Background to the Japanese Hedge Fund Industry
The hedge fund industry in Japan is currently experiencing an unprecedented period of growth. Aggressive independent fund management utilising advanced alternative investment management techniques specifically designed for Japanese institutional and high net worth investors was difficult to imagine as recently as five years ago. Investment in Japanese markets by foreign capital, once the dominion of "bulge bracket" investment and universal banks, is now equally likely to take place through offshore funds applying a variety of advanced financial strategies to Japanese equity and fixed income markets. Eurekahedge now estimates that the number of hedge funds operating in the Japanese market at 31 with total assets under management of US$4.6 billion. As with United States and European markets, the rise of the offshore funds as the vehicle of preference for talented traders and investment managers has brought the Japanese hedge fund market into its own over the past decade.
The Japanese hedge fund industry can be divided into two fundamental parts: (i) foreign investors using hedge funds to invest into Japanese capital markets; and (ii) Japanese institutional and high net worth investors using hedge funds to invest in international (primarily United States and European) capital markets. In both cases, due to regulatory and tax concerns, the "fund" is established in an offshore jurisdiction (most typically in the Cayman Islands, the British Virgin Islands, Dublin or Luxembourg). This Article is directed primarily at the latter category of investors: Japanese institutional and high net worth individuals who are interested in learning more above this "exotic" investment vehicle, how it is offered for investment in Japan, and how to perform due diligence on the investment manager and investment structure to compensate for the low level of regulation applicable in foreign jurisdictions.
Part I below reviews briefly the structures that are used for hedge funds in which Japanese investors typically invest. Part II examines the interaction between offshore hedge funds as investment vehicles and the Japanese investment regulatory system including the system for regulating the business of providing investment advice to and from Japan, and the offering process for hedge funds investments to Japan resident institutional and individual investors. Part III provides a summary discussion of the most important concepts and terms used in hedge fund documentation with the objective of assisting investors in reviewing disclosure documentation for hedge funds in which they may wish to invest. Finally, Part IV provides a roadmap for conducting due diligence on a hedge fund including a review of the important role of professional advisers in this process.
Part I: The Structure and Operation of Japanese Hedge Funds
Unlike other collective investment vehicles with which Japanese domestic investors are familiar, most first time Japanese investors, whether institutional or high net worth, are almost entirely unfamiliar with the nature of the interest they are investing in when they deliver investment capital to a hedge fund investment manager. Almost all hedge funds are organised in one of three forms: (i) offshore exempted corporations; (ii) limited partnerships; or (iii) investment trusts. Although analogs of each of these forms exist in Japanese practice, the rights of a holder of an interest in these investment vehicles differs significantly from those of the comparable Japanese form of entity.
The "exempted corporation" ("exempted" refers to the fact that such corporations are not taxable on income so long as they do not engage in business in the jurisdiction of their establishment) is a corporate form entity typically with very limited statutory or organisational shareholder protections. Such corporations have Boards of Directors and many of the traditional attributes of the corporate form of organisation (limited liability, corporate accountings, interests in the form of shares, etc.). However, for a variety of tax and operational reasons, exempt corporations are most often encountered in hedge funds as the form used to hold the investment manager (or general partner) of the relevant fund vehicle.
The "limited partnership" (LP) and its close corporate analogue, the limited liability corporation (LLC), is largely unfamiliar to the Japanese investor community. Typically, LPs used in hedge fund practice are organised under an abbreviated statutory framework in a jurisdiction which permits almost unlimited flexibility in the definition of an investor's legal right to investment profits, the manner in which funds are managed, and the investment authority of the investment manager (i.e., general partner). Japanese investors with limited familiarity with this type of organisation are cautioned to review investment documentation in detail and to familiarise themselves with the statutory framework of the jurisdiction in which the limited partnership is organised. Experienced professional assistance with analyzing structured investments utilising this form is essential for even the largest and most experienced investors. Because of the great flexibility in selecting governance, accounting and investor rights attributes of this form of organisation, it tends to be highly popular with sophisticated investment managers for structured investments.
The investment trust is far more familiar to Japanese investors because of their familiarity with its domestic counterpart, the Japanese investment trust used in the Japanese mutual fund and real estate investment trust industries. However, unlike the Japanese investment trust, the investment trust used in hedge funds can take two forms: (i) an investment trust created by contract similar to the Japanese investment trust, and (ii) a trust established under a declaration of trust. Unlike the Japanese investment trust which is created between heavily regulated trust banks and a regulated investment trust management companies, a contractual hedge fund investment trust is typically made between a largely unregulated investment management company in the form of an exempted company and a simple trust company which again is largely unregulated.
