Hedge Fund Vista Webinar – 30 June 2020

Carry structures for hedge funds

The use of carried interest structures for hedge funds is a trend; increasingly start up managers in the UK ask us about structuring their performance fee as a carried interest private funds style. What they want is for the principals to receive the 20 per cent profit allocation, or equivalent percentage, direct - not as a fee via the manager -- but with the capital gain nature of the underlying transaction passed through to them individually.

This topic is relevant to UK managers new and old but when is it appropriate, how does it affect fund structures and what are some of the practical points in implementation?

When is this structuring appropriate?

This is something we are increasingly seeing at the moment. It's one of the trends that comes and goes every few years. On the question of when is it appropriate, it is probably better to think about where it may not be appropriate.

If a manager has a very active trading strategy (systematic managers, high frequency trading arrangements, or any situation where the fund is likely to be trading), then carry is inappropriate. There are two reasons for this: (i) if it's a trading strategy then giving an individual manager a share of the trading return doesn't actually give a better outcome; and (ii) clearly, if there is a fund which is trading for UK tax purposes and there is a UK based investment manager, the manager will want to ensure that the requirements of the Investment Manager Exemption are satisfied in order to prevent the profits of the fund being brought within the scope of UK tax. One of the requirements of the Exemption is that the manager receives remuneration which is not less than customary for what the manager is doing. The concern with the structure where carry goes straight to the individuals is that the customary remuneration requirement may then be breached.

In summary, don't do carry if you are a trading fund. Carry is however being used in (i) credit - where there may be longer term investment strategies; (ii) in some equity strategies with a long only buy and hold approach; and (iii) in some co-invest arrangements - managers are looking at structuring these in a way which is capable of delivering carry rather than in classic hedge fund performance fee arrangement terms.

What is HMRC's attitude towards hedge fund managers adopting carried interest strategies for the structures that do work?

There is a degree of scepticism in HMRC and this is a reason to be thoughtful about whether, or when, to use this sort of arrangement. Previously, HMRC said that hedge funds don't do carry, which maybe leads to a bigger question as to what a hedge fund is - the line has clearly blurred between what hedge funds and private funds do, but it is a point to be cautious on. If people push these types of arrangements too hard, they are liable to have enquiries opened and legislation could be introduced to counteract what is being done. Providing that people have the right type of strategy in the areas outlined, and are structuring things in a relatively straightforward manner, then using carry is perfectly doable.

Fund structures that support carry

Funds would typically be structured as a partnership to incorporate these carry structures. Whilst in principle, it may be possible to do something akin to carry in a corporate vehicle, a partnership is a lot more typical. Whilst individuals could participate in carry directly, the most common arrangement would be to have a special limited partner, which is itself a partnership, with the individuals sitting behind that. A number of jurisdictions have been used for those vehicles, such as Delaware and Guernsey, where you can have a limited partnership as the vehicle through which the individuals can participate.

Where you have a fund structured as a partnership and you are looking for a limited partner that is itself a partnership, you need to look for an entity that has legal personality, because partnerships in some jurisdictions will only permit partners who are legal entities. This is the reason for which people look to Scottish partnerships and Delaware limited partnerships, amongst others, for the fund.

This will mean that there could be a proliferation of entities in this structure, as not only will there be a master fund and a Scottish or Delaware limited partnership as the carry vehicle but general partner entities are also needed. These general partner entities will typically be located in the jurisdiction where the partnership is going to be established. It is also important for managers to consider where the general partner fits into their management group structure. Typically the general partnership entity wouldn't be held by the UK regulated firm, because that could give rise to consolidation and other regulatory issues. If a UK based general partner is being used, consideration must be given to permissions and regulatory issues.

