Funds
Private Equity, Hedge and All Core Structures
The Wiley Finance Series

Investment funds are the driving force behind much global private economic development, and yet the world of investment funds can be complex and confusing.

Funds: Private Equity, Hedge and All Core Structures is a practical introductory guide to the legal and commercial context in which funds are raised and invest their money, with examinations of the tax and regulatory background, and an analysis of the key themes and trends that the funds industry face following the financial crisis. The book looks at asset classes, investor return models, the commercial and legal pressures driving different structures and key global jurisdictions for both fund establishment and making investments. It also contains a comprehensive analysis of fund managers, from remuneration, best practice through to regulation.

The book is written for readers from all backgrounds, from students or newcomers to the industry to experienced investors looking to branch out into alternative asset classes, or existing asset managers and their advisers wanting to know more about the structures elsewhere within the industry.

1.1 Why this book? 1

1.2 Alternative assets 1

1.3 What is a fund? 2

1.4 Categories of funds 3

1.4.1 Ways to categorize 3

1.5 Choosing a vehicle 5

1.6 Open-ended and closed-ended fund structures 6

1.6.1 Introduction 6

1.6.2 Impact of the credit crisis 7

1.7 Contents of this book 8

2 Limited Partnerships – Use in Alternative Asset Funds 9

2.1 Introduction to limited partnerships 9

2.1.1 Suitability of limited partnerships for alternative asset funds 9

2.1.2 Benefits of limited partnerships 9

2.1.3 Types of limited partnerships 9

2.2 Structure of limited partnership funds 9

2.2.1 Role of general and limited partners 9

2.2.2 Management and operation of the partnership 10

2.2.3 Remuneration 11

2.2.4 UK limited partnerships 11

2.2.5 US limited partnerships 13

2.2.6 Parallel funds 15

2.2.7 Master/feeders 17

2.3 Establishment of the fund 18

2.3.1 Process 18

2.3.2 Documentation 19

2.4 Investing 20

2.4.1 Investment objective and returns 20

2.4.2 Investment strategy 20

2.4.3 Investment period 20

2.4.4 Term 21

2.4.5 Fund borrowing 21

2.4.6 Investment restrictions 21

2.5 Commitments by investors 22

2.5.1 Commitments/drawdowns 22

2.5.2 Recycling 22

2.5.3 Default 23

2.5.4 Management team’s commitment 24

2.5.5 Closings/equalization 24

2.5.6 Investor clawback 25

2.5.7 Withdrawals 25

2.5.8 Transfers 25

2.6 Economics 26

2.6.1 Management fee/priority profit share 26

2.6.2 Distributions/carried interest 26

2.6.3 Carried interest, escrow and clawback 29

2.6.4 Carried interest structure 30

2.6.5 Expenses 30

2.6.6 Transactional or monitoring fees 30

2.7 Governance 31

2.7.1 Removal of the general partner/manager 31

2.7.2 Key person 32

2.7.3 Advisory committee 33

2.7.4 Reports and meetings 33

2.8 Some conclusions 33

3 Hedge Funds 35

3.1 Introduction 35

3.2 Types of hedge fund strategies 35

3.2.1 Market neutral or directional 35

3.2.2 Discretionary or systematic 35

3.2.3 Strategy implementation and instruments 36

3.2.4 Typical strategies 36

3.3 Where are hedge funds located and what are the tax drivers? 39

3.3.1 Cayman Islands 39

3.3.2 British Virgin Islands 40

3.3.3 Jersey 41

3.4 Hedge fund investors 42

3.4.1 Seed and cornerstone investors 42

3.4.2 Incubator funds 42

3.4.3 Fund of funds 42

3.4.4 Individual investors and family offices 43

3.4.5 Platforms 43

3.5 Principal vehicles 43

3.5.1 The fund vehicle 43

3.5.2 Offshore management vehicle 43

3.5.3 Onshore advisory entity 44

3.6 Types of hedge fund structures 44

3.6.1 Simple hedge fund 44