B. Representative Structure
Recently, the most common form of a hedge fund is a master fund in the form of an trust established under a Declaration of Trust by a Cayman Islands trustee company. Under the trust instrument, the trustee enters into agreements with specific providers of services to the fund including the investment manager which directs the management of the trust (and typically is the sponsor of the trust investment plan), an administrator which maintains accounting and asset records for the trust, a custodian which maintains the physical property of the trust (typically share certificates or asset registers with relevant custodians and sub-custodians in foreign jurisdictions) and directly or indirectly, a prime broker (a registered broker-dealer in the relevant jurisdiction for trading) who provides securities trading services including margin and securities lending facilities.
Where investors from multiple jurisdictions may invest in the fund, it is not uncommon to have one or more "feeder" trusts or limited partnerships through which investors in foreign jurisdictions may invest in the "master" fund. Use of a separate feeder investment vehicle can accomplish several goals, although it increases considerably the costs associated with the establishment of the structure. First, where investor groups are different in character (e.g., large institutional investors versus high net worth individuals) fee differences may be handled at the feeder level. Second, where the currency of investment and currency of account of the fund are different, hedging of the currency of account back into the investor's currency of investment can occur at the feeder level, thereby ensuring that other investors, whose currency of investment may be the same as the currency of account, are not charged for the hedging costs to hedge back to the currency of investment. Third, where the investors in a particular jurisdiction prefer the use of a particular type of feeder entity for tax, regulatory or other purposes, a feeder structure allows investor tailoring of this type.
Master-feeder structures should be distinguished from so-called "funds of funds". A master-feeder structure almost always has the same investment manager at both the feeder and the master level, while a fund of funds will typically have one investment manager for the master fund and a different investment manager for each of the sub-funds in which it invests. In addition, the fee structures of master-feeder and funds of funds are very different such that funds of funds (because of the compounding effects of fee "layering" and the absence of a heavy management burden once the fund is established) having a reduced administration fee and a lower carried interest (see discussion below).
Part II. Regulations Relevant to Hedge Funds Sold to Japanese Investors
A. Licensing of Market Intermediaries
In Japan, both the business of marketing and selling securities and the business of providing investment advice to individuals and institutions are heavily regulated. As in other jurisdictions, this means that, in order for an offshore fund to have an onshore presence to provide investment input into the offshore fund's management, in most circumstances a registration will need to be made with Japanese regulatory authorities to conduct such activities. In addition, if the fund's interests are to be sold to Japanese investors through solicitation and marketing activities in Japan, the party undertaking such marketing activities must be licensed and, in most cases, the fund interests must be registered with Japanese regulators. The discussion below focuses first on the business of providing investment advice, then on the business of marketing securities to Japanese investors, and finally on the product registration process.
1. Investment Advisory Business
With respect to the provision of investment advice, there are two levels of advisory activities permitted under the Securities Investment Advisory Business Law ("SIABL"): (i) Investment Advisor ("IA") business and (ii) the Discretionary Investment Manager ("DIM") business. An IA is permitted to provide advice concerning the valuation of "securities," as that term is defined in the Securities and Exchange Law ("SEL"), with respect to investments in (purchases and sales of) securities. An IA is only permitted to provide investment advice and may not engage in activities to implement an investment program based on such advice. If an IA wishes to obtain the authority to direct investments on behalf of a client, the IA must obtain DIM authority from the Financial Services Agency ("FSA"; hereinafter such an IA with DIM authority will be referred to as a DIM).
The DIM authority permits a DIM to act solely in an agency role to direct investments in securities through a licensed securities company. Such authority does not allow the DIM or its representatives to solicit the sale of any particular securities products to Japanese investors. A DIM is only permitted to engage in investment implementation activities specifically enumerated under Article 2.4 of the IABL. Marketing activities in connection with specific financial products is not included in this list. Thus, a DIM is permitted to market advisory and discretionary investment management services, but may not market specific securities products, even if it is the advisor to the issuer of such securities products (e.g., an investment fund). Currently, the marketing of most fund products (i.e., securities) requires a securities broker-dealer license or a securities sale representative license (see discussion below).