Practical implementation

Hedge funds are typically open ended funds, which operate on a NAV per share basis, whereas the carried interest model operates on the basis of realised gains and doesn't charge fees on a NAV basis. If trying to apply carried interest to an open ended fund, there are two potential solutions. The first of these is where you are only applying the carried interest in relation to side pocket investments, where you have removed the redemption right (so the NAV becomes inconsequential in relation to the side pocket class). The second solution relates to open ended funds generally. If you have an open ended fund then you might have, for example, multiyear lock ups but still operate on a NAV per share basis, in this case then you are going to need to accrue for this fee that is going to be based on realised gains. Therefore, if you do have redemptions during the life of the fund, where there is an accrual but the carried interest hasn't been crystallised, you could crystallise the carried interest vehicles' carry on redemption. It is very likely that there won't be a gain at the time, sufficient to allocate to that, therefore it won't be possible to pass up capital gains through this structure to the individuals in the carry vehicle. This means that the structure doesn't work in respect of that element and the capital gains treatment won't be available to the relevant principles, but that doesn't mean it won't work in respect of other gains realised within the portfolio - therefore if it is even 80 per cent successful, it is still worth aiming for.

You may lose the benefit on those redemptions during the life of the investments, but on those you could just take a fee in the normal way and, subject to having set things up in the correct way, you can still have the objective at the end of receiving the amount, ideally taxed as gains.

If there is a part of the strategy that is sufficiently buy and hold for this structure to work, and another element that is too close to trading, then the approach to take depends on the weighting between those two buckets. You could put a few buy and hold positions under the main master fund in a partnership with a carry entitlement or, alternatively, if there is only a small proportion which may have trading risk, those may be undertaken in an investment vehicle which sits below the main partnership, through which the other investments are held. It is also important to think carefully about fees and other areas, especially for example if you've got carry but your liquid portfolio is not performing, consideration must be given to how you deal with this. In corporate funds, it is essential to have a separate share class per investor so that structurally there is the ability to do the netting off of gains and losses on different investments.

The above appears to be affecting the choice of UK limited company versus UK LLP for some UK managers. It may be a factor leading to managers thinking of operating through a limited company, the reason for this being that then the carry would be an employment related security (because the individuals would get it because they are employed by that limited company). This allows you to potentially navigate through some of the more difficult areas of the UK tax regime.

The LLP versus limited company discussion is the balance of a range of factors and is possibly something that might impact a new manager setting up, but is not the only reason.

Summer breaks and regulatory issues

As lockdowns are lifted, some investment professionals are relocating for the summer to second homes in other countries. There's a trend of requests to go and work, in those overseas locations, on a semi-permanent basis. There's a potential issue here of whether the relevant individual is carrying on licensable financial services activities. If they are an investment professional, then the activities they are carrying on in their day job may well trigger a financial services licensing requirement. The best practice for the firm, upon request from the individual to work abroad, is to take local advice on a case to case basis, as to what the most they can do is without compromising the firm's regulatory position. This will vary between countries and the individual, as to the role they have, and the amount of contact that they have with local clients or the local market, and whether they hold themselves out as operating within the market. There will not be a one size fits all approach and it is important, when you get these requests, to check and ensure that from the firm's perspective, the firm fully understands the legal implications. Other recommendations include putting out communications to all staff and asking them to seek pre-approval before going abroad. There have been a couple of unfortunate incidents where staff have relocated abroad, without informing the firm, and firms have found out retrospectively. If this has happened, retrospective diligence on what issues the individual may have caused, is essential.

How different is this to a usual summer holiday? The distinction is the duration, or degree of permanence of the visit. If it's a shorter holiday, most regulators (at least in Europe) will say this is not a licensing issue. If, however, the individual is requesting to spend two to three months or more, working permanently in another country, then that potentially raises financial services licensing issues. This also may potentially raise a tax issue, as to whether the individual is creating a permanent establishment in another country. There may also be immigration issues, personal tax issues, employment law issues for the firm (as to whether the individual would be gaining the status of employee in that jurisdiction), insurance issues, and health and safety concerns.

