensiveness of activities Investors seek long-term approach Investors profit primarily from capital appreciation, dividends, and interest Expenses of investors are subject to 2% limitation Income of investors constitutes “portfolio income” for purposes of passive loss limitation

Trader Fund Traders are engaged in the trade or business of buying and selling securities Traders do not hold inventory Traders realize capital gain or loss from sale of securities Traders seek profits from short-term price swings Profits derived mainly from frequent and substantial trading activities Not profit primarily from dividends, interest or long-term appreciation Income from activity as trader is not classified as “passive” for purposes of passive loss limitations

Other Accounting Issues Hurdle Rate: Only above this level can the fund charge performance fee Water marks: If fund drops below water mark, cannot charge performance fee until it gets back to the watermark level Carry forward of high water marks of inclusion of hurdle rte return provisions to reward investors who reinvest proceeds from failed fund of the manager

Other Accounting Issues Clawback Account: 50% of incentive allocation (if any) is credited to capital account of General Partner and 50% is credited to claw back account Carry forward of high water marks and inclusion of hurdle rate provisions

Anees T. Din, CPA – Partner Practice Strengths Mr. Din possesses over 20 years of experience in providing auditing, accounting, and consulting services in the financial services industry to such clients as Gabelli Funds and Skudder/Dreman Value Funds. He has extensive experience in domestic and foreign investment partnerships, registered investment advisors, broker/dealer audits, and public companies in the time-sharing industry. He actively solicits new business with service providers in the financial services industry.   Industry Expertise Financial Services Real Estate (Time Shares) NASD Registered Public Companies Technology Licenses and Accreditations Certified Public Accountant, New York Affiliations American Institute of Certified Public Accountants New York State Society of Certified Public Accountants, Stockbrokerage Committee Securities Industry Association, Internal Audit Group, Executive Committee Member and Education Committee Education BBA, City University of New York, Bernard Baruch College MBA in Investments and Finance, University of Pennsylvania, Wharton Graduate Division Advanced Education Diploma in Leadership and Management – Columbia University Consultancy Assignments and Speeches Consultant to Fidelity Investments on Hedge Funds Speaker on hedge funds at the SIA annual conference Speaker on hedge funds at SIA Educational Committee seminar Recent Achievements Adjunct Professor, Pace University (graded for various accounting professors) Adjunct Professor, Baruch College (taught financial and cost accounting courses)