Starting A Hedge Fun - A Canadian Perspective

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Ernst & Young in Canada is a leading provider of assurance, tax arid advisory services to hedge fund managers, their funds, and third-party administrators. Whether you are looking to set up a new fund or improve your business processes, our hedge fund industry experience and comprehensive approach to service quality will help you achieve your goals. The global marketplace is too complex to go it alone-let us help you piece it together. ey.com/ca/FSI
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Starting a Hedge Fund a Canadian Perspective

2008 Edition
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Starting a Hedge Fund -
a Canadian Perspective
2008 edition
This book has been compiled from the contributions of the authors indicated in each chapter, and the views expressed by such authors do not necessarily reflect the views of their respective firms. This book is intended as a general guide only. Its application to specific situations will depend upon the particular circumstances involved, and it should not be relied upon as a substitute for obtaining appropriate professional advice. While all care has been taken in the preparation of this book, neither the publisher, sponsors, advertisers nor any of the authors accept responsibility for any errors it may contain, or for any losses howsoever arising from or in reliance upon its contents.
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Hedge Fund Administrators
The long and the short of it

It's a dog-eat-dog investment marketplace and in order to succeed, you need a hedge fund administrator you can depend on. Commonwealth Fund Services, a leading Canadian hedge fund administrator, alleviates the day-to-day burden of backoffice operations. We deliver a superior suite of essential services, so you can do what you do best - execute strategies that maximize returns. • Subsidiary of federally licensed trust
.. ~~!?-i!IlY' regulated
• Independent
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by OSFI
Onshore and offshore structures and objective Accurate and timely monthly NAV s and investor reporting
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Shareholder
recordkeeping
Regulatory compliance • Fee computations

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Scalable technology solutions
Contact Alex Chapman Commonwealth Fund Services
416.361.4563
ac@commonwealthfundservices.com www.commonwealthfundservices.com
COMMONWEALTH
FUND SERVICES
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Contents
Foreword Phil Schmitt, Chairman, Alternative Investment Management Association
1 (AlMA) Canada, Toronto
Chapter One: Who Invests in Hedge Funds in Canada? Market Overview and Analysis Katrina Rempel, BMO Capital Markets, Toronto Who is investing? What are they buying? Raisinq money Chapter Two: The Role of the Prime Broker Maggie DiStasi, BMO Capital Markets, Toronto Introduction The basics 'Ph~~*factor Time is of the essence And in this corner Who do you know? Is anybody listening? Does size matter? Conclusion Chapter Three: Structuring a Hedge Fund Ronald M. Kosonic and Carol E. Derk, Borden Ladner Gervais LLP, Toronto Fund Legal Fund Fund formation structure of hedge funds features management complex
3 3
.4 7
7
11 11 11 12 12 12 12
15
15 17 19 19 21
Chapter Four: Offshore Fund Administration Greg Bennett and John Lewis, Butterfield Fund Services Limited, Cayman Islands You're thinking of setting up an offshore hedge fund Administrator responsibilities Administrator's skills what are the first steps?
21 22 23 v
Contents
Starting a Hedge Fund Domicile/offshore Conclusion market.
23
24 25
Chapter Five: Registration in Canada Prema KR. Thiele, Ronald M. Kosonic and Laurie J. Cook, Borden Ladner Gervais LLP, Toronto Introduction Registration requirements Registration reform in Canada Chapter Six: Keeping Current with Your Compliance Obligations Lynn M. McGrade and Ronald M. Kosonic, Borden Ladner Gervais LLP, Toronto Introduction Provincial securities regulations Different structures, different obligations Reporting requirements for hedge funds Dealing with the public - delivery of disclosure documents and due diligence obligations of hedge fund managers Conflicts of interest and self-dealing Other compliance matters for registrants Understanding the privacy legislation and how it applies to hedge funds and their managers How the anti-terrorist and anti-money laundering laws apply to hedge funds and their managers If you are a commodity pool. Conclusion Chapter Seven: A Starter Guide to 130/30 Strategies Alex Chapman, Commonwealth Fund Services, Toronto Introduction Examining the risks Actual performance Implementation and other considerations Conclusion ,,~Gflapter· Eight: Managing Risk ......•...•................................................................................................................................... Kathryn Ash and Scott McEvoy, Borden Ladner Gervais LLP, Toronto General risk Chapter Nine: Taxation Martin Wickens and Fraser Gall, Ernst & Young LLP, Toronto Introduction Choice of hedge fund vehicle: trust, partnership or corporation Status of hedge fund as qualified investment for tax-deferred plans General tax considerations Canadian fund managers advising an offshore hedge fund Chapter Ten: Building an Effective Governance Program W William Woods, Independent Review Inc., Toronto What is fund governance? Hedge funds are a special type of business But the governance issues are the same The role of the board The 'Canadian solution': independent review committees vi for Hedge Funds
25 25 28 31
31 31 31
33 34 35 35
36 36 36 36 39
39 39
.40 .42 .43 45
.45 51
51 51 52
55
60 63
63 63
64 64 64
Contents
Independent advisory board Key issues for a fund board Conclusion
65 65 66 67
Chapter Eleven: The Role of Independent Directors Geoff Ruddick, International Management Services Ltd., Cayman Islands Introduction Duties: What are a director's duties? Terminology: What do 'independent' and 'non-executive' Role: What do you do? Value-added: What value will you add? So, where do you start? Now, what should you be asking? Conclusion Chapter Twelve: Exiting Strategies Peter Draper and Peter Astleford, Dechert LLP, London Introduction Needs and objectives of the incubatee Needs and objectives of the incubator Fees and costs Planning for exit. Case studies Forward planning Chapter Thirteen: World's Unions Debate: Are Hedge Funds 'Locusts' Christopher Holt, AIIAboutAlpha.com, Toronto Chapter Fourteen: Long/Short Equity Strategy Colin Stewart and Keith Tomlinson, AlMA Canada, Toronto What is long/short equity? WJ;tat"are the nuts and bolts of long/short equity? What are the sources of return of long/short equity? What are the key risk factors of long/short equity? The historical performance of long/short equity What is a practical example of a long/short equity trade? Conclusion Author Biographies or 'Termites'?
67 67
mean? 68 68 68 70 70 72 73
73 73 74 74 75 75 76
77
81
81 81 83 83 85
86 87 91 97
Contacts
vii
AlMA Canada, is pleased to support and endorse this publication which encourages sound practices among participants in the hedge fund industry and we look forward _______ - _to..w.elcomi!l9_neW-fuAdsas_future-member-so-
Foreword
AlMA Canada is the Canadian Chapter of the Alternative Investment Management Association (AlMA) - an international non-profit trade association based in London UK. AlMA has over 1,300 members operating in 49 countries and its core goals are increasing investor education, supporting best practices and liaising with regulators and policy makers on alternative investment matters.
Phil Schmitt Chairman, Alternative Investment Association (AlMA) Canada
Management
The hedge fund industry has experienced dramatic growth in recent years - in terms of asset growth and the number of industry players. As the industry has matured through its life cycle, there has been a sharp increase in the number, style and range of funds - creating an ever broadening product offering. With more products to choose from, each with a unique investment profile in terms of risk and return, investor interest has shown a corresponding increase. Initially the preserve of high net worth investors, the industry has more recently attracted strong interest from institutional investors, as well as smaller investors who see hedge funds as a good fit for their portfolio requirements. All of this will translate into further growth and more fund startups, as the cycle continues. Given these trends, this lSI publication, Starting a Hedge Fund - a Canadian Perspective 2008, updated from the 2005 edition, provides invaluable and timely information for those considering getting into hedge fund management. In this volume, seasoned practitioners provide valuable insight on the issues involved in starting and managing a hedge fund business that will give new managers an understanding of the full scope of the task they are undertaking - and help them avoid potential mistakes and pitfalls.
Acanthistius
Brasifianus
Butterfieldus
fundi servicium
Abudefduf
saxatifis
Small enough to be quick. Big enough to swim with the big fish.
There's an ideal size for a fund administrator. At Butterfield Fund Services, we're small enough to offer the rapid, personal service you may not get from those at the top of the food chain. Yet with a well-established financial institution behind us, we have enough weight to offer additional services like banking, custody, money market funds, lending, trust and foreign exchange. You'll find us in the well-regulated waters of Bermuda, The Bahamas, the Cayman Islands and Guernsey. For more information, please contact: Head Office: Bermuda - Andrew R. Collins Tel: (441) 299-3954, E-mail: andrewcollins@bntb.bm The Bahamas- Heather Bellot Tel: (242) 677-8200, E-mail: heatherbellot@butterfieldbank.bs Cayman Islands- John C. Lewis Tel: (345) 815-7592, E-mail: john.lewis@butterfieldbank.ky Guernsey - Patrick A. S. Firth Tel: (44) 1481-737756, E-mail: patrick.firth@bfmgl.gg
Butterfield Fund Services

Services provided by subsidiaries of The Bank of N.T. Butterfield www.butterfieldbank.com and Son Limited.
~.
Chapter One:
opportunities. There are numerous hedge funds that target high net worth and retail investors. Potential investors must meet certain wealth criteria in order to be eligible to purchase a hedge fund. Investment in hedge funds has typically occurred in the exempt market and, thus, there are restrictions on those who are eligible to invest in hedge funds. In most Canadian provinces, the accredited investor rules require that individuals (with their spouses) must have net financial assets of $1 million. Alternatively, an individual with a net income of $200,000 in each of the last two years or a combined income with a spouse of $300,000 for the past two years, and who has a reasonable likelihood of maintaining this income in the future, is also an accredited investor. Some hedge funds offer accredited investors the opportunity to invest as little as $5,000, although many hedge funds have minimum investment requirements of $150,000 or higher. In certain Canadian jurisdictions, individuals are required to invest a minimum $150,000 in hedge funds in order to participate in the exempt market, which generally means that only the affluent can invest in hedge funds.
Who Invests in Hedge Funds in Canada? Market Overview and Analysis

Katrina Rempel BMO Capital Markets, Toronto
Institutions
Institutions, such as pension plans and insurance companies, are active in the hedge fund market, making up about 35% of all hedge fund investments. The stock market crash in the late 1990s caused heavy losses for many pension plans, leaving them under-funded and at risk that they will not be able to meet their future obligations unless they raise the required pension plan contributions or generate better returns in the future. Institutions are increasingly turning to hedge funds to help close the gap between their future obligations and the resources that they have available to meet them. In addition to the possibility of higher returns, hedge funds may offer institutions the benefit of increased diversification, thus affecting the risk-reward profile in a positive way. There is the opportunity to lower a portfolio's correlation with the market through the use of hedge funds. According to a study by Deutsche Bank, a traditional asset portfolio which had a hedge fund component had higher expected returns than a traditional-only portfolio on a risk-adjusted basis between 1990 and 2003.
Who is investing?
Few investment strategies have received as much press as hedge funds have in the past five years. The number of
hedge funds in Canada appearsto'have grown exponentially

as have the assets invested in hedge funds. Definitive figures are difficult to confirm, but Investor Economics estimates that approximately $16 billion was invested in Canadian hedge funds by mid-2005, including investment in stand-alone hedge funds, fund of funds and principal protected notes. According to HedgeFund Intelligence, global hedge fund assets topped $2 trillion by January 2007. This source of growth is coming from high net worth individuals, family offices, institutions and plan sponsors that are seeking higher returns and increased portfolio diversification. While American investors have generally embraced hedge funds (and indeed all alternative investments) much more readily than Canadian investors, alternatives are gaining more prominence in Canadian investment portfolios.
What are they buying?

Once the decision is made to enter the hedge fund world, investors have almost limitless investment options in regards to strategy, geographical focus, asset class and sector. Like any other investment, it is essential to do due diligence on a hedge fund before investing. In addition to researching the particular fund, it is important that investors understand the nature of the investment, the specific details about the strategy and the impact that it will have on the portfolio as a whole.
High net worth individuals and family offices

The stock market boom of the 1990s resulted in an increasingly sophisticated and educated investor base. Individuals have accumulated wealth with unprecedented success and are searching for attractive investment
Who Invests in Hedge Funds in Canada? Market Overview and Analysis

Canadian Perspective
130-30 strategies are the current darlings on the hedge fund scene. This increasingly popular strategy has attracted institutional investors with an easy to understand concept, relatively low fee structure and the ability to add alpha while maintaining a dollar exposure of one. Execution involves buying a benchmark and adding a market neutral overlay. For example, a manager buys an index, short sells 30% of the securities that are expected to under-perform and buys an additional 30% of the securities that are expected to outperform. Funds that are executing 130-30 strategies have targeted institutional investors, but it is likely that a similar product will be available for retail investors in the future. Principal protected notes (PPNs) are targeted exclusively at retail investors. The return on a PPN is made up of two parts. The first component is an investment in an instrument that is intended to ensure the return of original capital at maturation. The second component will be invested in an instrument that will provide the return on the investment. For example, at inception, a PPN of $1 ,000 might buy $700 worth of a fixed income security (such as a zero coupon bond) that will mature to $1,000 at the time the PPN matures. This guarantees the principal. The remainder of the investment ($300) is 'swapped' to a hedge fund (or other investment fund). The return earned on this component provides the return on the investment. A single strategy fund executes a single strategy in a unique way, adhering to a particular strategy. This type of fund is manager and strategy focused. A single strategy fund must pursue its stated strategy even when market conditions are not optimal for the particular strategy. This risk can seriously impact an investor's returns. A multi strategy fund uses various strategies simultaneously to capitalize on multiple investment opportunities, by focusing on whichever strategy seems the most appropriate for the current investment climate. This strategy allows the investment manager much more flexibility than having to stick with a single strategy, no matter what the state of the markets. Although the manager has several different strategies to draw upon, he or she will not necessarily execute all strategies at all times. Both a single strategy fund and a multi strategy fund carry the risk of underperformance or manager insolvency. This manager risk can be mitigated by opting to invest in a fund of hedge funds (FoF). FoFs are popular as a way of ensuring instant diversification. A FoF invests in various hedge funds, pools them and then repackages them to sell to investors. A FoF may focus on a single strategy, a region or a particular sector, such as natural resources. Investing in a FoF is the easiest way to get broad exposure to the hedge fund market. This is a very
attractive option for investors who do not have the time or the resources to research several hedge funds. A reputable FoF will do the due diligence and research on the funds in which they invest. It is necessary for an investor to choose the FoF very carefully, taking into account management, strategies and how the FoF will complement the rest of the investment portfolio. A disadvantage to investing in a FoF rather than directly in stand-alone hedge funds is that they may charge higher fees. A hedge fund's fee structure usually encompasses a management fee (generally about 1-2%) with a performance bonus added on when returns are equal to, or greater than, a predetermined high water mark. The FoF typically adds its own layer of fees on top of that. Many institutions prefer to invest in FoFs. Despite the higher fees associated with these investments, it may still be much more cost effective than setting up a department to research and do due diligence on potential hedge fund investments.
Raising money
One of the main challenges for a hedge fund, especially newer hedge funds, is attracting investors and raising capital. While some managers with an established track record have a group of ready investors, most managers find it difficult to raise funds. Many managers start by approaching family and friends while also investing some of their personal funds. Various studies have shown that friends and family constitute up to 25% of the assets invested in Canadian hedge funds compared to approximately 8% invested in US hedge funds. While many hedgeflJl1ds prefer'targetil"lg large ihvest6rsstJch as FoFs and institutions, they generally need substantial assets under administration before large investors will inject capital. Many institutions have a minimum investment size and if they invest in a small hedge fund, they could be the largest investor by a substantial margin. Most investors do not want to be the controlling investor and prefer investing in a fund that can easily absorb their investment. One way around this limitation is to establish a managed account. Managed accounts have become increasingly common in recent years. Several Canadian hedge funds have successfully gathered assets from large institutions in this way. The prime broker opens the managed account in the name of the investor who then grants trading and management authorization to the hedge fund manager. This way, the investor is able to invest with a smaller hedge fund manager without the complication of being the majority investor in a pooled fund. This type of account also allows for great transparency for the investor, which is an additional attraction.
Who Invests in Hedge Funds in Canada? Market Overview and Analysis Starting a Hedge Fund - a Canadian Perspective
A potential source of capital for hedge funds is their prime broker. Many prime brokers offer a capital introduction service to their clients. Capital introduction opportunities take many forms including functions where several hedge funds share presentation time and one-on-one meetings between investors and managers. Some managers opt for hiring thirdparty marketers. This is a company that raises capital for the hedge fund. In return for this service, the marketing company receives a percentage of the funds that the manager raises as long as the investor stays invested in the manager. Raising money will take much of a manager's time especially in the early stages of the business. If possible, it is best to have an in-house marketer to spend the time raising capital so the manager can focus on the portfolio. All hedge funds need a certain level of assets under administration to be economically viable as a business, and it is desirable to reach this point as soon as possible. The quest for capital is very competitive and many managers find raising assets more difficult than they anticipated. There are many factors that affect how successful a hedge fund is at raising money. The two key factors are good returns and exposure. The hedge funds that are successful at raising capital are those that get their message out to as many potential investors as they possibly can. Any fund that maximizes its time presenting to potential investors will have an advantage over the funds that do not do this. However, if a fund doesn't have attractive returns and a successful track record, raising assets will be very difficult or impossible. Prospective hedge fund managers need to carefully consider a marketing plan before setting out. Raising capital is likely the most difficult hurdle that new managers face. By ·esfablishing ·whb the targetinvestbrs are, hailing· realistic asset raising targets and a solid marketing plan, a manager is maximizing the chances for success.
Katrina Rempel, CFA BMO Capital Markets katrina.rempel@bmo.com
4163597524
Chapter Two:
The Role of the Prime Broker
building) and support for longevity are all examples of attributes hedge fund managers should look for in a prime broker. Client service has been ranked among the most important qualities a prime broker can have in various industry surveys, and the reasons why are explored in detail in the body of this chapter.
The basics
Before a hedge fund manager assesses a prime broker's soft-sell approach, they must ensure that the prime brokers under review meet the basic requirements to operate in that capacity. These requirements include offering the following services: securities lending; trade reporting; trade settlement; margin; corporate action processing; account administration; reporting and technology; and capital introduction.
Maggie DiStasi SMO Capital Markets, Toronto
Every hedge fund manager and their needs are slightly different; however, if they cannot communicate the details of an executed trade to their prime broker, or depend on a corporate action to be processed on time, their frustrations are equally as significant.
Introduction
Hedge fund managers are united globally in their purpose: to r~~liz~profit on uniguetrading strategies and positions.Their primEn:>rokers facilitate this through the provision of certain services: trade settlements, securities lending, reporting, account administration and corporate action processing, to name a few. All prime brokers are required by their clients to offer these services and more, so what differentiates one prime broker from another? What should a hedge fund manager look for in their prime broker for added value? The answer can be found in the intangible qualities of the prime broker - those seemingly unaccountable characteristics that make the difference between picking up the phone and knowing there is competent assistance on the other end of the line, or choosing not to call at all because your blood pressure is high enough already. Hedge fund management is no exception, where time wasted can be expressed as a big red mark on your balance sheet. Fortunately, in the world of prime brokerage, intangible qualities can be measured. Reaction time and responsiveness, experience and industry knowledge, contacts and influence, communication and listening skills, as well as start-up assistance (in the form of capital introduction and relationship
Securities lending
Short-selling (the practice of selling a security that one does not currently own, in anticipation of buying it back at a lower price) maybe undertaken to offset· market risk or generate revenue (ie, profiting from the expectation that the price of the stock will drop in the future). Regardless of the reason for which it is employed, almost all hedge fund managers will find themselves in the position of needing to borrow securities for the purpose of short-selling. The choice of prime broker to execute the short-sale on your behalf is dependent on several factors, including: the prime broker's ability to acquire hard-to-borrow securities; the amount of protection the prime broker can offer in terms of security recalls and buy-ins; and how competitive the prime broker'S lending rates are in comparison with other prime brokers, including rebates on interest accrued on the proceeds of the short sale. The prime broker's reach as it pertains to their capacity to secure hard-to-borrow securities can be determined by the relationships the prime broker has established on the street with other custodians and broker-dealers. While this is difficult to measure quantitatively, often the prime broker's reputation

precedes them and can be confirmed through conversations with various counterparties. In addition, the bigger the prime broker, and the longer it has been in business, the more likely it has rnultiple resources and tirne-proven assoclatlons to depend on for borrowing securities without being at risk of recall or being bought-in in the near future. Lending rates and rebates are essential in differentiating between the lending services that prime brokers provide. This is particularly true in Canada, where only a handful of prime brokers exist and are able to short-sell on behalf of their clients. Prime brokerage and hedge fund businesses rely heavily on fees and the less a hedge fund incurs in operational overhead, the more profit it will be able to extend to its investors. Prime brokers are generally willing to compete in this area, so it is often worth shopping around for the most reasonable fee structure. It is a matter of give-andtake, however, and attempting to gouge the prime broker's pocketfor a few extra basis points is not going to be received well either - remember, prime brokers have a bottom line to meet as well.
Trade reporting does not end at the point at which the prime broker is notified of the trade details. Despite the technological advances that have been realized in the brokerage industry, mistakes can still be made, whether it is a matter of miscalculated accrued interest on a bond or the currency of trade execution. The hedge fund manager must be able to modify or cancel trades prior to settlement. Again, an on-line interface is required, whether the hedge fund manager can login and view the trades and make the changes themselves, or submit amendments in their trade blotters, or if they employ a third party to report the changes for them via an automated exchange. The capability of the prime broker to support multiple methods of trade entry, cancellation and correction should be taken into consideration when judging their overall competency in maintaining and nurturing your business. Trade reporting is also not limited to technology. Hedge fund strategies range from trading highly-liquid equities over multiple exchanges (ie, market neutralsecurities hedging) to leveraging complicated option strategies, currency forwards or futures. The prime broker interface must allow hedge fund managers to report trades in a wide variety of instrument types as well as currencies, with opportunities to settle the trades in currencies differing from execution. Find out which security types your prime broker can support along with reporting and settlement currencies.
Trade reporting
The prime broker's role begins as soon as they know about your trades. It sounds simple, but sometimes communicating the details of a trade to a prime broker in a cost-efficient and timely manner can be more arduous than anticipated. Trade reporting has evolved substantially over the years, the industry's focus being on eventually achieving straightthrough-processing (STP), whereby the entire process from trade execution to settlement and custody is automated. In the meantime, it is still not unusual for clients to report trade details and resolve settlement issues using manual =~iorms.ofcommunication .: je.Phone.or..eomail). The. question ( is: where is your prime broker headed? Are they actively involved in STP-related activities, encouraging the use of new technology to process trades through settlement? At a minimum, the prime broker should make available an on-line trade reporting facility which enables the hedge fund manager or authorized individuals to submit trade details from any location with Internet access. Because of the potential for large volumes of trades on a daily basis, a trade blotter import option should exist in addition to individual trade entry. This way, a trader can consolidate all of the trades they have executed across the street into one or more formatted blotters and report the trades to their prime broker with the touch of a button. For larger hedge funds or those with sufficient technical support, the prime broker should provide the ability to use file transfer protocol (FTP) or similar procedures to accommodate completely handsoff trade reporting. Prime broker interfaces to client trading platforms and trade management systems can also increase automation and reduce communication errors.
Trade settlement
The financial industry continues to strive towards T +1 settlement, as demonstrated by the phased implementation of National Instrument 24-101 Institutional Trade Matching and Settlement requiring trade matching on trade date. Indw;;try members were requireq to have policies and procedures in place to support this initiative on 1 April 2007, and the Instrument became effective in October 2007 with the initial target of matching 80% of trades by noon on T +1. Subsequent targets and associated deadlines have been established with the ultimate goal of matching DAPI RAP trades by midnight on trade date (T) by July 2010. Correspondingly, the prime broker's settlement procedures and infrastructure become even more fundamental to the success of the hedge fund in terms of profitability. A failed trade, or a trade settled against the wrong money in a T+3 environment is costly enough to the hedge fund manager. When T +1 settlement becomes reality, the prime broker must be able to affirm trades almost instantaneously and respond to differences or security lending requirements as soon as the trade is reported. In the same way that a hedge fund manager can determine the prime broker's securities lending wherewithal by reputation, so can they ascertain the prime broker's ability to settle trades accurately and on time. Success depends on a combination of factors, beginning with how quickly the prime broker can set up a trade for the other side to affirm
Starting a
The Role of the Prime Broker Hedge Fund - a Canadian Perspective
or reject. If the trade is affirmed, settlement should take place without incident on T +3. If the trade is rejected, the reason for the rejection needs to be relayed to the hedge fund manager within a reasonable time frame, allowing them to respond with a correction to the trade reported or confirmation to the counterparty. The trade correction must be conveyed to the appropriate settlement department to replace the original trade information with the new details, thus enabling settlement to take place. As hedge fund trading strategies involve short-selling of much sought-after securities, trades do fail from time to time. This should be the only reason a trade will fail past settlement. If a prime broker is continuously failing trades as a result of money differences or other variances in trade details, there is obviously a communication breakdown which requires immediate resolution.
come in various forms, as agreed upon between the hedge fund manager and the prime broker (eg, e-mailed election notices, on-line corporate action reporting), preferably as soon as the prime broker becomes aware of the action, followed up by reminders closer to the expiry date. This task of alerting the hedge fund to an upcoming event can be crucial to a trading strategy, and a conscientious prime broker will be aware of that. The legal considerations involved in the processing of a corporate action vary depending on the nature of the corporate action. A mandatory corporate action (ie, a name change or stock split) is fairly straightforward and can be largely automated. The prime broker submits the number of shares outstanding as of the record date to the clearing corporation which communicates with the company itself to provide the appropriate number of replacement shares for exchange or additional shares required for deposit to the account. There is generally little need for discussion over which accounts are affected or how - it is assumed that all are, and without any contribution to the process. Voluntary corporate actions, on the other hand, (ie, a tender offer with multiple election options from which the holder can choose) may involve the legal teams of all parties concerned: the hedge fund, the prime broker, the transfer agent, the clearing corporation and the company undertaking the corporate action. The hedge fund's participation in the corporate action may be limited by the country of its incorporation or may allow them additional options if they are recognized as 'accredited investors' (as defined by federal law). The prime broker must work with those involved to make this determination and process the corporate action accordingly. Not only does the prime broker need to act on behalf of the hedge fund with respect to corporate actions, but their response time must be optimal. If the hedge fund manager's strategy is dependent on a corporate action being processed through their account, the prime broker must ensure all corresponding trades are settled on the record date (based on trades executed by the fund manager) if those shares are affected by the event. Or, the client may be waiting to cover a short sale with proceeds from a corporate action, and in order to fend off a buy-in the prime broker must again act quickly. There are numerous additional event-driven trading strategies that the prime broker is responsible to help facilitate simply by processing all aspects of the corporate action in a timely manner.
Margin
The extension of margin on an account basis is regulated by the Investment Dealers Association of Canada, which publishes a rulebook as well as regular updates and interpretations to the rules contained therein. The prime broker's expertise in this area is fundamental in maximizing the value of the equity managed in the hedge fund portfolio. While the regulations governing margin loans on single positions (long or short) are relatively straightforward, significant benefit can be realized with respect to complicated strategies involving multiple long and short positions offsetting each other. A diligent prime broker will not only recognize the existence of these strategies and immediately apply the appropriate margin values to them, but will also anticipate potential influences on margin and be able to recommend alternatives (ie, a fund may be eligible for acceptable
instilllfion 01"acceptable counferpal"tysfafus· which entitles

them to more favourable margin rates).
Corporate action processing

While the processing of a corporate action through a client account is administrative in nature, the risk involved is considerable to the hedge fund manager, especially if their involvement with the corporate action is strategic rather than an incidental result of holding a position. There are three key aspects to consider with respect to corporate action processing: notification; the legal facets of the corporate action (particularly in relation to your fund); and timing. The prime broker is required to manage all three aspects in order to minimize the hedge fund's market and operational exposure. First and foremost, the prime broker is responsible for notifying the hedge fund manager of pending corporate actions on shares in their accounts. Because the prime broker custodies all or part of the hedge fund portfolio, they are the point of communication from the clearing broker and company initiating the corporate action. Notification may
Account administration
Account administration is a catch-all phrase for all of the other account maintenance duties of the prime broker not captured in trade execution and settlement or corporate action processing. These include cash management (deposits/withdrawals/transfers, interest on cash balances), 9

dividend and interest payments (as well as applicable nonresident taxes), regular and one-time fee processing (borrow/ lend fees, away trade fees), and position administration (ie, automatic removal of date restrictions, securing power of attorneys for stock registered in client name, submitting legend removal requests when securities are sold). The prime broker is also responsible for ensuring all account documentation is up to date, especially the authorization of individuals with certain privileges (ie, trading, trade reporting, cash management, electronic/mail account access). Hedge fund managers and their prime brokers work as a team to reconcile the activities in their accounts to establish its accuracy. Effective prime brokers will make use of exception reporting to alert hedge fund managers to potential issues, rather than administrators on both sides having to pour through each and every transaction that is processed through the accounts. Exceptions may include, but are not limited to, settlement differences (where settlement entries do not match the original trade details), expected vs. actual payments or changes in share quantity/status (applies to trades, dividends, interest, fees, corporate actions and security restrictions). The more capable the prime broker is at isolating items requiring attention, the more efficient the hedge fund manager may be in resolving any outstanding problems.
Depending on the size and nature of the hedge fund, hedge fund managers may also request profit and loss reporting, performance (ROI), what-if scenarios, hard-to-borrow/ availability lists, tax reporting, tax loss accounting, and so on. The secret, however, is in the customization of the reports. Every hedge fund manager needs to look at their data in a different way, to suit their particular strategy or in-house systems. Prime brokers want to enable their clients to filter, sort, consolidate, breakdown, exclude, and include any values they wish in any manner they desire. Some hedge fund managers prefer to sort their positions by asset type or strategy, others prefer to convert all values to the currency of their choice or a default value. Still others like to filter trades by executing broker and summarize commission accordingly, or consolidate all of their accounts for an overall view of their portfolio. The more customization options the prime broker can offer, the better it is for each individual hedge fund. Not only is the presentation of essential data important, but the format and time that it is available as well. Many hedge funds run their own proprietary or vendor applications and are required to import external data into them for analysis. As a result, prime brokers have had to develop methods of providing data in multiple formats to suit the individual requirements of each fund. PDF, Excel, CSV and text versions of all reports may be retrieved through e-mail, online interfaces, FTP servers and more. Thanks to automation in the industry, a hedge fund manager can view data extracted from a variety of sources by 6am each morning if they wish. This means that the prime broker must be able to process the data and make it available at this time and throughout the day as well (some hedge fund managers prefer real-time updates and others prefer to assess their position at the close of business). Again, the more options, the better. Along the same lines as customization and availability is flexibility of data for the purpose of interfacing with several applications. The hedge fund communication network is expanding rapidly to include data exchanges between executing brokers, direct access trading facilities, clearing houses, banks, prime brokers, and so on. Some exchanges are direct and others are processed through a central data facility such as SWIFT (Society for Worldwide Interbank Financial Telecommunication) or FIX (Financial Information Exchange protocol). Either way, the prime broker needs to ensure the data that they provide or the applications they use to receive data are flexible enough to support the data exchange so as to minimize the work required by the hedge fund to implement and maintain the prime brokerage relationship. Raising capital and realizing profits from trading is the hedge fund manager's priority. Learning how to use three different on-line interfaces or read five different reports is not. Any type of technology that a prime broker implements (whether it be a new format of report or the installation of a portfolio
Reporting and technology

Technology is ranked higher in the prime brokerage industry than in most financial businesses, and for good reason. Hedge fund management is unique in its multi-faceted approach: trading through multiple executing brokers, settling trades through prime brokers and custodying positions held at several brokerage firms. Not only must the hedge fund 'manager be awareoftheir overall and fund-speCifiC Cash and security holdings and current activities underway, they need to report this back to their clients in a clear and intelligible manner. Thus, the reliance on prime broker technology and its functionality is of ultimate importance to the hedge fund business. Requirements include: reporting: types of reports, customization; format/availability of data; flexibility/ability to interface with multiple applications and processes; learning curve, user-friendliness; and support.
At a minimum, the prime broker needs to provide the hedge fund manager with a daily (if not real time) snapshot of their assets (cash and positions) and summary of the transactions in their accounts. In addition, any margin requirements or margin in excess must be reported to the hedge fund manager on a trade and settlement date basis to give them an accurate picture of their potential loan value going forward.
10

accounting application on the client desktop), is only as useful as it is easy to operate. Some hedge funds are large enough to employ resources to interpret and manipulate data from its original source, but most will gravitate towards functionality which is cost-efficient. It is a constant challenge to maximize the functionality of an application or interface while minimizing the learning curve, but the prime broker that focuses on both will find their competitive advantage increases accordingly. Finally, even the most flexible, customizable and user-friendly products on the market need support, and prime brokerage technology is no exception. The hedge fund manager needs to be confident that their prime broker retains a technical contact or team with business knowledge that is available at all times, in case of a system failure or simply to answer a 'how-to' question. Time wasted trying to resolve technical problems can mean lost opportunities in the market and a prime broker who understands your business will take every step to address these issues and resolve them without delay.
What type of skill sets and industry knowledge do the members of the prime broker team possess? Who can your prime broker introduce you to? Does the prime broker recognize your uniqueness, and listen when there's a problem? Does the size of your hedge fund and invested capital matter to the prime broker?
While the answers to these questions may not appear in the marketing literature the prime broker supplies, they can be sourced from other hedge funds and parties that deal with prime brokers and should be explored as a fundamental aspect of the prime broker selection process.
Time is of the essence

We've looked at timing with respect to processing trade reporting and settlement, corporate actions and reporting. But how far is this going to get the hedge fund manager if they cannot even reach their prime broker by phone? In the institutional trading industry, time is of the essence, and voicemail is a curse. The first matter to be determined is the hedge fund manager's appointed contact on the prime brokerage side, an individual who is at all times familiar with the goings-on in their accounts and can respond to questions readily and knowledgeably. If the contact is away from the phone or e-mail, is there sufficient back-up? If an issue does require further investigation, how long does it take to receive a response? Your prime brokerage contact is your key to multiple sources of information, including trade settlement, corporate actions, technology, account administration. and more. The faster their turnaround time, the faster and more informed the hedge fund manager is able to get on with their business.
Capital introduction
You need money to make money. In order to start a hedge fund the hedge fund manager must attract capital in the form of investment into the hedge fund. While the availability of start-up money is usually the motivation for the creation of a hedge fund (for example, one or two high net worth investors express interest in taking advantage of your trading or money management skills), in order to sustain the momentum of the fund, additional and ongoing capital is required. Whether you are just starting out, or you are managing a mature fund which needs an injection of capital to take it further, capital introduction by your prime broker is key. This may carneln the form· ()f olle-on-one introducti()ns to individuals with money to invest, referrals, or the chance to speak in a capital introduction series with numerous prospective investors as your audience. Your prime broker should give you equal billing time as the other hedge funds they support and most will do so if they see potential in the business case you present.
And in this corner ...