3.6.2 The master/feeder structure 45

3.6.3 EU UCITS-compliant funds 47

3.7 Establishment of the fund 50

3.7.1 Process 50

3.7.2 Documentation 51

3.8 Management and performance fees 52

3.8.1 Management fee 52

3.8.2 Performance fee 52

3.8.3 Hurdle rate 52

3.8.4 High water mark 53

3.8.5 Redemption fees 53

3.9 Other key terms 53

3.9.1 Liquidity 53

3.9.2 Lock-ups 53

3.9.3 Gating provisions 54

3.9.4 Capacity 54

3.9.5 Early stage or seed investors 54

3.9.6 Key man 54

3.9.7 Equalization 54

3.10 The use of side pockets 55

3.11 Regulation 55

3.12 Some conclusions 56

4 Structural Variants and Alternative Structures to Chapters 2 and 3 57

4.1 Introduction 57

4.2 Pledge funds 57

4.3 ‘Combo’ fund structure 58

4.3.1 Introduction 58

4.3.2 The blind-pool or committed capital fund 58

4.3.3 The pledge fund 58

4.3.4 The combined (or ‘combo’) fund 59

4.4 Investment clubs 60

4.5 Fund-lites 60

4.5.1 Introduction 60

4.5.2 Shorter life of the fund 61

4.5.3 Reduced scope of the investment objective 61

4.5.4 Fees 61

4.5.5 No key man clause 61

4.5.6 No escrow or clawback for carry 61

4.5.7 No re-investment of realized funds 62

4.5.8 No restrictions on future funds 62

4.5.9 Fund-lites: some conclusions 62

4.6 Top-up, bridge and side pockets 63

4.7 Managed accounts 63

4.7.1 Introduction 63

4.7.2 Comparison with funds 64

4.7.3 Advantages 65

4.7.4 Disadvantages 65

4.7.5 Some conclusions 66

4.8 Corporate vehicles 66

4.9 Special purpose acquisition companies (SPACs) or cash shells 67

4.10 UK enterprise investment scheme 68

4.10.1 Introduction 68

4.10.2 Legislation 68

4.10.3 Conditions 69

4.10.4 EIS funds 71

4.10.5 Tax 71

4.11 UK unit trusts 72

4.11.1 Introduction 72

4.11.2 Legislation 72

4.11.3 Authorized unit trusts 72

4.11.4 Undertakings for collective investment in transferable securities 73

4.11.5 Pricing 74

4.11.6 Risk 74

4.11.7 Fees 74

4.11.8 Taxation of unit trusts 74

4.12 Offshore alternatives 76

4.12.1 Unit trusts 76

4.12.2 Cell companies 76

4.13 Jersey property unit trusts 76

4.13.1 Introduction 76

4.13.2 Jersey FS law 77

4.13.3 Types of JPUT 77

4.13.4 Some JPUT conclusions 78

4.14 Some conclusions 79

5 Investment-specific Strategies 81

5.1 Introduction 81

5.2 Private equity/venture capital 81

5.2.1 Introduction 81

5.2.2 Strategies 81

5.3 Public equities 82

5.3.1 Introduction 82

5.3.2 Strategies 82

5.4 Bonds 83

5.5 Credit funds 83

5.5.1 Introduction 83

5.5.2 Senior debt 83

5.5.3 Mezzanine debt 84

5.5.4 Bonds 85

5.5.5 Asset-backed securities (ABSs), collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs) 85

5.5.6 Fund diversity 85

5.6 Shadow banking 86

5.6.1 Introduction 86

5.6.2 SIVs/conduits 86

5.6.3 Perceived risks 87

5.6.4 Proposed added US regulation 88

5.7 Real estate and infrastructure 89

5.7.1 Introduction 89

5.7.2 Real estate strategies 89

5.7.3 Infrastructure strategies 90

5.8 Energy funds 91

5.8.1 Old energy 91

5.8.2 New energy 91

5.9 Commodities funds 92

5.9.1 Introduction 92

5.9.2 Agriculture 92

5.9.3 Metals 92

5.9.4 Energy 93

5.9.5 Direct or indirect investment 93

5.9.6 Regulation 94

5.10 Social impact funds 95

5.10.1 Introduction 95

5.10.2 The rewards of social impact funds 95

5.10.3 The risks of social impact funds 96

5.11 Secondaries funds 96

5.11.1 Introduction 96

5.11.2 Key legal points 97

5.11.3 Aspects of secondaries investment 98

5.11.4 Some criticism of secondaries investment 98

5.12 Derivatives funds 99

5.12.1 Introduction 99

5.12.2 Issues around derivatives 99

5.12.3 Specific regulation 100

5.13 Currency funds 100

5.13.1 Introduction 100

5.13.2 Issues around currency funds 101

5.13.3 Specific regulation 101

5.14 Hedge fund strategies 101

