No doubt you have heard of what a hedge fund is, perhaps even aspired to work for one. The prestige. The wealth. The glory. But how well do you know how a hedge fund is structured? For that matter, do you know what an investment company is?
You have also probably heard of the balance sheet and the income statement. Maybe even the statement of cash flows. But do you know about the schedule of investments – another financial statement that is key to understanding the operations of an “investment company.”
An investment company has the following two key characteristics: 1
- It obtains funds from investors and provides investment management services.
- Its primary business purpose is to invest money in order to generate capital appreciation or investment income.
Investment companies are either registered or unregistered with the SEC. Registering with the SEC is mandatory unless an exception is obtained.
Structure
Investment companies are commonly structured as follows:
The investment company, Hedge Fund XYZ, is usually organized as a pass-through entity such as a limited liability company or a limited partnership. In this structure, individual partners are responsible for their share of income taxes.
ABC Capital Management, General Partner of Hedge Fund XYZ, oversees investment decisions. ABC’s most important job is to raise capital from limited partners such as Homer, Ned, and Marge.
ABC will normally use a third-party administrator (TPA) to handle the accounting and recordkeeping. The TPA is responsible for preparing the monthly/quarterly/yearly financial statements and the individual investor statements.
A bank is necessary for custody of the Fund’s assets. Independent auditors are either required by regulation or seen as the bare minimum by potential investors. Think of it like this – would you invest your hard-earned money into an unaudited Fund?
Capital Activity
ABC will secure a “capital commitment” from the limited partners investing into Hedge Fund XYZ. If each of ABC, Homer, Ned, and Marge commit $10 million to XYZ, the total commitment to the Fund is $40 million. The commitment amount is not the total amount currently invested in XYZ, but rather the amount that XYZ can legally “call” from the invested partners.
Investment managers use different terminology for the movement of money. However, all pretty much mean the same thing.
When a partner invests money into a fund: subscription, contribution, addition.
When a partner takes money out of a fund: redemption, distribution, withdrawal.
Limited partners that want to exit must meet redemption requirements outlined in the investment company’s partnership agreement. These requirements can be anything, but generally fall into three categories:
- Notice requirement: LPs must provide prior written notice to the Fund to withdraw any portion of their balance. 45 – 90 days is common.
- Amount requirement: LPs are subject to restrictions on the amount withdrawn. An example would be to limit the total amount of withdrawals to a percentage of net assets of the Fund. 20 – 25% is common.
- Lockup requirement: LPs are not allowed to withdraw until meeting a time restriction. 1 – 2 years after initial investment is common.
Financial Statements
Investment companies prepare generally the same statements as a “regular” company (think Coca-Cola) with a few exceptions. There are a few naming differences across statements: 2
| “Regular” Company | Investment Company |
|---|---|
| balance sheet | statement of assets, liabilities, and partners’ capital |
| income statement | statement of operations |
| statement of cash flows | statement of cash flows |
| statement of shareholders’ equity | statement of changes in partners’ capital |
Schedule of Investments
A unique statement required for investment companies is called the schedule of investments.
Understanding how to read a schedule of investments is critical to understanding how an investment company is allocating its money. It can provide insight into the industries and countries of the investment portfolio. It can also warn if the investment company is too concentrated in a single investment.
Below is an example of a SOI for a nonregistered investment company. For this basic example, partners’ capital is $100 million, and the Fund has no liabilities (i.e. total partners’ capital = total assets). The SOI is organized by: 3
- Type of investment – Fund has common stock and fixed income securities.
- Country – Fund is invested in the United States and France.
- Industry – Fund is invested in consumer, technology, insurance, government debt, and corporate debt.
Any single investment with a fair value that exceeds 5% of partners’ capital must be disclosed. In this case, Walmart makes up 10% and Treasury bills make up 20%. All other investments are below the 5% threshold and are aggregated together by the 1-3 classifications above.
Fund of Funds
An interesting phenomenon occurs when an investment company is invested in another investment company. In this case, the first investment company is called a “fund of funds” because it does not directly invest into stock or debt.
Say that Fund XYZ has an investment in Fund CMS that is worth 20% of partners’ capital. Now add that Fund CMS has an investment in Walmart worth $30,000,000. Fund XYZ must look-through to the underlying Fund to determine if the Fund CMS Walmart investment needs to be disclosed on its schedule of investments. In this case, YES:
$30,000,000 * .20 = $6,000,000 > $5,000,000 (5% of $100,000,000 partners’ capital)
What if Fund XYZ is invested in Fund CMS which is invested in Fund HDS? In this case, Fund XYZ needs to perform a look through to the third level, Fund HDS. Inception.
Unique Structures
It is quite common for investment companies to have a master-feeder structure. Feeder funds accept capital from partners and then turn around and invest the capital directly into the master fund. The investments sit at the master fund level. This strategy is used to accumulate capital efficiently across different geographic regions. For example, one feeder fund could be for domestic partners and another could be for international partners.
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