The IA registration is a relatively straightforward registration involving the filing of identifying and background information. Both legal entities and individuals may apply for the registration. The DIM authority, on the other hand, is in the nature of an institutional license and requires a corporation having capital in excess of ¥50 million or, with respect to the Japan branch of a foreign corporation wishing to obtain such license, a foreign corporation (but not a partnership, limited partnership or limited liability company) with a similar level of capital. Obtaining the DIM authority is far more difficult and information intensive. Among other elements, the application must demonstrate that the applicant corporation has sufficient human resources and a fully formed and prudent compliance structure. In addition, the applicant must furnish a substantial business security deposit, and make periodic reporting to regulators.
2. Securities Business Registration
Only a domestic corporation or the Japan branch of a foreign securities company with a securities broker-dealer registration may conduct a securities business in Japan. SEL Article 2.8 defines a "securities business" to include, among other things, the trading of securities, securities futures transactions, securities options transactions, and the intermediation, agency and brokering of trading in these activities. The list of "securities" under Article 2 of the SEL includes among other instruments stocks, bonds, beneficiary certificates of investment trusts, similar instruments issued by foreign issuers, warrant certificates, and certificates of deposit. Thus, most products which are generally viewed as securities products in other jurisdictions are covered under this definition. In addition to securities products, a registered broker-dealer may market certain other financial products such as credit derivatives products, loan intermediation products and money lending and foreign exchange products upon obtaining a side business registration for each specific product.
It should also be noted that, unlike in other jurisdictions, Japan law and regulation takes the approach that only products specifically listed in Article 2 are covered by the SEL. Therefore, certain instruments which are less familiar to Japanese practice, such as partnership interests, are not treated as securities under the SEL, and thus at present the issuers of partnership interests may market these interests in Japan without a securities broker-dealer registration. This exception of partnership and limited partnership interests from SEL coverage has long been viewed as a loophole in the coverage of the SEL and, as a result, the FSA has recently submitted to the Japanese Diet a bill to amend the SEL to cover investment partnership interests by adding these interests to the list of securities under Article 2. The FSA intends these amendments to become effective as of December 1, 2004.
The securities broker-dealer registration is one of most heavily supervised licenses/registrations in Japanese regulatory practice. A registered securities broker-dealer is required to, among other things, have a minimum level of regulatory capital, employ sufficient qualified personnel, participate and contribute to an investor protection fund, and maintain certain solvency reserves. In addition, securities marketing and other activities conducted by a registered securities broker-dealer and its representatives are regulated in considerable detail both under the SEL and under regulations issued by the Japan Securities Dealers Association ("JSDA"), Japan's principal securities industry self-regulatory organisation. This regulatory regimen includes restrictions on marketing of securities products by any securities employee other than trained and duly registered sales representatives required to pass an examination administered by the JSDA.
Because of the above heavy regulatory burden to obtain and maintain a securities broker-dealer registration, a hedge fund which wishes to market to Japanese investors will almost never seek this authority. Instead, they will either work with an established securities company or they will seek to establish a securities sale intermediation entity.
3. Securities Sales Intermediary Registration
The concept of a Securities Sales Intermediary ("SSI") business for the sale of securities represents a dramatic departure from the traditional Japanese regulatory pattern for securities sales where basically only registered securities broker-dealers are permitted to engage in securities intermediary activities in Japan. Under the recently amended SEL, an individual or firm may register to provide SSI services as firms entrusted by, and acting on behalf of, one or several registered securities broker-dealers and some other qualified financial institutions. The SSI services include the conduct of intermediation of securities transactions including securities transactions, securities index future transactions and securities option transactions on stock exchanges, as well as foreign securities transactions and foreign securities future transactions on foreign stock exchanges.
Since a SSI is acting as an intermediary for its sponsoring securities broker-dealer, the SSI may market only those securities products that the sponsoring securities broker-dealer is permitted to market to investors in Japan. For instance, a SSI may not market a foreign securities product to Japanese investors if that product has not been registered by a securities broker-dealer with the Japanese regulators for distribution in Japan and thus may be marketed in Japan. SSI services are limited to intermediation services between an investor client and the sponsoring securities broker-dealer that the SSI is serving. Consistent with this structure, the actual securities trading contracts and other securities related contracts are to be made in the names of the sponsoring securities broker-dealer and the investor client. This means that, as intermediaries, SSIs are not permitted to receive or handle cash or instruments in connection with a securities acquisition transaction with the investor. In other words, a SSI may only undertake securities marketing activities and may not undertake any back office functions left which must be handled by the sponsoring securities broker-dealer.