The hedge fund manager needs to know that their prime broker is operating from their 'corner of the ring', and is armed with three essential tools: • the appropriate skill sets; sensitivity to the business of hedge fund management; and an understanding of the hedge fund manager's role.
The X factor
Most prime brokers will provide for all of the services mentioned in 'The basics' section above as a matter of course - they would not survive in the business otherwise. So, again, how does the prospective hedge fund manager identify those characteristics that set one prime broker apart from another? They can start by ascertaining the following: What is the prime broker's response time to questions and issues?
Prime brokerage is a multi-faceted business and as such, requires a diverse range of experience and knowledge within its staff. While more institutions are offering specific courses and programs relating to hedge fund management, prime brokers often draw on individual proficiency in specialized
11

areas to produce a well-rounded team to support every need of the hedge fund. People with expertise in trading, securities lending, regulatory and compliance oversight, settlement, corporate actions, brokerage administration, and technology are all sourced for the purpose of offering the best service available, and a hedge fund manager should look for all of these types of experience in a potential prime broker. Hedge fund management is a time-sensitive and detailoriented business. It is critical that your prime brokerage representatives appreciate this fact and act accordingly, whether that involves going the extra mile at 5pm on a Friday, or simply double-checking a transaction to ensure its accuracy. Judging the prime broker's commitment to the success of your fund is similar to a job interview pose questions on how the prime broker would deal with a particular situation and speak to everyone on the team (within reason) to confirm 100% dedication to your business. Each hedge fund manager has a different style - this is often what attracts investors to the fund in the first place. In a smaller fund, they may be very involved on the operational front. Established funds may require less of the hedge fund manager's involvement at the transactional level, with their responsibilities focused more on marketing and research. It is up to the manager and their prime broker to understand each other's requirements from day-to-day, and how each can contribute most effectively to the administration of the fund. Procedures can be established and technology utilized to ensure the most efficient use of time and resources.
in something new, whether it be technology or a trading strategy. What is the prime broker's response to a problem or innovation - are they receptive and willing to work towards resolution, or do they throw account agreements and technical limitations at the hedge fund, insisting that change cannot be accommodated? Again, with respect to problem resolution, it is important to sit down with the prime broker at the beginning of the relationship and at regular intervals throughout to discuss potential issues and how the prime broker will approach these issues if required. A conscientious prime broker will listen to your concerns and take concrete steps towards addressing them. Regarding new ideas and opportunities, an adept prime broker will recognize growth potential for the business overall and will work with the hedge fund towards execution.
Does size matter?

No. It shouldn't, at least to your prime broker. Unfortunately, many prime brokers do require a minimum amount of trading activity and/or net equity in your hedge fund account before they will take you on. However, far too often these prime brokers have passed over a start-up fund in favour of a more established vehicle, only to regret their decision as the startup quickly builds their asset base and soars far beyond the potential of the mature fund. It can be worthwhile to take a chance on a hedge fund in its infancy stage, because the potential benefits that may be reaped from the investment can be significant. A prime broker that manages its operating costs effectively should be able to support a broad range of hedge funds in multiple phases of growth and maturity, and a hedge fund manager should look for evidence of this when shopping for a prime broker. Prime broker efficiency can be measured in multiple ways, including the number of years the prime brokefhas Operafediri thaf capacity, the reputation of its management team, or again, through casual conversations on the street - do settlement departments of counterparties and clearing brokers complain about the ability of a prime broker to set up trades and settle them accurately and on time? Or are existing clients pleased with the service they receive from their prime broker? A referral is worth its weight in gold and more importantly, can signal a prime broker's value to the hedge fund manager.
Who do you know?

One of the primary roles the prime broker plays is that of '""liais()n. Hedge fund .management reql.Jir'esthein\lolvemerit of many players, and rather than the hedge fund manager attempting to contact each individual area of expertise themselves, the prime broker is employed to make these connections or act on your behalf. Look for the competent prime broker to put you on the line with their derivatives trader when you need one, a counterparty to resolve a settlement issue, and their borrow/lend desk to secure a borrow. They have legal and technical contacts waiting to set you up with direct access trading, or open a new fund. They can put you on the list of guest speakers at their next capital introduction luncheon or speak to their bank associates to confirm the receipt of a wire. The prime broker's scope of influence is, and should be, far-reaching in order to maximize the hedge fund manager's efficiency, and minimize the effort required to manage.
Conclusion
Selecting the right prime broker(s) to administer your hedge fund and maximize its profit-making potential through capitalraising activities, strategic account and position margining, and competitive lending rates and account fees is essential to the long-term success of the fund. The prime broker's role is to support the hedge fund in all aspects of the business, from marketing to trading to technology. The differentiating factor lies in the manner in which the relationship is conducted -
Is anybody listening?
From time to time, a hedge fund manager may experience difficulty having a request fulfilled or becomes interested
12
I·
I
Starting a
The Role of the Prime Broker Hedge Fund - a Canadian Perspective
specifically, the prime broker's understanding of the hedge fund's needs, and efforts to service them as effectively and in as cost-efficient a manner as possible. The hedge fund and prime brokerage industry is constantly evolving, and the prime broker's willingness to evolve with it in order to promote the growth and prosperity of the hedge fund contributes to the potential returns the hedge fund may realize. Maggie DiStasi BMO Capital Markets maggie.distasi@bmo.com
4163595527
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14
Chapter Three:
Structuring a Hedge Fund
assets. So-called aggressive funds or concentrated funds only exacerbate that risk. A manager, then, may wish to adopt a legal structure that insulates fund investors from any excess liability. As discussed below, some structures offer certainty of limited liability to investors and are more appropriate for funds with investment strategies that carry a higher risk that liabilities could exceed assets. Similarly, hedge funds may be structured in a way to achieve certain tax results for investors and/or for the principals of the fund manager. Funds that are structured to accept registered plan money, to 'convert' income to capital gains (which are taxed at a lower rate), to defer tax liability, or to allow the principals to share in the profits of the fund in the manner earned by the fund (for example, capital gains) rather than through performance fees (which are taxable as income) are exposed to varying degrees of risk of reassessment by the taxation authorities. Multi-strategy funds may wish to offer investors a tax effective means to switch from one strategy to another or to change the mix of strategies. The structure selected for the fund can reflect the tax needs and the risk appetite of the principals and their investors, whether they take a very conservative approach to taxation or offer more aggressive tax planning.
Ronald M. Kosonic and Carol E. Derk Borden Ladner Gervais LLP, Toronto
Single-strategy
vs multi-strategy funds
Structuring a hedge fund in Canada depends on a number of factors, having regard to the fund's investment objective, the strategies it employs, the risks associated with those strategies, whether it is a single manager fund Or Cl funcl offunas, whether it is a single-strategy or a multi-strategy fund, how the principals wish to be compensated, limited liability and tax considerations, the target investor market and applicable securities laws. Tax, securities and commercial laws particular to Canada help shape the structure chosen and often require hedge fund products and features that are popular in the US or offshore to be modified for Canadian investors.
Fund formation Investment strategies and risk

Each fund structure carries different levels of risk (liability risk or tax risk) and the structure chosen depends on which factors are most important to the fund manager. Despite the name, many hedge funds carry a degree of risk that long-only mutual funds do not. While a long-only fund stands to lose, at most, the value of its investments (plus any accrued but unpaid fees and expenses), hedge funds that employ leverage, sell short and/or invest in certain derivative instruments can theoretically (and in some cases, quite possibly) have liabilities that Significantly exceed their
Whether the fund manager offers a single investment strategy or multiple strategies, and whether multiple strategies are offered in a single fund or a family of related funds, also factor into the legal structure(s) chosen. A single-manager, singlestrategy fund may be offered in one of three legal forms: a corporation, a limited partnership or a trust, as discussed below. The multi-strategy fund can be structured in many differentways.ln.·itssimplestform,amulti-strategyfundis managed by a single manager and all investors participate equally in one portfolio that employs multiple strategies. This structure will look very much like a single-strategy fund. Investment mix among the strategies can be fixed, or subject to maximums, in respect of the amount of the portfolio that can be allocated to anyone strategy. Alternatively, the fund can operate as an 'opportunity fund' that gives the portfolio manager full discretion as investment opportunities present themselves. Multi-strategy fund managers who wish to separate strategies (or portfolio managers) have a number of options: a single fund with distinct portions of the portfolio allocated to a strategy or portfolio manager; a multi-class single fund, with each class deriving its value from a separate pool of assets; a series of separate funds under common administrative and portfolio management; or a suite of different products under common administration but engaging a third-party portfolio manager for each product. Each separate strategy can employ the services of a thirdparty portfolio manager directly through a segregated account or by investing in the portfolio manager's own pooled fund product (a 'fund-on-fund' structure). Corporate structures offering multiple strategies through different classes of shares
15

Compensation of managers of hedge funds
Hedge fund managers generally receive two forms of compensation: a management fee, which is typically between 1% and 2% per annum of the net asset value (NAV) of the fund, and a performance fee, which is based on the appreciation in the NAV of the fund or the units of the fund held by an investor. Performance fees are typically 20%, but may range between 10% and 30% of the increase in the value of the fund or its units. Management fees are typically paid monthly or quarterly. Performance fees are typically paid quarterly or annually. The calculation of performance fees may be subject to a 'high water mark', so that if the fund experiences a loss, additional performance fees are not accrued until the fund's (or unit's) NAV surpasses its previous high water mark. Hedge funds that pay a performance fee may also have a 'hurdle rate' over which the fund or unit must perform (above the high water mark) before the performance fee is paid. The hurdle may take the form of a fixed percentage or may be tied to an index or treasury bill return, depending on the nature of the hedge fund. Funds with a hurdle rate may also have a 'catch-up fee' feature, which entitles the manager to receive profits over the hurdle rate until such time as it receives its 'share'. For example, if the hurdle rate is a fixed 4% of the high water mark and the performance fee is 20% of the increase in the NAV over the high water mark, then, with a catch-up fee feature, the investors are first entitled to earn their 4% of the high water mark before the manager earns any performance fee, but, once the 4% has been earned, the next 1% increase in the NAV is payable to the manager as a catch-up fee (resulting in the manager receiving 20% of the first 5% increase in the NAV). If the increase in the NAV exceeds 5% of the high water mark, the investors and the manager will participate ratably .(ie,·on an 80/20. basis) in the excess •.Hedge fund managers may also charge an early redemption fee of up to 5% of the redeemed units' NAV, which fees are typically payable if the units are redeemed within the first year of their issue ('early redemption' might be as short as 90 days or as long as three years). The rationale for such a fee is to create a disincentive to short-term investing and to compensate the manager for its up-front costs in bringing a new investor into the fund (these costs would otherwise be absorbed over time by the fees earned from a longer-term investor). The legal structure can influence how and to whom such payments are made. For example, where a limited partnership structure is used, the general partner may take some or all of the fees, or may take a profit participation instead of the manager receiving a performance fee. Profit participation may allow the general partner to receive profits in the character that they were earned by the fund, thereby receiving capital gains treatment on some or all of the distributions made to it. It is not unusual for the general partner itself to be a limited partnership in order to afford the principals the ability to do some personal tax planning. There are tax issues related to this profit participation structure that
('switch corporations' or 'corporate class funds') can offer investors the ability to switch between investment strategies without triggering capital gains (switching between funds that are not classes of the same legal entity generally triggers capital gains). However, there is a cost to this corporate structure that may outweigh an investor's potential tax benefits. As well, cross-liability is a concern when different 'funds' are offered in the form of separate classes of the same legal entity.
Multi-strategy funds vs funds of funds

Single-manager hedge funds may follow one or more hedge fund strategies. However, from an investor's perspective, there are a number of problems with direct hedge fund investing, such as conducting the required due diligence, having the expertise required for fund and manager selection, conducting appropriate risk analysis and monitoring the fund and the manager on an ongoing basis. To diversify among various investment styles and strategies of hedge funds as well as among hedge fund managers, a multi-manager hedge fund can take the form of a 'fund of funds', providing a diversified portfolio of hedge funds to investors. The fund of hedge funds approach provides advantages over the use of a single investment manager for individuals and smaller institutional investors. As many hedge funds have high minimum investments or other investor restrictions, a fund of hedge funds provides economies of scale and permits investors to access a variety of hedge fund managers that otherwise may not be available to them. In addition, investors rely on the fund of hedge funds manager to conduct the required due diligence and to have the expertise required for fund selection, risk management c~.and·monitoring, Eunds. of ftlnds potentially carry with them valuation, redemption and financial reporting challenges, as the funds in which they invest will have varied year-ends and reporting periods and different redemption terms. Funds of funds, therefore, tend to have longer redemption notice periods, higher hold backs on redemption proceeds (pending completion of the fund's audit) and later financial reporting. The most significant downside to funds of hedge funds is the overlaying of management fees - investors must be aware of the duplication offees and the direct and indirect expense ratio associated with fund of funds investing. A form of fund of funds popular outside of Canada is the so-called master-feeder (or hub-and-spoke) structure, which allows two or more 'feeder funds' to invest in a single 'master fund', providing the fund manager with a single pool of assets to manage. Feeder funds are typically set up in different jurisdictions, but sometimes may be differentiated by their fee loads or may separate taxable from non-taxable investors. The use of a master-feeder in Canada is limited by the size of the market and by Canadian federal tax laws that discourage the mixing of Canadian and non-Canadian investors directly or indirectly in a single pool.
16

must be considered by the fund manager's and the investors' tax advisers.
The target market

The hedge fund manager's target investor market will also influence the structure chosen for the hedge fund product. Hedge fund products for retail investors are quite a bit different than products for accredited investors and other exempt purchasers. (,Exempt purchasers' are those to whom the hedge fund may sell its units without using a dealer and without preparing a prospectus that has been filed and accepted by the applicable securities commission.) Hedge funds set up as redeemable investment funds are generally not available to retail investors, as securities laws applicable to retail products prohibit many of the strategies that hedge fund managers want to employ. Restrictions or limits on leverage, short sales and the use of derivative investments make retail investment funds unattractive as hedge fund vehicles. As a result, any retail hedge funds that are currently available tend to be watered-down versions of the fund manager's hedge fund products that are sold to exempt purchasers. Commodity pools are also not popular as hedge fund vehicles. Although they permit greater use of derivatives than their mutual fund counterparts, they still have retail fund and distribution restrictions that limit their market appeal. Products such as linked notes (including principal protected notes or PPNs) have been used in Canada to give 'retail' investors some exposure to hedge fund strategies. However, their use for this purpose has diminished in the past few years as a result of recent regulatory attention and initiatives. Similarly, retail funds may use derivative instruments, such as forward contracts, to replicate hedge fund returns. However, these structures are relatively ~~R~Jl§ive.and theJook-through.provisions that apply to retail mutual funds can be restrictive. Even in the exempt market, a hedge fund's structure is influenced by the fund's target investors. Hedge fund managers that want to attract registered plan money may choose a trust structure over a limited partnership; however, the number of investors they plan to attract may influence that decision as well. The risk appetite of target investors will determine whether a hedge fund with novel tax planning strategies will be successful.
about disclosing securities positions publicly. Differences in limited partnership laws may also cause a fund manager to prefer to set up its fund in a certain jurisdiction. Under Manitoba law, for example, the limited liability of investors who participate in investment committees is more certain than in other provinces. Securities laws do not generally prefer one form of legal structure over another. Laws applicable to 'mutual funds' (pooled investment vehicles whose securities are redeemable on demand at their NAV) apply equally to corporations, limited partnerships and trusts.
Legal structure of hedge funds

Single hedge funds in Canada can be set up using a number of different legal structures. The most appropriate structure depends on preferred tax treatment, legal liability considerations and the need for flexibility.
Corporation
Hedge funds can be set up as corporations under either provincial or federal corporate legislation. A corporation is created by the filing of articles of incorporation with the appropriate governmental authority. A general by-law, adopted by the initial director(s) and shareholder(s) of the corporation, governs the affairs of the corporation. The corporation is managed by its board of directors and by those officers that are appointed by the board. Investors subscribe for, and are issued, shares (generally pursuant to a subscription agreement) in order to become shareholders of the corporation. Thebiggesfadvantagedfthei:::brpbrate structure is that it offers limited liability to investors - the most that an investor can lose is his or her investment in the corporation. For example, if short sale obligations or margin calls exceed the assets of the corporation, the corporation alone, and not its shareholders, would be liable for the difference (only in cases of fraud or other extreme circumstances would a court 'pierce the corporate veil' and hold shareholders accountable for the debts of the corporation). Corporations are also familiar to, and easily understood by, the investing public. The disadvantage of the corporate vehicle, and what makes it an unpopular structure in Canada for hedge funds, is that federal income tax is imposed at the corporate level. Depending on the type of income or capital gains earned by the hedge fund, a corporation can be less tax efficient than other structures. In addition, there is no opportunity to flow income or losses through to the investors.
Applicable securities laws

As the Canadian Securities Administrators move toward harmonization of securities laws across Canada, the ability to arbitrage differences in securities laws when structuring a hedge fund has become very limited. However, financial reporting requirements for privately-offered hedge funds in certain provinces of Canada are not as onerous as in others, and there has been some 'jurisdiction shopping' by hedge fund managers in deciding where to set up their hedge funds. This is particularly the case where there are sensitivities
Limited partnership
Hedge funds can also be formed as limited partnerships, with investors becoming limited partners in the partnership. Limited partnerships are formed by the filing of a certificate
17

or declaration of limited partnership under applicable limited partnerships legislation and the execution of a limited partnership agreement by the general partner(s) and the initial limited partner(s). The limited partnership agreement sets out the rights and obligations of the investors, much like the articles and by-laws of a corporation. The general partner (typically a corporation) is responsible for the management of the limited partnership and has unlimited liability for the debts ofthe limited partnership. Investors become limited partners by signing the limited partnership agreement or by agreeing to be bound by the agreement pursuant to a subscription agreement. In addition, the subscription agreement for limited partnership interests contains standard representations as to the investor's eligibility and residence, and a power of attorney in favour of the general partner that allows the general partner to make certain regulatory and tax filings on behalf of the partnership and/or the limited partners. Limited partnerships that are used as open-ended investment funds are typically 'unitized' (meaning that a limited partner's interest is described in terms of a number of distinct units, which may be issued in different classes and series). Depending on the features desired in the fund and the expectations of investors, traditional capital accounting rather than unit accounting may be employed for modern hedge funds; however, the differences are more in form than in substance. A limited partnership is similar to a corporation in that it offers limited liability to each investor (provided all necessary filings have been made in the investor's jurisdiction of residence and the investor does not participate in the management of the partnership). It has the added advantage of flowing income ,,(orlosses ).directly.through. to individual investors. so.that.iUs taxable (or deductible) in their hands. Income may, but need not be, actually distributed to investors for this purpose. For this reason, a limited partnership can be the most tax efficient vehicle for a hedge fund. The ability to flow through losses, however, may be restricted in several circumstances. First, a limited partner's ability to claim losses of the limited partnership for tax purposes is limited by the 'at risk' rules. If the limited partner borrows to make an investment in the limited partnership or receives certain benefits as a result of being a limited partner, this may reduce the amount of any loss allocated to the limited partner that the limited partner can deduct against other income. Second, losses can be restricted where a limited partnership registers, or ought to have registered, as a tax shelter. Generally speaking, a limited partnership that can expect to have losses and deductions (taking into account interest expense but not taking into account any offsetting gains) in its first four years that at least equal the investors' contributed capital, ought to register as a tax shelter. There are severe penalties imposed on a promoter of a limited partnership
that is required to, but does not, register as a tax shelter. Finally, if an investment in the limited partnership is a tax shelter investment, which will be the case if the partnership is a tax shelter, debt incurred by the limited partnership or by the limited partner may restrict the ability of the limited partnership and/or the limited partner to deduct losses. The limited partnership structure may also enable key individuals to participate in profits (both income and capital gains) through ownership of the general partner, rather than by earning a performance fee through a third-party investment manager. Both tax and securities law considerations impact this type of profit participation structure. Flow-through tax treatment, limited liability and the flexibility afforded to limited partnerships to allocate income fairly and to track performance and charge fees on a per unit basis make the limited partnership a popular structure for hedge funds. The limited partnership structure presents some drawbacks. In certain provinces there is a requirement that a list of all investors in the limited partnership (including name, address and capital contribution) be filed on the public record and kept current. Other jurisdictions, while not requiring the information to be posted on the public record, require that it be provided to anyone who asks for it. In the past, limited partnerships were not eligible for investment by registered plans, as they were required to be listed on a stock exchange in Canada to so qualify. (Recent amendments to federal tax laws have greatly expanded the list of recognized stock exchanges for that purpose, and include certain exchanges that have more liberal listing and lighter reporting requirements.) Finally, the requirement that income be allocated to partners can result in an investor being taxable on income earned by the limited partnership but.not actually ..Oistributeci .tothe .investor.
Trust
The third form of hedge fund vehicle is the commercial investment trust (or unit trust). Investors become beneficiaries of the trust and are generally referred to as unitholders. Commercial investment trusts are formed by the execution of a trust agreement or a declaration of trust, which sets out the rights and obligations of the trustee and the unitholders. At common law, the trustee has plenary powers to manage the trust; however, modern commercial practice is to have the trustee delegate almost all of the management functions of a commercial investment trust to a manager (unless the trustee is also the manager) and/or to an investment manager. For the purposes of a commercial investment trust created in Ontario, for example, a registered trust company must be engaged as the trustee unless an order is obtained from the Ontario Securities Commission permitting the fund manager to so act (managers of retail funds rely on a blanket order that permits them to serve as trustee of their funds; managers of privately-offered funds must apply for an order, which is generally granted if the manager is registered under
18
Starting a Hedge
Structuring a Hedge Fund Fund - a Canadian Perspective
the Securities Act or has experience acting as a trustee of retail mutual funds). In most instances, a trust cannot offer the same degree of certainty of limited liability for investors as a corporation or limited partnership. Although the predominant view has been that, in most circumstances, the risk of liability to unitholders of a commercial investment trust is low, this issue is not settled at common law and must be considered by hedge funds that employ leverage, short sales or other investment techniques that increase the risk that the liabilities of the fund could exceed its assets at a given time. Legislation in Ontario and Alberta offers specific statutory protection for investors in retail trust vehicles, but not for investors in privately-offered investment trusts. A trust must pay tax on its income for a taxation year at the top marginal rate for individuals, but can minimize or eliminate its income and taxable capital gains by distributing its income and taxable capital gains to its unitholders, to be taxed in their hands. It is common practice for distributed income to be automatically reinvested in the trust by the issuance of additional units. As with a limited partnership, this could result in investors being taxable on income or taxable capital gains without actually receiving a cash distribution. Unlike a limited partnership, a trust cannot flow losses out to its unitholders, but can carry them forward in accordance with the normal income tax rules. The unit trust is the preferred structure for hedge fund managers who wish to offer the fund to certain pension plans, registered retirement savings plans and other deferred plans. Trust units can be qualified for investment by registered plans if they are.rede.e.mable on demand attheirnet asset value ancrffthe trust has more than 150 unitholders (each holding a block of units having a net asset value of at least $500) or the trust applies under the Income Tax Act (Canada) to become a registered investment. The drawback of registering as a registered investment is that the fund manager is then limited as to the types of instruments the fund may invest in, and many popular hedging techniques are not permitted.
series are often used when a performance fee is charged based on the increase in the NAV per unit, so that the performance fee can be separately calculated and deducted from the NAV of each series. In order to avoid having too many series outstanding, it is useful to collapse all of the series into one following the payment of the performance fees. There are practical constraints and potential tax consequences in Canada that warrant caution when issuing hedge fund securities in classes and series, depending on the legal structure of the fund, the fee calculation methodology used and the desired tax consequences to investors.
Side pockets
Side pockets have become a useful tool for dealing with illiquid investments within a relatively liquid portfolio, particularly for investment funds that are in continuous distribution and offer redemption on demand or with relatively short notice periods. Illiquid investments can be isolated (put into 'side pockets') and valued separately from the main body of investments in a fund's portfolio. When investors redeem their interest in the fund, they receive immediate proceeds based on their respective interest in the main pool of fund assets, but they must wait until any side pocket investments are realized or otherwise become liquid (which could take months or years) before they receive the value of their respective interest in those side pockets. Side pocket interests may be represented by a separate class of units (one for each illiquid interest) or may be embedded in the main class of fund units held by investors. Some funds allow investors to elect whether or not to participate in side pockets. As each side pocket investment becomes available, only investors who are in the fund at that time will participate in the investment. Future investors, whether 'participating' or 'non-participating', do not acquire .anintere.stin the EJxistingside pocket. The value .of a side pocket investment is typically carried at cost and is only revalued when a 'valuation event' occurs for accounting purposes.
Fund management complex

In addition to considering the structure of the fund itself, the manager must also decide on how fund management services will be provided to the fund and how the entities involved will be owned. The fund structure chosen by the fund manager may reflect a number offactors, including tax planning at the management level, in-house expertise and infrastructure, regulatory considerations and the principals' appetite for 'legal clutter' in structuring their affairs. In its simplest form, a hedge fund complex will consist of the fund itself and the fund manager, who provides all of the necessary services to the fund, including distribution, administration and portfolio management. To the extent that other service providers are retained, they may offer their services either to the fund manager or directly to the fund. 19
Fund features
There may be certain features of hedge funds that make the fund structure important in the Canadian market.
Classes and series of units

Regardless of the structure chosen, it is common practice for hedge funds to issue units in separate classes and separate series. In most cases, separate classes are used to allow for different fee structures (for example, as between institutional and smaller investors), but may also be used to reference a different pool or mix of assets. Separate series within each class may be created with each new issue of units. Separate

How the fund manager is owned will depend on the personal tax needs of the principals and whether their business plan contemplates future strategic partners or possible equitysharing with key employees. Whether a single entity or multiple entities are used to provide the necessary services generally depends on two factors: whether the fund manager has the internal expertise to provide the service and whether the manager (assuming it has the internal expertise) wishes to separate 'registrable' from 'non-registrable' activities. Recently, there has been a trend in Canada to separate the fund adviser function from the fund management function (whether or not the fund adviser is related to the fund manager) because the fund adviser must be registered to carry out portfolio management services (there are no practical exemptions from this registration requirement in Canada). Registration of a portfolio manager with the applicable securities authorities carries with it, among other things, proficiency, capital and insurance requirements, the obligation to prepare audited financial statements and the prospect of a regulatory audit. Separating the portfolio management responsibility from the other responsibilities of a fund manager saves the fund manager the expense of including the non-registrable activities in the financial statement audit and may (but not always, as experience has proven) keep the regulators' eyes off of those other activities. The distribution of a fund's securities by way of a private placement to accredited investors or pursuant to other prospectus and registration exemptions is not currently a registrable activity, except in Ontario and Newfoundland and Labrador, where the registration exemption is taken away from market intermediaries, thereby requiring either the fund
Limited partnerships -
a magic bullet?
There is a common misconception in the Canadian marketplace that if the general partner of a limited partnership makes investment decisions on behalf of the partnership, the general partner is not required to register in any capacity. This has caused many hedge funds to be formed as limited partnerships in Canada without seeking registration in any category and without hiring a registered adviser. Fund managers who follow this advice do so at their own peril. The Canadian Securities Administrators have published their view that, regardless of the legal structure chosen, any person or company making discretionary investment decisions on behalf of a pooled entity that was formed for that very purpose is required to register as an adviser with the applicable securities commission. In addition, the new registration rules expected in early 2009 will require the general partner to register as an investment fund manager in the province(s) where it effectively carries on its business and as an exempt market dealer in every province where it distributes its limited partnership interests (the requirement to register as a limited market dealer already exists in Ontario and Newfoundland and Labrador) or to engage a registered firm to carry out those registrable activities. Ronald M. Kosonic Borden Ladner Gervais LLP rkosonic@blgcanada.com
4163676621
Carol E. Derk Borden Ladner Gervais LLP cderk@blgcanada.com
4163676181
"=managefOr' thepOrtf6liO managert6Carry8speCial
category
of dealer registration ('limited market dealer') if units of the fund are sold in those provinces. In Ontario, therefore, it is typical to have one entity provide all registrable activities, with the portfolio manager typically providing portfolio management, marketing support and distribution services. With proposed changes to the Canadian registration rules (expected to be in force in early 2009), a fund manager will need to be registered and the dealer registration requirement for intermediaries (in a new category, 'exempt market dealer') will apply across Canada. Because of capital, insurance and ongoing compliance requirements associated with registration in Canada, it is likely that we will see a trend back to creating a single entity to provide all of the management, portfolio management and distribution services to its Canadian hedge funds.
20
Chapter Four:
Offshore Fund Administration
Most importantly, unlike domestically-regulated mutual funds, hedge funds are defined mainly by their lack of government-mandated investment restrictions. Rather each hedge fund will have a specific investment style (or styles far multi-strategy funds) and potentially investment restrictions defined in its .offering document. investors are assumed to be sophisticated and are deemed ta perform whatever due diligence is necessary and ask any questions they consider appropriate before investing in a fund. They often perform such due diligence an an ongaing basis. Other significant features include: hedge funds routinely charge complex incentive fees requiring equally complex and custom accounting systems; funds also typically process subscriptions and redemptians through fund-specific, multi-page, paper documents that have ta be carefully reviewed and processed; minimum subscriptions are typically $1 millian with a legal minimum of $100,000; each subscription will need to be considered in relation ta the relevant anti-maney laundering regulatians.
• Greg Bennett and John Lewis Butterfield Fund Services Limited, Cayman Islands
You're thinking of setting up an offshore hedge fund ... what are the first steps?
Sa you have a track record of managing proprietary and you are loaking to move out on your own. You ~~~?investar, .. ut.he ne.eds.thefundt.o. be.offshare. ~ nave a successful Canadian-damiciled fund and appeal to a wider investor base. What do you da? maney have a Maybe want to
you
Clearly, yau will need to have a prime broker (unless yau are laaking to set up a fund of funds), although you may already have a gaad relatianship that will continue to wark far you. Yau'li need offshore legal counsel, althaugh your Canadian firm may recommend someone. Hawever, far hedge funds that look ta domicile and distribute offshore, engaging an experienced and independent administrator is a necessity, nat a luxury. 'Experienced' means experience with offshore funds and offshore investors, as they are nat the same as their onshore cousins and you do nat want to be at the bleeding edge of an administratar's experience curve. In order to understand why administration is such an important part of the hedge fund setup process, it is helpful ta first consider same of the unique characteristics of hedge funds.
Hedge funds are private investment pools that are effectively unrestricted by law in terms of trading style, underlying securities and ability to take leverage. It is the market (by, far example, making leverage available) and the specific .offering document that mandates what a specific hedge fund can and cannot do. The effect is that hedge funds trade a wide range of products, from straightforward equities and bonds, as do mutual funds, through to esoteric derivatives, illiquid products or IilyenpriYfltlilhqlqi[lgs, .unliI<IilJl1l1tlJClI.funds, They also. often employ leverage and typically charge a performance fee in addition ta a management fee. The end result is usually a much mare complex structure and operation than a typical mutual fund. Your hedge fund administrator must have an in-depth understanding of these similarities and differences, utilize systems that can account for the breadth and depth of securities hedge funds may trade, and offer ather specialized services, such as the ability ta account far performance fees and make an assessment of difficult-to-value holdings. When starting a hedge fund, the initial selection and angaing function of a fund administrator is of critical importance. Keep in mind, nat only will your administrator be intimately involved with the day-ta-day operations of your fund, but they will also have responsibility far dealing with your mast important asset - your investors. Further, mast investors today demand that a quality independent administratar be engaged prior ta investing. While historically, this has been commonplace for offshore funds, mare and mare often this is also becoming the de facto standard for onshore funds. This is incrsasinqly being driven by the growth in minimum standards far corporate governance in the post Sarbannes-
21