Seward & Kissel Investment Manager COVID-19 survey results

The survey (the full results of which can be found here) was sent out to S&K's entire alternative investment manager mailing list (but only went to managers and not to service providers). Recipients included hedge funds, private equity, private credit, real estate and others. The participants were, based on the survey results, 75 per cent open ended funds and the rest came from others including closed ended funds and real estate. The majority of the responses came from Chief Financial Officers, Chief Operating Officers, Chief Compliance Officers and General Counsels. Two thirds of these had one office and around twenty per cent had more than two offices. 58 per cent of the participants had their main office in New York City (Manhattan). 

The size of the firm dictated a lot of the results. Where the firm had large workforces, there was much less optimism about the return to office before 2021. 56 per cent of firms with less than 100 employees were optimistic about a return before 2021. Interestingly, New York City participants were more optimistic about the timeline of their return compared to non New York City firms, with 90 per cent of New York City participants believing that 50 per cent of their workforce would be back before year end, whereas only 75 per cent of the non New York City participants believed the same.

Another focus area was the working from home / remote working position. Pre COVID-19 - just over 50 per cent of all firms had a working from home policy. Where there was a smaller firm, the more common the existence of a working from home policy. The issue of this for larger firms seems to have been collaboration. Interestingly, bigger firms are typically the ones going after the most impressive talent, but they are now competing with other firms, for example tech firms, who have said they are closing offices until at least 2021. Whilst the bigger firms may feel like, based on the results, they need to be in the office for collaboration, from a recruitment standpoint, they may need to approach things differently as they compete with the tech firms and smaller firms. One of the responses was that 72 per cent of all firms expect a major change in their working from home policies.

Real estate and remote talent was also considered. 28 per cent of New York City participants expect their firms to reduce office space, whereas only 5 per cent of non New York City participants believe the same. It is very likely that commercial real estate in New York City will change dramatically - people can work remotely and, in doing so, reduce the overheads of office space.

40 per cent of all participants believed that their firm is likely to consider hiring remote operations, accounting and IT personnel going forward on a permanent basis and 34 per cent believe that their firm is likely to consider hiring more remote investment professionals. This is another big trend that is likely to change the face of the industry and the whole dynamic of hiring and compensation.

There was also a focus on fundraising and investor relations. Previously, we did a "Capital Raising in age of Coronavirus" survey, with one of the takeaways being that people were doing more virtual calls, but now, in this latest survey, less than 10 per cent of all participants reporting granting investor friendly concessions on fees, liquidity, or reporting terms, during COVID-19. The managers who have benefited the most during this time tend to be either: (i) larger managers - because the allocators and investors know them already and no one particularly wants to negotiate with the larger managers; or (ii) opportunistic structures -- there were a lot of opportunistic strategies, funds, Separately Managed Accounts and Special Purpose Vehicles' that came out, who tend to be much more: limited capacity, best idea, high demand type products.

This will likely be another theme we will see more of. The longer that this continues and the longer that the due diligence firms and allocators see that they can do due diligence in other ways, then the more the industry is opened up to the smaller managers. There is likely to be a lot of pressure on the bigger managers here, as at some point the smaller managers may challenge them.

Funds round up

We are now seeing movement in the market towards including a specific pandemics/COVID-19 risk factor in prospectuses. We are now suggesting a pandemics risk factor for inclusion going forwards called "Effect of Health Crises and Other Catastrophic Events". The next time we update your prospectus, we will be suggesting putting that risk factor in.

The Cayman Islands Monetary Authority has (in May 2020) also issued New Rule Contents of Offering Document for Cayman Islands' Regulated Mutual Funds. Our standard prospectus includes all requested content, apart from two mandatory statements that need to be included. We will be updating this next time we update your prospectus (an immediate update is not necessary).

Finally, a reminder that the deadline to register any section 4(4) funds under the Cayman Islands Mutual Funds Law - these are the limited investor funds which are restricted to having no more than 15 investors, a majority in number of whom are capable of appointing or removing the operator of the mutual fund - is 7 August 2020. If you haven't already, you should start updating your documents and arranging to make the filings now.