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

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

3. 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)

4. 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?)

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

6. 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

7. 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

8. 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.

9. 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

10. 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

11. 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

12. 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

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

14. 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

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

16. 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

17. 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

18. 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

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

20. 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.

21. 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

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

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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

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

31. 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)

32. 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

33. 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

34. 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

35. 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

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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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)