Oxley world, where institutional investors need to be able to prove that they meet these standards and the absence of an independent administrator Oust like the absence of an independent aifdltor) can prevent an investment regardless ofthe prowess ofthe investment manager. The global nature of the business demands expertise on a number of fronts and it is important that any administrator under consideration has the appropriate knowledge and experience to service the structure envisioned, along with the international reputation that will be expected of your prospective investor base. Given UCS importance, assessment and selection of an administrator should be done very early in the setup process. In addition to being actively involved in the dayto-day operation of the fund, your administrator should also provide invaluable advice in terms of setup and structuringincluding domicile selection, legal structuring, fee structures, an introduction to offshore auditors and general operational matters.
applicable anti-money laundering laws. Responsibilities also include maintaining the share register, including effecting share issuance, redemptions and transfers, in accordance with thefl.lnd's offeringrnernbrahdurn and other c:::ohstitl.ltioh documents. Finally, the administrator will disseminate the NAV to investors and deal with any general enquiries, including requests for subscription agreements, audited financials and so on.
Valuations, accounting, reporting

The other primary responsibility of the administrator is to maintain the principal books and records of the fund to the trial balance level, calculate the management, performance and other fees and determine the NAV of the fund based on information received from the investment manager, prime brokers, sub-fund administrators and any other relevant service providers to the fund. The two main areas involved in determining the NAV involve trade capture and reconciliation and the independent valuation of the portfolio. Trade capture and reconciliation In order to ensure completeness, accuracy and the existence of all portfolio positions, the administrator should have the capability to capture and reconcile all trade data received from the investment manager back to the independent prime broker or custodian. This includes the following: Order management system - The ability to accept trade information directly from the manager in a variety of formats (driven by the investment manager's trading platform) and convert this into a stahdard forrnat forrec:::bhc:::iliatiol1tb prime broker! the custodian to import into the administrator's accounting system. • Trade reconciliation - Trade data received from the manager then needs to reconciled to the prime broker/custodian. As such, the administrator needs to be able to accept portfolio data from all major brokers/ custodians and convert it into a format that matches the information accepted from the order management system. A reconciliation of this data then needs to be done, with any breaks/exceptions identified and resolved. Security master file - A system is required that maintains a list of all securities the fund will trade in a standard format, in order to facilitate an independent valuation process. Valuation Valuation of securities and the responsibilities of the various fund parties is currently a hot topic in the industry. Supporting
Administrator
responsibilities
In order to make an effective decision regarding selection, it is first important to understand the roles and responsibilities an administrator should be expected to fulfil.
Take on of the fund

As noted above, your administrator should be able to provide invaluable advice in terms of set up and structuring. They should also be reviewing and commenting on the fund's offering memorandum and other constituent documents. This includes considerinq accounting and operational issues, such as highlighting potential problems with valuation policies =or=pertormaneefee ealeulation- methodology.·· Finally, they should liaise with the other service providers, including legal counsel in Canada and elsewhere, in order to ensure the launch timetable is adhered to and all deadlines are met.
General administration
Although not the administrator's primary responsibility, as the name implies, the selected administrator should offer general administrative services, including monitoring bank accounts, assisting with the management of cash balances, and facllitatinq the settling of fees and expenses. The administrator will need to liaise with the other service providers on an ongoing basis, including the investment manager, prime brokers, sub-fund administrators, or any other service providers as and when required.
Shareholder services
One of the primary responsibilities of the administrator is to communicate with investors and maintain the official share register of the fund. This includes receiving subscription money, paying redemptions, paying distributions and dividends, and ensuring that all money is compliant with
22

this are recent public comments on valuation by a number of industry groups, including the International Organization of Securities Commissions and their Objectives and Principles of Securities Regulation (the 'IOSCO Principles'), which provides guidelines for simplifying hedge fund disclosure and the Alternative Investment Management Association's (AlMA) recently issued AlMA's Guide to Sound Practices for Hedge Fund Valuation. As a result, best practice now dictates additional disclosure and the application of much more detailed and stringent valuation guidelines. This is in contrast to the more generic boiler plate disclosure that have historically been included in offering memoranda, which may have sufficed for the valuation of major exchange traded securities with a high degree of liquidity; however, they provide very little value in terms of the more esoteric portfolios. In this regard, and consistent with AlMA's original 2005 Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry, responsibility for the valuation of a fund's portfolio ultimately resides with the fund's governing body (directors, general partner or trustee - depending on the structure). As such, it is up to the governing body of the fund to establish the valuation policies, in consultation with the other stakeholders. As is industry best practice, these policies need to be robust, workable and consistent with the nature of the securities the fund trades. For example, if independent pricing sources are not readily available for certain portfolio holdings and models are used, the models and inputs should be independently tested and verified. Once established, the production of the NAV, in accordance with these policies, can be delegated to an administrator who should be ensuring that
Does the administrator have the appropriate knowledge and expertise related to the proposed strategy and can they account for and independently verify the value of the securities the fund will trade? Is their process automated and will they be able to cope with the expected trading volumes? Similarly, can they handle the performance fee calculations and required investor reporting? How is the service team organized, is there a team structure with dedicated accountant managers and client relations officers? What are the skills, background and experience of the staff? Do they have professional accounting qualifications? What is the current capacity of the administrator and what is their staff turnover rate? Does the administrator have a comprehensive and disaster recovery plan? BCP
How is the control environment? Is the firm audited, both by an external and an internal auditor? Have they had their control environment audited and received a SAS 70 report or similar? • What is the reputation of the firm in the marketplace and can they provide references from clients that trade a similar strategy? What is the size of the administrator, including number of locations, staffing, assets under administration, number of funds serviced and number of clients? • What are the expectations investors? of your prospective
the~prit:ihgp(jlicyappliedisC(jhsisteht
disclosed and that independent the manager's marks.
WithWhafhas been
pricing evidence supports
Administrator's
skills
With a basic understanding of the roles and responsibilities of an administrator, the next step is to consider the services and skills they should have in order to effectively deliver as required. The list below is not exhaustive, however it attempts to cover the main areas that should be considered when assessing an administrator. Does the proposed administrator have expertise across jurisdictions and of the various structural and operational issues relevant to the fund? It is important that your administrator be able to facilitate the growth of your business and although issues such as offshore capability may not be an initial consideration, the prospect of this sort of growth should also be considered at this stage.
Will they service the business out of a time zone that will be conducive to dealing with your own back office and operations staff? Can they provide ancillary services such as banking, custody, forex and other similar services? Do they provide custom fund of fund services? The final issue should be fees. Although always important, fees are only one of a number of factors and they should always be considered in terms of the overall service package.
Domicile/offshore
market
Finally, there is a very large pool of prospective investors outside of Canada that may have a great deal of interest
23

in your strategy, however they will very likely insist on an offshore structure in order to invest. Specifically, non-taxable US investors (pension plans, endowments, fund offunds) and European or Asian institutions or HNW's will all likely require you establish an offshore structure. Taxable US investors prefer a US Limited Partnership, usually out of Delaware. Although there is a cost associated with establishing an offshore structure, reasonable estimates are that the fund should have commitments of anywhere from $25-$50 million in order to justify the set up. However, there are clear benefits in terms of attracting an institutional investor base. In terms of domicile, there are approximately 9,000 'offshore' vehicles, with the vast majority domiciled in Cayman, although other locations such as BVI, Bermuda and Bahamas are often selected. Things to consider in selecting an offshore jurisdiction: • Tax policy - is the domicile truly 'tax neutral', ensuring that your investors will not be subject to double taxation? International reputation - are your target investors familiar with the domicile and will it meet their objectives? Clearly you do not want the choice of domicile to impact or limit your ability to raise funds. As such, the jurisdiction selected should be well known and regarded internationally. Government policy - is the government stable and what is the basis of the legal system? Is the legal - system based on the legal system of an established onshore country? Is there appeal to courts in an established onshore jurisdiction? Location - is the domicile within a time zone that will allow for effective communication with your offshore legal and related service providers? Infrastructure - does the jurisdiction have the necessary infrastructure of required professionals, communication systems, and BCP contingency plans to ensure the ability to service the vehicle into the future? Flexible structuring - is the jurisdiction's legal system robust in terms of available legal forms (offering companies, partnerships, trusts, etc.) and is there flexibility in terms of structuring, allowing for stand-alone funds, master feeder vehicles and sideby-side structures?
Although such discussions will clearly need to be had with onshore and potentially offshore counsel, the above should serve as a good starting point for this discussion.
Conclusion
There are many opportunities to grow a hedge fund business offshore, but it is not a route you should look to take without bringing in an experienced professional early in your launch process. As well as your trusted counsel, this should include any proposed external (independent) directors and your chosen independent administrator. John Lewis Butterfield Fund Services john.lewis@butterfieldbank.ky 3458157592 Greg Bennett Butterfield Fund Services greg.bennett@butterfieldbank.ky 3458157579
24
Chapter Five:
Registration in Canada
Any person or company that 'trades' in securities must also be registered as a dealer, or a trading officer or representative of a registered dealer, or otherwise be exempt from the dealer registration requirement Trading includes, among other activities, 'any sale or disposition of a security for valuable consideration and any act, advertisement, solicitation, conduct or negotiation, directly or indirectly, in furtherance' of any sale or disposition of a security. The definition of 'trading' is extremely broad. It includes the solicitation or servicing of prospective investors or existing investors in respect of any trading activity. Certain activities, including back office, administrative and bookkeeping functions, do not constitute trading and, accordingly, do not require registration. In this chapter, wherever possible, we will discuss registration issues from the perspective of Ontario securities laws, unless the laws of another Canadian jurisdiction are substantively different. Proposed changes to securities laws, which are expected to be in effect in early 2009, are designed to put in place a nationally harmonized and streamlined registration regime. Significant changes to existing registration requirements are summarized at the end of this chapter.
Prema K.R. Thiele, Ronald M. Kosonic and Laurie J. Cook Borden Ladner Gervais LLP, Toronto
Registration requirements Adviser registration

Any party (the adviser entity) who provides investment management services to an investment fund such as a mutual fund or hedge fund generally must be registered, or exempt from registration, as an adviser in the jurisdiction in which the investment fund is established. The Ontario Securities Commission (OSC) currently takes the view that an adviser entity, which provides investment management services to an investment fundthatdistributes its securities in Ontario, is advising Ontario investors. As a result, the OSC considers the adviser entity to be acting as an adviser in Ontario even though the advice may be given to, and received by, the investment fund outside of Ontario. An entity which is acting as an adviser in respect of securities in Ontario (and where an exemption from the registration requirement is unavailable) is required to register in one of the following categories of adviser registration: International adviser An adviser entity may register as an international adviser in Ontario under OSC Rule 35-502. That Rule permits the registration of non-resident advisers who provide investment management services to a limited group of sophisticated investors ('permitted clients') in Ontario. Other Canadian jurisdictions have a similar category of registration based on similar terms and conditions. An international adviser may only advise in respect of non-Canadian securities (although it may advise in respect of Canadian securities if this activity is incidental to its acting as an adviser for non-Canadian securities). The definition of permitted clients includes:
Introduction
Securities matters are subject to the jurisdiction of the individual provinces and territories in Canada. Each jurisdiction has its own securities legislation. Accor~i~~ly, depending on the nature and location of the activities involved, the legislation of one or more Canadian jurisdictions may require market participants to be registered with the local securities regulator. In general, those who advise others in respect of investing in securities must be registered as an adviser, or an advising officer or representative of a registered adviser, or be exempt from the adviser registration requirement. Although each Canadian jurisdiction regulates securities and commodity futures similarly, the Provinces of Ontario and Manitoba regulate securities and commodity futures through separate statutes. Those who advise in respect of commodity futures contracts and commodity futures options 1 in those provinces must be separately registered as advisers under the commodity futures legislation of those jurisdictions, or be exempt from the registration requirement. Practically speaking, the permitted exemptions from the requirement to register as an adviser are limited. As a result, the adviser registration process is typically unavoidable.
25
persons or companies registered as brokers or investment dealers, where they act as principal or as agent for accounts fully managed by them; pensionJundshavingassets of at least G$tOO million as of the date of that fund's most recent audited balance sheet; individuals whose net worth is at least C$5 million, excluding the value of their principal residence; corporations whose shareholders' equity is at least C$100 million; and investment funds that only distribute their securities in the jurisdiction to other permitted clients. International adviser registration is available only to an adviser that carries on its business outside of Canada (in respect of securities of the same type as it proposes to act as an adviser in Ontario) and not more than 25% of the aggregate consolidated gross revenues from advisory activities of the international adviser (and its affiliates) for the most recent financial year arise from its acting as an adviser for clients in Canada. The applicant must provide evidence that it is registered in its home jurisdiction or that it is not required to register under the laws of its home jurisdiction. In Ontario, there are no capital, insurance or proficiency requirements imposed by the OSC over and above those in the international adviser's home jurisdiction; however, there are stipulations on custodianship and segregation of assets. Investment counsel and portfolio manager or non-Canadian adviser In Ontario, an adviser may register as an investment counsel and portfolio manager (or if the entity is created outside of Canada, as a 'non-Canadian adviser' in Ontario only) in "~ordertoprovideadvisoryservicestoany person or entity resident in Ontario or to an investment fund, wherever situate, if an Ontario resident has invested in the fund (the equivalent categories under the commodity futures legislation are commodity trading counsel and commodity trading manager). An adviser so registered does not need to limit its advice to permitted clients, nor is it limited to advising on non-Canadian securities. In most provinces, the adviser entity will be required to meet certain proficiency, insurance and capital requirements in order to obtain registration. An adviser entity will only obtain registration if it has an advising officer who meets the specified criteria (generally, a Chartered Financial Analyst with at least five years experience as a research analyst, three of which were under the supervision of a registered portfolio manager). Exemptive relief could be sought in this regard if it can be established that the officer has comparable education and experience. Registration as a non-Canadian adviser would be granted on the basis of compliance with all other usual requirements applicable to advisers resident in Ontario, as well as additional requirements including the
appointment of an agent for service in Ontario, agreeing to inform the OSC of any investigation or disciplinary action by any regulatory authority, requiring client funds and securities to be held either by the dientorby a custodian that satisfies prescribed requirements, submission to the non-exclusive jurisdiction of the Ontario Courts, and disclosure of the adviser's non-resident status to its clients. In Quebec, advisers who deal exclusively with certain 'accredited investors' within the meaning of the Securities Act (Quebec) are exempt from the adviser registration requirement. No other jurisdiction in Canada has a statutory exemption for persons advising sophisticated or institutional clients, and no jurisdiction in Canada exempts a person from registration as an adviser based on minimum or maximum assets under management. Dealers who provide incidental advice in the course of a trade of a security, for which they are properly registered as a dealer, are generally not required to register as an adviser for that purpose alone.
Exemptions from adviser registration

An adviser entity that is not resident in Ontario is exempt from the adviser registration requirement in Ontario if the adviser entity acts as a sub-adviser to an adviser that is registered under Ontario securities law, provided that the adviser entity enters into an investment management agreement with the registered adviser and the registered adviser agrees to assume responsibility for the advice provided by the adviser entity. Adviser registration is also not required if the adviser entity is not resident in Ontario and gives advice to an investment fund that is outside of Ontario, the securities of the fund are offered primarily outside of Ontario, and such securities are offered in Ontario under a private placement exemption through an Ontario-registered dealer. Finally, if an adviser resident outside of Ontario,together with its affiliates who are also resident outside of Canada, has no more than five clients in Canada and has not solicited their business, and each of those clients would be permitted clients for an international adviser, then that adviser need not register in Ontario. To the extent such exemptions are not specifically granted for the purpose of commodity futures legislation, or in other Canadian jurisdictions, such relief can generally be obtained on a discretionary basis upon application (and subject to certain terms and conditions).
Dealer registration
Investment funds are intermediary vehicles that operate between the adviser entity and the investor. When an investor purchases the securities of an investment fund, a trade is effected and the nature of the services being provided directly to the investor changes from that of 'advising on' to that of 'trading in' securities. An adviser entity generally need only register as an adviser in the jurisdiction in which the fund is established. In contrast, in the case of investment funds, only registered dealers in the jurisdictions of the investors' province of residence may effect trades for such investors
26
unless an exemption from the registration requirement available or a discretionary order is obtained.
is
records. Members of the MFDA are prohibited from having discretionary trading authority over client funds (for this reason, the OSC has granted an exemption from having to
The majority of the jurisdictions of Canada provide an exemption from the dealer registration requirement if the investor purchases units of the investment fund having an aggregate price equal to or greater than $150,000, or the investor is purchasing as principal and is an 'accredited investor'. In Ontario and Newfoundland and Labrador, certain market participants cannot rely on those exemptions. Ontario has a 'universal registration system', which closes off the exempt market (ie, trading in respect of which there is otherwise a dealer registration exemption) to any entity that is classified as a 'market intermediary'. A market intermediary is any person or company that engages in, or holds itself out as engaging in, the business of trading in securities as principal or agent in Ontario. Any entity classified as a 'market intermediary', which would include an entity soliciting or involved in the sale of units of an investment fund, would be required to be registered with the OSC as a dealer. A hedge fund offering its securities in Ontario must determine whether the fund's manager (or other entity involved in the distribution of the fund's securities) must register as a dealer or whether a third-party dealer must be engaged. The category of dealer registration required for any intermediary would be dependent on the particular security being distributed. Newfoundland and Labrador is the only other province in Canada that has adopted the universal registration system. In connection with the sale of hedge fund securities in Ontario, a market intermediary would have to be registered under one of the following categories of registration: Limited market dealer This category of registration only permits the dealer to participate in exempt trades, but is sufficient and most often relied upon for the private placement of hedge fund securities. The process to obtain registration in the category of limited market dealer is relatively simple (there are currently no capital, insurance or proficiency requirements) and inexpensive. Mutual fund dealer Market participants who wish to sell securities of hedge funds that qualify as mutual funds (generally any investment pool whose securities are redeemable on demand at their net asset value) and which are offered by prospectus, may apply for mutual fund dealer registration. In Ontario, this requires registration with the OSC and membership with the Mutual Fund Dealers Association of Canada (MFDA). In addition to proficiency requirements for the dealer's directors, officers and salespersons, the dealer is required to carry minimum capital and insurance, prepare and file audited financial statements annually, operate under a set of approved policies and procedures, and keep certain books and
jOirithe MFDAt6 rrll.lfl.lalfund dealersthafarealso
registered
advisers and that sell only units offunds that they themselves manage). Securities commissions in certain provinces have taken the position that mutual fund dealers are required to also obtain a limited market dealer registration in order to sell exempt products, even if the product is a security of a mutual fund. Hedge funds offering their securities in Canada pursuant to prospectus and registration exemptions must take care if proposing to sell through mutual fund dealers. Investment dealer This category of dealer registration is unrestricted and permits a dealer to sell any type of security, including mutual fund securities and exempt hedge fund products (whether offered pursuant to a prospectus or by private placement). To obtain such registration with the OSC, one must concurrently become a member of the Investment Dealers Association of Canada (IDA). Investment dealers are generally held to higher proficiency, capital and insurance requirements than are mutual fund dealers because of the broader range of products and services an investment dealer may provide; however, these requirements will differ depending on the level of membership obtained (introducing brokers tend to have lower capital and insurance requirements than do carrying brokers, as only a carrying broker would have custody of client funds, for example). All IDA members must prepare and file audited financial statements, operate under an approved set of written policies and procedures, and maintain prescribed books and records. Incljvidllal§jn.anJPAD1ernpeJ.firnlc.an.peJ~C9gniz:edbyJhe IDAas portfolio managers if they meet prescribed proficiency requirements (similar to those for advising officers of adviser firms), which would allow them to have discretionary trading authority over client funds. For this reason, some fund managers obtain investment dealer registration and become IDA members to permit them to provide the full range of services to the investment funds they manage, from distribution of the fund's securities to management of the fund's portfolio and, in limited instances, to execution of the fund's portfolio trades (subject to compliance with conflict of interest rules). The alternative, and in particular where the manager wishes only to offer funds without a prospectus, is to obtain registration as both a limited market dealer and an adviser.
Dealer exemptions and referral fees

The interplay of private placements of securities of hedge funds and dealer registration exemptions is further complicated by the position that certain securities commissions in Canada have taken with regard to the payment of referral fees and split commissions to persons or entities that are not registered in any capacity. A market intermediary, who is exempt from
27
Canadian
Perspective
registration as a dealer (in provinces other than Ontario and Newfoundland and Labrador) in connection with a private placement of fund securities, is not exempt from registration
Registration of investment fund managers

The new registration category of 'investment fund manager' will apply to Canadian managers of all investment funds, inCluding funds fhafarereporting issuers orprivafely ()ffered. The term 'investment fund manager' is defined as 'a person or company that directs the business, operations and affairs of an investment fund'. Investment fund managers will only be required to register in the province where the person or company that directs the management of the fund is located (in most cases, where the head office of the fund manager is located). Investment fund managers resident outside of Canada that do not direct the management of the fund from inside Canada will not have to be registered in this category.
asanadviseriflhey
offer any advice toa prospective investor
with respect to the investment. Hedge fund managers and their registered affiliates who enter into agency or referral arrangements with non-registrants, even in respect of the distribution of fund securities pursuant to prospectus and registration exemptions, should consult with legal counsel in Canada where they propose to make such payments to determine whether there are any prohibitions, restrictions or conditions on payments under these arrangements.
Registration reform in Canada

In early 2008, the Canadian securities administrators (CSA) released for a second comment period a proposed national instrument (which will be adopted by every securities regulator in Canada), along with a companion policy and draft consequential amendments to other regulatory instruments (the Registration Reform Rules) designed to put in place a nationally harmonized and streamlined registration regime for firms and individuals. Once in force, the Registration Reform Rules will significantly alter the status quo for financial services firms doing business in Canada. The rules will cover the requirements for firms and individuals to become registered with the various securities commissions, as well as the regulation of registrants' activities in Canada, such as referral arrangements and registrant client relationships. The CSA suggest that these amendments will be passed by the various provincial governments during 2008 and 2009, so that the Registration Reform Rules can come into force by April 2009. The Registration Reform Rules will expand or ~"clarify existingreglllation of hedge fund managers, advisers and distributors by: introducing a new category of registration for 'investment fund managers'; introducing a new category of registration for 'exempt market dealers'; introducing a new 'business trigger' test for determining when registration is required; increasing capital and insurance requirements across all categories of registration; changing proficiency requirements for individual registrants; introducing requirements for handling complaints and conflicts of interest; enhancing compliance and supervisory expectations; governing referral arrangements; and increasing financial reporting requirements. Although the Registration Reform Rules will be further amended prior to final publication, the following summarizes the important changes that these Rules will bring about.
Exempt market dealer registration

'Exempt market dealers' will replace the 'limited market dealer' category in Ontario and Newfoundland and Labrador and apply across Canada (with few exceptions). Unlike limited market dealers, a registered exempt market dealer may be subject to minimum capital and insurance and will have proficiency requirements for its dealing representatives, its ultimate designated person and its chief compliance officer. Also, exempt market dealers may be subject to the know-your-client and suitability requirements, depending on the client.
Registration trigger'
exemptions
and the 'business
Today's securities legislation imposes a 'business trigger' for determining whether an entity must register as an adviser (ie, whether the market participant is or holds itself out as being in the business of advising others as to the buying and selling of securities). Inc()ntrast, an entity is caughftoday by the deafer registration requirements simply by participating in a trade. The business trigger test will be introduced in all provinces and territories and across all registration categories.
Increased capital and insurance requirements

Minimum capital required for investment fund managers will be $100,000; for dealers $50,000; and for portfolio managers $25,000. Generally, the required capital will be adjusted upward to reflect deductibles under required insurance policies and other risk-related factors. For firms registered in more than one category, these minimums will not be cumulative. Minimum insurance requirements will also increase for firms with significant assets or assets under management, to as high as $25,000,000 in some cases. Dealer firms that are members of a self-regulatory body (SRO) such as the IDAor MFDAwili continue to comply with the SRO's capital and insurance requirements.
Conduct Rules
A registered firm will be required to establish and enforce a system of controls and supervision that ensures the firm's
28
Starting a Hedge
Registration in Canada Fund - a Canadian Perspective
compliance with all applicable requirements. This system of controls must be documented in the form of written policies and procedures. The registered firm will also be required ·enSl.Jrethatits ·cbmpliahcemonitorihgahd .supervision policies and procedures take into account conflicts of interest management issues. To the extent that certain duties (eg, back office administration) are delegated to third party service providers, the registrant firm principally charged with the responsibility will be required to conduct appropriate due diligence on all such service providers and to regularly monitor their activities. Ultimate responsibility for the actions of the service providers will remain with the registrant.
to
Endnote
1.
A commodity futures contract is defined as 'a contract to make or take delivery of a specified quantity and quality, grade or size of a commodity during a designated future month at a price agreed upon when the contract is entered into on a commodity futures exchange pursuant to standardized terms and conditions set forth in such exchange's by-laws, rules or regulations' and a commodity futures option is a long or short position on a commodity futures contract. In addition to what are commonly known as commodities, 'commodities' as defined under the Commodity Futures Act (Ontario) also include treasury bills and commercial paper, as well as equity futures and other derivatives that trade on a commodity futures exchange.
Prema K. R. Thiele
Borden Ladner Gervais .. LP L

pthiele@blgcanada.com
4163676082
Ronald M. Kosonic Borden Ladner Gervais LLP rkosonic@blgcanada.com
4163676621
Laurie J. Cook Borden Ladner Gervias LLP Icook@blgcanada.com
4163676639
29
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Provincial securities regulations

Before delving into the actual compliance issues for hedge funds·in Canada,·itisimportanttounderstandthe regulatory framework in which they are formed. Canada does not currently have a national regulator (such as the SEC) and does not have a uniform national securities act. Each province of Canada has its own securities regulator, provincial securities act, regulations, rules and policies. However, in an effort to reach consensus and harmonization on certain matters that are of national concern, the Canadian Securities Administrators (CSA), representing each of the provincial regulators, has adopted national instruments (applicable nationwide) and multi-lateral instruments (applicable in more than one, but not all, jurisdictions). There are, for example, national instruments that regulate investment funds that are reporting issuers. As well, as noted below, there is a specific national instrument that regulates the continuous disclosure obligations of investments funds, both reporting issuers and certain non-reporting issuers. Although all Canadian securities legislation is premised on the two themes that securities may only be distributed pursuant to a prospectus unless a prospectus exemption is available, and that a registered dealer must be engaged to sell the securities unless a registration exemption is also available, and although the CSA have adopted a single national instrument to harmonize these exemptions, there remain differences in each province with the prospectus and registration exemptions that are available. As a result of this patchwork approach to securities regulation in Canada, a hedge fund manager must consider the securities laws in the jurisdiction where its fund is formed and managed, and ineachjurisdictionvvhere the securities ofthe fund are sold, in order to understand its compliance obligations as manager of the investment fund. We will primarily focus this chapter on Ontario and will note any substantive differences that may exist in the other Canadian jurisdictions. We recommend that you seek advice from legal counsel for the specific rules that may apply if you plan to distribute securities in any province or territory of Canada.
Chapter Six:
Keeping Current with Your Compliance Obligations
Lynn M. McGrade and Ronald M. Kosonic Borden Ladner Gervais LLP, Toronto
Introduction
The purpose of this chapter is to provide an overview of tn~"gompJiance obligations of a hedge fund manager in respect of the hedge fund it manages. This chapter does not discuss the specific compliance obligations that a hedge fund manager may have in its capacity as a registrant. For example, we will not discuss the obligations of a dealer or adviser (or commodity trading manager) in this chapter; however, under Canadian securities laws, a hedge fund manager may be required to register in one or more of those categories. You will find more information about the regulatory framework in Canada for dealers and advisers elsewhere in this publication. In addition, we have not specifically addressed the regulatory framework for the distribution of hedge fund securities in Canada because that topic has also been addressed elsewhere in this publication. It is important to note the currency of the information provided herein, because we are writing this chapter in a changing regulatory landscape. We may make reference in this chapter to an 'investment fund', a regulatory term that includes what is generally called a 'hedge fund'.
Different structures, different obligations Public versus private

In Canada, the majority of hedge funds are offered in the exempt market, although there are a few funds currently being offered by prospectus (the retail market). A 'prospectus' is an offering document that is subject to regulatory requirements as to content, and is filed with and reviewed and officially 'receipted' by one or more securities regulator in Canada. In contrast, an 'offering memorandum', which is typically
31

used in an exempt offering, generally has no mandated disclosure requirements and although it may have to be filed with certain securities regulators it is neither reviewed nor receipted by them. The hedge funds that are being offered by prospectus are typically redeemable once per year at most, and achieve liquidity for their securityholders by becoming listed on a recognized stock exchange, primarily the Toronto Stock Exchange (TSX). Issuers, including investment funds, that sell or have sold their securities by prospectus and/or list their securities on a Canadian stock exchange become 'reporting issuers' under Canadian securities laws and are subject to continuous disclosure and regulatory compliance requirements. By limiting redemptions to once annually, these prospectus-offered hedge funds are outside the application of the national rules for mutual funds (that is, investment funds that are redeemable on demand) that offer their securities by prospectus and, as a result, their investment strategies are not restricted by the investment and concentration restrictions generally applicable to retail mutual funds. In the case of a retail hedge fund, in addition to the compliance obligations summarized in this chapter, there would also be obligations under the securities rules that apply to the delivery of a prospectus, the sale of prospectus-offered securities and the rules of the applicable stock exchange. As well, governance rules require investment funds that are reporting issuers to appoint an independent review committee, a body designed to review and, in many cases, approve transactions in which the fund manager is actually or potentially conflicted in interest. As noted above, the majority of hedge funds in Canada are offered in the exempt market. The result is that hedge funds are generally only available for sale to more sophisticated purchasers who are permitted to purchase securities without =a-prospectos: The exempt market is intended to provide issuers, including investment funds, with access to capital from high net worth and institutional investors without the heavy disclosure burden of a prospectus offering and without the on-going compliance burden and continuous public disclosure obligations of being a reporting issuer.
Trusts A trust is an entity that is created by contract, either by declaration of trust (if the manager is the trustee) or by trust agreement {if an institutional trustee is the trustee}. This trust document will set out the nature of the trust, powers of the trustee and the rights and obligations of its unitholders. In order to settle the trust, the trustee must sign the trust document and put some money or something of value in the trust (as little as $10, typically). Each trust is governed by the jurisdiction in which it is created and must abide by the trust laws in that jurisdiction, which includes, in Ontario, a body of common law (judqe-rnade law}. To change the trust document, the trustee must abide by the provisions set out therein with regard to meetings and amendments. The trust document is not filed with any regulatory body. The trust must file tax returns and relevant elections in accordance with the tax rules that apply to trusts that are investment funds, and must report to unitholders the amount of all distributions made to them in the year (which are typically automatically reinvested in additional units of the fund, meaning that unitholders will not necessarily receive the distributions for which they are taxable). The tax yearend of a trust that is an investment fund must be December 31, although it may elect to have a different fiscal year-end for other purposes. Limited partnerships Many hedge funds are organized as limited partnerships. A limited partnership is also established by contract between a general partner (often a corporation) and the limited partners (the investors). Like a trust document, the limited partnership agreement generally sets out the nature of the limited partnership, the powers of the general partner and the rightsahdbbligatiblis bftheliliiifedpartliers. Ali· advantage of the limited partnership structure over a trust structure is the certainty of limited liability for its investors. To the extent that they comply with the limited partnership agreement and the provisions of the limited partnership legislation in the province in which they are formed, the liability of each limited partner will be limited to the contribution that they make to the partnership (subject to any additional specific liability they agree to incur in the limited partnership agreement). A limited partnership must register as an extra-provincial limited partnership in each Canadian province in which it intends to carry on business, and the general partner, if a corporation, generally must also be registered in each such jurisdiction. It is important to complete these registrations prior to selling interests in the limited partnership in the province, because this is generally considered to be 'carrying on business' in most Canadian provinces. There are forms to be completed and fees to be paid in connection with this registration process and the registry office in certain jurisdictions requires a copy of the limited partnership agreement for its files. To the extent that the general partner \
Corporations, trusts and limited partnerships