The process of registering as an SSI is less burdensome than that for a securities broker-dealer registration or DIM license. The SSI registration does not require a business security deposit, any specific capital amount, dedicated compliance resources, or a heavy reporting burden to regulators and other self-regulatory bodies. However, individual marketing representatives in a SSI must hold a securities representative registration from the JSDA. Moreover, an SSI will need to maintain securities business compliance manuals, ensure that its representatives maintain qualification as securities sales representatives and comply with supervision provided by its sponsoring securities broker-dealer.
B. Registration and Offering of Securities in Japan
Subject to certain small offering exceptions, the offer and sale of securities in Japan to residents of Japan requires registration of the relevant instruments with a regional financial bureau ("FB"). Offerings in Japan can be divided into two major categories: (i) public offers and (ii) private placements. Public offers are those offers involving the solicitation of 50 or more persons for the purchase or sale of the same issue of securities within a six month period . Private placements involve offers to less than 50 persons (or to less than 50 persons and up to 250 qualifying institutional investors) of the same issue of securities. Registration statements for public offerings and registration notifications for private placements are filed with the relevant FB with respect to securities covered by the SEL and with the FSA for securities covered by the Investment Trust and Investment Corporation Law.
1. Public Offers
With respect to public offers to 50 or more persons, where the relevant offer involves instruments having an aggregate value of less than ¥10 million, no filing is required. If the aggregate value of the offering is more than ¥10 million but less than ¥100 million, then a Securities Notification (an abbreviated form of registration) is required. If the aggregate value of the offering is ¥100 million or more, a Securities Registration Statement filing is required with the FB. Both a Securities Registration Statement and a Notification require certain documents to be filed as attachments in addition to the actual filing application. These include: (i) documents establishing the investment vehicle, such as a trust deed, partnership agreement or articles of incorporation; (ii) the Offering Memorandum (required for an SRS and for a Notification if such disclosure documentation is existing ); (iii) if the issuer is a foreign fund, then a legal opinion opining to the valid establishment and existence of the relevant investment vehicle; (iv) certain ancillary documents such as a power of attorney for filing and board resolutions; and (v) for a Securities Registration Statement, any other relevant agreements relating to the investment vehicle, including management agreements and custody agreements.
The key differences between a Notification filing and a Securities Registration Statement include the volume of documents typically required to be filed - a Notification is typically approximately only ten percent of the volume of a Securities Registration Statement. In addition, Securities Registration Statements require a much greater level of disclosure and are more carefully reviewed by Financial Bureaus than are Notifications. In the case of a Securities Registration Statement, there will be a 15 day waiting period after filing an SRS before any solicitation activities may be commenced while with a Notification the minimum period is one day prior to commencing offering activities. Finally, a Securities Registration Statement is a public document while a Notification is not.
If the foreign fund falls within the definition of a securities investment trust , issuer registration filings are made with the FSA under the Investment Trust and Investment Corporation Law ("ITICL") rather than with a relevant local FB under the SEL. It should be noted that, unlike with filings under SEL, the aggregate value of the offering does not effect the required filings. In addition, FSA Filings are only required to be filed prior to the commencement of solicitation activities--in practice, people tend to file one day prior to commencing offering activities. For domestic funds, the filing requirements are relatively straightforward, requiring mainly the filing of the trust deed. For foreign funds, the filing requirements are not as onerous as with the filing of a Securities Registration Statement but are significantly more involved than with the Securities Notification. Like Notifications, filings with the FSA are also not disclosed to the public. In principle, the relevant attachments to filings with the FSA under the ITICL are the same as the SRS and Notification requirements.
2. Private Placements
Most fund interests sold to institutional investors in Japan are sold in private placements. There are two types of private placements: (a) offerings to a small number of investors where the number of offerees is less than 50 and where restrictions on transfer exist to ensure that there is a very low likelihood that securities will be transferred to more than 50 persons; and (b) offerings to professional investors who fall within the definition of Qualified Institutional Investors ("QII") and who are subject to restrictions on transfer designed to ensure that the securities will not be transferred to non-QII. For private placements under the SEL, a filing with the relevant local FB is only required if the aggregate value of the offering is ¥100 million or more. The Securities Notification filing for a private placement is very similar to the Securities Notification filing for a public offering. In the case of a private placement under the ITICL, the same filing requirement as for public offerings made with the FSA.