5.15 Some conclusions 101

6 Stock Markets and Listed Funds 103

6.1 Introduction 103

6.2 Listings of private funds 103

6.2.1 Introduction 104

6.2.2 Direct funds 104

6.2.3 Feeder funds 104

6.2.4 Taxation 104

6.3 UK markets and listed fund structures 105

6.3.1 Background 105

6.3.2 The London markets 105

6.3.3 Vehicles in London appropriate for listing investment funds 106

6.3.4 Obtaining a London listing – Main Market and AIM 121

6.4 New York 121

6.4.1 Background 121

6.4.2 The New York markets 121

6.4.3 Vehicles in New York appropriate for listing investment funds 122

6.5 Europe 128

6.5.1 The European markets 128

6.5.2 European exchange traded funds (ETFs) 128

6.6 Alternative offshore stock exchanges 131

6.7 Some conclusions 132

7 Principal ‘Offshore’ Fund Locations 133

7.1 What are the characteristics of an attractive investment fund location? 133

(A) OFFSHORE CROWN DEPENDENCIES 134

7.2 The Channel Islands 134

7.2.1 Background 134

7.2.2 Common structures 134

7.2.3 Regulation of the fund 136

7.2.4 Stock exchange 138

7.2.5 Taxation 138

7.3 The Isle of Man 139

7.3.1 Background 139

7.3.2 Common structures 139

7.3.3 Regulation 140

7.3.4 Taxation 141

7.4 Other Channel Islands 142

7.4.1 Alderney 142

7.4.2 Isle of Sark 142

7.4.3 Herm 142

(B) SPECIFICALLY REGULATED EU FUND JURISDICTIONS 142

7.5 Ireland 142

7.5.1 Background 142

7.5.2 Common structures for funds 142

7.5.3 Regulation 143

7.5.4 Stock exchange 144

7.5.5 Taxation 144

7.6 Luxembourg 144

7.6.1 Background 144

7.6.2 Common structures 144

7.6.3 Regulation 146

7.6.4 Stock exchange 147

7.6.5 Taxation 147

7.7 Malta 147

7.7.1 Background 147

7.7.2 Common structures 148

7.7.3 Regulation 149

7.7.4 Stock exchange 150

7.7.5 Taxation 150

7.8 Cyprus 150

7.8.1 Background 150

7.8.2 Common structures 151

7.8.3 Regulation 151

7.8.4 Stock exchange 152

7.8.5 Taxation 152

7.9 Gibraltar 152

7.9.1 Background 152

7.9.2 Common structures 153

7.9.3 Regulation 153

7.9.5 Taxation 155

(C) REST OF EUROPE 156

7.10 The Netherlands 156

7.10.1 Background 156

7.10.2 Common structures 156

7.10.3 Regulation 157

7.10.4 Stock exchange 157

7.10.5 Taxation 157

7.11 Switzerland 158

7.11.1 Background 158

7.11.2 Common structures 158

7.11.3 Regulation 158

7.11.4 Stock exchange 159

7.11.5 Taxation 159

(D) CARIBBEAN AND ATLANTIC 159

7.12 The Cayman Islands 159

7.12.1 Background 159

7.12.2 Common structures 159

7.12.3 Regulation 160

7.12.4 Stock exchange 161

7.12.5 Taxation 162

7.13 The British Virgin Islands 162

7.13.1 Background 162

7.13.2 Common structures 162

7.13.3 Regulation 163

7.13.4 Taxation 163

7.14 Bermuda 164

7.14.1 Background 164

7.14.2 Common structures 164

7.14.3 Regulation 165

7.14.4 Ongoing reporting 165

7.14.5 Funds outside regulation 166

7.14.6 Segregated Accounts Companies 166

7.14.7 Stock market 167

7.14.8 Taxation 167

(E) ASIA 168

7.15 Hong Kong 168

7.15.1 Background 168

7.15.2 Common structures 168

7.15.3 Regulation 169

7.15.4 Stock exchange 169

7.15.5 Taxation 169

7.16 Singapore 170

7.16.1 Background 170

7.16.2 Common structures 170

7.16.3 Regulation 171

7.16.4 Stock exchange 171

7.16.5 Taxation 171

7.17 Dubai 172

7.17.1 Background 172

7.17.2 Common structures 172

7.17.3 Regulation 172

7.17.4 Stock exchange 173

7.17.5 Taxation 173

7.18 Mauritius 173

7.18.1 Background 173

7.18.2 Common structures 173

7.18.3 Regulation 174

7.18.4 Stock exchange 175

7.18.5 Taxation 175

7.19 Some conclusions 175

8 Principal ‘Onshore’ Fund Locations 177

8.1 Introduction 177

(A) ASIA 178

8.2 People’s Republic of China 178

8.2.1 Background 178

8.2.2 Common structures 178

8.2.3 Regulation 180

8.2.4 Stock exchange 181