Both public and privately-offered investment funds may be structured in one of three ways: as a corporation, as a trust or as a limited partnership. Generally, the decision as to structure is heavily influenced by the tax efficiencies that the investment fund is trying to achieve, including the flow through of income and capital gains from the investment fund to its securityholders. Because corporations are the least efficient structures to achieve this flow through, they are seldom used in Canada to structure investment funds, and hedge funds in particular. The tax implications of, and other considerations for, these structures are discussed in more detail elsewhere in this publication.
32
Keeping Current with Your Compliance Obligations Starting a Hedge Fund - a Canadian Perspective
or the limited partnership makes changes to its name, head office or other administrative changes, or if there are changes in the limited partners (which is likely if the fund is in continuous distribution and/or redeemable on demand), these must be reported to the relevant registry office. A limited partnership is not itself subject to federal income tax but must report its taxable income and gains (and/or losses) to the Canada Revenue Agency. It must also make allocations of such income/gains/losses to its partners, and report such allocations to the partners for tax purposes. In addition, since the general partner itself is typically a corporation, it will be subject to any required corporate and tax filings applicable to a corporation in the jurisdiction. In Ontario, there is an annual tax return that must be filed and an annual corporate filing which must be made. If there are changes to the directors or officers at any time, there is also a requirement to notify the corporation's branch. Rule governs how instructions in this regard are to be obtained from investors. Investment funds that are reporting issuers have additional reporting and filing requirements, including delivery of an Annual Information Form and a Management Report of Fund Performance, quarterly portfolio disclosure, Material Change Reports (if applicable), change of auditor disclosure (if applicable), net asset value and management expense ratio calculation requirements and reporting on proxy voting. Trade reports and fees. Investment funds are obligated to report all sales of units of the fund in a form prescribed by the securities regulators (Form 45-1 06F1) and to file such form within 30 days of the financial year-end of the fund. In most provinces, upon filing the form, a fee is also payable based on a percentage of the subscription proceeds collected in each jurisdiction. In Ontario, the fee is fixed; however, a participation fee may instead be required to be paid to the Ontario Securities Commission by the fund manager (whether or not the fund manager is registered with the Commission in any capacity), based on profits earned in Ontario or from Ontario investors (directly or indirectly) by that manager. General securities law reporting and compliance. As a market participant in Canada, hedge fund managers must inform themselves of general securities laws and reporting requirements in Canada, including the filing of: early warning reporting reports (which generally kick in when the aggregate number of shares of a reporting issuer held or controlled by a portfolio manager exceeds 10% of the public float, however this threshold may be reduced to 5% if a formal takeover bid is in process); insider trading reports (which must be filed by any shareholder holding more than 10% of the shares of a reporting issuer); formal take-over bid circulars and related filings (once a purchaser of securities, together with all those with whom the purchaser is 'acting jointly or in concert', holds more than 20% of any class of equity or voting securities following such purchase, formal take-over bid rules apply unless an exemption is available); and advance warnings of sales from a control block, which may be required once the shareholder exceeds the 20% threshold. Legal counsel should always be contacted in this regard, as the rules differ as to which securities must be counted and how percentage holdings are to be calculated for each purpose. Fund managers must also be cognizant of insider trading prohibitions (and in particular anti-front running rules) and the prohibitions, restrictions and/or reporting obligations when there is a potential conflict of interest between the manager and the fund.
Reporting requirements for hedge funds

No matter what structure a hedge fund manager chooses for its hedge fund, there are certain reporting requirements imposed by the securities laws that apply to investment funds, including those that are offered in the exempt market, depending on the jurisdiction of their formation and whether they have a redemption-on-demand feature. These include the following: • Annual and semi-annual financial reporting. There are two levels of filing obligations for investment funds: one for reporting issuers and one for privately offered funds. Investment fundsorQanized under laws of British Columbia, Alberta, Manitoba or Newfoundland and Labrador that are not reporting issuers are not subject to these rules at all, nor are privately offered investment funds wherever formed if they are not redeemable on demand. Annual financial statements of all other investment funds must be prepared in accordance with National Instrument 81-106 Investment Fund Continuous Disclosure (the Continuous Disclosure Rule) and be audited. Such statements must be made available to each securityholder of the fund and filed with the relevant securities regulators within 90 days of the year-end of the fund (however, non-reporting issuers subject to the Continuous Disclosure Rule can exempt themselves from delivering their statements to the regulators by simply notifying the regulators and placing a note in their financial statements). Semiannual unaudited financial statements must also be prepared, filed (unless exempted) and made available to investors within 60 days of the end of the interim period. Investors may elect whether or not to receive financial statements, and the Continuous Disclosure
33

Dealing with the public - delivery of disclosure documents and due diligence obligations of hedge fund managers Available exemptions from the prospectus and registration requirements
National Instrument 45-106 Prospectus and Registration Exemptions, together with related forms and a companion policy, (the National Exemption Rule) is an exempt distribution regime that permits distributions of an issuer's (including an investment fund's) securities to occur in any jurisdiction of Canada without a prospectus and without the involvement of a registered dealer. The most commonly used exemptions relied on by investment funds are: The 'accredited investor exemption', which permits sales to be made to government agencies, institutions, high net worth individuals and other specified sophisticated investors. The 'minimum purchase exemption', which permits sales of anyone class of securities of an issuer to be made to an investor, provided the aggregate purchase price is at least CDN$150,000 (a 'top-up exemption' is also subsequently available provided the investor continues to hold securities of that class that have an initial purchase price or a current net asset value of not less than CDN$150,000). The 'investment fund reinvestment exemption', which permits the automatic reinvestment of distributions by an investment fund in additional units of the same class or series. The 'offering memorandum exemption', which may be relied on by investment funds in certain provinces (but, notably, not Ontario), that sell their securities pursuant to an offering memorandum that complies with the specified disclosure requirements of the National Exemption Rule. There are restrictions that may apply (and that vary from province to province), including limits on the amount anyone investor may invest under this exemption, for example. The National Exemption Rule does not limit the number of investors to whom securities of the fund may be sold under any of the above exemptions.
declaration executed by the purchaser that states that he or she is an accredited investor by virtue of meeting the criteria prescribed in the National Exemption Rule.
Delivery of an offering memorandum

If the hedge fund is relying on one of the above noted exemptions (other than the 'offering memorandum exemption') for the sale of hedge fund securities to a purchaser, there is no statutory requirement to deliver an offering memorandum. The definition of 'offering memorandum' is very broad and may include marketing materials. If any details of the offering are provided in writing, other than a basic term sheet, then the hedge fund is obligated to comply with certain provisions (under local provincial rules) that apply to the delivery of an offering memorandum to prospective investors. There are generally no specific requirements as to content for an offering memorandum (except under the 'offering memorandum exemption'); however, if an offering memorandum is delivered to investors, it may have to contain a description of the statutory rights of action that are available in some provinces to a purchaser if the document contains a misrepresentation. If certain exemptions (such as the 'offering memorandum exemption', orthe 'minimum purchase exemption' in Alberta) are relied on, a certificate is required to be attached to the offering memorandum in prescribed form. The certificate must be signed by: (i) the CEO and CFO of the manager of the hedge fund; (ii) the trustee (if applicable, or general partner or directors) on behalf of the hedge fund; and (iii) the promoter of the hedge fund. Because of the personal liability that attaches to individuals signing the certificate, consideration should be given to whether those exemptions will be relied on. If a sale of securities is made pursuant to an offering memorandum, then a copy of that offering memorandum and any amendment thereto must be delivered to the securities commission in certain provinces if a trade is made in those provinces. Typically, the offering memorandum must be filed within 10 days of the first trade made pursuant to that offering memorandum; however, an offering memorandum that is delivered to a purchaser in Quebec, for example, must be filed with the securities regulator 'without delay'.
Dealer exemptions
In most provinces, the prospectus exemptions described above also apply to exempt the person selling the securities from the dealer registration requirement. In Ontario and Newfoundland and Labrador, the dealer exemption that is available to the issuer of the securities is not available to any market intermediary participating in the trade. A market intermediary includes all persons, acting as principal or agent, who are in the business of trading in securities, other than for their own account. As a result, persons who are market intermediaries are required to register as a dealer in
Obligations of the issuer

It is the obligation of the hedge fund to determine if an exemption is available in respect of each purchaser of fund securities. This is generally achieved by including representations and warranties of the purchaser in the subscription document. In the case of the 'accredited investor exemption', there may be a separate certificate or statutory 34
Keeping Current with Your Compliance Obligations Starting a Hedge Fund - a Canadian Perspective
order to trade in securities in Ontario and Newfoundland and Labrador, even when securities are or can be sold by way of prospectus exemptions (however, a category of dealer .:.......: limited market dealer':"""':is available for this purpose, for which there are currently no proficiency, capital or insurance requirements). Accordingly, hedge fund securities generally must be sold through registered dealers in Ontario and in Newfoundland and Labrador or by employees or officers of the fund (if there are any). Under proposed registration rules that will apply in all jurisdictions in Canada (which are expected to be in force in early 2009), such intermediaries will be required to register in all provinces in which securities of the fund are sold, under a new category of registration, 'exempt market dealer', which will have proficiency, capital and insurance requirements. These proposed rules are discussed in further detail elsewhere in this publication. The rules described above are of particular importance when a manager is considering a fund of hedge funds structure. Relief from some or all of these provisions may have to be appliedfol', but is typically grarifedbY securitiesregulafors so long as they are satisfied that there will be no duplication of fees (or all direct and indirect fees are fully disclosed) and that investors in a top fund are granted contractual rights to vote their indirect holdings in the bottom fund.
Other compliance matters for registrants

There are many compliance obligations that apply to a portfolio manager as a registrant that do not specifically relate to its role as a hedge fund manager. Generally, these compliance obligations are set out in an internal compliance manual for the portfolio manager. Included in this compliance manual will be certain policies and procedures that relate to derivatives, proxy voting of securities held by the fund, conflicts of interest (including as described above), personal trading and related-party transactions, all of which may, from time to time, apply to the management and investment management obligations of the hedge fund manager. The securities regulators from time to time publish a summary of the results of their compliance audits of firms, which hedge fund managers operating in Canada should read carefully. The Ontario Securities Commission publishes annual reports as well as special reports on their 'sweeps'. The annual reports summarize the common deficiencies that Commission staff encounter in their detailed compliance audits of registrant firms and provide guidance on the top ten deficiencies each year. 'Sweeps' are compliance audits that target a wider sampling of firms (including non-registrants such·asJundmanagers),.·butonspecifictopics(forexample, marketing practices) and provide somewhat more detailed guidance as to the regulators' expectations. In addition to ensuring compliance with specific statutory and regulatory provisions, Commission staff have taken a principles-based approach to compliance, emphasizing registrants' duties to 'establish and enforce written policies and procedures that will enable them to serve their clients adequately' and to develop procedures that conform with 'prudent business practice'. Prudent business practice can be determined both by common industry practice and by proscriptive requirements of the regulators. In this regard, hedge fund managers operating in Canada should be cognizant of conduct rules applicable to retail funds (referred to as the '81 Series' of rules), to similar rules in other jurisdictions (such as the US and the UK) and to best practices published by industry organizations and governmental committees. (Examples of the latter include the April 2008 publication 'Best Practices for the Hedge Fund Industry - Report of the Asset Managers' Committee to the President's Working Group on Financial Markets' out of the
Conflicts of interest and self-dealing

In general, securities legislation in each of the jurisdictions contains conflict of interest provisions that apply to investment funds in that jurisdiction. The conflict of interest provisions generally apply only in part to investment funds that are nonreporting issuers. For example, investment funds in Ontario that are mutual funds (ie, redeemable on demand), whether or not reporting issuers, are prohibited from: making an investment by way of a loan to any officer or director of the investment fund, its manager or its distributor or any associate of them or to any individual, where the individual or an associate of the individual is a substantial securityholder (holds 20% or more of the outstanding voting securities) of the fund, the manageLor..thedistributor;or making or holding an investment in: any person or company who is a substantial securityholder of the fund, the manager or the distributor; any person or company in which the fund, alone or together with one or more related funds, is a substantial securityholder; or an issuer in which any officer or director of the fund, the manager or the distributor or an associate of any of them, or any person or company who is a substantial securityholder of the fund, its manager or distributor has a significant interest (a 10% equity interest). In addition, the conflicts of interest and self-dealing provisions generally prohibit certain trades by a portfolio manager on behalf of a fund, if such trades are made to or from a 'responsible person'. A 'responsible person' generally includes a portfolio manager, its affiliate and any officer, director or partner of either of them.
35

January 2008 publication 'Hedge Fund Standards: Final Report' out of the UK; and AlMA Canada's series of best practices publications.) Also, the CSA have been very
us; the
activeinrecenlyeatsln
amending ahdcreatilig new nnss
and regulations that apply to the investment fund industry as a whole, and Commission staff have a tendency, in the course of their compliance audits, to jump the gun somewhat by applying rules that have yet to come into force.
Understanding the privacy legislation and how it applies to hedge funds and their managers
In Canada, the Personal Information Protection and Electronic Documents Act (Canada) (PIPEDA) governs the application of privacy law in each province other than those provinces that have substantially similar legislation. There is also legislation in many provinces that will need consideration if a hedge fund manager intends to carry out commercial activities in those provinces. Every business that carries out 'commercial activities' (defined broadly) is subject to the application of PIPEDAas it relates to the collection and use of personal information from clients (the provisions that apply to employees do not apply to private businesses). In general, when collecting personal information from customers, hedge fund managers will need to inform their clients as to the purposes for which the information will be used and to whom it may be disclosed outside the organization (this may include a service provider doing client relationship materials or mailing annual reports). The hedge fund manager must get consent, express or in certain circumstances, implied, from each client in order to use the information. The consent may be withdrawn at any time by c=,tneelienLTneeonsentwiliapplytatneuseaftne·infarmatian for purposes that the client would generally expect in the circumstances. PIPEDA also sets out rules and guidelines regarding keeping personal information and providing access to personal information. The subscription agreement used by the hedge fund can be tailored to meet the disclosure and consent obligations under PIPEDA.
As a result, hedge fund managers must comply with the obligations under such laws to report suspicious transactions (guidelines for determination of 'suspicious transactions' are setout by the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC)) and transactions that may be related to terrorist activities. As well, hedge fund managers must comply with the record-keeping and reporting requirements relating to large transactions and implement policies for the collection of information regarding the identity of investors. Information necessary to comply with such laws can be collected in the hedge fund's subscription agreement. Firms registered with the Ontario Securities Cam mission must make monthly filings respecting terrorist financing and confirming that their investors do not include 'designated persons' (or providing specific disclosure if they do).
If you are a commodity pool

In Canada, there is currently a national instrument (the Commodity Pool Rule), that applies to the creation and distribution of commodity pools offered by prospectus. A commodity pool is an investment fund that invests in specified derivatives or physical commodities in a manner that generally is not permitted by the rules governing prospectusoffered mutual funds. Such commodity pools are, however, subject to certain other rules applicable to retail mutual funds, and hedge fund managers in the managed futures arena must be cognizant of all such rules.
Conclusion
As· you-may- have-noted-from .this-enapter, there are many issues to consider prior to establishing a hedge fund in Canada. Unfartunately, ongoing compliance tends to be dealt with after the fact. Dealing with these issues at the outset of the project will save the hedge fund manager time and money. We recommend that a hedge fund manager planning to establish a hedge fund in Canada meet with legal counsel to discuss the proposed structure well in advance of the intended launch date of the fund. It is ideal for the hedge fund manager, when meeting with his or her lawyer for the first time, to come prepared to discuss the nature of the investment objectives of the fund, the market that the manager would like to sell to, and the jurisdictions in which the manager anticipates initially selling the product. Hedge fund portfolio managers who manage individual client accounts and who now wish to establish a pooled fund to meet the needs of their investors (by creating economies of scale that reduce transaction costs and provide access to investments that a single investor may nat otherwise have access to), must recognize the shift that is taking place
How the anti-terrorist and anti-money laundering laws apply to hedge funds and their managers
In Canada, hedge fund managers, if they are registered as advisers or dealers with the applicable securities regulators (as is generally required), will be subject to federal antiterrorist and anti-money laundering laws and regulations. Such hedge fund managers are considered 'securities dealers' for the purpose of such laws, which define a 'securities dealer' as any person engaged in the business of dealing in securities, including portfolio management and investment counselling. It also includes retail distributors and fund managers.
36

from a regulatory perspective. The hedge fund manager is changing its business model from just providing an advisory service to also selling product, ie, a security of the hedge fund ..The .. edgefunditselfnowbecomes h Iheclient of the hedge fund manager as adviser, and individual investors become clients of the manager as dealer (unless sales are made through the dealer network). In any event, the hedge fund manager assumes additional responsibilities as the fund itself is subject to securities laws in Canada. These responsibilities will increase somewhat when new registration rules come into effect in Canada in early 2009, which will require, among other things, the registration of investment fund managers. Lynn M. McGrade Borden Ladner Gervais LLP Imcgrade@blgcanada.com 4163676115 Ronald M. Kosonic Borden Ladner Gervais LLP rkosonic@blgcanada.com 4163676621
37
38
Chapter Seven:
A Starter Guide to 130/30 Strategies
This strategy is not trying to replace hedge funds, but offers investors who may have shied away from what they deemed to be 'risky' hedge fund strategies, a way of beating the market but to still track the market's overall volatility. As you can imagine, this has been an easier sell to those investors who have been scared away from other alternative investments by names such as Portus or Norshield, and in the same respect, is easier for the dealer networks to both understand and explain to their clients. Currently, it is estimated that there is greater than US$50 billion invested in 130/30 strategies globally, with the strong expectation that a large percentage of the traditional long-only money will flow into 130/30 strategies. A recent Merrill Lynch survey predicted that US$1 trillion will be invested in 1XO/XO strategies by 2011, while the Tabb Group predicted double that amount. So, are these strategies here to stay or are they just a fad? This was the subject of a recent debate at the Canadian branch of the Alternative Investment Management Association (AlMA). It was clear that the majority of the approximately 150 attendees agreed that 130/30 strategies are here to stay and were not to be used as a temporary stepping stone by the traditional long-only investors who do not want to launch a full hedge fund strategy. However, some inherent risks are embedded in these strategies which the traditional long-only manager may not be used to dealing with, which could potentially undermine the benefits gained by adopting a short extension.
Alex Chapman Commonwealth
Fund Services, Toronto
Introd uction
130/30 strategies, sometimes known as 1XO/XO strategies, have become one of the hot alternative investment topics in Cl'Iffada and' iii thegldbalilivestmelifwdrld. Several dfthese strategies have been implemented by Canadian managers since 2006, with most of the prime brokers expecting several more to be formed before the end of 2008. So what makes these strategies so popular among the managers? A 130/30 strategy is often referred to as a short extension or active short strategy allowing a mutual fund manager to extend his normal long-only strategy by using leverage and stock borrowing. Essentially, the manager sells and borrows shares or 'goes short' in 30% of their most overvalued positions and then uses the proceeds to invest additional funds into their most undervalued positions. Overall, this creates a 100% net long strategy that aims to match the volatility of the market they are tracking; hence, giving a beta of 1. Where the value, or alpha, is derived is in the ability of the manager to pick the right stocks when deciding which are the most under or overvalued positions, effectively, the 30/30 strategy layered on top of the long-only strategy. Therefore, the aim is to beat the market in which they are tracking, but not deliver an absolute return similar to what hedge fund strategies may offer.
Examining the risks Increased risk of tracking error

The tracking error inherent in the 130/30 strategy is not the sarn~Clf' th~a$$QciClt~cl traGking~rrQrinher~nt in atraditional long-only strategy. This is because most risk models used to establish tracking errors are based on a long-only model and hence long-only data, therefore they are not suitable for a 130/30 strategy. A 130/30 strategy has 160% gross exposure, so risk models would not take into account this additional exposure and the true tracking may not be understood until it is realized. Also, as mentioned below, the additional costs associated with this strategy would further enhance the potential tracking error.
Inexperience with stock borrowing

A long-only manager's first foray into stock borrowing may not be as simple as it sounds. As well as getting to know the right people on your broker's borrow desk, it is important to establish that the broker has a sufficient book in order to lend the stock required to implement the strategy. The ongoing monitoring and risk management for the short portfolio is also new territory, and it may be advisable for the manager to appoint someone who has specific experience with these types of investments.
39

Additional costs/fees
The management expense ratio (MER) is usually higher in 130/30 strategies compared with their long-only counterparts. Not only are there added transactional costs for the additional 60% gross exposure, but there are also ongoing borrowing costs associated with the short positions. The margin required for these short positions may also inhibit the manager from completely utilizing the full liquidity in the fund. It is also more common for managers to charge higher management fees for the additional active management involved in implementing the strategy. Some 130/30 funds even have performance fees built into them, following the hedge fund fee example.
Standard & Poor's (S&P) Methodology, from S&P:
launched November 2007
The S&P 500 130130 Strategy Index is rebalanced quarterly and, at each rebalancing, is comprised of:
a core 100% long position in the S&P 500 (the

parent index); 1% overweight positions in 30 S&P 500 constituent stocks (the long basket); and 1% underweight positions in 30 S&P 500 constituent stocks (the short basket). To arrive at the long and short baskets, the index employs a clear, rules-driven framework that leverages qualitative and quantitative factors. Constituents of the overweight basket each have their weights increased by 1% relative to the S&P 500, while stocks in the underweight basket each have their weights decreased by 1% relative to the S&P 500. Since most stocks in the S&P 500 have less than 1% weight, underweight positions typically result in short exposures. The qualitative variables used in the basket selections are from the well-recognized STARS recommendations from analysts in the S&P Global Equity Research Group. They employ a scale of 1-STARS to 5-STARS, with 1-STARS equating to 'strong sell' and 5-STARS to 'strong buy'. These recommendations are overlaid with quantitative fundamental variables to arrive at the final long and short baskets.
Actual performance
As the 130/30 strategy aims to beat the market performance in which it is fundamentally tracking, the best way of demonstrating performance is if the strategy actually beats the market and by how much. A number of indices have recently been launched specifically tailored to track the performance of funds with 130/30 strategies or to track a quasi 130/30 strategy. Let's examine a couple of the major back-tested indices against the market they are tracking.
Results
1300.00
1200.00
Year 2008 2007

-SSP -SSP 130130 500
S&P 130/30 -9.00% 4.09%
S&P 500 -9.92% 3.53%
1100.00
1000.00 900.00 800.00
·,""··~oe·"M·~"~·4&.§i9/o=-,",4&.egDf(Y2005 2004 2003 5.72% 6.96% 26.11% -21.51% -11.47% 3.00% 8.99% 26.38% -23.37% -13.04%
700.00
2002 2001
C> C>
600.00
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'" o C so C c ., "? "? "" ., "" ., ., ::> " -=l 0 .., 0 -=l 0 0 "
in C> C>
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40
A Starter Guide to 130/30 Strategies Starting a Hedge Fund - a Canadian Perspective

The data, comparing monthly returns from December 2000 to March 2008, shows that the 130/30 Index beats the S&P Index, generating a compound annual return of 1.125%, while the S&P Index it tracks generates a compound annual return of only 0.025%, an annual difference of 1.1%. On a year-toyear basis, the 130/30 Index did not consistently beat the S&P Index it was tracking, specifically in 2002-2004 the S&P Index performed better than its 130/30 counterpart. Dow Jones launched March 2008 The index universe for the Dow Jones RBP LargeCap 130130 Index is defined as all stocks included in the Dow Jones Wilshire U.S. Large-Cap IndexSM1.
RF3Pprobabllity scores are calculated by Transj5areiif
Methodology, from Dow Jones: The Dow Jones RBP Indexes are quantitative strategy indexes developed and calculated by Dow Jones Indexes using rules-based, published analytics supplied by Transparent Value, LLC. The new indexes are designed to underlie financial products.
Value for each of the 750 companies in the Dow Jones Wilshire U.S. Large-Cap Index. The 30 stocks with the highest RBP probability scores become components of the Dow Jones RBP Large-Cap Leading 30 Index. The 30 stocks with the lowest RBP probability scores become components in the Dow Jones RBP Large-Cap Lagging 30 Index. Components for the Dow Jones RBP Large-Cap Leading and Lagging 30 indexes are subject to a screen that requires components to have a three-month average daily trading volume of at least $2.5 million USD. The Dow Jones RBP Large-Cap 130130 Index measures the performance of the 750 stocks in the Dow Jones Wilshire US Large-Cap Index as well as an additional 30% long position in the Dow Jones RBP Large-Cap Leading 30 Index and 30% inverse exposure to the Dow Jones RBP Large-Cap Lagging 30 Index.
Results
DJ Industrial DJ Large Cap 130130
41

The data covers the period December 2004 to March 2008. We can see from these results that the 130/30 Index outperformed the Dow Jones Industrial Index by a considerable amount. The DJllndex has a compound annual return of 4.2%, while the DJ 130/30 Index performs significantly better at 7.35%, an annual difference of 3.15%. However, similar to the findings of the S&P Index, the DJllndex stili outperformed the 130/30 Index in both 2006andQ1 of 2008. These results tell us that these two 130/30 indices are unconvincing, showing a greater overall return, but certainly not a consistent one. This leads us to believe that either the risk tracking in these 130/30 indices have not been adequately set up, or that the tracking error is higher than it should be. Simple correlation shows that the DJ 130/30 Index is correlated to the DJI Index at 0.9766, while the S&P 130/30 Index has even stronger correlation at 0.9933. Therefore, the monthly performances are very consistent with the indexes they are tracking. Considering that these are not traded indices and they just try to emulate the way a 130/30 fund may be structured, they are probably not the best representation of what an actual active manager could generate in terms of alpha. Furthermore, they have the gift of foresight, which gives perhaps an even less genuine demonstration of the fundamental alpha in a 130/30 strategy. A better representation of real 130/30 performance can be seen in a recent study by eVestment Alliance, who have been collecting data from managers of institutional funds for some time now. The graph below prepared by Allaboutalpha.com, using eVestment Alliance's data, shows the number of 130/30 funds tracked as well as the relative performance when compared with the S&P 500 Index. Although only four funds were tracked in 2003, there were 68 funds with a 130/30 strategy by 2007.
31.9%
!iii sap 500 Including O;vi<lencls • l3C/30 Universe
2003
2004
2005
2006
2007
The real-world performance shows consistent alpha generated year on year by the managers, demonstrating that 130/30 strategies do live up to their reputation. Additional interesting information from eVestment Alliance reveals the actual fees being charged for 130/30 funds. The average 130/30 institutional mandate charges about 75bps while the average 130/30 mutual fund in their database charges about 120 bps. This compares to about 50bps for large-cap core mandates tracked by the firm. This also confirms the higher reward for the 130/30 managers for producing the alpha.
Implementation and other considerations

We have already discussed the differences between a 130/30 strategy and a traditional long-only strategy, but what do you need, or more importantly, who do you need to implement such a strategy?
Operations
The additional short extension to a long-only manager creates additional systemic processes that need to be developed by the manager to ensure that these borrows are filled successfully. Most long trades are entered electronically through direct market access with the broker, but the short trades are not as simple to execute. The manager will need to appoint a prime broker that
42

has a borrowing desk similar to what is traditionally used by hedge fund managers. The first step is to confirm the stock availability by either contacting the borrowing desk directly orchecking·with the trader on the availabHity of the steek. The trade can then be entered either through the broker's electronic platform or with the borrowing desk directly. It is essential that the stock be marked short to differentiate it from the other long trades. The exchanges in which the stock is traded are also notified that the trade is a short by the broker. Similarly, the middle office must understand the differences in settlement processes and risk management by trading in these short positions. The risk management process is probably the most complicated of these processes, as the manager still needs to track the market risk as closely as possible, but also follow the 130/30 mandate. This need for correct controls and processes becomes more evident when the portfolio is rebalanced. It is important that these controls are tested in a non-live environment to ensure they work before they are implemented. The manager may wish to consult or even hire support staff that have specific experience in managing risk in long/short strategies.
gains on these positions may not always be considered as capital gains and may be treated as normal income. This is a tax disadvantage to the investors, and the manager may need to make specific elections to ensure- that these gains can be treated as capital.
Conclusion
Whether people like 130/30 strategies or not, they are here to stay and set to become one of the fastest-growing strategies worldwide over the next few years. If you are looking to launch your own 130/30 strategy, ensure that you have contemplated and addressed the inherent risk in the short extension and have engaged the necessary support staff to help you implement the strategy. Alex Chapman Commonwealth Fund Services ac@commonwealthfundservices.com 4163614563 Special thanks to Christopher Holt, AIIAboutAlpha.com.
Administration
Now that we have established the differences in front/ middle office operations, there are also some fundamental differences inherent in the back office process. The two key differences are reporting the short positions and the possibility of a performance fee built into the strategy. Where the manager has traditionally performed the back office function themselves, they may find that their systems are not able to handle these differences and, therefore, should fljncti9n.te> .<'1. thir9~p,gI"tY.~cllTliQi~!r<'lt()r: It is important to find a suitable admlrlisirator who has experience in dealing with these types of fund strategies, and a good way to start is by looking at the administrators who are used to handling hedge funds. The performance fee calculation can be very complicated to calculate without a dedicated system, and becomes exceedingly complex when series accounting or equalisation techniques are used in the calculation. This calculation should certainly not be performed on a spreadsheet. By implementing the correct controls and procedures and selecting the correct systems, the manager will be able to fully execute and track a 130/30 strategy themselves, but it is certainly advisable to use some of the expertise readily available in the market to make the whole process a lot less painful.
19~915!gQut$9urc.~this
Taxation
With the introduction of short positions there are some specific tax rules that the manager should research. The exact details are covered elsewhere in this book, but generally, the realized
43
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consistently across the disclosure documents and marketing materials. Aspr'eviOlJslY disclJssed in this Guide, interests in hedge funds may be offered by way of distribution under a prospectus or by private placement (generally pursuant to an offering memorandum) depending on the nature of the fund and the target client market. Prospectus The prospectus must contain 'full, true and plain disclosure of all material facts relating to the securities' offered by the prospectus and may not contain 'an untrue statement of a material fact nor omit to state a material fact that is required to be stated or that is necessary to make a statement not misleading in the light of the circumstances in which it was made'. The term 'material fact' means a fact that significantly affects, orwould reasonably be expected to have a significant effect on, the market price or value of the securities being offered. (i) Penal liability: Ifthe prospectus contains a statement which, at the time and in the light of the circumstances under which it is made, is a misrepresentation, the person or company who made such a statement is guilty of an offence and is subject to a fine or imprisonment or both. In Ontario, every director and officer of a company who authorized, permitted or acquiesced in the making of the misrepresentation is guilty of an offence and is liable to a fine of not more than $1,000,000 or imprisonment for a term of not more than two years, or both. (ii) $t~tlJt()l)'c::ivil.lil:ll>ility: .. .Qntilrio,.if the pro~pectus I. n together with any amendment to it contains a 'misrepresentation', each person who purchases a security offered by the prospectus during the period of distribution has, without regard to whether the purchaser relied on the misrepresentation, remedies against certain parties, including the hedge fund and each person who signs the prospectus. 'Misrepresentation' is defined in the Securities Act (Ontario) to mean an untrue statement of material fact, or an omission to state a material fact that is required to be stated or that is necessary to make a statement not misleading in light of the circumstances in which it was made. The term 'misrepresentation', therefore, covers not only errors and incorrect statements, but also omissions. Recent amendments to the Act include in the definition of misrepresentation a misrepresentation of 'forward-looking information' unless certain disclaimers accompany the forward-looking information. The meaning of misrepresentation is consistent with the basic requirement that the prospectus shall provide 'full, true and plain disclosure of all material facts' about the fund and its securities. A purchaser may succeed in an
Chapter Eight:
Managing Risk
Kathryn Ash and Scott McEvoy Borden Ladner Gervais LLP, Toronto
One view of hedge funds is that they are designed to manage or limit investment risk. For example, some of the earliest hedge funds used leverage and short selling to 'hedge' or mooage theexposure.thatmQvernE3nts in the. equity markets presented to their equity investments. Here, we deal with managing other risks: risks that might be posed to the hedge fund or its management as a result of the hedge fund's activities or the activities of its manager or other entities associated with the operation of a hedge fund. We propose to describe the general risks associated with the fund's mandate or strategy, governance, contractual obligations and operation. Compliance with statutory requirements is dealt with elsewhere in this Guide.
General risk Mandates and strategy