Prior to April 1, 2004, the SEL provided that if a distributor solicited the sale of securities with a resale restriction to less than 50 investors, such a securities offering was exempt from public disclosure requirements under the SEL through a private placement exemption (the "Private Placement Exemption"). The exemption applied only to fixed income and not equity securities. The previous Private Placement Exemption required QIIs to be counted in the number of solicitees, which required to be less than 50 to be within the exemption. However, an amendment to the Private Placement Exemption which recently became effective now exempts up to 250 QII's from being counted as solicitees. In order to qualify for this liberalized Private Placement Exemption, the securities being offered to the QIIs must include a resale restriction requiring sales solely to QIIs. The recent amendments have also extended the scope of the Private Placement Exemption to include equity securities including stocks, warrants, stock options and foreign investment securities. As in the past, the exemption applies only to initial offerings.
Part III. Terminology in Hedge Fund Establishment
Whether considering investments in a hedge fund as an investor or contemplating the structuring of a hedge fund as a manager, certain key areas and provisions warrant particular attention. A thorough understanding of the underlying rationale of particular fund provisions and an appreciation of how these individual provisions work together in a fund can assist both the investor and manager in structuring a fund that provides the economics sought by each party and the chances of achieving a successful fund. Although obtaining advantageous terms in the absolute sense may be desired in the short term by both parties, it should be noted that funds with a strong alignment and balancing of investors and manager interests often achieve greater long term gains for all parties involved.
Negotiations surrounding fee provisions often comprise a significant portion of the negotiations for a new fund. At the most basic level, managers seek to maximize the fees payable to them by the fund, while investors seek to minimize these fees. From this starting point, there are various methods of structuring fees that can be beneficial to both investors and managers.
Fees of managers are typically made up of two components. The first component is a fee based on a modest percentage of the assets under management, typically in the 0.25% - 2.0% range depending on the type of fund. This fee is often called the "management fee". Although this fee is meant to cover the overhead and other operating expenses of the manager while providing a modest income, in most cases, fund managers are not acting as investment managers in order to earn these fees. Instead, investment managers expect to earn the bulk of their profits from the second component of fees, often referred to as the "incentive fee," "carried interest" or the "promote". This component is calculated on the profits of the fund and is earned by the managers not as a return on their capital invested (which is usually nominal, if any), but as a return on the efforts they make in managing the fund. Depending on the fund managed, this fee component will typically be between 10-25% of the profits generated by the management of the assets comprising the fund.
As can be seen from the above ranges of management and incentive fees, there is room for negotiation with respect to the percentages earned by the managers. However, in addition to the magnitude of percentages charged as fees, there are other issues that need to be considered with respect to fees. With both the management fee and incentive fee, one crucial factor is how to calculate the base amount for purposes of calculating the fee. For example, with the management fee, should the fee be calculated using the aggregate value of assets under management (which would tend to change over time as assets are acquired or disposed), the aggregate commitments (which may be different from assets under management if the fund is structured as one in which there are capital calls over time), the market value of the aggregate assets of the fund, or the book value of the aggregate assets of the fund? If using a measure which changes over time, such as the market value of the aggregate assets of the fund or the value of assets under management, how often should the fees be calculated (i.e., monthly, quarterly or annually)?
The structuring of fee components of a fund must be considered carefully in order to satisfy the economic expectations of both parties, while aligning the interests of the parties. For instance, if the management fees are calculated based on assets under management determined on a particular day in each quarter, the fees may be out of line with the amount of assets under management during the rest of the quarter. Further, the manager has an incentive to hold as large a pool of assets as possible on such fee calculation date and such incentive may be at odds with the goal of achieving optimal returns on the disposition of assets.
For the calculation of incentive fees, there are a large number of possible formulas for the timing of fees earned and the base amount used to determine the fees. Institutional investors negotiating a new fund with a manager should ask themselves a number of questions before entering into negotiations committing funds to the new investment fund. Should the investor have its capital invested returned first or its total aggregate commitment returned first? Should the investor have priority with respect to the amount invested in a certain asset? Should there be some preferred return, or hurdle rate, for the investor before the manager receives any incentive fee? When should the manager receive an incentive fee? Are incentive fees calculated on an asset by asset basis or on the aggregate portfolio of the fund? Are incentive fees calculated on total profits earned during each calculation period or on a high-water mark basis (i.e. on profits earned above the highest profits earned in the previous calculation period). To the extent that incentive fees are paid and there are subsequent losses on future investments, should the manager be required to refund previously earned incentive fees under a clawback mechanism? Investors who have not thought through these issues and are not prepared to discuss them forcefully with the manager are less likely to find themselves participating in an economically rewarding fund.
