1. XI. Unregistered Investment Companies

2. A. Unregistered Investment Companies: An Introduction Pension Funds Hedge Funds Private Equity Venture Capital Angel Capital Bank Professional Asset Management Services

3. B. Pension Funds Pension funds are established by employers to facilitate and organize the investment of employees' retirement funds. – Pension funds in sum hold over $20 trillion in assets for their beneficiaries. – More than half of working Americans participate in pension plans (including 401k plans), representing very diverse ownership structure somewhat representative of the U.S. population. – Regulators, in part due to ERISA tend to discourage pension plans from taking imprudent risks. – But, what constitutes imprudent risks?

4. ERISA (1974) The Employee Retirement and Security Act of 1974 (ERISA) requires private pension funds to: 1.Maintain a fiduciary responsibility to employees and fulfill investment standards, including investing as a "prudent man" would, 2.Maintain funding so as to fulfill their pension obligations, 3.Provide for employee vesting, 4.Established the Pension Benefit Guarantee Corporation, 5.Regularly disclose to the Labor Department and to their investors how their money is being managed and the performance of investment funds and 6.Provide adequate access to the federal court system for employees whose obligations are not being fulfilled.

5. C. Hedge Funds Hedge funds are investment vehicles that enable investors to pool investment assets under professional management. The majority are unregistered private funds To avoid S.E.C. registration and regulations, hedge funds usually only accept funds from small numbers (often less than 100, though normally less than 500) of accredited investors, typically high net worth individuals and institutions. Usually structured as limited partnerships or LLCs. The earliest funds date from the 1940s (Alfred Jones) and now manage over $2 trillion in the U.S. The largest in the U.S. (2012) is Bridgewater Associates (~$70 billion). They typically have restrictions on who can invest, minimum amounts and minimum holding periods

6. Hedge Fund Strategies Because most hedge funds have only a small number of managers, they typically focus their investment strategies on the expertise of a few key managers. – Hedge funds tend to invest in liquid instruments. – Many hedge funds seek investment opportunities or niches where larger institutions are constrained due to regulatory restrictions. For example, because many banks, pension funds and other institutions cannot focus activities in the securities of distressed corporations, some hedge funds will. May specialize in short sales and derivatives to hedge against market downturns – Arbitrage opportunities. Cross market and cross security arbitrage Pairs trading Stat Arb

7. Hedge Fund Compensation and Performance – Hedge fund managers typically take a proportion of assets invested (2% is a norm) and another portion of profits (20% is typical) as compensation. – While hedge funds are frequently able to report results that beat the market, investors should realize that performance results do not usually include the last several months of a hedge fund’s existence, which is when a fund is most likely to fail. – Consider 60 months of 10% monthly returns (1.1 60 =304) followed by one month with a -100% return.

8. D. Private Equity Private equity refers to (normally) unregistered asset managers that normally make equity investments in companies that are not publicly traded. Private equity markets provide funding for start-up firms, private middle-market firms, management buyouts (MBOs), leveraged buyouts (LBOs; e.g., KKR)), firms in financial distress, public firms seeking buyout financing, etc. Typically LLC structure. Private equity firms frequently take active monitoring, management and advising roles in their portfolio firms. Many types of private equity firms, ranging from venture capital (VC) firms to hedge funds and LBO firms.

9. Private Equity Firms Private equity firm shares are not publicly traded (with a few exceptions; e.g., 144A markets, Blackstone and KKR on NYSE), are illiquid and normally exempt from SEC registration requirements The Blackstone Group is the largest as of 2013 with over $200 billion under management. Its investment portfolio has included, Hertz, Hilton Hotels, LaQuinta, Allied Waste and many more Compared to hedge funds, private equity firms usually make longer-term investments, invest in less liquid investments and frequently participate in management of portfolio companies.

10. E. Venture Capital Firms A venture capital firm (VC) is a financial intermediary that invests capital in private portfolio companies. The typical VC such as Charles River Associates or Matrix Partners is a private equity firm with a limited partnership structure. VC lives are typically fixed (e.g., 10 years). The VC will typically invest in the illiquid securities of a portfolio firm in an early stage of its existence – typically a growth start-up firm. The markets for initial public offerings (IPOs) provide crucial exit routes for venture capital (VC) investment Venture capitalists provide an important source of supply for IPO markets. In most cases, VC firms will maintain active roles in the monitoring, management and governance of the firms in which they invest.

11. VC Partners and Compensation The VC fund is formed by the partnership agreement between general and limited partners. The agreement establishes the expectations of general and limited partners and outlines the terms of the general partners’ compensation structure. Annual investment fees paid by limited partners to general partners tend to be substantial, ranging from 1% to 3% (2% to 2.5% are norms) of committed capital. In addition, agreements normally provide for 20% of carry interest when the fund liquidates.

12. The Venture Capital Process Only a small portion of VC proposals are even given more than a cursory review. Most VC firms typically seek investment projects in the $250,000 to $4,000,000 outlay range. VC firms normally require expected annual returns in the 30% to 40% range, partly as compensation for the large number of portfolio company failures. More specifically, VC firms look for the following in prospective portfolio companies: 1. A solid technology/business concept 2. A strong management team 3. Market opportunity

13. VC Exit VC funds exit their portfolio company investments through 1.company or entrepreneur share repurchases 2.reorganizations (e.g., ESOPs, MBOs or bankruptcies) 3.private sales, mergers 4.IPOs 5.liquidations (particularly in the event of failure). Private sales, mergers and IPOs typically provide for the highest exit valuations, but other exits are very common since the rates of failure are so high. Private sales and mergers enable the VC to recapture its investment without the expense and publicity associated with the IPO. An IPO certainly enhances the public profile of the portfolio firm.

14. Angel Capital Angel capital refers to investment in small companies by wealthy individuals. The term “angel” dates from the early 1900’s for investors funding high-risk Broadway theatrical productions. Angel capital is often taken to fill the gap in start-up financing between "friends and family" (sometimes the acronym FFF, meaning "friends, family and fools") and venture capital firms. Many angel investors are entrepreneurs themselves Some providers of angel capital prefer to have substantial ownership stakes and participate actively in advising and monitoring their portfolio companies. Some of the more active angel investors are referred to as “guardian angels.” Angel financing is an important source of capital for seed ($25,000– $500,000) and start-up ($500,000–$3,000,000) funding.

15. Term Sheets The term sheet specifies: the type of security or instrument placed with the angel by the entrepreneur cash flow or dividend rights to the angel conversion provisions anti-dilution covenants other restrictive covenants board and director issues voting and other participation rights auditing and rights to receive financial statements and other information rights to participate in IPOs rights of first refusal, etc.

16. F. Other Unregistered Investment Institutions Banks also provide professional asset management services, including trust management for clients. – Trusts are legal entities or vehicles for enabling grantors that set aside assets in trusts on behalf of beneficiaries such as heirs, charities and others) to accomplish various financial goals. – Banks in their roles as trustees or asset managers manage trusts on behalf of grantors and their beneficiaries. Most banks maintain trust departments to serve as trustees. – Private banking refers to services such as banking and investment management provided by banks to high net worth clients. Commingled Funds are limited partnerships whose investors have pooled their resources for investment purposes.