Fundamental to every hedge fund is its investment mandate and the financial strategy associated with achieving it. Because the strategies are so essential and can be complex, they are often described in some detail in a hedge fund's disclosure documents and marketing materials. A clear description using plain language and explaining concepts in a way that can be readily understood by investors, will reduce misunderstanding and act to minimize potential exposure. Further, the manager should describe the strategy
45
Managing Risk
Common law liability A hedge fund offered either under a prospectus or offering memorandum and those making statements about the hedge fund; may be exposed to liability on the basis of negligent misstatements. The law with respect to negligent misstatement is well defined and requires a misrepresentation and reliance thereon to the detriment of the investor. The misstatement may be contained in the prospectus, offering memorandum or other materials such as marketing materials. The remedy for negligent misstatement is damages. An action may lie in negligent misstatement whether or not an investor is successful in a statutory civil action. Example It might be useful to structure a hypothetical example of the sorts of issues that might arise in connection with an offering of hedge fund securities. A prospectus or offering memorandum might state that as a result of the strategy the net asset value (NAV) of the hedge fund would not reduce more than a specified percentage over the course of a given period of time. Subsequently, market conditions were such that the NAV of the hedge fund did reduce more than the specified amount in the specified period of time. In fact, the managers of the hedge fund may have understood that the strategy was based on certain assumptions which, if they were not true, would result in the limit on expected loss not being true. However, unless those assumptions are clearly explained and stated, the fund might be exposed to claims for damages as a result of the description of the strategy. Maintenance One point that may be emphasized from the foregoing discussion is the importance of adhering to the stated strategy. If the strategy or an aspect of the strategy is material,
action for rescission (unwinding the purchase) or damages (cash compensation) if he proves the existence of a misrepresentation at the time of the purchase of securities. The purchaser need not prove that he wasmisledorthathe relied upon the misrepresentation in making his purchase. In addition to any other right a purchaser may have at law, a purchaser has the following remedies: damages for any loss suffered against the hedge fund; either damages for any loss suffered or rescission of the purchase against the underwriters of the offering; and damages against each person who signs the prospectus (if the fund is a corporation certain limitations apply to its directors). All or anyone or more of the possible defendants against whom a purchaser may exercise the foregoing remedies, including the hedge fund and each person who signed the prospectus, are jointly and separately liable for the full amount of damages awarded to a purchaser. If a prospectus contains a misrepresentation, there are certain defences to an action brought by a purchaser of securities offered by the prospectus, including that no person is liable if they prove that the purchaser purchased the securities with knowledge of the misrepresentation. Certain other defences are available to persons other than the issuer or a selling securityholder. However, the best way to avoid liability is to make the disclosure accurate. To the extent that the prospectus does not contain an accurate description of the strategy at the time of the purchase, there '·=may'oeliabilifYfoftheflihd'Or·those·persons'who·signthe prospectus. Offering memorandum In some provinces, if a hedge fund is sold under an offering memorandum which contains a misrepresentation, the purchaser has a right of action for damages against the issuer if the misrepresentation existed at the time of purchase. In some of those provinces, reliance on the misrepresentation may be required. Again, liability does not attach if it is proved that the purchaser purchased the securities with knowledge of the misrepresentation. In Ontario and certain other jurisdictions, statutory rights accorded to the investor must be included in the offering memorandum in specified circumstances (see Chapter Six, Keeping Current with your Compliance Obligations) . For the sake of consistency, where an offering is made in more than one jurisdiction, the rights of investors in other jurisdictions are often included, although they may not be legally required.
it shoUld··nofbe'c!1ahgecl UIllessproperdisd6sUrepLJrsl.lallt
to securities legislation is made to investors. Therefore, while market conditions may indicate that a departure from the disclosed strategy would be advantageous, it should not be changed without appropriate disclosure if such a change would be a 'material change' within the meaning of securities legislation.
Governance risk
Capacity Each hedge fund, regardless of the chosen structure, is established by statute or constating documents or some combination ofthe two. In either case, the capacity of the fund and the authority of those taking action on behalf of the fund flow from those documents. To manage compliance risks, it is important to draft the documents in the first instance so that they accurately describe the proposed actions to be undertaken by the fund. If, as part of its strategies, the fund intends to undertake derivative transactions, post margin, enter into short or long sales strategies, buy futures or
46
Managing Risk
commodities and take various other actions, the documents must ensure that it has the power to do so. If there is no power to undertake the transaction, the transaction may be found void,leading to potential losses by thafund.and.lts investors. It is also good practice to check the constating documents of the hedge funds from time to time, to ensure that they contain authority for the actions currently being undertaken by the fund or contemplated in the future. Chain of authority In addition to ensuring that the fund has the capacity to act, there must also be an unbroken chain of authority to the persons or entities who undertake the activity on behalf of the hedge fund. For example, if the hedge fund is structured as a trust, the trust document must contain a mechanism to permit the conduct of an activity by the person or entity intended to conduct it. If the trustee is to undertake the activity, no further documentation may be required. Alternatively, the trust document may stipulate that a manager or settlor or other party to the document reserves the power to undertake certain activities related to the management of the hedge fund. Again, no further documentation may be required. Finally, the trust document may permit delegation by the trustee or other party of the power to perform certain activities to others. Whatever method is chosen, the chain of authority to the person conducting the activity must be clear and must be sufficiently broad to allow it to conduct the activities. The chain of authority may go through several steps, depending on how the activities are conducted. For example, the authority may start in a trust document under which a manager reserves the power to manage investments. The manager may have the power to appoint others to carry out derivative transactions ·in""Gertainmarkets.The appointmentandtheiull scope of the power must be reflected in the agreement between the manager and such other person. That other person may have a further power to delegate various portions of the activity. In each case, the documents must specifically set forth: (i) the power to appoint others, if required; and (ii) the power to undertake the activities contemplated. Documents must be carefully drafted to include the appropriate powers and should be consulted from time to time to ensure that the actions are still within the authority set forth in the documents. To minimize exposure for the actions of other persons in the chain of authority, the agreement should contain an indemnity in favour of the entity granting the power equal in scope to the liability of that entity under the documents which gave it the power. In other words, the chain of authority must be accompanied by the chain of indemnity or liability of equal scope.
Consents, approvals and filings The documents under which the activities of a hedge fund are undertaken may require certain consents or approvals to be obtai ned before actions are undertaken. Further,certain actions may require the approval or consent of regulators or investors. Managing governance risk requires obtaining the appropriate approvals, in writing if necessary, and retaining records of those approvals or consents. Hedge funds structured as limited partnerships and as trusts are required to make certain regulatory filings in most cases. For example, there may be filings under the applicable limited partnerships legislation or of financial disclosure under applicable securities legislation. The manager must make such filings in a timely manner.
Contractual risk
A hedge fund may be a party to various contracts in conducting its operations, which may include the following: derivative contracts; loan agreements; margin agreements; brokerage agreements; prime brokerage agreements; purchase and sale agreements; securities lending, repurchase and reverse repurchase agreements; custody agreements; and depository agreements. Each contract will impose obligations on the hedge fund and, typically, its manager. Part of managing the risk associated with a hedge fund is to ensure that it discharges its contractual ()bligati()ns·appf()pfiat~lY.C()ritraCt§··ma\/§peCifY··l~verage limits, notice requirements, prior consents, approvals or conditions for various actions, report requirements and time limitation, as well as various other actions. Effective management requires knowledge of all contractual requirements and monitoring of compliance with them. It is good practice for a hedge fund in its contracts to limit recourse to the assets of the fund itself, whether the fund is a limited partnership, trust or other structure. The objective of limiting recourse is to protect the interests and assets of the investors in the fund. There is statutory protection for shareholders of corporations and for limited partners of limited partnerships. In the event that the hedge fund is structured as a trust, certain jurisdictions have legislation which limits the exposure of the beneficiaries of the trust (the investors) to their investment in the fund so that they are not liable for liabilities of the fund.
47
Managing Risk
Operational risk
Supervisorv relationships Delineation·of·the duties among those pmviding services! functions to a hedge fund will be important to the success of the fund. Documentation of these roles and duties among auditors, prime broker, administrator, fund manager and legal counsel will ensure that nothing is overlooked. Similarly, without proper documentation of roles it becomes more difficult to monitor the activities of sub-advisers where all, or a portion of investment advisory, management or other duty has been delegated. However, the execution of a contract stipulating the terms and conditions upon which the sub-adviser is expected to perform its duties to the manager or other administrator does not remove the regulatory obligations and fiduciary duties of the manager to its clients and the exposure of the manager for failure to discharge them. In the case of an adviser supervising a sub-adviser, the trading activities of the sub-adviser must be monitored for adherence to the objectives of the fund as well as applicable securities legislation. Adequate monitoring, in turn, requires that policies and procedures are in place to receive and evaluate information from sub-advisers. Procedures might include: performance of due diligence prior to the selection of a sub-adviser; due diligence might include such things as assessing the internal policies of the subadviser covering such matters as best execution and soft dollar arrangements, personal trading, allocation of investment opportunities, cross trading, money laundering; ·andanti4erroristreporting; requiring certification by senior officers of the sub-adviser confirming adherence to policies and procedures; periodic comparison of the securities held in the fund's trading account against fund objectives and strategies; and periodic testing and variance analysis of fund's portfolios to ensure proper valuation. In certain circumstances, securities regulation requires advisers to retain primary responsibility to the fund and its investors in the event of a failure by a sub-adviser to adhere to the investment objectives and strategies of the fund. Securities legislation requires the maintenance of books and records necessary to properly record the business and affairs of registrants. Investment advisers are, therefore, expected to retain sufficient evidence of their monitoring activities, including the resolution of any issues identified with regard to the performance of sub-advisers.
Sales activities (i) Registration: Canadian securities laws generally require raqistratlon.aa.a.nealer for trading in securities, including acts in furtherance of a trade. Any activity involved in marketing or promoting sales of securities of a hedge fund could be considered an act in furtherance of a trade in securities. While it may be likely that the hedge fund will be offered on a private basis to accredited investors in reliance on an exemption from the registration requirement and prospectus requirement, hedge fund managers should be aware that certain jurisdictions (most notably Ontario) require market intermediaries in the exempt market to register as limited market dealers. Proposed regulatory change would see a similar requirement apply nationally. (ii) Suitability: Hedge funds are typically marketed through broker-dealers who have a suitability obligation. A fund manager, or other entity acting as a market intermediary that distributes securities directly in the exempt market may also be subject to this same suitability obligation requiring it to collect and maintain current know your client information. Such information should allow the fund manager to ascertain the general investment needs of its clients, as well as the suitability of a proposed transaction. Prospective investors should be asked questions such as: What are their investment objectives? Does the investor have any investment restrictions? What is the investor's risk profile/tolerance for risk? What is the investment time frame of the investor and what are his or her expectations in terms of return? What are the expectations of the investor in terms of transparency? (iii) Due diligence: The manager should perform due diligence on prospective investors in the fund. Failing to do so will lead not only to a lack of understanding of the client's investment needs, but could also lead to operational problems in difficult markets. Uneasy investors who do not fully understand the product and its strategy may redeem too early, jeopardizing their own investment as well as the fund's portfolio. The fund must set some transparency expectations. Risks of strategies must be clearly articulated to investors and there must be a regular communication
48
Managing Risk
Starting a Hedge Fund of the risks to investors in order to provide them with a high degree of comfort and reduce future problems. Mostduediligence efforts are built upon the investor's self report of his or her income/net worth status. As economic trends place more individuals in the accredited investor category, the sufficiency of this approach may be challenged. However, without some legal requirement to obtain additional proof of status, prospective investors may be reluctant to reveal this information. If money is received from a prospective investor before it has been determined whether the investor is qualified to purchase securities of the fund, these monies should be received into a separate account rather than directly into the trading account of the fund. (iv) Use of the Internet: A hedge fund manager should ensure consistency in its marketing activities across media. If sales of a fund are restricted to accredited investors, access to information about the fund on the Internet should also be restricted and warnings and disclosure included. Marketing materials (i) General: Growth in the hedge fund industry has, in part, been attributable to the ability of hedge fund managers to adjust strategies to market conditions. Hedge funds often have broadly drafted disclosure in offering documents. The broad nature of this disclosure has the advantage of permitting hedge
disadvantages of hedge fund investing. Discussion of risks could include statements that hedge funds: engage in leveraging and· other speculative investment practices that may increase the risk of investment loss; can be highly illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as retail mutual funds; and often charge high fees. Consistency in disclosure Policies and procedures must be in place to ensure that all sales and marketing materials are consistent with the disclosure documents and constating documents of the fund. Where the manager's website is used as a marketing tool, one individual should have responsibility for control and posting on the site. This individual should ultimately report to the compliance function, ideally the chief compliance officer, to ensure consistency in communications. Similarly, the message communicated to those selling the product (whether in-house or through a registered dealer) must be consistent with disclosure documents. Policies and procedures must be in place to ensure adequate training and supervision of those individuals involved in selling the fund. Periodic reporting Mal1y.h.El.<:l!:lEl.fund managersproviciePElriodicreportsto thei.r investors, although they may not be specifically required to do so under securities legislation. Where the hedge fund is a 'reporting issuer' in a jurisdiction, it will be required to comply with the continuous disclosure regime, including the filing of financial statements and other information. Unless exemptions have been obtained (or elections made) certain of these filings (for example, annual and semi-annual financial statements) may still be required even where the hedge fund is not a reporting issuer. In preparing periodic reports, hedge fund managers should provide adequate information on a consistent basis clearly explaining significant assumptions that have been used in preparing the information. Often, a manager will provide account statements reporting capital account balances. Where performance information is provided, historical data should be audited and CFA Institute compliant. Managers should consider providing detailed information about a fund's investments. If the investment adviser has drifted from the fund's primary investment strategies this
funds
torespono·ih·
aflexlblefashibnfb
markEH
conditions. This flexibility, in turn, enables hedge funds to perform well in down markets. The disadvantages of broad disclosure is the risk that investors will not be provided with a sound basis for evaluating whether to invest in the fund, and it may not adequately disclose specific risks inherent in a strategy. (ii) Offering documents: For a hedge fund offered pursuant to the accredited investor prospectus and registration exemptions there are few requirements in relation to the form of the offering document. Often an offering memorandum will be used as a marketing and information document for prospective investors that describes the business and affairs of the issuer. As well as providing the basic terms of the offering, including objectives and strategies of the fund together with such details as the entities providing services in connection with the offering, the offering memorandum should seek to provide a fair and balanced presentation of the risks and potential
49
Managing Risk
should be explained. also be included.
Relevant
market commentary
may
Thifd~party reporting Information about a fund may be contained on websites sponsored by persons not connected to any hedge fund (a third-party website). Such sites may provide one location, listing descriptive and performance-related information about a number of funds. Sometimes this information is provided to subscribers for a fee. Hedge fund managers should ensure that the information contained in relation to the fund on these sites is accurate and complete. Where hedge fund indices are used on these sites, hedge fund managers should ensure that the assumptions used for the creation of a composite or database are accurate. Hedge fund managers should be cognizant that certain institutional reporting services and financial newsletters may also report information about hedge funds which contain inaccuracies. In today's heightened climate for 'stories' by the media, managers should be on their guard for any potential misreporting. Kathryn Ash Borden Ladner Gervais LLP kash@blgcanada.com 4163676746 Scott McEvoy Borden Ladner Gervais LLP smcevoy@blgcanada.com 6046404170
50
Mutual fund trusts and mutual fund corporations

If it is intended that a hedge fund will be marketed to tax deferred plans, the fund will often be structured to qualify as a mutualfundtrustforincometax purposes, Therequirements which a hedge fund must meet to qualify for mutual fund trust status are described below under the heading Status of hedge fund as qualified investment for tax deferred plansTrusts. The income and capital gains paid or made payable by the mutual fund trust to its investors in a taxation year, will be subject to income tax at the investor level only and not at the trust level. A fund that attains and maintains mutual fund trust status under the Canadian Income Tax Act (Tax Act) will be able to flow through the character of capital gains, dividends, foreign source income and related foreign taxes to its investors, provided appropriate designations are made under the Tax Act. However, losses of the fund cannot be flowed through to the fund's investors (in contrast to a fund structured as a partnership). Accordingly, a mutual fund trust operates as a limited flow through entity. Furthermore, to the extent that income or taxable capital gains is not paid or made payable to the fund's investors in a taxation year, the fund will be taxed on such income or gains at the highest tax rate applicable to individuals. Alternatively, a hedge fund may be structured as a mutual fund corporation under the Tax Act. The requirements which a hedge fund must meet to qualify for mutual fund corporation status are described below under the heading Status of hedge fund as qualified investment for tax-deferred plansCorporations. A corporation that attains and maintains mutual fund corporation status under the Tax Act, will generally be able to flow through capital gains and dividends from taxable Canadian corporations to its investors so that it is not subject to tax on such amounts. However, other types of income sl.Jch··as· interest; f6reighihvestmehfihcome··orincomefrom derivatives, cannot be flowed out to the fund's investors and will, therefore, be taxed in the corporation, resulting in a reduction of the investor's share of such income received by way of a dividend distribution from the corporation or as a result of the redemption of shares. Accordingly, a mutual fund corporation is generally not as tax efficient a flow-through vehicle as a mutual fund trust or a partnership. Both mutual fund trusts and mutual fund corporations are entitled to benefit from the capital gains tax refund mechanism (CGRM) in the Tax Act. Absent the CGRM, accrued capital gains on fund property would be double taxed: first, when investors dispose of their fund units at a redemption price that reflects the accrued gains on the fund property and, second, when the accrued gains on the fund property are realized by the fund and distributed to its investors. The CGRM operates slightly differently for mutual fund trusts and for mutual fund corporations. A mutual fund trust is able to obtain a refund of tax under the CGRM based on the
Chapter Nine:
Taxation
Martin Wickins and Fraser Gall Ernst & Young LLP, Toronto
Introduction
Similar to other types of investment funds, the tax sonseguence~ appliGClble.to. ah~dge fund \ViII dep~~d,in large=part, on the nature of the structure that is chosen to operate its investment and other activities, and the complexity of such activities. The tax status of the typical investor to whom the fund will be marketed will to a certain extent influence the preferred structure.
Choice of hedge fund vehicle: trust, partnership or corporation

A hedge fund, like any other pooled investment, may be structured generally as a corporation, trust or partnership. The choice of structure in a particular situation will depend on various factors, including whether the fund will be marketed primarily to taxable investors or to tax-exempt investors such as registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), deferred profit sharing plans (DPSPs) (collectively, 'tax deferred plans'). It is also important to choose a hedge fund structure that will maximize tax efficient distributions to the fund's investors, which will depend, in part, on the nature and source of income to be derived by the fund.
51
Taxation
added to the ACB of the partners immediately after the end of the partner's taxation year. If at the end of the fiscal period of a partnership the ACB is negative, the partner will realize a capitaLgain. A limited partnership may be structured so that limited partnership interests in the partnership are qualified investments for tax-deferred plans (see the discussion below under Status of hedge fund as qualified investment for taxdeferred plans - Partnerships).
amount of tax it has paid on capital gains and on the amount paid on redemptions of trust units. In contrast, a mutual fund corporation is able to obtain a refund of tax under the CGRM b~~edQn.cgpiJgJgaim;dividendspaidbyJbe.cQrporatiQn to its shareholders and on the amount paid on redemptions of shares. The tax paid by a mutual fund trust or a mutual fund corporation on realized capital gains is reflected in the fund's 'refundable capital gains tax on hand' account. A hedge fund structured as a mutual fund trust or a mutual fund corporation will generally also be able to benefit from the election in SUbsection 39(4) of the Tax Act to treat gains from the disposition of its 'Canadian securities' as capital gains, rather than income for income tax purposes. This election is discussed in more detail below in the section entitled Subsection 39(4) Election for 'Canadian Securities'.
Status of hedge fund as qualified investment for tax-deferred plans

If a hedge fund will be marketed to tax-deferred plans, an investment in the hedge fund must be a 'qualified investment' for tax-deferred plans within the meaning of the Tax Act. A taxdeferred plan will generally restrict its investment to qualified investments since it (and its beneficiaries) may otherwise experience adverse tax consequences under the Tax Act, which can include liability to pay a monthly penalty tax equal to 1% of the fair market value at the time of acquisition of the plan's non-qualified investments, as well as liability to pay tax on any income earned or capital gains realized in respect of the plan's non-qualified investments. The specific requirements for qualified investment status will depend on whether the hedge fund is structured as a trust, corporation or partnership. Each of these alternatives is discussed separately below.
Partnerships
The key distinctions between a partnership and a corporation are the absence of a separate legal personality and limited liability. The principal advantage of using a corporation lies in the fact that a corporation will provide protection from third-party liabilities. A partnership is not a legal entity, but is characterized at law as a relationship that subsists between two or more persons carrying on business in common with a view to profit. The classification of an entity as a partnership versus a corporation or co-ownership arrangement for tax purposes will depend on its precise legal attributes. The Canada Revenue Agency will generally classify an entity as a partnership for tax purposes if it has the legal attributes of a partnership under applicable provincial law.' =m-eomrast-to-a-corporatton oratrost; a partnerShip ts a fully transparent entity for purposes of the Tax Act and is, therefore, not liable to income tax under the Tax Act. Accordingly, both income and losses will flow through to a partnership's partners and will retain its character when allocated by a partnership to its partners. However, in determining the partners' income from the partnership for the purposes of the Tax Act, section 96 of the Tax Act requires that income be computed at the partnership level 'as if' the partnership were a person. It is important to emphasize that section 96 does not deem a partnership to be a person for purposes of the Tax Act as a whole, but only for the purposes of computing the partner's income from the partnership. Thus, rules for the computation of income are generally applied at the partnership level in order to determine a partner's income. In cases where a limited partnership is used, it is important to monitor the tax adjusted cost base (the ACB) of a limited partner's interest in the partnership. Allocations of income to partners in accordance with the partnership agreement will reduce the partner's tax ACB in the year received. The partner's entitlement to the income as computed under section 96 for the taxation year will be
Trusts
An interest in a trust will be a qualified investment at a PCir:tiC:IJIClrtime.JQL~7c:1Elterrec:l ..plgns.generaUy jf tbetrust either qualifies as a mutual fund trust or is a registered investment at that time under the Tax Act. A trust must satisfy the following specific requirements in order to qualify as a mutual fund trust at a particular time under the Tax Act: a. it must qualify as a 'unit trust' by either: (i) issuing units that are redeemable on demand, ie, that have conditions attached to them requiring the trust to redeem the units at the demand of unitholders and at prices determined and payable in accordance with such conditions, where the fair market value of such units was not less than 95% of the fair market value of all of the issued units of the trust; or complying with specified investment restrictions requiring it, among other things, to ensure that: at least 80% of its property at all times consists of any combination of shares, property convertible into, exchangeable for,
(ii)
52
Taxation
Starting a Hedge Fund or that confers a right to acquire, shares; cash; bonds, debentures, mortgages, tlyp()thec;ary claims, notes and other similar obligations; marketable securities; real property situated in Canada and interests in such property; and rights to, and interests in, any rental or royalty computed by reference to the amount or value of production from a natural accumulation of petroleum or natural gas in Canada, from an oil or gas well in Canada or from a mineral resource in Canada; not less than 95% of the trust's income for each year be derived from, or from the disposition of, the foregoing investments; and not more than 10% of the trust's property consists of bonds, securities or shares in the capital stock of anyone corporation or debtor other than Her Majesty in Right of Canada or a province or a Canadian municipality. b. it must be resident in Canada, which will generally be the case where its trustees have the power to manage the affairs of the trust and are resident in Canada; c. its only undertaking (i) (ii) must be:
(ii)
there must have been a lawful distribution in a province to the public of units of the trust and a prospectus, registration statemerifbl" simHaroocumenl was not required under the laws of the province to be filed in respect of the distribution; in respect of anyone such class of units of the trust, there are no fewer than 150 beneficiaries of the trust, each of whom holds units of the class having an aggregate fair market value of not less than $500, and at least one block of units, with a block of units being either not less than 100 units (if the fair market value of one unit of the class is less than $25), 25 units (if the fair market value of one unit of the class is $25 or more but less than $100), or 10 units (if the fair market value of one unit of the class is $100 or more); and
e. unless all, or substantially all, of the trust's property consists of property other than taxable Canadian property", the trust must not have been established or be maintained primarily for the benefit of non-resident persons. In structuring a hedge fund as a mutual fund trust, it should be noted that an open-ended mutual fund trust (ie, a trust that issues units that are redeemable on demand as described in subparagraph (a)(i) above) will have more flexibility in terms of the types of investments it can make than a closed-ended trust that must comply with specified investment restrictions. The types of investments and activities to be undertaken by the hedge fund also need to be carefully considered undertaking restriction described in paragraph (c) above. In that regard, the Canada Revenue Agency has issued a number of advance income tax rulings and technical interpretations providing its views on whether various investments made and activities carried on by a mutual fund contravene the investment undertaking restriction; it has generally interpreted the word 'investing' broadly, to include participating in various types of derivative contracts and hedging activities or transactions.
(iii)
the investing of its funds in property (other than real property or an interest in real property); the acquiring, holding, maintaining, improving, leasing.ormanagingof any real prqperty (or interest in real property) that is capital property of the trust; or any combination of the foregoing activities; and
t9 .. lO§U[Elttli:lt Jb.ElJrlJ§!.. ill ..... E ... ~ c;ornply .. ittl .. hEl...nve.strn.ent ~ t i
d. it must have complied with prescribed conditions relating to the number of its unitholders, dispersal of ownership and public trading of its units, as follows:
(i)
either: a class of the units of the trust must be qualified for distribution to the public such that a prospectus, registration statement or similar document has been filed with, and, where required by law, accepted for filing by, a public authority in Canada pursuant to, and in accordance with, the law of Canada or of any province, and there has been a lawful distribution to the public of units of that class in accordance with that document; or
The requirement in paragraph (e) above is proposed to be amended to provide that a trust is not a mutual fund trust after a particular time, if, at that time, more than 50% of the fair market value of the issued units of the trust is attributable to the fair market value of those issued units that are held by one or any combination of non-resident persons or partnerships other than Canadian partnerships (ie, partnerships of which all of the members are Canadian residents) unless not more than 10% of its property consists of 'taxable Canadian property', 'Canadian resource property', or 'timber resource property'. These amendments would apply generally to mutual fund trusts after 2004. According
53
Taxation
Canadian
Perspective
to Finance Canada, further discussions are being pursued with the investment industry concerning these proposed amendments and it is still uncertain as to whether they will be enacted in their current form; Mutual fund trusts, trusts that would be a mutual fund trust if paragraph (d) above were not applicable, and certain other trusts meeting specified conditions, may apply to the Canada Revenue Agency to be a registered investment for tax-deferred plans. A registered investment will automatically be a qualified investment for such plans from the date it becomes a registered investment, usually the date that the trust is established. Another benefit of becoming a registered investment is that the trust will retain that status, and therefore, its units will remain qualified investments for tax-deferred plans, unless and until its status is revoked by the Canada Revenue Agency after failing to remedy any deficiencies in its registration. Debt of a mutual fund trust will be a qualified investment for tax-deferred plans if it is a bond, debenture, note or similar obligation, and the units of the trust are listed on a prescribed stock exchange in Canada. Generally, the Canada Revenue Agency views a debt obligation to be similar to a bond, debenture or note if it evidences a promise by the issuer of the obligation to pay a specified amount on the terms set forth in the document to the person to whom the document is addressed. Under proposed changes to the Regulations, investment-grade debt issued by a trust resident in Canada may in limited circumstances also be a qualified investment.
b. it must be a 'public corporation' within the meaning of the Tax Act by making an election in a prescribed manner and generally complying with the following prescribedconditrons: (i) a class of the shares of the capital stock of the corporation designated by the corporation in its election must be qualified for distribution to the public, such that a prospectus, registration statement or similar document has been filed with, and, where required by law, accepted for filing by, a public authority in Canada pursuant to and in accordance with the law of Canada or of any province, and there has been a lawful distribution to the public of shares of that class in accordance with that document; there are no fewer than 300 persons, other than insiders of the corporation, each of whom holds shares of that class having an aggregate fair market value of not less than $500 and at least one block of shares of that class; and insiders of the corporation do not hold more than 80% of the issued and outstanding shares of that class.
(ii)
(iii)
c. its only undertaking must be: (i) (ii) the investing of its funds in property (other than real property or an interest in real property); the acquiring, holding, maintaining, improving, leasing or managing of any real property (or interest in real property) that is capital property of the corporation; or combination of the foregoing activities.
Corporations
~~The[e .iE)rnoreflEl)(ilJilityil1 .. UCllifyingE)hClrElsofJh.El.cClpital q ~~~~stock a corporation as qualified investments for tax of deferred plans. Under the Tax Act, shares of a corporation are qualified investments if the corporation is a public corporation, a mutual fund corporation or a registered investment, or if such shares are listed on a prescribed stock exchange in or outside Canada. Debt of a corporation will be a qualified investment if it is a bond, debenture, note or similar obligation, and the shares of the corporation are listed on a prescribed stock exchange in or outside Canada. Under proposed changes to the Regulations, investment-grade debt issued by a Canadian corporation may, in limited circumstances, be a qualified investment. The Tax Act prescribes detailed conditions that must be met by a corporation in order to qualify as a mutual fund corporation. Some of these conditions are similar to, or mirror, those prescribed for a mutual fund trust. In order to qualify as a mutual fund corporation within the meaning of the Tax Act, a corporation must satisfy the following requirements: a. it must be a corporation incorporated and resident in Canada;
(iii)
d. the issued shares of the capital stock ofthe corporation included shares that are redeemable on demand, i.e., that have conditions attached to them requiring the corporation to redeem the shares at the demand of shareholders and at prices determined and payable in accordance with such conditions, where the fair market value of such shares was not less than 95% of the fair market value of all of the issued shares of the capital stock of the corporation; and e. unless all, or substantially all, of the corporation's property consists of property other than taxable Canadian property, the corporation must not have been established or be maintained primarily for the benefit of non-resident persons."
A mutual fund corporation, or a quasi-mutual fund corporation (ie, a corporation that would be a mutual fund corporation if it could have elected to be a public corporation had the conditions prescribed for public corporation status
54
Taxation
required only that a class of shares of its capital stock be qualified for distribution to the public), may apply with the GClI1Clc:l9 BE:}YE:}Duej\9E:}nc:y tOt)E:}8 re9i~tered .inyestn1ent for RRSPs, RRIFs and DPSPs. If a corporation is accepted for registration as a registered investment, its shares will be a qualified investment for such plans unless and until its registration is revoked.
Partnerships
In order for units or debt of a partnership to be qualified investments for tax-deferred plans, the partnership must be a limited partnership, its limited partnership units must be listed on a prescribed stock exchange in Canada, and its issued debt must be a bond, debenture, note or similar obligation. A general partnership interest in a limited partnership or any interest in a general partnership will not be a qualified investment for tax-deferred plans. Generally, funds that will be marketed to tax-deferred plans are structured as mutual fund trusts. It should be noted that the regulation dealing with debt of a partnership as a qualified investment is still in draft form.
The Tax Act provides that certain taxpayers may elect to treat the dispositions of 'Canadian securities' on capital account (discussedinn10redetail bel()vv).(3E:}nerally, where such an election has not been made, the appropriate treatment with respect to security transactions will be based on each fund's specific fact situation and dependent on several factors: the taxpayer's intentions at the time the security is acquired, and the course of the taxpayer's conduct in dealing with the security from the time it is acquired until the time of dispositlon.' Generally, in the absence of the election to treat the gains on capital account, most gains and losses realized by a hedge fund would be on account of income. For example, receipts or payments under derivative contracts are generally not considered to give rise to capital gains or losses and are thus fully taxable or deductible. However, if the purpose of the derivative contract is to hedge capital property, a payment or receipt may receive capital treatment. Where a loss is realized on the sale of a security and the fund acquired an 'identical security', the loss may be suspended. One of the conditions that must be present for the suspended loss rules to apply, is that the fund must acquire the identical security within 30 days either before or after the disposition that triggered the loss and hold the identical security at the end of that period. Short sales In very simplified terms, a short sale is a sale of shares, bonds foreign exchange or commodities that the seller does not own, made in anticipation of a fall in prices. A short sale transaction is generally executed under a lending arrangement whereby a lender lends the security to a borrower who agrees to return the same number of identical securities at a later date ... (as.described.bel.ow..uod.erthe heading. TQX.t(E:}Cltment of securities lending arrangements). The Tax Act does not contain any specific provisions on the tax treatment of short sales. The immediate disposition by the borrower of the borrowed securities to a third party would generally not result in any tax consequences where the value of the securities has not changed in the interim between the receipt and disposition by the borrower. The gain or loss resulting from the difference between the proceeds from the short sale received by the seller and the cost of the securities, which the seller must remit to cover the sale is generally considered on income account. However, the Canada Revenue Agency has stated that where the short sale is entered into to hedge a taxpayer's position with respect to identical shares held on capital account the short sale may be on capital account. Forwards. futures and swaps As stated above, derivatives (such as forwards, futures and swaps) by their very nature will generally be considered to be held on account of income. The holder will generally only realize a gain or loss from the appreciation or depreciation in
Warrants, rights and options