It should be noted that the formula selected will have consequences beyond the amount of fees earned by the managers and will influence management behaviour. For instance, if the fees are calculated on an asset by asset basis, managers may have greater incentives to seek riskier investments where the payoffs, if earned, are potentially greater than less risky investments. However, certain profit clawback mechanisms may alleviate such incentives for riskier investments. Thus, when considering various fee structures, it is important to note that it is the totality and interplay of the provisions, rather than any single provision, that should be considered as being determinative of both the economics of the fund as well as he fees can be expected to alter or steer the management of the fund. Fee provisions require perhaps the most careful attention when drafting fund documentation and are a key element for negotiation when preparing a fund term sheet.
The provisions regarding the management of the fund are crucial to the operations of the fund and what the investors can expect from managers. There are competing considerations in this area as well. Investors will generally want greater control and limitations on the managers to ensure that their investments are adequately protected while managers will generally seek to reduce their obligations and any restrictions on their management activities. As in the case with fees, a well-balanced set of management provisions should be sought by both parties. Some of the more common ways of controlling the management are set forth below.
- "Key Man" provisions that ensure that certain managers continue to be involved in the management of the fund. Often the investors will have certain termination or withdrawal rights if certain key managers cease being significantly involved in the management functions of the fund.
- Investment committees made up of some representatives of the investors that have a range of functions from simple observer-type rights to decision making or veto rights with respect to some or many investment decisions.
- Investment guidelines that provide the types of assets the fund will be permitted to invest in. Investment guidelines may be drafted in a very general manner, giving a great deal of discretion to the managers or may be drafted in very precise terms that leave the managers with little or no discretion.
- Non-competition and non-disclosure provisions to ensure that the investment opportunities of the fund are not diverted to other investors or other investment vehicles managed by the managers. Non-disclosure provisions also help to ensure that investments or potential investments of the fund are not affected by competing bidders or additional demands for the particular asset. There can also be provisions that prevent the managers from establishing another subsequent fund with similar investment objectives to the existing fund.
- Provisions that set out the frequency and substantive content of reports also help monitor the effective management of the fund. Often managers will seek to report less information less frequently, citing administrative burdens and inefficient use of management time and resources as reasons.
- Provisions dealing with the level of duties of the managers are crucial. The level of duty can range from managers being responsible for strict breach to managers being liable only for damages caused by wilful misconduct or gross negligence. It should be noted that managers will generally not guarantee or be responsible for the performance of the fund.
While investors may want to restrict and monitor the activities of the managers, too many limitations and restrictions may hamper the effective investment management by the managers. For instance, if there are certain transactions that require approval by an investment committee, it may be that the investment requires a quicker response time than is feasible under the approval mechanism and the fund may thus be unable to participate in the investment. As in the case of the fees, a balanced structure that provides the investors with comfort that the managers are acting in accordance with their expectations and the investment goals of the fund while not hampering the effective management of the fund by the managers should be the ultimate goal of both investors and managers.
Prime Brokers, Custodians and Administrators
Unlike many other traditional investment funds, hedge funds are generally structured to include substantial participation by prime brokers, custodians and administrators. Prime brokers execute asset investment transactions for the fund, custodians hold the assets (and sometimes the documentation for the fund) and the administrator provides various administrative services, such as receiving and processing subscription agreements, helping distribute periodic reports to investors and processing redemption requests.
Although the division of labour in a traditional fund model consisting of an investment manager, custodian and administrator may be fairly well-defined, there are increasingly newer emerging models with additional parties, such as distributors and originators. With the introduction of additional parties, there will tend to be negotiations in connection with the respective roles and responsibilities of the parties. The investment manager should ensure that the division of roles and responsibilities is structured in a manner that ensures that all of the core functions and requirements of the fund are met and further needs to be certain that the fund is able to seek recourse from the appropriate party if problems arise. Investors should carefully evaluate fund documentation with these goals in mind. To this end, the indemnification sections should be reviewed with considerable care.
LLike fees paid to managers, fees paid to custodians and administrators also vary. However, generally fees tend to be flat annual-type fees or fees calculated as a percentage of the accounts, assets or funds under the management of the custodians and administrators. Although the behaviour of the custodians and administrators may not affect the performance of the fund in the same manner as the behaviour of the managers, it should be noted that the quality of administrators and custodians as well as the tasks and responsibilities that they are willing to undertake on behalf of the fund may vary and should be carefully considered by investors considering investment in a fund. Low fees alone should not be determinative in the engagement decision of custodians and administrators. In particular, custodian and administrator experience with the type of fund involved is critical.