8.3 Japan 182

8.3.1 Background 182

8.3.2 Common structures 182

8.3.3 Regulation 183

8.3.4 Stock exchange 184

8.4 India 184

8.4.1 Background 184

8.4.2 Common structures 184

8.4.3 Regulation 185

8.4.4 Stock exchange 186

(B) THE AMERICAS 186

8.5 Canada 186

8.5.1 Background 186

8.5.2 Common structures 187

8.5.3 Regulation 188

8.5.4 Stock exchange 189

8.6 The Federative Republic of Brazil 189

8.6.1 Background 189

8.6.2 Common structures 189

8.6.3 Regulation 190

8.6.4 Stock exchange 190

(C) ONSHORE EUROPEAN JURISDICTIONS 191

8.7 Russian Federation 191

8.7.1 Background 191

8.7.2 Common structures 191

8.7.3 Regulation 193

8.7.4 Stock exchange 193

8.8 Germany 193

8.8.1 Background 193

8.8.2 Common structures 194

8.8.3 Regulation 194

8.8.4 Stock exchange 197

8.9 France 198

8.9.1 Background 198

8.9.2 Common structures 198

8.9.3 Regulation 199

8.9.4 Stock exchange 200

(D) COMMONWEALTH OF AUSTRALIA 200

8.10.1 Background 200

8.10.2 Common structures 201

8.10.3 Regulation 202

8.10.4 Stock exchange 203

(E) ISLAMIC INVESTMENT FUNDS 203

8.11.1 Background 203

8.11.2 Key principles of Sharia’a law 204

8.11.4 Parties to an Islamic investment fund 206

8.11.5 Stock exchange 207

9 Sovereign Wealth Funds, State-sponsored Funds, Pension and Superannuation Schemes and Charities 209

9.1 Introduction 209

9.2 Sovereign wealth funds (SWFs) 209

9.2.1 Definition of sovereign wealth fund 209

9.2.2 Source of sovereign wealth funds 210

9.2.3 Types of SWF investment vehicles 210

9.2.4 SWF investment strategies 211

9.2.5 Taxation of SWFs 212

9.2.6 Transparency of an SWF 213

9.2.7 Key regulation 214

9.3 State-sponsored funds 215

9.3.1 Introduction 215

9.3.2 UK 215

9.3.3 Europe 217

9.3.4 The US 218

9.4 Pensions 219

9.4.1 What is a pension? 219

9.4.2 UK pensions 219

9.4.3 European pensions 221

9.4.4 France 222

9.4.5 Germany 222

9.4.6 US pensions 224

9.4.7 Australia 227

9.4.8 Pension funds as an investor 229

9.5 Charities 230

9.5.1 What is a charity? 230

9.5.2 UK history 231

9.5.3 Investment strategies 232

9.5.4 Taxation 232

9.5.5 Charities as investors 232

9.6 Some conclusions 233

10 Investment Manager Structures 235

10.1 Introduction 235

10.2 General partner in limited partnership structures 235

10.3 Regulation of investment managers 236

10.3.1 The UK Financial Conduct Authority 236

10.3.2 The US Securities Exchange Commission 237

10.3.3 Dodd–Frank Wall Street Reform and Consumer Protection Act 238

10.3.4 The EU Alternative Investment Fund Managers Directive 239

10.4 Structures of management vehicles 240

10.4.1 UK LLP 240

10.4.2 US Limited Liability Company 240

10.4.3 Company 241

10.4.4 GP as an LP structure 241

10.5 Investment manager fees 241

10.5.1 Closed-ended funds 241

10.5.2 Open-ended funds 242

10.5.3 Transactional or monitoring fees 242

10.6 Performance fees and carried interest 243

10.6.1 Closed-ended funds 243

10.6.2 Open-ended funds 244

10.7 Internal economics 244

10.7.1 Salary and fixed draws 245

10.7.2 Bonuses 245

10.7.3 Share and option ownership of investment company 245

10.7.4 Performance fee share and carried interest 245

10.7.5 Co-investment 245

10.7.6 Fund investment or the GP commitment 246

10.8 External ownership of investment manager groups 246

10.9 Listing of investment manager groups 246

10.10 Boards and committees of an investment manager 247

10.10.1 Board 247

10.10.2 Non-executives 247

10.10.3 Executive committee 247

10.10.4 Investment committee 248

10.10.5 Industrialists 248

10.11 Manager or adviser 248

10.11.1 Permanent establishment rules 248

10.11.2 Other drivers 248

10.12 Family offices 249

10.13 Some conclusions 249

11 Taxation Principles in Funds 251