A warrant or right issued by an issuer that is a trust, corporation or partnership, and that gives the holder the right to acquire a share or unit of the issuer (or of another person or partnership that does not deal at arm's length with the issuer) which is a qualified investment, will itself be a qualified investment for a tax-deferred plan as long as the issuer deals at arm's length with the beneficiary of the plan.
General tax considerations Characterization of income to hedge funds

The character, amount and timing of the income of a hedge fund are important because the income of the fund will generally be taxed in the hands of the investors on an annual basis. The tax rules and principles that are generally used to determine the income of mutual funds and their investors will also apply in the context of a hedge fund. However, hedge funds tend to undertake certain investment activities that are not as common to the typical mutual fund. Certain of these activities are discussed below. Only 50% of the gains realized by a hedge fund that are on capital account, must be included in taxable income whereas income gains, such as interest, are fully taxable. Therefore, it is generally beneficial if the gains that are realized on the fund's investment can be treated on capital account. To the extent the fund realizes capital losses, only 50% of those losses will be deductible and only against capital gains. Whether or not investment gains or losses should be treated on capital account will depend on the facts surrounding the investment.
55
Taxation
the value of a property to which the derivative is referenced to. Generally, the rights and obligations created under these types of transactions do not result in the acquisition
ofacapifalassef. AsWeTl,thesederivative frarisactiorisWiII

generally not qualify for the sub-section 39(4) election to have the gain treated on account of capital. Where the derivative is used to hedge a security owned by the fund that is held on account of capital, the gain or loss generated from the derivative may also be treated on account of capital. It is uncertain what criteria should be used to determine whether a security or trading activity constitutes a hedge of another security.
is made. The election cannot be rescinded. This election does not apply to a disposition of a 'Canadian security' by a taxpayer (other than a mutual fund trust or a mutual fund
corpOraliori)wh6 afthefimeofdisposiUori is:
a trader or dealer in securities; a financial institution; a corporation whose principal business is the lending of money or the purchasing of debt obligations or a combination thereof; or a non-resident.
Sub-section securities'
39(4) election
for 'Canadian
"=(esident ihCahada, ·auhit·ofammualfuridfrusf6fabOrid,
Sub-section 39(4) of the Tax Act allows certain taxpayers to treat all their Canadian securities as capital property and consequently, to treat any gain or loss arising on disposition of such a security as a capital gain or loss. Therefore, where there is uncertainty as to whether the gain or loss on the disposition of a particular security should be reported by the fund on account of income or on account of capital for tax purposes, the fund may consider making an election under sub-section 39(4) to have the disposition of the security treated on account of capital. With the election, the hedge fund would receive the benefit of capital treatment with respect to its gains; however, the fund would also be required to claim capital treatment with respect to its losses. The subsection 39(4) election is only applicable to the disposition of 'Canadian securities'. A 'Canadian security' is defined in the Tax Act and means a 'security, other than a prescribed security, that is a share of the capital stock of a corporation
Therefore, if the hedge fund is structured either as a 'mutual fund trust' or a 'mutual fund corporation', it can make the election even if its investment activities might be considered in the nature of a 'trader or dealer in securities'. Whether or not the investment activities of the hedge fund will be considered in the nature of a 'trader or dealer in securities' for a fund that is not structured as mutual fund trust or corporation, will depend on the particular facts of the fund. The term 'trader or dealer in securities' is not specifically defined in the Tax Act. A partnership is not entitled to make a sub-section 39(4) election. However, in determining the income of a taxpayer that is a member of a partnership, the Tax Act applies as if the Canadian securities owned and disposed of by the partnership were owned and disposed of by the taxpayer. Accordingly, a member of a partnership (other than another partnership) may make an election under sub-section 39(4) that applies to the Canadian securities disposed of by the partnership. The effect of this provision is that, to the extent that a gain or loss is allocated to a partner in respect of the Canadian securities, the amount is treated as-a capital gain or loss. Where the hedge fund is structured as a partnership, each partner will be treated as owning the security and each partner will be treated as disposing of the security. Therefore, each member of a partnership elects on his or her own behalf under subsection 39(4) and the treatment of his or her share of the gain or loss from a disposition of a Canadian security held by the partnership will depend on whether he or she has elected under sub-section 39(4). An election by a member of a partnership in respect of a Canadian security held by the partnership will not affect the tax treatment that may apply to another member of the partnership on the disposition of a Canadian security. Where the ownership of the hedge fund involves tiered partnerships, the election is not available to the partners of the top partnership. It is the CRA's view that a Canadian security owned and disposed of by a lower partnership is not considered to be owned and disposed of by the members of the top partnership."
debenture, bill, note, mortgage, hypothecary claim or similar obligation issued by a person resident in Canada'. Prescribed securities that do not qualify for the election are listed in Regulation 6200 and include: shares of corporations (other than public corporations), where the value of the shares may reasonably be considered to derive from real property or resource property owned by the corporations; debt instruments of corporations (other than public corporations) with which the taxpayer has not dealt at arm's length; and shares or debts acquired by the taxpayer in a transaction in which the taxpayer was not dealing at arm's length. The election applies to the disposition of 'Canadian securities' in the taxation year in which the fund makes the election, and also to all subsequent dispositions of 'Canadian securities'. Therefore, this is a lifetime election that applies to treat all subsequent dispositions of securities that qualify as 'Canadian securities' to be on account of capital. The election must be made by filing the prescribed form T123 entitled 'Election on disposition of Canadian securities' with the fund's return of income for the year in which the election
56
Taxation
Foreign investment entity rules

The proposed 'foreign investment entity' (FIE) rules" (Proposed Rules )gre intepcted to C1PplytoinvestrnElnts made by Canadian-resident taxpayers in foreign entities that principally earn investment income. More specifically, the Proposed Rules are intended to address the Canadian Government's concern that Canadian taxpayers were able to earn passive investment income in foreign entities that allowed them to defer Canadian taxes that would otherwise have been payable had the income been earned in Canada. Where a particular investment is caught by the Proposed Rules, the Canadian taxpayer becomes subject to an income imputation regime; the primary result is generally an acceleration in the timing of the income recognition. The following analysis should be made in determining whether a hedge fund's interest in a particular foreign entity is caught by the Proposed Rules. Is the hedge fund an 'exempt taxpayer'? An exempt taxpayer would include: an individual (other than a trust) who was not resident in Canada more than 60 months (in total) before the end of the year; a person whose taxable income is exempt from tax, such as tax-deferred plans; or a trust where certain conditions are met (including where the only beneficiaries of the trust are persons exempt from tax as described above).
A non-resident entity is: a non-resident corporation or trust; or
an enlitV(6fhefthanac6rp6Yati6norlrustPhafeXists
and was formed, organized or last continued under the laws of a foreign country or political subdivision thereof, or is governed under such laws. The terms - participatinq interest, entity and non-resident entity - are so broadly defined that most common forms of equity investment in foreign entities will generally be captured. If this is the case, the hedge fund needs to determine whether the participating interest in the non-resident entity is an exempt interest or whether the non-resident entity is a foreign investment entity. It is usually relatively easier to determine the former rather than the latter. Is the participating interest an 'exempt interest'? The most significant type of exempt interest for taxpayers concerned with structuring investments in foreign affiliates is probably a share of a controlled foreign affiliate. Such investments are already subject to the Foreign Accrual Property Income regime under which the taxpayer is generally required to include in income its share of the passive income earned by the controlled foreign affiliate. Other exempt interests would include where: • • the non-resident entity is a partnership; the non-resident entity is a 'qualifying entity' that is a foreign affiliate of a taxpayer in respect of which the taxpayer has a 'qualifying interest'; and the participating interest is an 'arm's length interest', the taxpayer does not have a 'tax avoidance motive', and.either; the non-resident entity is resident in a country in which there is a prescribed stock exchange and identical participating interests in the nonresident entity are listed on a prescribed stock exchange; or the non-resident entity is governed and exists (was formed or organized or last continued) under the laws of a country with which Canada has entered into a tax treaty, and is resident for treaty purposes in that country.
If the taxpayer is an exempt taxpayer, no further analysis is required. Hedge funds would likely not be exempt taxpayers. Ther<sfore, the hedge fund must-make the following determinations. Does the hedge fund have a 'participating interest' in an 'entity', and is the 'entity' a 'non-resident entity'? An entity for these purposes is defined very broadly to include 'an association, corporation, fund, joint venture, organization, partnership, syndicate and a trust, but does not include a natural person'. A participating interest in such an entity is defined as: a share of a non-resident entity that is a corporation; if the non-resident entity is a trust, certain specific interests therein; if the non-resident entity is not a corporation or a trust, an interest in the non-resident entity; or a property that is convertible or exchangeable into one of the interests described above or into another property whose fair market value is determined primarily by reference to the fair market value of such an interest.
Where the taxpayer does not hold such an exempt interest, the Proposed Rules will apply unless the non-resident entity is not a foreign investment entity. Essentially, the Proposed Rules are designed to exclude investments in entities that are principally engaged in an active business. Is the non-resident entity a 'foreign investment entity'? A foreign investment entity (FIE) is any non-resident entity unless:
57
Taxation
the entity is a certain type of 'exempt foreign trust'; the 'carrying value' of all of the entity's 'investment property' does not exceed one-half of the carrying value of all of its properties; or the entity's principal undertaking is carrying on a business that is not an 'investment business'. Tracking interest in a tracking entity Even if a foreign investment is not a FIE, it may still be a 'tracking interest' in a 'tracking entity'. The intent of the rules is to prevent the circumvention of the FIE rules through the acquisition of an exempt interest or an interest in an entity that is not a FIE. The Proposed Rules will, therefore, generally apply to a participating interest in a non-resident entity that owns certain types of property, and where the interest provides an entitlement to receive payments that are determined primarily by reference to production from, or use of, the property, gains or profit from the disposition of the property, income, profit, revenue or cash flow from the property, or any other similar criteria. Income inclusion methods Where the interest held is subject to the Proposed Rules, the hedge fund is generally required to include in income annually an amount calculated under one of three prescribed methods. The first method, which is the default method, is referred to as the 'prescribed rate regime'. Under this regime, income is imputed to a taxpayer in respect of the taxpayer's participating interest in a FIE or a tracking entity. The amount =.~.f.imputed ..incomeis. determined. byapplyinga.prescribed interest rate to the taxpayer's 'designated cost' of the participating interest. The second and third taxation methods generally apply where the taxpayer makes an election, provided certain conditions are met. Under the second method, the taxpayer is required to include in income any increase in value in the FIE that accrued during the year (the 'mark-to-market method'). Under the third method, the taxpayer's share of a FIE's income, computed using Canadian income tax rules, is required to be included in income (the 'accrual method'). The election to have the mark-to-market regime or the accrual method regime apply must generally be made for the first taxation year the interest is subject to these rules. The election is to be made by notifying the Minister of National Revenue (Minister) in writing, in the taxpayer's return of income for the first taxation year in which the rules apply. This election will be deemed to have been filed on a timely basis if it is filed with the Minister on or before the taxpayer's
filing due date for the taxpayer's taxation year that includes the day on which the Proposed Rules are assented to.
Tax treatment otseciirltiiis
lending arrangements
A 'securities lending arrangement' (SLA) typically involves a borrowing of shares, debt securities or more recently, units of listed mutual fund trusts to cover a 'short position' or a transaction failure, which arises when securities are sold that the vendor does not own. In effect, the vendor sells the securities for a specified price on a specified date, with the intention of subsequently acquiring those securities at a lower price. The need to borrow securities arises on a short sale because the purchaser to whom the vendor has sold short will require delivery of the securities on the closing date. In order to make delivery without actually acquiring the securities, the vendor will borrow them from a third-party lender. The borrowed securities are ultimately returned to the lender when the borrower/vendor actually acquires the securities and eliminates the short position. Before the introduction of section 260,7there was considerable uncertainty regarding the tax consequences of SLAs. The tax issues arose in connection with the following three elements of these transactions: • the initial loan and eventual return of borrowed securities; compensation payments made by the borrower to the lender for any dividends paid on borrowed securities during the term of the loan; and the characteristics of payments made under an SLA for withholding tax purposes under Part XIII of the Tax Act.
Section 260 applies generally to any transfer or loan of a qualified security between parties dealing with each other at arm's length and any payments made under such arrangements. It also applies to such arrangements between related parties where it is not intended that the arrangement or series of arrangements be in effect for more than 270 days. Securities lending arrangement An SLA is defined as any arrangement under which: 1. a person (the lender) transfers or lends a 'qualified security' to another person (the borrower); 2. there is a reasonable expectation at the time of the transfer or loan that the borrower will transfer or return an identical security to the lender at a subsequent time; 3. the lender's risk of loss or opportunity for gain or profit with respect to the borrowed security remains unchanged in all material respects;
58
Taxation
4. in the case of an SLA involving shares that are qualified securities, the borrower is obligated to pay the lender cOrnpensationfor all dividends that would have been received by the borrower, if the borrower had held the shares during the entire period of the loan or transfer; and 5. in the case of an SLA involving non-arm's length parties, it is not intended that the arrangement, nor any series of SLAs, loans or other transactions of which the SLA is a part, be in effect for more than 270 days. The definition of an SLA refers to a 'transfer' or 'loan' of a qualified security and, therefore, should include both a loan of a security and a repurchase transaction. A repurchase transaction is structured somewhat differently from a loan; it consists of an initial sale of securities and a contemporaneous agreement to repurchase them at a predetermined date and price. Qualified securities An SLA is defined to include a transfer or loan of a 'qualified security'. In general, qualified securities include publiclytraded shares and debt of public corporations and publiclytraded units of mutual fund trusts. More particularly, the definition of 'qualified security' in SUb-section 260(1) includes the following four categories: a share of a class of the capital stock of a corporation listed on a prescribed Canadian or foreign stock exchange; a bond, debenture, note or similar obligation of a corporation described in (1) above, or a corporation thatiscontrolledby. such a corporation; a bond, debenture, note or similar obligation of, or guaranteed by, the government of any country, province, state, municipality or other political subdivision, or a corporation, commission, agency or association controlled by any such person; a warrant, right, option or similar instrument with respect to a share described in (1) above; and a unit of a mutual fund trust that is listed on a prescribed Canadian stock exchange. The definition ensures that the debt of a subsidiary of a public corporation as well as of a Crown corporation is considered a qualified security. Tax consequences of an SLA
any transfer or loan of a security under an SLA is deemed not to be a disposition by the lender; and the borrowed security is deemed to continue to be the propertY6fthe lender.
These deeming rules ensure that an SLA structured as a loan will be treated on the same basis as an SLA structured as a repurchase transaction. Consequently, the lender will not recognize accrued gain or loss on the transfer or loan of a security under an SLA. Dividend compensation payments With respect to compensation payments made by a borrower to the lender under an SLA, the rules deem certain dividend compensation payments to maintain their character as dividends depending on the nature of the parties to the SLA and the nature of the underlying security. Therefore, dividend compensation payments in respect of 'taxable Canadian corporation' shares will generally be eligible for the intercorporate dividend deduction where the lender is a corporation and for the dividend gross-up and tax credit mechanism for individuals (including trusts). For compensation payments received in respect of a non-resident corporation (even though the shares may be qualified securities) they will be subject to tax in much the same way as dividends from a non-resident corporation. Dividend compensation payments made in respect of 'taxable Canadian corporation' shares by a borrower are not deductible, except that a registered securities dealer is allowed to deduct an amount equal to two-thirds of compensation payments that are deemed to be received by the lender as taxable dividends. However, dividend compensationPCiym~nts. may. r§dqce JhegmoLJot of allY other taxable dividends received from corporations resident in Canada that are otherwise required to be included in a Canadian resident individual's taxable income. Interest compensation payments As with a borrowing of shares, the lender of debt securities under an SLA will expect the borrower to make compensation payments in respect of interest on the securities during the term of the loan. However, unlike a borrowing of shares, section 260 contains no rules governing the deductibility of interest compensation payments made to a Canadian resident lender. The rules deem an interest compensation payment received by a lender to be interest. It is generally assumed that such payments are deductible for a borrower. Mutual fund distribution compensation payments Effective for arrangements made after 2001, section 260 provides for rules governing the tax treatment of compensation payments in respect of distributions made by a mutual fund trust that is listed on a prescribed stock exchange. Where a trust makes the required desiqnation, the source of income earned by the trust can be 'flowed
Transfer or loan of borrowed securities - general rule Under an SLA, the lender continues to bear the risk of loss and the opportunity for gain or profit in respect of borrowed securities. The SLA rules recognize this economic reality and provide the following deeming rules:
59
II
Taxation
through' to its beneficiaries. The rules generally apply to deem compensation payments in respect of payments from a mutual fund trust to have the same characteristics and source as if the amounts wete·paidbylhetruSl. The deductibility to the borrower of amounts in respect of payments from a mutual fund trust will depend on whether the borrower has disposed of the units of the mutual fund trust. Where the borrower has disposed of the units and has !nc!uded the gain or loss from the disposition in computing Its Income, the compensation payment is fully deductible. In any other case, the deduction is limited to the lesser of the ?ompensation amount and the amount included in computing Income for any taxation year in respect of the mutual fund trust distribution. Withholding tax In general, the rules tend to ensure that withholding tax under Part XIII of the Act is imposed on payments made under an SLA to a non-resident lender. In the absence of the provision, resident taxpayers could potentially use SLAs as a means of obtaining short-term financing from non-resident lenders free of withholding tax. For example, a taxpayer could borrow securities from a non-resident and sell them immediately. Until identical securities were acquired for return to the lender, the borrowing and sale would effectively raise funds for the borrower. Dividend or interest compensation payments and any lending fees paid to the lender would constitute the cost of the financing for the term of the loan yet would be free of Part XIII tax because the payments are not covered by any specific provision. The rules generally deem any compensation payments made by a borrower to a non-resident lender to be interest subject to withholding ~!§x..Ho""ever, paYrnentsmadeund~r .certain.other. non-SLA ~arrangements, such as a· total return swap, may not be subject to withholding taxes.
The federal capital tax, known as the Large Corporations Tax (LCT) has been phased out effective in 2006.
Withholding taxes
Distributions of fund income from mutual fund trusts, and taxable dividends from mutual fund corporations, are subject to a 25% withholding tax, unless a tax treaty between Canada and the recipient's country of residence allows for a lower rate. Distributions of realized capital gains (other than 'taxable Canadian property' gains) from mutual fund trust and capital gains dividends from mutual fund corporations are generally not subject to withholding tax. Non-residents are not subject to tax on any realized gains from the disposition of units or shares, unless the units or shares disposed of constitute taxable Canadian property (ie, shares of a private corporation or where the non-resident alone or together with non-arm's length persons, owned 25% or more of the units of the trust, or 25% or more of any class of shares of the private corporation at any time in the 60 months prior to the disposition). Even so, a tax treaty between Canada and the non-resident's country of residence may provide for an exemption from Canadian tax. Foreign taxes paid on foreign-source income may be deducted as an expense or claimed as a credit against taxes payable. As well, the amount of foreign taxes payable may be affected by a tax treaty between Canada and the country of source of the particular income.
Canadian fund managers advising an offshore hedge fund

Where a hedge furidis established offshore it is essential that the nature of any services provided to it by a Canadian manager are closely monitored. Provided that the fund has successfully established it is a non resident of Canada under Canadian tax law, the fund must ensure that it does not inadvertently subject itself (if established as a corporation or trust) or its members (if established as a partnership) to Canadian taxation. Generally speaking, a non resident would be subject to tax in Canada where it: a. was employed in Canada; b. carried on a business in Canada; or c. disposed of a taxable Canadian property. Of the three scenarios above, instances b) and c) are possible in an offshore hedge fund structure. In respect of b) the concern usually is whether the non-resident is carrying on business, and if it does, whether a business is being carried on in a particular location. The distinction between the fund transacting outside Canada, which does not necessarily result in Canadian tax, or within Canada which generally does result in Canadian tax is a factual determination based upon
Capital tax
Depending on the choice ofthe structure that is chosen (that is, a corporation, trust or partnership), the hedge fund may be liable to provincial capital tax. Hedge funds that are structured as corporations are subject to capital taxes, but funds that are established as trusts are not. For hedge funds that are structured as partnerships, each corporate partner is generally subject to capital tax on their share of the taxable capital of the partnership computed on the basis that the partnership was a corporation. The rates vary depending on the province, but generally range between 0.3% and 0.6% of taxable capital. Some of the provinces also have threshold amounts below which no tax is payable. Provincial capital tax is generally deductible in computing income for both federal and provincial income tax purposes."
60
Taxation
factors established by jurisprudence. In the context of hedge funds, one of the factors that may otherwise be indicative of thefLJndcarrying onbLJsiness inc:;anada is when a Canadian fund manager or investment advisor is providing services to the offshore fund. Such services could be tantamount to carrying on a business in Canada. Typically such services may be in the form of investment advice, execution of trades and back office support. To enable Canadian investment advisors access to the world hedge fund market, subsection 115.2 of the Tax Act provides a 'safe harbour' provision whereby a Canadian service provider (the CSP) may provide designated investment services (DIS) without the provision of the those services solely causing the non-resident to be carrying on business in Canada. To be eligible for the safe harbour provision, the offshore fund must meet specific criteria. While the tests differ somewhat depending upon whether the fund is organized as a corporation, trust or partnership, the rules can be summarized as follows: 1. The fund has not, directly or through its agents, directed any promotion of investments in themselves principally at Canadian investors. 2. The fund has not sold an investment in itself that is outstanding to a person who was a Canadian investor at the time of the sale and who is presently a Canadian investor.
b. purchasing and selling quaiified investments, exercising rights incidental to the ownership of qualified investments such as voting, conversion andexchange,and·eriferirig·TrifoaridexeCl..lfirig agreements with respect to such purchasing and selling and the exercising of such rights; and c. investment administration services, such as receiving, delivering and having custody of investments, calculating and reporting investment values, receiving subscription amounts from, and paying distributions and proceeds of disposition to, investors in and beneficiaries of the person or partnership, record keeping, accounting and reporting to the person or partnership and its investors and beneficiaries. There is significant opportunity for Canadian advisors to be involved in offshore hedge funds provided the safe harbour provision is considered and respected. A CSP can potentially make trading decisions subject to the investment policy of the fund as well as handle most, if not all, back office activities such as computing the NAV of the fund, maintaining records and cash related to subscriptions, redemptions and distributions and accounting and reporting services. It is generally thought that activities such as loan origination are outside the scope of acceptable services.
Endnotes
1.
See Interpretation Bulletin Partnership?', paragraph 2.
IT-90,
'What
is a
3. The fund has not, directly or through its agents, filed

any document with a public authority in Canada in accordance with the securities legislation of Canada or of any province in order to permit tne.distnbution of interests in the Fund to persons resident in Canada.
2.
4. In the fund, the total fair market value of investments that

are beneficially owned by persons and partnerships that are affiliated with the Canadian administrator does not exceed 25% of the fair market value at the particular time of all investments in the Fund. Simply put, a CSP is any corporation, Canadian trust or partnership that is resident in Canada. DIS' are defined in the Act to encompass a broad variety of activities. However it should be noted that any activities that are indicative of mind and management control of the fund occurring in Canada, such as decision making authority, would fall outside the scope the safe harbour provision. For purposes of the Act, DIS encompasses: a. investment management and advice with respect to qualified investments, regardless of whether the manager has discretionary authority to buy or sell;
Taxable Canadian property includes: a. real property situated in Canada; b. unlisted shares of a Canadian resident corporation: c. unlisted shares of a non-resident corporation or an interest in a non-resident trust if, at any time during the preceding 60-month period: (i) more than 50% of the fair market value of all the properties of the corporation or trust consisted of one or any combination of taxable Canadian property, Canadian resource property, timber resource property, an income interest in a Canadian resident trust or an interest in, or option, in respect of any of the foregoing property; and (ii) more than 50% of the fair market value of the shares or interest was derived directly or indirectly from one or any combination of real property situated in Canada, Canadian resource property or timber resource property; d. listed shares of a corporation or units of a mutual fund trust if, at any time during the preceding 60-month period, the taxpayer, 61
Taxation
e.
f. g. h.
persons with whom the taxpayer did not deal at arm's length, or the taxpayer and such nonarm's length persons owned 25% or more of the issued shares of any class of the capital stock of the corporation or issued units of the trust; an interest in a partnership if, at any time during the preceding 60-month period, more than 50% of the fair market value of all the properties of the partnership consisted of one or any combination of taxable Canadian property, Canadian resource property, timber resource property, an income interest in a Canadian resident trust or an interest in or option in respect of any of the foregoing property; a capital interest in a Canadian resident trust (other than a unit trust); a unit of a Canadian resident unit trust (other than a mutual fund trust); and an interest in, or option, in respect of a property described in paragraphs (a)-(g) above.
8.
Capital taxes paid to provinces are not deductible in computing income for Alberta purposes.
MartihVViCl<ihS Ernst & Young martin.wickins@ca.ey.com 4169432598 Fraser Gall Ernst & Young fraser.gall@ca.ey.com 4169432930
3.
This requirement is proposed to be amended generally after 2004 in the same manner as described above for mutual fund trusts. Interpretation Bulletin IT-479R entitled 'Transactions in Securities' dated 29 February 1984 lists several factors that should be considered in determining whether a taxpayer's gain from the disposition of securities should be treated on 'income account' or on 'capital account'. See Technical Interpretation Partnerships. 2002-0141425, Tiered
4.
5.
6.
The latest version of the Proposed Rules, set out in proposed sections 94.1 to 94.4 of the Tax Act, was released in revised form by the Department of Finance as draft legislation on 9 November 2006, and will be effective for taxation years (of taxpayers) that begin after 2006. Although the Proposed Rules have not yet been enacted into law, the legislation is now found in Bill C-33 to amend the Tax Act. Section 260 of Tax Act contains a set of rules governing many aspects of the tax treatment of SLAs. The provision was originally introduced in the April 1989 budget in an attempt to clarify several issues surrounding the tax treatment of these arrangements and is subject to certain amendments proposed on 27 February 2004 to expand the rules to apply to partnerships and to arrangements between related parties having a term of 270 days or less.
7.
62
Chapter Ten:
Building an Effective Governance Program for Hedge Funds
are elected by, and are accountable to, the shareholders, and takes into account the role of management who are appointed by the board of directors and who are charged with the ongoing management of the eorvoration;·lntheease of a fund, 'fund governance' refers to the oversight role and decision-making processes of the governance body of that fund. If the fund is structured as a company, that means the board of directors and any board committees. If the fund is a unit trust, the governance body is the board of trustees and any committees of that board. Whenever one is considering what the appropriate standards of governance are for a fund, it is important to bear in mind the perception that regulators in Canada, and throughout the world have of funds, which can best be summarized as follows: 'The national public interest and the interest of investors are adversely affected when investment companies (funds) are organized, operated and managed in the interest of others, rather than in the interest of their securityholders.' In managing an investment fund, the manager must: act honestly and in good faith, and in the best interests of the investment fund; and exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances However, the manager may not be able to objectively determine whether it is acting in the best interests of the investment fund when it has a conflict of interest.
W. William Woods Independent Review Inc., Toronto
In the case of publicly-listed companies, there are now well established standards of best practice and guidelines in respect of corporate governance. These standards have Elvolvedthrough 'Elgislativeand. regulatory reforms and the irll'tia11'vesof capital market participants over the last four years, including detailed requirements in respect of reporting on internal controls over financial reporting - for example Sarbanes-Oxley in the United States and Multilateral Instrument 52-109 in Canada. The corporate governance of public mutual funds is now regulated in Canada through National Instrument 81-107 Independent Review Committee for Investment Funds. National Instrument 81-107 came into full effect on 1 November 2007. Although the National Instrument is only applicable to investment funds which are offered to the public, even private hedge funds will experience pressure from investors to follow the same standards - particularly if they seek large institutional shareholders.
Adequate oversight and effective decision-making are, therefore, seen as critical by regulators for the protection of the fund's securityholders. N181-1 07 is designed to reinforce oversight in those areas where the manager may have a conflict of interest and, thus, may not be objective in making decisions about the fund.
themanager'sfidueiarY duties, bufiliipbses independent
Hedge funds are a special type of business

Unlike operating companies, a fund business usually outsources most of its operations, including the investment management and the administration functions. Hedge funds tend to be relatively small in comparison with public mutual fund organizations and rely more heavily than other funds on outsourcing many functions to third-party service providers. This type of 'externalized management' is not common in other industries and makes hedge funds a special type of business. This outsourcing allows a small number of principals to manage very large amounts of assets. There is now over US$1.5 trillion under management in over 10,000 hedge funds worldwide.
What is fund governance?