Generally, a passive investor in a hedge fund will have limited ability to influence the selection and the terms of engagement of the administrator and custodian. Thus an investor considering an investment into a hedge fund which has already been established or over which the investor will not have any influence in selecting the administrator and custodian should review the existing terms to ensure that the reporting and regulatory requirements of the investor, if any, are addressed adequately. For instance, certain regulated investors may have more demanding reporting requirements than certain funds have been structured to provide.
There are numerous other provisions that should be considered by the investors and managers including termination provisions and transfer provisions. Hedge funds can vary greatly in their discrete provisions and rather than any one provision being the crucial or determinative provision, both investors and managers should consider the structure as a whole, with the business objectives of the fund in mind when reviewing or negotiating the principal terms of the hedge fund.
Part IV. Conducting Hedge Fund Due Diligence
Unlike Japan, where the FSA requires a hedge fund manager to register either as a non-discretionary or discretionary investment advisor under the IABL, many jurisdictions do not require similar registration. For example, the United States, home to more than 7,000 hedge funds and hedge fund of funds, exempts hedge fund managers from registration as investment advisors under the Investment Advisors Act of 1940. Even assuming the United States Securities Exchange Commission ("SEC") decides to require such registration in the near future, investors should not view registration with the SEC, the FSA or similar regulatory requirements in other jurisdictions as a substitute for conducting due diligence on a fund manager and the fund it manages. Although registration with a securities regulatory agency is touted as being beneficial to the investing public, investors should understand that examiners and officers of such regulatory agencies simply do not have the necessary skills to conduct an audit to determine whether a given hedge fund manager's risk management, for example, is or is not appropriate for the strategy and the markets being traded by that manager. Therefore, registration as an investment advisor standing alone does not guarantee prospective investors that a particular hedge fund manager will be managed in a certain manner. Accordingly, investors must rely on their own efforts to screen managers before investing. Basic due diligence should focus on the following items.
Alignment of Interests
From an investor's standpoint, perhaps the single most important issue is whether the manager has invested his own money in the fund to ensure that the manager's interests are aligned with his investors. Though nearly all offering memoranda will state that the investment manager or the general partner is going to invest a substantial portion of his net worth in the fund, very few investors ever ask for verification of his investment. Even fewer investors examine the trust deed or partnership agreement to determine whether the investment manager or the general partner can withdraw his money at any time, and whether he has a legal obligation to notify investors of such a redemption or withdrawal from his own fund.
Because the managers - not the investors - typically hire the lawyers forming hedge funds, the managers are typically given great latitude in implementing or pursuing a certain investment style. However, if an offering memorandum is predicated on the manager following a certain investment style, then investors should check the governing documents of the fund to see if those documents authorize a broader or narrower investment mandate. Moreover, if the fund documents do state that certain investment restrictions will be observed by the manager in implementing his strategy, the investor should check whether the restrictions are legally imposed on the manager by the fund documents, or whether the restrictions mentioned in the offering memoranda merely serve as guidelines.
Fees and Expenses
Investors should ask whether the fund's fees are competitive with the market: In the U.S. and Europe, management fees of 1% and incentive fees of 20% are common, while in Asia, management fees of 2% and incentive fees of 20% are more the norm. Fund-of-funds have a double layer of fees in that such funds invest in a pool of hedge funds, and then add another layer of fees for providing the extra diversification. Generally, an investor that wants to create his own basket of hedge funds should expect to invest at least ¥10 billion to obtain sufficient risk diversification. Otherwise, investors with a smaller asset base should use a fund of funds, and expect to pay accordingly for the diversification provided.
When reviewing the offering memorandum of a fund, prospective investors should attempt to ascertain whether the offering memorandum provides enough information to answer the following questions, or if not found therein, to directly ask the manager about how these issues will be handled. Set forth below is a basic "checklist" of issues in reviewing an offering memorandum.
- Is the investment manager (and the members of his staff) invested in the fund? If so, what percentage of his/her net worth is invested in the fund?
- What is the general compensation procedure or system for the investment manager and his staff? Is compensation for the manager and his staff directly tied to investment decision making ability and fund performance?
- How much money is being managed by the manager in the fund? Is the manager also managing other accounts or funds? If so, what is the growth rate in funds over a three-year period? A growth rate in assets under management that is slowly increasing over time is not necessarily an indication that the manager is investing poorly, but rather may indicate that the manager has a particular style or trading strategy.
- Does the fund describe a relationship between the size of the fund and the strategy, investment objective or process of the fund? Certain investment strategies lend themselves to larger assets, while others do not. In any event, prospective investors should understand the relationship between asset size, strategy and a manager's ability to manage a certain pool of assets. Many managers simply do not have the ability or the staff to manage large sums of money.