11.1 Introduction 251

11.2 Taxation of funds 251

11.2.1 UK 251

11.2.2 US 253

11.2.3 EU 254

11.2.4 Permanent establishment rules 255

11.3 Investors 257

11.3.1 UK 257

11.3.2 US 259

11.4 Investment manager companies 264

11.4.1 Closed-ended funds 264

11.4.2 Open-ended funds 265

11.5 Principals of an investment manager 266

11.5.1 Equity ownership of investment manager and the fund 266

11.5.2 Management fees 267

11.5.3 Carried interest 267

11.5.4 Performance fees 268

11.6 Some conclusions 268

12 Regulatory Environment 269

12.1 Introduction 269

12.1.1 US, UK and EU regulatory environment 269

12.1.2 Other regulatory environments 269

12.2 UK regulatory environment 269

12.3 Financial conduct authority 270

12.3.1 Statutory objectives 270

12.3.2 Regulation 270

12.3.3 Exemptions 271

12.3.4 Financial promotions 271

12.3.5 Supervision of firms 271

12.3.6 Supervision of individuals 271

12.4 Prudential Regulation Authority 272

12.4.1 Statutory objectives 272

12.4.2 Regulation 272

12.4.3 Supervision of firms 272

12.4.4 Supervision of Individuals 273

12.5 US regulatory environment 273

12.5.1 The United States Securities and Exchange Commission 273

12.5.2 The Commodity Futures Trading Commission 275

12.5.3 The Dodd–Frank Wall Street Reform and Consumer Protection Act 276

12.5.4 The Foreign Account Tax Compliance Act (FATCA) 279

12.5.5 FBAR reporting requirements 279

12.6 EU regulatory environment – the Alternative Investment Fund Managers Directive 280

12.6.1 Background 280

12.6.2 Authorization requirements for AIFMs 281

12.6.3 Authorization requirements for small AIFMs 282

12.6.4 Marketing of AIFMs 283

12.6.5 National private placement 284

12.6.6 Delegation 284

12.6.7 Depositaries 285

12.6.8 Capital requirements 285

12.6.9 Code of conduct 286

12.6.10 Transparency 286

12.6.11 Leverage and asset stripping 286

12.6.12 Remuneration 287

12.6.13 Valuation 287

12.7 Other EU regulation 287

12.7.1 Basel III 287

12.7.2 Solvency II 288

12.7.3 European Market Infrastructure Regulation (EMIR) 289

12.7.4 EU energy infrastructure proposals 289

12.8 Regulation – some conclusions for alternative asset fund managers 290

13 Comparisons and Conclusions 293

13.1 Introduction 293

13.2 Evolving structural drivers 293

13.2.1 Tax efficiency 293

13.2.2 Regulation 294

13.3 Core structures compared 296

13.3.1 Key differences between private equity funds, hedge funds and quoted funds 296

13.4 The paperwork 299

13.5 The actors 299

13.6 The supporting actors 301

13.7 What is trending? 302

13.7.1 Internet 302

13.7.2 Multi-immediate media 302

13.7.3 Onshore/offshore debunked 303

13.7.4 Change of focus 304

13.7.5 Masters of the Universe 305

13.7.6 Paradigm bashing 305

13.7.7 Book conclusion 305

Appendix I Definitions 307

Appendix II Abbreviations 311

Appendix III Acknowledgements 319

Index 327

About the author

Matthew Hudson is an entrepreneurial lawyer with over 25 years of Private Equity experience, both as a lawyer and as an investor. Matthew is a well-known industry figure and regularly speaks on new developments concerning the Private Equity industry.

Matthew has helped build and manage four of the major Private Equity law firms:

• Founder of MJ Hudson
• Co-founded the Private Equity Group of SJ Berwin
• Re-established the O’Melveny & Myers London office, and chaired the European Private Equity and M&A Practices
• Created the Proskauer Rose, London office

Further, Matthew has also worked in three Private Equity houses:

• Leveraged buy-outs for a group built within CSFB
• Founded Far Blue Ventures, the Venture Capital house, backing IP spin-outs from universities
• Coller Capital, the global Secondaries firm