In the case of a company, 'corporate governance' relates to the activities of the board of directors of the company who
63

In addition, hedge fund securities are now being held by a much wider range of investors, including many individuals of modest net worth, either directly or through pension funds (which are··increasingly··jnvesting.jnhedge funds). This growth in assets under management and the widening of the investor base has already led to an increasing regulatory focus on hedge funds, especially in Canada, where a number of hedge fund scandals have heightened concerns about how hedge funds are operated.
operation of the fund - ie, it must assume leadership and control of the fund. Fund boards have, in addition to their general oversight responsibilities, an extra duty to monitor those areas where conflicts·· of interest might exist Since many hedge funds now have institutional investors (such as pension funds) and some have several thousand individual investors, the governance standards of hedge fund boards can have a significant impact on a large number of investors, even though the funds themselves may not be listed or publicly traded. Therefore, it makes sense for the Canadian hedge fund industry to voluntarily adopt international standards of fund governance, in order to avoid giving Canadian regulators an excuse to start imposing such standards on them by way of unwanted regulatory oversight. So, what are the relevant fund governance Canadian hedge funds? standards for
But the governance issues are the same

As with every investment manager, a hedge fund manager can find him or herself in situations where their business and commercial interests conflict with their fiduciary duty to act in the best interests of the fund. As we have seen, the regulators believe that there is potential for abuse if a fund is organized, operated and managed in the interests of the investment manager and not the security holders. All investment managers can experience two different types of conflict situations - business conflicts and related-party conflicts. Now that investment management is increasingly just a part of a full service financial business, the potential for related-party conflicts is increasing. Although hedge fund managers tend to be independent entities - so have less 'related-party' conflicts - there are still plenty of potential business conflicts including, inter alia: pricing the portfolio - the manager obviously has an interest in the pricing of the securities, since fees are derived from the net asset value (NAV). There have been enough scandals involving mispricing to these issues and nowadays most hedge fund managers out-source pricing to an independent fund administrator; inter-fund trading or purchasing or continuing to hold securities issued by an entity which is related to the manager (eg, where the manager personally invests in the issuer); advising other investment funds or accounts at the same time as the hedge fund - how are expenses and costs allocated?; having multiple business relationships with the main service providers to the fund; best execution issues, including 'soft dollar' arrangements or directed brokerage; and deciding how to allocate trades between the hedge fund and other accounts.
Due to the unique organizational structure of funds, regulators sometimes require that they have a significant number of 'independent' directors. The independent directors are responsible for monitoring carefully the relationship between the fund and the manager and any other service providers. The term 'watchdog' has been used to describe the independent directors' role. In the US, public mutual funds have been required to have independent directors since 1940. The SEC requires that the chairman and at least 50% of the board of directors of all public mutual funds must be totally independent from the fund manager. Partly becadsebftheexteht ofthepotehtiar conflicts of interest, many hedge funds around the world are now appointing independent directors, even though they are not yet required to do so by regulations.
orfraudbyhedgefUndmanagersfo alert investors
The 'Canadian solution': independent review committees

In Canada, National Instrument 81-1 07 Independent Review Committee for Investment Funds came into force on 1 November 2007. NI 81-107 is applicable to all investment funds which are offered to the public, including exchangetraded, closed-ended funds. It does not apply to private hedge funds that are offered to high net worth investors by way of a prospectus exemption. However, over the next couple of years, private hedge funds will experience pressure to adopt the same or similar standards from both existing and prospective shareholders.
The role of the board

The board of directors or board of trustees (in both cases, the 'board') of the fund is ultimately responsible for the
64

Under NI 81-107, every public investment fund must set up an independent review committee (IRC). NI 81-107 states that a manager may not be able to objectively determine whether it is acting in the best interests of-the-mutual-fund when it is in a conflict of interest situation. NI 81-107, therefore, requires that any situation in which a reasonable person would question whether the manager has a conflict of interest must be referred by the manager to the IRC for a second review and recommendation. An IRC must comprise at least three people who are totally 'independent' of the fund and the manager. In the case of inter-fund trades and investments in related entities - which are currently prohibited by Canadian securities regulations - the manager cannot take action without the approval of the IRC. The IRC, thus, acts as a sounding board where the manager's proposed actions on conflict of interest matters are subjected to a sober second review.
and experienced service providers appropriate for the size of the fund. The directors should ensure that all the service providers have the standing and expertise appropriate to theirflmct~onforthehedgefund.The service provider's role, responsibility and any service level commitments should be clearly documented in a service agreement approved by the board. The board should also monitor the performance and fee levels of all service providers on a periodic basis against the committed level of service.
Re-appointment
of the manager
In the US, the independent mutual fund directors have to review the manager's agreement annually and have the power to terminate the appointment. However, this power is rarely used. Some commentators have called for an equivalent power in Canada for public mutual funds. This issue is less relevant in the context of hedge funds, because investors select hedge funds based on the performance or trading magic of a specific manager or individual at the hedge fund management company.
Independent advisory board

In order to match these new standards, every Canadian hedge fund should consider having the equivalent of an IRC. There are some hedge funds that already have such committees, although they are generally called 'advisory boards'. The advisory board provides independent oversight of the fund and the fund manager. Having an advisory board demonstrates to potential investors that the fund manager has considered the governance issues and has established ~!')_j1JQE:lpE:lnqentg()v(3rnance body for the. protection of investors in the fund. In this way, the fund manager is able to act more as a service provider to the fund rather than as its controller.
Compliance issues
The closure and high-profile investigation of the Portus hedge fund group has clearly illustrated the importance for all hedge funds of regulatory compliance. Every hedge fund should, therefore, have a designated 'compliance officer'. In addition, where there is an advisory board, key staff or consultants with compliance issues that are not being addressed by the fund manager, can raise those issues with this independent governance body.
Remuneration.. issues
For public companies, management remuneration has been a major public issue in the last few years. Independent mutual fund directors generally get a fixed annual fee or a 'per meeting' fee. Independent mutual fund director fees are increasing rapidly in the US and Canada. In the area of manager remuneration, hedge funds can, in some ways, be said to be ahead of public companies, since the investment manager's primary reward is the performance fee, which is based solely on the performance of the fund. The basic management fee for hedge funds tends to be much lower than that for traditional mutual funds (1-2% rather than 3-5%). Moreover, where the performance fee methodology includes hurdles and high watermarks, the investment manager is only rewarded when the investor's holdings actually increase in value (contrast that with the so-called 'fat cat' directors on public company boards).
Key issues for a fund board

In addition to the straight 'conflict of interest' issues, the independent directors on a fund's board and any independent advisory board, should be involved in the following key areas: • • the appointment of third-party service providers; the re-appointment of the investment manager; compliance issues; remuneration issues; and effective communication.
Appointment of third-party service providers

One of the prime duties of the directors of a hedge fund is to review and approve the appointment of all the third-party service providers. A hedge fund should only appoint reputable
65

Effective communication with security holders

Corporate governance standards now require the adequate disclosure of information to investors on a consistent and timeJybasis. In.the case. of hedge funds,this means that regular performance data (and any commentary from the manager) is communicated to all securityholders as soon as possible after the NAV is finalized following each valuation period. The board should also seek to ensure that any material items of information or changes are disclosed to all investors affected by those items or changes (and, generally, not seek to differentiate communications to investors or the timing of disclosures, based on the size of the investor's investment or the nature or content of the disclosure).
Conclusion
Due to the size of investors' assets now held by hedge funds and the expansion of the investor base, the governance standards demanded of publicly-listed companies and public investment funds, with some limitations, are broadly applicable to hedge funds. Canadian hedge funds should, therefore, adopt international standards and have independent directors and/or establish an independent advisory board. Voluntary compliance now will help to avert the imposition on Canadian funds of more rigid governance standards in the future.
W. William Woods
Independent Review Inc. wwoods@independentreviewinc.com
4168491928
66
asked questions regarding independent directorship, and provides some direction regarding the selection process.
Chapter Eleven:
Introduction
We begin with questions, questions and more questions. The runner-up questions often asked during the selection process of an independent director are: 'How much?' (referring to 'How much do you charge for the provision of independent directorship services?') 'How many boards do you sit on?' (translated as 'How many manager relationships do you service and do you have the capacity to effectively service another one?') Services Ltd., However, the grand prize-winning question usually is: What do you do?' (meaning What role do you play and what value will you add if appointed to the board of directors of the fund?') These are all questions frequently asked during the selection process of an independent hedge fund director. The main purpose and underlying theme of this article is to address the latter question, then briefly address the other queries (and more) in turn. That being said, prior to addressing these queries, it's always good to provide a bit of background and address a couple of related issues.
The Role of Independent Directors
Geoff Ruddick International Management Cayman Islands
This chapter addresses some of the typical questions posed during the selection process of an independent hedge fund director and provides some background to the role.
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In a nutshell, the basic role of a director is to oversee the business and affairs of the fund, with the fundamental task of being diligent in representing the interests of the investors. In most common law jurisdictions there are specific legal duties underlying the role of directors. Although beyond the scope of this article, these duties can broadly be summarized as follows: 1) fiduciary duties - loyalty, honesty, and good faith; and 2) duties of skill, care, and diligence. In summary, directors must act in what they believe are the best interests of the fund itself, and avoid putting themselves in a position where they are conflicted between their personal interests and the duties owed to the fund. They must exhibit such skills as they possess, and such care and diligence as would be expected of a reasonable person in the same situation.
independent director is the underlying reason behind your search. Probably, given the spectacular hedge fund and corporate collapses in recent years, part of the reason is the desire for effective corporate governance. In today's environment, corporate governance is no longer a luxury, but a necessity and, often, a requirement. Regulators and exchanges are increasing their scrutiny and investors are demanding it - so should you. Aside from corporate governance, one of the driving factors for independent directorship is often tax-related. Independent directors may be appointed in a tax-neutral jurisdiction to assist with the tax planning of the investment manager or to secure the fund's offshore tax status by ensuring that the jurisdiction in which the mind, management and control of the company is exercised, is clearly offshore. Regardless of the reason, a qualified, experienced, independent director will assist in meeting the underlying requirements. This article addresses some of the frequently
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Terminology: What do 'independent' and 'nonexecutive' mean?

Before- we get into the·· core of the ·article;iet'sgetsome terminology that inevitably seems to crop up out of the way. In the context of a hedge fund director, the term 'independence' generally refers to someone who is independent of all service providers - the investment manager, administrator, registrar and transfer agent, prime broker, custodian, auditor and legal counsel. As explored further below, such independence is critical in order to ensure that the director is free from any inherent or potential conflicts and, thus, is able to effectively discharge their duties. The term 'non-executive' stems from the typical hedge fund structure, as the fund itself will rarely have any direct employees or, if you will, 'executives', when referring to the upper echelons. As such, non-executive directors are not employees of the fund and they are not involved in the dayto-day management of the fund's affairs. Although these terms are descriptive in nature and helpful from an explanatory standpoint, bear in mind that 'a director is a director' in the eyes of the law. An executive director and their independent, non-executive counterparts have the same responsibilities, duties, potential risks and personal liabilities.
performance of the fund and its service providers, reviewing and executing agreements, attending directors' meetings, and dealing with any extraordinary issues, such as approving side Jettersand resolving conflicts.
Value-added: What value will you add?

Below are a handful of areas in which independent directors add value.
Independence
Independent directors add value by being free of any relationships with service providers. Such independence helps ensure that the fund abides by the fundamental principles of effective corporate governance. This, in turn, decreases the potential for mismanagement and corresponding potential litigation. It also supports the legitimacy of the corporate and tax structuring of the fund. If a director is not independent, conflicts of interest will inevitably arise and interfere with the director's ability to act in the best interests of the fund. In the event that a director is employed by, or affiliated with, a service provider, they must keep in mind that their fiduciary duties are owed to the fund itself - not to their employer or any affiliate.
Regulators, exchanges and tax authorities

The trend towards increased scrutiny by tax authorities, exchanges and regulators is clear, and additional scrutiny appears probable in the future. If the investment adviser to the fund is regulated by the Financial Services Authority (FSA) or the Securities and Exchange Commission (SEC), the representation of independent directors on the boards of inlJe.$trn(3ntfU('lgsj$$(3enqllite"fCllJourClbly.J~.(3gulatorsand exchanges of other jurisdictions now go as far as to require independent board representation. Furthermore, independent directors may be appointed in a tax-neutral jurisdiction to secure the fund's offshore tax status by ensuring that the jurisdiction in which the mind, management and control of the company is exercised, is clearly offshore. As is common practice, independent directors approve transactions that attract a high degree of scrutiny from authorities such as the SEC and the Internal Revenue Service (IRS) - side letters, deferred fee arrangements and principal and agency cross-trades, to name a few.
Role: What do you do?

An independent director will only have an intermittent involvement with the fund's affairs. Although they are not required to give continuous attention to the fund's affairs, ~!h,ey should.,b,eprt3S(3nt,C3t 111~(3ting,s Wh(3I1t3V(3f pO§$iplt3"Qn ~an ongoing basis, the director's role is typically performed at periodic board meetings or, more commonly, by written resolutions. Therefore, the duties and responsibilities pertaining to the dayto-day operations of the fund are delegated by the directors to the service providers. For example, the investment manager or adviser manages the fund's portfolio; the administrator calculates the net asset value (NAV), maintains the fund's financial books and records, and ensures that any antimoney laundering requirements have been fulfilled; the prime broker executes and clears trades, provides financing, etc. Each service provider fulfills a specific function, which is expressly outlined in their respective contract with the fund. The directors are responsible for the negotiation and oversight of such agreements. In essence, provided the fund is investing in conformity with the investment strategies and restrictions as outlined in its offering document, an independent director's role predominantly consists of periodically reviewing the
Investor confidence
Increased vigilance by investors, particularly institutional investors, makes effective corporate governance a top priority. As the trend of pension funds, endowments and charities investing billions of dollars continues, many fiduciaries of such investors are seeking to put their dollars in
I·
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hedge funds that have independent director representation. Some investors go as far as to demand it to ensure their inYElstrnElntsarElbetter protected. When investors perform their due diligence, independent board representation builds investor confidence as they gain comfort by the increased independence and resulting enhanced corporate governance. Investors know that independent directors will provide the credible decisionmaking on behalf of the fund that is required in today's environment. Independent board representation not only increases investor confidence, but also can indirectly assist with the marketing of the fund, thus, attracting or retaining investors.
provisions or the suspension of redemptions have all been headlines as of late. An irideperiderifdiredOrCariassistirimakiiig aii Uiibiased determination in the best interests of the fund, its investors and creditors, during such uncertain times. As such, comfort is gained in the knowledge that the independent directors will monitor the performance of the fund and all service providers in both normal and extenuating circumstances. As SEC chairman Arthur Levitt stated when referring to the role of fund directors, 'Yours is a complex job that requires enormous diligence, skill and responsibility. You must be prepared to step in at any time, you must know what to look for and you must know when to act.'
Service provider confidence, monitoring and conflict resolution

The confidence-building factor is not restricted to that of investors and regulators. Although the constitutional documents, offering documents and respective agreements with each service provider provide guidance in the event of a conflict or uncertainty, the reality is that unforeseen complexities and scenarios will inevitably arise. Part of the independent director's role is to monitor the performance of all service providers, including the investment manager, in accordance with the terms of their agreements. Thus, all service providers gain confidence in knowing that conflicts will be resolved by directors who are not affiliated with another service provider to the fund. The interests of the fund and its investors may differ from the interests of its investment adviser, administrator or other service provider. This can put a director in a position Th~Wffrchthey have a coiiflictofiiifetest, Whether it be at initial establishment when contracts are being negotiated or during the ongoing operation of the fund regarding issues such as: monitoring service providers' performance; adherence and changes to investment strategies and restrictions; the valuation of assets; or during extreme events.
Approval of documentation
and agreements
The approval, oversight and negotiation of the fund's documents and agreements with service providers are a key component of the role of an independent director. Whether it be prior to the fund's launch, or an amendment of terms at a later date, the board of directors is ultimately responsible and must approve such documentation and agreements. As an example, independent directors usually spend a significant amount of time reviewing the offering document to ensure that all details are fully and accurately disclosed. These include: • the fund's structure; investment manager and key personnel; identification of other service providers; investment objective, strategy, universe and restrictions; targeted investor base; frequency of dealings and valuations; anti-money laundering and compliance issues; accounting principles; risk factors; and whether the fund will be listed.
• •
• •
Individual investors' and service providers' interests often diverge further during extreme market conditions. For example, the valuation of illiquid securities in normal times is a common issue, and recent events pertaining to the extenuating circumstances surrounding the sub-prime fall-out emphasize this area of concern. As has recently transpired, the valuation of related financial instruments has been difficult, if not impossible, and the corresponding effects have created situations in which an independent director's involvement has been critical. Issues such as the pricing of the illiquid securities themselves, the knock-on effects of the suspension of NAV calculations, the invoking of gating
The directors must confirm that they have taken reasonable care to ensure that all facts and statements in the offering document are true and accurate in all material respects, and that they are not aware of any other material fact that has been omitted, which would make any statement in the offering document misleading. They also must confirm that they have received and carefully reviewed the agreements with each respective service provider, such as the administration agreement, investment management agreement, etc. Ultimately, the directors accept responsibility for the contents of the offering document and agreements and any corresponding omissions, so the process is taken seriously.
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Jurisdictional/corporate governance knowledge and experience

Inci§PElnc!EllltciirElgtors..rElsidentinthe jurisdictic)nin ... vvhigh the fund is established will possess specific knowledge and experience of the jurisdictional requirements therein, and have a thorough understanding of the principles of effective corporate governance. Such knowledge and experience is an invaluable resource to investors, the investment manager, and other service providers. Many independent directors work full-time in providing this service. They sit on numerous boards and, therefore, there is a great deal of knowledge and experience that rests with these individuals. Now that you have an idea of what independent directors do and what value they add, the question remains, how do you go about the selection process and determine who is the right person for the job?
suggested 'top 10' for consideration follows. Add and subtract as you will; it is by no means all-inclusive, but it will hopefully point you in the right direction. 1) Independence: Is the prospective director independent of the investment manager, administrator, legal counsel and all other service providers? Independence is the 'Holy Grail' of effective corporate governance. If a director is not independent, conflicts of interest will inevitably arise and interfere with the director's ability to act in the best interests of the fund. 2) Experience: Does the individual have relevant industry experience and experience with the fund's strategy specifically? You will get a good idea of their experience from their 'bio', which will eventually appear in the offering document of your fund. You will also want to ask if they have sat on boards with similar strategies. Independent directors do not need to be experts; however, a general understanding of the fundamentals of the underlying strategy is essential. 3) Qualifications: Does the individual professional qualifications? have relevant
So, where do you start?

Your legal counsel and administrator are a good starting point and will have a shortlist of those individuals they recommend. Once you have their recommendations, you should make additional enquiries to find the individual who is right for the fund. Investigate your options and don't limit your search to the first name on the list. Keep in mind that independent directors come with varying backgrounds, experience, qualifications, styles, interpersonal skills and corporate support - check around to compare and contrast. The process of looking for an independent director is somewhat analogous to the search for a new employee and the corresponding interview. If you have been in the =unfortunate-posttion-of-hlnnq the wrong·personfor·a job, you will understand the feeling of regret that comes upon you if it becomes evident you made the wrong choice. You now wish, with hindsight as your judge and jury, that you had performed more due diligence and asked more questions at the outset. You will have some questions for the prospective director, and should expect that they will have some for you in return. Both parties need to be comfortable and confident with each other in order to have a conducive and effective working relationship. If you can meet the individual in person, it is better, although this is not usually a practical solution. A telephone conversation will suffice in most circumstances.
You possess academic credentials and qualifications of your own and will expect it of the people you employ. You should require it from an independent director as well. Remember, the directors are ultimately resp()nsibl~ f().r .t~e .. v.ersig.. of th.e.fun.d's affCli.r~.:.A o ht legal, accounting, compliance, investment or other relevant qualification, combined with experience, will provide a good indication of where their specific expertise lies and how they will add value. 4) Capacity: How many boards does the director currently sit on and how many manager relationships do they service? An excellent question and one that is extremely important to ask. 'Capacity' is a key concern in any line of work and, arguably, is more so in the context ofthe role of an independent director. The directors oversee the affairs of the fund, and time and effort is required to effectively fulfill their duties. Everyone wants to know the magic number. Unfortunately, there is no definitive number as every relationship will be different and have its own nuances and complexities. However, if you receive a vague response to this question or, worse yet, they just don't know the answer, it will be an indication of the level of responsiveness you can expect to receive from them.
Now, what should you be asking?

The two issues mentioned at the beginning of this article (capacity and remuneration) are two of the most frequently posed questions when looking for an independent director, although there are obviously no hard and fast rules, or an all encompassing list of questions you should ask. However, a
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Directors should know exactly how many relationships and corresponding fund boards they serve on at any given time. If they sit on an excessive number of boards or-have-too-many manager relationships; they will be unable to adequately serve the fund. An independent director who has too many appointments will likely be passive in nature, will not add much value and should, therefore, be avoided. On the other hand, an independent director who services a reasonable number of manager relationships will possess a great deal of knowledge and experience to the benefit of the fund. A good balance is the key - as can be said for many things in life. A related question is whether the director has the ability to remain in direct contact with the affairs of the fund from formation onwards. Each director must personally be aware of the fund's affairs, and having an adequate support infrastructure to gather information can facilitate this. Confirm with the candidate how they, or their company, are structured and operate in this regard. 5) Back-up/coverage: Does the individual work for a director services company or are they a stand-alone operation? Although most consideration should be given to the capabilities of the prospective director, there may be times when the actual person you have selected may not be available. People take vacations, encounter emergencies, come and go from an organization or jurisdiction, and start-up businesses often fail. Confirm whether your director has a support ~~~organization of lorlgstahdirlg,withsUfficieht sUpport infrastructure to cover these contingencies, and if they have colleagues who can be appointed in their place should the need arise. Selecting your director from a director services company can carry distinct advantages in such situations. Factors to consider when selecting a director services company are: how long it has been in business; its reputation; whether it is licensed and regulated in relation to the fund services it provides; whether it is sufficiently capitalized; and can the company supply more than one director if required. Last, but not least - the 'what ifs'? Those of us who live and work in disaster-prone geographies know that 'what ifs' do happen. For example, Hurricane Ivan was a wake-up call to the Cayman Islands and
inevitably tested most, if not all, disaster recovery plans. Ascertain whether a director or directorship services company has a formal and documented disaster recovery plan inplaee;Gonfirmifithasever been put to the test and whether it was a success. The reality is that 'what ifs' do happen, and it is critical to know that a director will be able to continue to serve the fund. 6) Regulatory approval or refusal: Has the individual, or entity by which they are employed, been approved or refused by a regulatory body? An individual, or entity, who is approved and subject to a regulatory body's ongoing scrutiny can offer the reassurance and credibility that they are not only fit and proper, but also familiar with the jurisdiction's legal and regulatory regime. 7) Charges/convictionslinvestigations: Has the individual ever been charged or convicted of an offence or are they currently under investigation? Carefully pick your choice of words, but this question needs to be asked. Adverse events such as fund blow-ups or fraud that generate negative publicity do happen. By itself, it does not mean that a director implicated is incapable or guilty of any wrongdoing. The question is whether it is in the fund's best interests to be associated with any potential headline risk and corresponding reputational risk. Confirm if the candidate has ever been censured, disciplined or criticised by any professional bodies.
IfsO,ascertail1thellhdeflyirig
reasons· and confirm
whether there was a satisfactory resolution. 8) Insurance: Does the director require the fund to hold directors' and officers' liability insurance or does the director carry adequate insurance? Directors' and officers' liability insurance is becoming increasingly necessary given today's litigious environment. Depending on the individual candidate and the specifics of the fund, some directors will require insurance to be provided by the fund. Others will maintain their own policy or have one provided by their company. Still, some will 'roll the dice' and not have coverage at all. Confirmation that insurance coverage is maintained will provide an indication of the financial standing of the individual and organization, as well as provide comfort that they have an understanding of the litigation risks prevalent in today's environment.
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Starting a Hedge Fund 9) Remuneration:
Effective corporate governance is imperative, and some of the recent issues, scenarios and outright collapses as of late should highlight this point. As regulators and investors continuouslyincreasetheir.focusoncorporategovBrnance, the requirement for the appointment of independent directors is becoming more essential. In today's environment, corporate governance is no longer a luxury, but a necessity and, often, a requirement. The days of directors with inherent conflicts of interest or passive (nominee) directors are effectively over.
How much will they charge?
And now on to that ever important question of 'How much?'Althoughareasonablequestion ,.ifit'sthe.only question asked, it is often an indication that there is a lack of awareness of the importance of the role that independent directors play or a lack of commitment to effective corporate governance. Now that the right individual has been found they must be compensated fairly. Remember, the directors oversee the affairs of the fund, and time and effort is required to effectively fulfil their duties. Directors have personal liability, and the penalties associated with a failure in fulfiling their duties will far exceed the fees received from their post. The remuneration of a director needs to be sufficient to attract and equitably compensate high-quality individuals. Remuneration may comprise an annual fee and compensation for time spent, or it may be a fixed annual charge. Out-of-pocket expenses will also be incurred, which may include standard administrative expenses in addition to travel, lodging and other expenses properly incurred attending meetings or in connection with the business of the fund. Whatever the arrangement, be sure to compensate directors fairly. As the saying goes, 'you get what you pay for' . 10) References: Who will vouch for them?
Geoff Ruddick International Management Services Ltd. gruddick@ims.ky 3458142872 Geoff Ruddick is a senior company manager for International Management Services Ltd. (IMS), which specialises in the provision of directors to hedge funds.
Any thorough 'interview' will end with the question of references. You are half-way there if your lawyer or administrator has put in a good word for the candidate: It ·would,however,beprudent··toreceive some positive feedback from clients who utilise the candidate's services or who serve on the board with the individual. Ask for a couple of references and follow through with these.
Conclusion
Looking for an independent director does not have to be an arduous, time-consuming process; however, the decision should not be taken lightly. Your objective is to find a competent individual with a commercial mind set, who will be responsive to the affairs of the fund. A reasonable degree of due diligence should be conducted to satisfy yourself that they have the knowledge, skills, qualifications, experience and time to make a positive contribution to the board. Remember, the directors are accountable for promoting the fund's success by leading and directing its affairs. It is an important decision, so take your time, be thorough and ask questions.
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Chapter Twelve:
Exiting Strategies
All models pre-suppose that one party needs something, money or services, which the other can provide. However, the needs or objectives will be different from the perspective oftheincubatee; whetherfundormanager;andtheineubatoL If this difference in needs is fully appreciated when the arrangement is established, formulating appropriate exit provisions becomes much easier.
Needs and objectives of the incubatee

The objectives of a hedge fund or hedge fund manager seeking to enter into an incubation agreement will typically include one or more of the following: Seed capital: A start-up fund or manager, especially one with no independent track record, will often require some form of seed capital to reach critical mass in order to make the venture viable. In this case the seed capital will often be in the fund (providing an income and, more importantly, a viable showcase to other investors) rather than in the capital of the investment manager, where capital needs are typically low. Seed capital will also be useful for a start-up manager who either does not have the skill or resources required for fund-raising or who is preoccupied with trading his portfolio and does not have the time, skill or inclination for marketing. At a later stage in a fund's or its manager's life, the incubator's access to capital might help shift a fund to a different league, thereby making them more attractive to bigger or more institutional investors. After the track record has been established, the fund has grown to a viable size and/or the manager has developed his own fundrgi§iml?kill.a.nd.re.?ources,the.seed .capital mayno longer be required and the manager may look to exit. Here the exit pre-supposes that the initial need for seed capital has passed and that alternative sources of capital are available (or available on better terms) and to achieve such an exit successfully, the fund or manager has to be able to sever (or at least be prepared to live with) any strings which come attached to the seed capital. Regulatory umbrella: Managers will frequently require some form of regulatory umbrella to work under until the resources are acquired to achieve their own authorization from the Financial Services Authority or other regulator. A manager (at least one sited in a regulated jurisdiction) will also require compliance expertise and personnel and the required level of regulatory capital, all of which are available from many incubators. A successful exit from this type of incubation will be contingent on the manager obtaining its own regulatory cover and, therefore, the manager needs to plan ahead and understand what
Peter Draper and Peter Astleford Dechert LLP, London
Introduction
Incubation suggests transience, a hatching, a 'forced growth' intodomething .bIgger or more advanced .. One vvou lei, therefore, expect parties who enter into such arrangements to be aware at the outset that incubation is just a temporary phase; that it will not last for ever; that sooner or later, there will inevitably be an exit. Remarkably, this is often overlooked. There can be a variety of causes for exit. It may occur through lapse of time if the incubation was for a set period, by formal termination, whether for breach of agreement or relationship breakdown (inter- or intra-party), by desire of one party for whom it becomes too expensive or intrusive to be sustainable, or because it is disrupted by external factors such as a market crash, other liquidity issues, or a takeover (or even insolvency) of one of the parties. This chapter focuses on incubation arrangements for hedge funds and their managers. In the hedge fund investment management world there are many different forms of incubation model and the structure of the model will, ultimately, impact on the exit decision and strategy.
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Exiting Strategies
is required to achieve this (and take account of the necessary lead times).
.•
to the above; any investment management business will require office accommodation, infrastructure and IT services and support, legal, accounting and administrative services and marketing/investor relations functions. Some managers will require assistance with some or all of these infrastructure services, either because they need to develop more critical mass and expertise of their own or because, for whatever reason, they prefer to rely on outsourced provision of certain of these services by third parties. When considering the infrastructure/services element of an incubator model the manager should ask himself whether the services are required to fill a short term need or will they be required longer or even indefinitely. He should examine comparative costs of using the incubator's services, of doing them in-house (both at the outset and later when time and resources permit), and of outsourcing some or all the services to a third party who provides an un-bundled package. In assessing cost, account should be taken of both current and longer-term charges by the incubator (eg, equity shares) or other strings attached for the provision of the services. The result of this analysis will impact how the exit strategy should be dealt with in the arrangement. A successful exit requires advance planning, not only to develop a manager's own infrastructure to satisfy his needs, but also to ensure he retains the freedom or flexibility to pick and choose.
Tracktecotd:The incubatioh arrangemeht gives the manager lead time to build his track record and may also give access to a platform or index. Both of these factors will enable him to enhance his fund's reputation and, thus, hopefully, its size. If his objective in this case is simply to obtain assistance in moving more quickly toward a state of independence, which will be easier once a track record has been created, then to achieve his 'exit' the manager will need to make this record as clearly his 'own' as possible. Will operating on a platform or under the incubator's regulatory umbrella achieve this?
Infrastrueture:+n··add+t+on
'capture' manager talent and/or obtain capacity for the seeder; share a manager's business growth (via a revenue/ pmfitleqHityshareinthe· manager); exploit under-utilised resources (ie, the infrastructure referred to above); develop an incubation service provider business; and pure financial gain. A fund or its manager should carefully review the incubation agreement the incubator provides in order to assess whether it is consistent with the objectives (both expressed and implied) of the incubator in entering the arrangement. For instance, where a fund is being added to an incubator's platform the manager must expect to lose a significant amount of control over his fund structure, the service providers he can use and his own 'brand'. 8y contrast, where an incubator is endeavouring to attract talented portfolio managers in return for seed capital, the manager's bargaining position will be enhanced. He will, nonetheless, likely be required to provide the incubator with a significant level of transparency over his portfolio trades, may need to assume some netting risk and, thus, possibly, earn reduced performance fees and, where he is operating within the incubator's regulatory authorization, will have to observe the incubator's own compliance regime.
Fees and costs

A crucial element in both entering and exiting an incubator model are the fees and costs involved. The manager will pay a price and the incubator earns a reward for incubation. Incubation services may be provided in exchange for: a flat or scaled fee; a share of the manager's revenues; a share of the manager's profits; a reduction in management and performance fees payable to the fund or the manager on seed capital; an equity share (or phantom equity) in the manager; or a combination of the above. The fee structure of the incubation arrangement will impact the method, cost and timing of an exit. Incubation arrangements typically provide for ongoing payments to the incubator after the provision of one or more incubation services has ceased. Revenue-based fee deals will often require payments calculated on revenues from all a manager's funds, not just funds which received seed capital. In profit or equity share deals, the manager should expect to have constraints imposed upon his ability to reduce profits by manipulating expenses or staff bonuses, and establishing or diverting profits or revenues to other entities.
Needs and objectives of the incubator

The objectives of an incubator seeking to incubate a fund or a manager will also vary, but will generally include one or more of the following: add funds or strategies to its existing platform; earn an enhanced investment return by making seed investments;
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Exiting Strategies
If the manager wishes, one day, to exit the incubation smoothly, he will need to plan how and provide a mechanism at inception to extricate himself from these restrictions or 'strings'.
Planning for exit

The key to a successful exit, from both the point of view of the incubator and the manager, is to be clear about your principal objective( s) for entering the incubator arrangement and to gear your agreement accordingly. In addition, the manager must ensure that he develops the necessary track record, regulatory cover, assets under management and resources needed to break away. Once this has been achieved, then exit becomes a matter of timing and cost. Whether a user or provider of incubation services, these keys should help ensure value is not jeopardized on exit.
Had the manager sought advice before entering the agreement, he should have been told that the standard fund offering memorandum provided by the incubator was not really appropriate for .afundwitb.an.event-driven ..nvesnnent i strategy that was as illiquid as his, and this could cause problems if the market moves against the strategy and large redemption requests are tendered just before a key investment is due to mature. Furthermore, the restrictive agreement terms would really bite, just when the manager needed the flexibility to manage his way out of difficulties. Even if he then has the reputation to attract replacement investors, he will not be able to offer the fee inducements they will probably seek, as he still has to pay the incubator's revenue share. He would not even be able to close down and start a new business or team up with another partner to avoid the agreement's restrictions, unless (when his bargaining position is at its weakest) he can negotiate satisfactory exit terms with his incubator. Matters could be worse still if the adverse market movements put him in breach of the additional investment restrictions, or if the faces or internal politics at the incubator have changed since inception of the arrangement. Careful scrutiny of all elements of the relevant arrangements is necessary and professional advice on their effect is desirable before they are entered into. Many of the terms of the incubation agreement may be superfluous to the incubator's principal needs and might be negotiated away if addressed at outset. In addition, negotiating a call option to buyout the incubator's revenue share could at least provide the flexibility to 'exit' in this case.
Case studies
Two real life examples may make the point more clearly.
Example one
Imagine a young manager with resources to establish his own small hedge fund management business, but who also has a need for seed capital and assistance with marketing. He does not have a limitless legal budget, so relies on the incubator's experience of fund and manager structuring. The incubator is an established player who uses a detailed .anet-oontrolling seeding agreement, withterms accumulated from years of experience. Key terms include: a revenue share in respect of all the manager's and his associates' and all his fellow manager's and their associates' fund management activities, running for seven years from the launch of each fund; • a veto on any involvement with new funds or managed accounts for three years or until assets under management reach $2 billion; a veto on the manager's ability to share profits with new partners; • serious and non-compete and non-solicit covenants;
Example two
BycOhfr'asf, howirnagihEflw6 rnanagers, (both ex-blq
institution) who want to 'run their own shop', but require the provision of premises, equipment and back-office services for at least five years. They identify an incubator who has under-utilized infrastructure resources which it is using to build an incubation service business. The incubator asks for a profit share for so long as services are provided, but with a five year minimum and a share of the managers' equity to reflect the incubator's contribution to growing the business. The incubator's main reason for wanting equity is to keep the manager honest and not to be short-changed on its share of profit, if the managers sell out. In this case, the managers do seek professional advice and are told that a flat fee might be more appropriate, because if the business grows successfully a revenue-based or profit share deal could become very expensive for provision of what are, essentially, 'hotel' services. The managers feel that a profit share will be cheaper for them in the short to medium term, so decide to proceed regardless. However, they do this having considered the implications and do take on board the further advice which is given. They, therefore,
heavy investment restrictions in addition to those contained in the fund's offering memorandum.
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Exiting Strategies
negotiate a right to terminate the services at any time by payment of a multiple, reducing overtime and as the business grows, of the incubatee's profit share. This is based on the ii1c;ubatElEl'sh ist()ric;.al1nLl§li2:eq. pr()fit .sh§rEl's() §stClProviclEl more certainty and lead time in planning any exit. They do grant the incubator its desired equity interest, but using a shareholder's agreement, they limit its rights to interfere in the management of their business and agree a call option to re-purchase it if they terminate the services agreement, so that, in effect, the equity interest becomes no more than security for the profit share buy-out amount. It remains to be seen whether their decision to pay away a profit share was good or bad, but at least they did it knowingly.
Forward planning
The above examples demonstrate the importance offorward planning. Before entering into an incubation arrangement both parties should: identify the most vital benefits to be gained from the incubation and those less important where concessions can be made; undertake due diligence on each other - there is plenty of choice, for both sides, so one can afford to be choosy; always plan in advance for the exit contingency and structure accordingly - even if one intends remaining in incubation indefinitely, surprises happen; • do not promise what cannot be delivered and be adaptable to cater for changed circumstances; and ensure the link between services and price preserved when one or the other terminates. If this process is adopted, a smoother 'exit' should follow. This chapter is based on a talk presented by Peter D. Astleford to the 2007 Hedge Fund Incubation and Seeding Conference in London. Peter Draper Dechert LLP peter.draper@dechert.com is
44207 1847614
Peter Astleford Dechert LLP peter.astleford@dechert.com
44 20 7184 7860
76
Chapter Thirteen:
World's Unions Debate: Are Hedge Funds 'Locusts' or 'Termites'?