- Does the fund adequately describe the risk management system of the fund? If so, does the fund use proprietary management systems, off-the-shelf risk management, or some combination thereof?
- Is the fund primarily following a single investment strategy or is it following a multi-strategy investment scheme? If the latter, does the offering memorandum describe how the manager allocates assets among the various strategies?
- Does the fund use a trading strategy that was developed in-house or purchased through outside vendors? Is the trading strategy primarily opportunistic and discretionary or quantitative and non-discretionary? If non-discretionary, does the manager clearly explain under what circumstances he would override the model?
- What drives the performance of the trading system? For example, does the manager's system depend more on a trending market, or on a certain amount of volatility? Do you understand how the trading system makes money?
- Does the offering memorandum describe how money is lost or made, especially in respect of the trading strategy or investment objective?
- What is unique or compelling about this manager's fund or his investment objectives or risk management?
- If the fund is oriented toward futures trading, is there a self-imposed limit for drawdowns? A drawdown measures the magnitude of a decline in account value, either in percentage or dollar terms, as measured from peak to subsequent trough. For example, if a trader's account increased in value from $10,000 to $20,000, then dropped to $15,000, then increased again to $25,000, that trader would have had a maximum drawdown of $5,000 (incurred when the account declined from $20,000 to $15,000) even though that trader's account was never in a loss position from inception.
- What is the investment universe of the fund? How many positions are generally held? How much trading does the manager expect to do?
- Are there any position limits? If the manager follows a fundamental long-short approach, is the fund primarily tilted toward the long side (most common) or toward the short side (least common)? What is the balance between long and short positions?
- Where does the manager get and how does he develop investment themes? This question directly addresses the intellectual capital that the manager is committing to the fund and its investors.
- If a large sum of capital came into the fund at once, would the manager be able to invest all the capital at once or would he allocate the new capital over a period? If the latter, does the offering memorandum explain why and how and over what period of time large sums of new capital would be allocated? If not invested, who - the manager or the fund - gets the interest earned on money waiting to be invested?
- What are the liquidity provisions of the fund, i.e., does the offering memorandum clearly and unambiguously describe procedures for redeeming investments in the fund or withdrawing entirely from the fund?
- Does the fund use leverage? If so, is the leverage used for all strategies or is it distributed across certain investment themes, markets or positions?
- If the fund is well established, has the fund published monthly volatility measures? If new, what volatility measures does the manager expect to use and why?
- Is the fund targeted toward a certain benchmark? If so, does the offering memorandum describe why a certain benchmark is the most appropriate against which to measure performance?
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As discussed at the outset, the hedge fund industry in Japan remains in its infancy but is growing fast. The demands of Japanese institutional and high net worth investors for better returns and their growing experience in the retention of investment managers based on asset management performance rather than relationships suggests that the Japanese hedge fund industry with continue to expand rapidly in coming years. Included in this article are preliminary guides for potential investors in hedge funds with respect to the structuring, offering and evaluation of hedge funds. However, these guides are no substitute for experienced fund advisors both in law and accounting firms whose services will contribute materially to ensuring that both investors and managers achieve their goals in establishing hedge funds.
*©2004 White & Case, all rights reserved. The White & Case Tokyo Investment and Hedge Fund Support Desk is comprised of one partner (Christopher Wells), three Japanese lawyers (Koichiro Ohashi, Tomoko Fuminaga and Go Kondo), three lawyers admitted in foreign jurisdictions (Scott Peterman, Carol Tsuchida and Tom Lamacchia) and two Japanese filing professionals (Hiroko Yonekura and Hiromi Katchi). The Support Desk works together with securities and finance professionals in the network of White & Case globally, notably the New York, London and Hong Kong offices. The Support Desk was established on May 1, 2003 to provide expert services to the Tokyo hedge fund community. This article is also available in Japanese. Please contact Christopher Wells or Aaron Kleiman.
1 That is, protections set forth in the Articles of Incorporation.
2 Note that, unlike is certain other jurisdictions, the test applies to offers, not sales of securities.
3 Preparation and delivery of an offering memorandum represents best practice in a private placement given the investor anti-fraud protections incorporated in the SEL.
4 Issuers are cautioned that the categorization of foreign fund interests as securities or as securities investment trusts can be complex. It is not required that the foreign security actually be an interest in a trust, an interest in corporations, limited liability companies and other entities can also qualify in certain circumstances. A better guide is whether the relevant entity can be viewed as a collective investment vehicle for multiple investors and independent management.