Christopher Holt AIIAboutAlpha.com,
We're obviously biased toward private equity and hedge funds atAIIAboutAlpha.com. But we're also sensitive to their impact on other stakeholders. Private equity, by its very nature, will ·alwaysbe ·aIUg=of=watbvereconomicoutpulbetween the owners of capital and other stakeholders (employees, suppliers, neighbours, NGOs etc.) Given the massive and sudden growth in private equity and hedge funds, there is no doubt that these issues will need to be addressed sooner rather than later. In fact, we know of various multi-lateral initiatives tackling these problems right now. However, while this report attempts to make an important contribution to the global debate, it makes excessive use of fallacies and half-truths that reveal a populist anger over bigger issues of economic inequality. The resulting potpourri of socio-economic beefs does little to advance a rational dialogue on the role of hedge funds and private equity funds. Before cracking the cover, we took a wild guess that the ITUC wasn't crazy about alternative investments. And since many of you may not be crazy about unions (or reading the report's dense 52 pages), we distilled a few of the more colourful claims below. The ITUC's overall feelings about hedge funds and private equity can be summed up in the following excerpt from the report: In what now appears as the early days of the leveraged buyout boom, private equity and hedge funds were compared to a swarm of locusts. More recently, it has been remarked by some that is an insult to the locusts: the protagonists of financigli??tiQrJ .are. more like termites. They teeve nothing behind to yield new crops, but destroy everything on their way. Whether termites or locusts, such comparisons are a clear call for revamping regulation. That call will be echoed in the last chapter of this report. The report claims that the primary objective of a hedge fund is actually quite simple: ... hedge funds are basically investors that try to make a quick buck by speculating in everything possible. And the reason for taking a company private is not to increase its value, but to avoid Sarbanes-Oxley: .. .fund managers and corporate executives are increasingly eager to take companies from public to private because by doing so they escape the growing number of reporting requirements and corporate governance regulations that followed in the wake of the Enron and WorldCom scandals. Hence, going private really means increasing the privacy of your business.
Toronto
Please note that this chapter is an opinion piece, and has been included to reveal some of the controversial and thought-provoking ideas that exist within the Canadian, and globaf;hedge· fund industry. AIIAboutAlpha's Christopher Holt argues that recent kneejerk calls to eradicate hedge fund 'locusts' are like spraying toxic pesticide on global capital markets - well-intentioned, but sure to produce unintended consequences. Recently, hedge funds have been tacitly accused of putting the global financial system at risk. But in a curious twist, the UN released a report on 21 June 2007 that raises the 'global capital flows' warning flag not on hedge funds (per se), but on pension plans. Yes, pensions. Working men and women of the world, it is you, not the hedge fund managers who are the real problem in today's Wild West of global capital flows. We stumbled across this report (released mid-June) by the Brussels-based International Trade Union Confederation (ITUC), which responds to the potential global financial calamity that might be caused by the seemingly benign pension fund community. The report is called Where the House Always Wins: Private Equity, Hedge Funds and The New Casino Capitalism. To access the report in its entirety, go to www.ituc-csi.orgIlMG/pdfIlTUC_casino.EN.pdf.
77

The report seems downright schizophrenic on several issues. Firstly, it attacks hedge funds for obsessing about short-term results (eg, 'a quick buck'). The life of a fund is typically up to ten years, in which the limited partners have committed their capital and are unable to retrieve it. But then it sides with investors as it complains that private equity funds have extended lock-ups: Furthermore, they (pensions) and their trustees should be aware of and consider carefully the consequences of the non-liquid nature of these investments ... the inefficient nature of private equity markets ... of the irregular cash flow characteristics that such investments have ... The report goes on to say that investments in private equity will force pensions to take an active role when they should actually remain 'neutral': Investing in hedge funds and private equity may, furthermore, be against the interests and principles of pension funds because it can get them involved in setting individual company policies, hence taking them out of the sphere of making neutral investments. But in its ensuing list of recommendations, the report suggests that pension plans should indeed get involved in setting individual company policy: If pension funds do invest in hedge funds, they should take their shareholder responsibilities seriously by attending shareholder meetings, making their voice heard and ensuring -""""----"-"~-=thl1t·th~··forrd·actsit'f·acc6rdance· Wifh···thepriiiCij51es·ofthe pension fund in all its dealings with companies. The report also seems to ignore basic principles of company valuation when it says that private equity firms only care about the short-term profitability of their investments: ... the long-term profitability and value are not the main aim of the buy-out and the firm behind it: that is the returns that can be generated for the fund during the years that it holds the company. The report seems to ignore that fact that the investment return for the fund will be based on the exit price and that the exit price is determined by the present value of future profits, not simply current earnings. So private equity funds are actually very focused on proving to the investment community that the firm will be profitable in the long term. ITUC makes liberal use of a tired, decade-old case study (Long-Term Capital Management) to prove the systemic
dangers of hedge funds. But in case that doesn't scare the reader enough, it also conjures up a more recent example -Amaranth - proving nothing more than the fact that good case studies comes along every nine years; ... the American fund Long-Term Capital Management (LTCM) crashed in 1998. Its investors and creditors were only rescued by a bail-out from the US Federal Reserve. In 2006, the hedge fund Amaranth similarly went into liquidation. A pension fund of employees in San Diego reportedly lost US$105 million on this. The report is conspicuously silent on how much San Diego lost on US large-cap stocks in, for example, 2002. Naturally, the report includes a popular claim that hedge funds are over-levered: With general leverage levels of four to five - ie, meaning that the funds can borrow money to a value of four to five times the value of the actual money they have raised ... You may recall that Bridgewater Associates recently raised concerns about the hedge fund industry and the amount of leverage being applied today in order to get returns to a point where they become attractive. The chart at the top of the next page from Bridgewater illustrates this. Apparently prime brokerages started giving away money to everybody sometime in Q4, 2003. But, note that leverage was routinely around 200% until 2001. And according to this chart it's now back at around 200% (not 500%). The ITUC report cites a New York Federal Reserve report as evidence·of{dahgerousIY)highcor+elafionhetwee!1varfOus hedge fund strategies. In fact, the report actually pointed to low volatility, not high co-movement, as the reason for this statistical phenomenon. The New York report is available at www.allaboutalpha.com/blog/2007/05/06/what-that-fedreport-actually-said/. In their description of private equity, the authors of the ITUC report attempt to raise the alarm over the motivations of private equity funds, but actually end up making cogent arguments in favour of private equity: ... private equity firms generally go for targets that have under-geared balance sheets and space for taking on debt, so that the company can hold the leverage needed to finance both the takeover and recapitalizations for dividend payouts. Moreover, fund managers look for poorly performing companies that are cheaper than their peers, that seem easy to improve, or where there are possible synergy effects to be gained by matching them with companies already in the fund's portfolio.
I
\
i
78

_- _ All FlltlflS: Tcllill M!ie5 (flinS $) _
All FWUlS To1a1 E:.posure (Mselsx
Leverage
filM $)
1500
50::'
()
114
95
9B
97
sa
= =.
ss
00 0)
fl}
'J3
04
05
r.t'l
'Poorly performing companies' ... 'easy-to-improve' ... 'synergy' ... ? One needn't be a later-day Gordon Gekko to appreciate the opportunity to improve poorly performing companies. The report seems to suggest that 'so-called alpha' is also something nefarious. But in doing so, it ends up making a point we have often made at AIiAboutAlpha.com: When public equity markets are in a downturn, these funds tend to outperform them. This is because their strategy is based on making so-called 'alpha' returns that are not baselii,on average marketperformance, Butwhen thepub/ic markets are rising, hedge funds find it much more difficult to stand out. Hence, in the last four years investors would have been better off investing in the equity market in long-term positions than investing in hedge funds. Later in the report, the authors hold this up as a central reason to avoid hedge funds. (... and, by extension, plow all of their money into equity markets, we ask?) But no anti-hedge fund report is complete without making a case that hedge funds are excessively volatile The claim in this report is relatively weak compared to most: ... private equity and hedge funds are generally associated with higher levels of risks than most investments ... Yes. Private equity and hedge funds are 'generally associated' with higher levels of risk - thanks to self-reinforcing nature of reports like this one. But compare the standard deviations
of HFRllndex with the S&P 500 and it becomes clear which one has proven its risk. (Hint: it starts with an'S' and ends with a 'P'). Apparently realizing that pension committees are likely to take the report's over-the-top arguments with a healthy grain of salt, the ITUC throws a Hail Mary pass by suggesting the returns of private equity and hedge funds stink anyway. Private equity companies generally aim at, indeed promise, returns of above 20% per year. They often fail to meet these aims. Don't believe the hype ... private equity has underperformed during the last decades while hedge funds have done so for the last couple of years or more. We're no experts on private equity (although we are aware of academic research which suggests there is some manager return persistence in the private equity world). But the report's conclusion that pensions should invest in, say, public equities because hedge funds have under-performed the S&P for a few years is like saying they should invest in growth funds, since value has underperformed for the past few years. This amounts to blatant return-chasing. Furthermore, investors also expect hedge funds to outperform the markets - if they did not do so, there would be no reason to invest in these funds. But for the last four years, as already noted, it is hedge funds that have been out-performed by the equity markets. So the pressure is on hedge funds to deliver.
79
World.s Unions Debate: Are Hedge Funds 'Locusts' or 'Termites'?

The ITUC is perfectly within its right (some might even say responsibility) to put forth the countervailing arguments against relatively unconstrained global capital markets. But
the. reality isthatifhedgeJundsandpril,late.equityJunds.are

'locusts', then ill-considered, knee-jerk government reactions to thern is analogous to spraying pesticides to fix the problem. They are a blunt instrument, developed with the best intentions, but whose toxicity may easily lead to dangerous and unintended consequences down the line. So while this report recommends liberal spraying of Roundup, the best solution is to understand the root causes of this alleged 'locust' problem - taking a holistic approach to addressing the growing dissonance between private equity and hedge funds and other important stakeholders.
Christopher Holt AIiAboutAlpha.com chris@allaboutalpha.com
416572 2127
80
on the downside and, theoretically, infinite on the upside. Conversely, selling equities short, theoretically, has unlimited risk."
Chapter Fourteen:
Long/Short Equity Strategy
Colin Stewart and Keith Tomlinson AlMA Canada, Toronto
The components of equity returns include the dividend (if any), the dividend's growth and the change in the share price, which depends on the market's valuation of a company's future cash flows (typically, revenues, earnings and dividends). This valuation or cash flow multiple and how it changes, has been a primary equity return driver over the past 50 years. Prevailing interest rates and the risk premium demanded by shareholders also have a strong influence on equity valuations. Further, a company's management effectiveness is a key determinant of fundamental equity returns and also has an indirect influence on valuations. Activist long/short equity managers often try to use their influence to enact management changes to generate returns for shareholders. Activist managers may also work with existing management teams to enhance shareholder value. Each of the return components, together with a company's management effectiveness, provide long/short equity managers with fundamental factors to evaluate. These factors help to determine the appropriate long and short equity positions. The respective long and short positions are also a function of market volatility, where long positions with high betas require more offsetting capital on the short side (ie, on an absolute dollar basis). Long/short equity funds generally use fundamental analysis and discretionary trading, and may also use technical analysis. There are also modeldriven variants with systematic trading, such as statistical arbitrage, which is a component of equity market-neutral, as this. strcategy typicaUyhasno net.market.exposure.3 The steps in a traditional long/short equity strategy are as follows:
A long/short equity strategy shifts the principal risk from market risk to manager risk based on the premise that skilled stock selection drives positive returns.
What is long/short equity?

The long/short equity strategy is rooted in the classic Jones Model, which combines three strategies - long equities, short equities and modest leverage to generate optimal riskadjusted returns. This model is based on the premise that skilled stock selection drives positive returns. A long/short equity strategy, therefore, shifts the principal risk from market risk to manager risk. According to Hedge Fund Research Inc. (HFRI), long/short equity (also referred to as hedged equity) is currently the largest strategy with approximately 30% of US$1 trillion in hedge fund assets.'
1. Screen and identify
undervaluedlovervalued stocks: Long/short equity managers look for fundamentally or technically mis-priced stocks. Trading ideas are generated through fundamental research, quantitative screening methods and the hedge fund manager's networks and contacts. The idea generation process is an important consideration for investors.
What are the nuts and bolts of long/short equity?

Long/short equity is a versatile strategy given the size, depth and liquidity of global equity markets and the ease and transparency of public equity pricing. In a company's capital structure, the shareholders have a residual claim on the assets after creditors and risk losing all of their capital. The range of outcomes for shareholders is, therefore, zero
2. Select appropriate stocks: This process generally involves fundamental analysis of a particular stock, including industry analysis, review of historical financial information, forecasting future financial results, valuation analysis and company management interviews. Fundamental field work, including company visits and customer and employee interviews, is often more effective in less developed or under-researched markets. 81

The specific approach used by a long/short equity manager generally determines the fund's sources of return. While approa<;hE3s..o.l()nglshort.eq t uityyary ."videly, .... rnCjnagers can be categorized by one or more of the factors in Table 1 below. A manager's approach to market exposure defines the market hedge (ie, the total long and short positions, and the net market exposure). There are generally two approaches: 1. Bottom-up stock selection: The net market exposure is a residual of bottom-up fundamental stock selection. Little attempt is made to target or manage the specific market exposure and the resulting portfolio volatility. Gross and net portfolio exposures are driven purely by stock selection. 2. Top-down net market exposure: The manager may make top-down decisions concerning sector and net market exposure in place of, or in addition to, bottomup stock selection. In effect, stock selection, sector allocation, and gross and net market exposures are actively traded and managed. Investors should ensure that the strategy's return attribution matches the fund's stated approach to market exposure. While an active trading strategy should deliver superior riskadjusted returns, return attribution can be difficult to measure. Similarly, a strictly bottom-up, fundamental approach may generate more volatile returns. Investors must understand whether this approach is statistical 'noise' or, in a drawdown, a permanent capital loss. Managers may combine a 'core and satellite' approach to market exposure by holding a 'core' portfolio of fundamentally researched positions and also maintain a trading book
3. Weight portfolio positions and execute trades: In general, the manager uses a combination of fundamental and technicai factors to select stocks, siZe the pOsiti6ns and execute the trades. The trading function is also a major risk management function, especially with defined trading rules such as stop-loss limits. Trading is a key tool to maintain appropriate position weights, to manage risk and to take advantage of short-term opportunities. 4. Build portfolio with appropriate long/short ratio: The manager establishes the appropriate amount of long, short and gross market exposure, as well as the net market exposure, which may be as a residual of stock selection or deliberately managed using options and/or futures. Managing the 'short book' is a key determinant of the portfolio's performance. Managers who have high net market exposure typically use modest or no leverage, while managers who have low net market exposure tend to have higher gross market exposure and may use leverage.' 5. Manage portfolio risk: The dynamics of the long and short equity books differ in that short positions increase when they go against the manager and, theoretically, have unlimited risk. Therefore, managing the short book is a primary risk consideration. Further, the manager must manage the portfolio's long, short, gross and net exposures on both a company and sector basis, within the limits set out in the fund's offering memorandum. Long/short equity managers use trading, underlying company due diligence, and strict portfolio exposure limits to appropriately managerisk.acrosstheirportfoJios. (NQte:.. Vediscuss V .. the specific risks of a long/short equity strategy in detail below.) What are the different approaches to long/short equity?
Table 1: Key factors Style Market capitalization • Small • Mid • Large Geographic
of a long/short
equity strategy Sector Philosophy
Market exposure • Net Short • Neutral • Net Long
• Value • Growth • Momentum
US Japan Europe Canada Emerging markets • Asia • Global
• • • • •
• Specialist • Generalist
• • • • •
Trading Thematic Activist Combination Fundamental
82
Starting a
Long/Short Equity Strategy Hedge Fund - a Canadian Perspective

sector exposure, net market exposure, gross market exposure, and significant differences in stock selection. A. managElL mel)' make poor judgments regarding anyone of these· variables. As a result, assessing manager skill and style is essential when evaluating a long/short equity strategy. (Note: manager risk also includes the firm's operational risk.)
of 'satellite' positions. Managers typically have a core competency and should maintain this approach through v§riQLls.rnarketc;()llclitions.lt lTl§ybeavv§flling sign of style drift if a significant amount of a manager's attribution is generated from a non-core style (eg, a fundamental bottomup manager generates significant returns from macro calls on equity market direction rather than from stock selection). Short-selling skill is the crucial component of all long/short equity approaches. This skill enables managers to capitalize on corporate events, earnings announcements, regulatory changes, mergers and acquisitions, as well as buyouts. Short-selling stocks has a myriad of complexities and is not simply the opposite of executing long positions. Special considerations include: potentially unlimited losses, declining returns as positions become profitable, borrowing securities and short squeezes. At the portfolio level, the short book provides a crucial market hedge. Investors should look for strong short-selling experience and results, together with a sound risk management process in a long/short equity strategy.
2. Market risk (beta risk): Long/short equity managers do not typically manage a market-neutral portfolio and are, therefore, exposed to a certain degree of market exposure (long or short), depending on the portfolio's net exposure at a given time. This exposure also varies depending on the long equity portfolio's beta, relative to the short equity portfolio's beta. Long/short equity managers often measure the beta-adjusted net exposure to help gauge the level of market risk. 3. Leverage: Long/short equity managers may borrow funds to magnify returns and to allow a larger amount of capital to be invested in a given set of positions. While this leverage risk is somewhat mitigated by the fact that a manager has reduced market exposure with offsetting long and short positions, leverage can result in significant losses if not used prudently. 4. Liquidity: The manager's ability to enter/exit a position with minimal market impact directly affects profitability. This risk can be magnified if a manager provides fund investors with generous liquidity terms and receives significant redemptions offund assets in a short period. The liquidity of a manager's underlying securitiescan .. lso impact friction .or trading costs and a affect net returns. 5. Stock loan: An effective short stock sale depends on a manager's ability to secure and maintain a costeffective borrow on the short stock positions. Short positions in stocks with high levels of short interest may be difficult to maintain, and even if secured, can be costly to borrow. If a stock loan is 'called-in' at an inopportune time, it could adversely affect the trade's profitability. 6. Counterparty risk: As with any hedge fund strategy, high quality global service providers are essential. For a long/short equity strategy, an effective prime broker well suited to the manager's particular market helps to ensure sound trade execution and secure stock loan. Using a large and well-capitalized prime broker assists a long/short equity manager in minimizing counterparty risk.
What are the sources of return of long/short equity?

The sources of return for a long/short equity strategy are diverse, and the contribution from leverage is generally modest relative to other strategies. Figure 1, on the following page, provides an overview of the typical return sources for a long/short equity strategy. (The sources of return in Figure 1 can be cross-referenced with the respective explanations included. The numbers in Figure 1 are based on the long/ short equity example in Table 3.) The proportion of a long/short equity fund's return from each of the different sources varies widely depending on the manager's style, whether long-biased, short-biased, growthoriented, value-oriented and based on other characteristics by geography or sector. For example, a long-biased fund would attribute less of its return from gains/losses on short positions and short rebates. Certain sector-focused or growth-oriented funds may hold largely non-dividend paying stocks. In general, a significant number of longlshort equity funds would typically generate a significant proportion of returns from long positions.
What are the key risk factors of long/short equity?

The following strategy: are the key risks of a long/short equity
1. Manager risk: Long/short equity managers use a broad array of sub-strategies and variations in style, including differences in position concentration,
83

attribution (no leverage used)
2:;%
Figure 1: Example of equity.long/short.return
13.3%
-0.2%
.0.6%
-0. 6%
0%
Long Returns +
Short Returns
Dividend Income
Interest Ca~h
SI.OIt Rehal e
CO" of Shares
Dividend
Margin -()).;t';(OIlShort)
(,,,,,t
of
+Eamed OIl +Intere.,:t-
Borrowing - Payment
Leverage
(nil Long)
Total Return
Notes on figure
1:
The return attribution for a long/short equity portfolio has been simplified to highlight the key concepts. The portfolio is $1 long and $0.75 short, resulting in gross market exposure of 175% and net market exposure of 25%. Note: No leverage is used on the long side in the example. The volatility of this type of long/short equity portfolio is typically lower than that of a long-only equity portfolio. Returns generated on long positions + short positions: Capital gainsllosses, either realized or unrealized, that are generated on long and short positions in various equity securities (ie, equities, options, warrants, etc). Returns are affected by growth in company earnings, cash flow and valuation contraction or expansion.
+ Dividend
income (on long positions):
Dividend income earned on long equity positions.
+ Interest earned on cash: Interest is earned on excess cash balances, typically when a manager has low gross market exposure and holds a cash balance rather than using leverage (eg, a long exposure of $0.55 and a short exposure of $0,30 results in net market exposure of $025, gross market exposure of $0,85; and a cash balance of $0.15).
+ Short interest rebate: A short stock sale is typically executed with the following steps: borrow shares, sell shares short, receive cash in return for stock sale, earn interest on cash proceeds from short sale (ie, the short rebate), buy back shares and return shares to the stock lender. The rebate varies depending on prevailing market interest rates (ie, typically the broker 'call rate,' which is the prime rate minus 50-75 bps). Cost of borrowing shares: When a short stock sale is executed, a long/short equity fund must borrow shares to facilitate the transaction. The fund typically pays the stock lender a nominal rate based on the total value of the shares borrowed and the period of the stock loan. The available supply of a particular stock impacts the borrowing cost with tightly held, illiquid stocks often commanding a premium borrow rate. Dividend payment (on short positions): When a long/short equity fund holds a short position in a dividend-paying stock, that fund must pay the stock lender the value of any dividends that would have been received on the shares. Margin costs (on short): by jurisdiction.) Costs associated with shorting stocks. (Note that the general cost of margin loans often differs
Cost of leverage (on long): If the fund manager uses leverage to increase long positions beyond $1, the fund must pay interest on the loan to its prime broker. 5 (Note: No leverage has been used on the long side in this trade example.) The total return would depend on the amount and cost of leverage employed.
=
84
Total return (ie, gross return before fees)

Starting a Hedge Fund The historical equity
of long/short
7. Security and sector risk: Security-specific risk can impact a long/short equity manager if adverse and unexpected developments arise in a company. Sighificanllbngol'shortexpbsoretoa particular sector or sub-sector can also magnify the risk level of a particular long/short equity strategy.
performance
8. Currency
risk: Buying and selling stocks in multiple countries creates currency risk for a long/short equity fund. The cost of hedging, or not hedging, can significantly affect the fund's return. risk: Geopolitical events can result in higher market and currency risk. This event risk is a key risk for all investments.
As Table 2 highlights, a long/short equity strategy, measured by the HFRI Equity Hedge Index, produced stable and attractive returns from January 1990 to December 2005. The long/short equity returns compare favourably with long-only equity returns. With higher returns and lower volatility (ie, standard deviation), an equity long/short strategy generated a superior Sharpe Ratio to traditional long-only equity.
9. Macro and geopolitical
Table 2: Equity longlshort
performance
comparison
(January
1990 to December 2005)
Index
Annualized compound return 17.3% 11.5% 8.6% 10.9%
Annualized standard deviation 8.8% 14.0% 13.6% 14.7%
Maximum drawdown (loss) -10.3% -44.7% -46.8% -43.2%
t-month maximum gain 10.9% 11.4% 10.5% 11.9%
t-month maximum loss -7.7% -14.5% -13.4% -20.2%
HFRI Equity Hedge Index (US$) S&P 500 Total Return Index (US$) MSCI World Index (US$) S&¥tTSX(Toronto) (in Cdn $)
Sources: TO Securities Inc. and Hedge Fund Research Inc. (Hedge fund data is net of all fees.)
85

What is a practical example of a long/short equity trade?

Table 3 below summarizes a hypothetical long/short equity pairs trade. Background to the trade: The trade involves a long position of $1,000,000 in Retail Co. A with a beta of 1, and a short position of $750,000 in Retail Co. B with a beta of 1.5, assuming $1,000,000 of capital. Retail Co. A's dividend yield is 1%, while Retail Co. B's dividend yield is 0.8%. It is assumed that the manager holds the positions for one year. It is assumed that margin costs are 2.5% p.a. Table 3: Example of long/short equity trade
I. Determining Exit proceeds $1,200,000
total return
Return source Long position: Retail Co. A
Cost base $1,000,000
Return ($) $200,000
Assumptions/Notes 100,000 shares purchased @ $10/sh.; Beta = 1.0 75,000 shares shorted @ $10/sh.; Beta = 1.5 Dividend yield of 1% on Retail Co. A No excess cash Rate of 1.5% earned on short proceeds of $750,000 Rate of 0.25% paid on initial stock loan with a borrow value of $750,000 Dividend yi' of 0.8% on Retail Co. B
Short position: Retail Co. B
($750,000)
($825,000)
($75,000)
Dividend income (on long position) Interest earned on cash Short rebate (on short position)
$10,000 $0 $11,250
Cost of borrowing shares
($1,875)
Dividend payment (on short position) Margin costs (on short position)
($6,000) ($5,625)
$1,000,000 capital; Long cost = ($1,000,000); Short cost = margin of $225,000@2.5%, which is calculated as follows: ($975,000)6 + $750,000 proceeds = ($225,000); Net margin used = ($1,000,000) + ($225,000) + $1,000,000 in capital = ($225,000) in margin @ 2.5% rate Note on leverage: No leverage has been used on the long side of this trade.
Cost of leverage (on long position)
$132,750 13.3%
Total return % Return
$132,750Ilnitial
capital of $1 ,000,000
86

Table 3: Example of long/short
equity trade (continued)
I1:Assessiifgnelexifosiiffi Details At trade inception 100.0% -75.0% 25.0% 175.0% -12.5% At trade exit 120.0% -82.5% 37.5% 202.5% -3.75% Notes Note on beta-adjusted net exposure: Trade inception: (long exposure of 100%X beta of 1) + (short exposure of75% X beta of 1.5) = (100% - 112.5%) = -12.5% Trade exit: (long exposure of 120% X beta of 1) + (short exposure of 82.5% X beta of 1.5) = (120% - 123.75%) = -3.75%
Long exposure Short exposure Net exposure Gross exposure Beta-adjusted net exposure
III. Analyzing return sources (cross-reference Return source Long position: Retail Co. A Short position: Retail Co. B Dividend income (on long) Interest earned on cash Short rebate Cost of borrowing shares Dividend payment (on short) Margin costs (on short) Cost of leverage (on long) Total return
to Figure 1)
Contribution 20.0% -7.5% 1.0% 0.0% 1.13% -0.19% -0.60% -0.56% 0.0% 13.3%
Conclusion
The long/short equity strategy is the most diverse of all hedge fund strategies. The significant size, depth and liquidity of global equity markets has cultivated a broad array of sub-strategies within the long/short equity group. Long/short equity remains the most prevalent of all hedge fund strategies with more than US$300 billion in assets. The strategy focuses on exploiting manager skill while mitigating market risk. Long/short equity managers use a variety of approaches across key factors, such as style, market capitalization, geography, market exposure, sector and philosophy. Due to the diversity of long/short equity strategies, investors must carefully assess a manager's skill and risk management process. Short selling skill is particularly important, as it differentiates long/short equity from a traditional long-only equity strategy. With the continued growth of global equity markets, long/short equity will likely remain one of the largest and most diverse hedge fund strategies available to investors.
Endnotes:
1.
Source: Hedge Fund Research Inc., September 2005. AlMA Canada's paper, An Overview of Short Stock Selling, summarizes the mechanics of selling stocks short. AlMA Canada's paper Equity Market-Neutral Strategy provides a detailed discussion of this strategy.
I·
2.
3.
87

Canadian
Perspective
4.
In a long/short equity portfolio, the gross market exposure may range from less than 100% (eg, $0.60 long exposure + $0.30 short exposure = $0.90 of gmss···market·exposure,·with ···netmar.ketexposure of $0.30; this portfolio is deemed to use no leverage on the long side) to more than 200% (eg, $1.30 long exposure + $0.80 short exposure = $2.10 of gross market exposure, with net market exposure of $0.50; this portfolio uses leverage of $0.30 on the long side). AlMA Canada's paper An Overview of Leverage summarizes the key definitions and types of leverage used in the different hedge fund strategies. AlMA Canada's paper, The Role of a Prime Broker, provides an overview of the general prime brokerage functions. The 130% short margin is based on the prime broker's margin requirement (ie, $750,000 X 130% short margin = ($975,000)).
Short (interest) rebate: a portion of the interest in aT-bill account earned by a hedge fund from shorting a security. When selling a stock short, a hedge fund borrows the stockfromaprime ... broker.(who.bor~owsjtJroman.existing shareholder) and the short sale proceeds are typically held in a T-bill account as collateral with the prime broker. Much of the T-bill interest is then rebated to the hedge fund. (Note: the hedge fund must pay dividends to the original shareholder. ) Short-selling stock: borrowing shares to sell in the open market with the goal of buying these shares back at lower prices in the future, and at that time return the shares to the lender. Style drift: the tendency of hedge fund managers to deviate from their stated investment style or strategy over time. Survivorship bias: tendency for failed hedge funds (that no longer exist or no longer report to data providers) to be excluded from historical performance analysis. Survivorship bias causes the results of hedge fund analysis to skew higher, because the analysis only includes funds that are successful enough to survive to the end of the analysis period. Technical analysis: a method of forecasting security prices and market direction by examining patterns of variables such as trading volume, price changes, rates of change, and changes in trading volume, without regard to underlying fundamental market factors. Volatility: the degree of price fluctuation for a given asset, rate, or index. The variability of investment returns is one form of investment risk and is measured by the standard deviation oHhereturns.
5.
6.
Glossary of key terms

Beta-adjusted net exposure: (beta of long positions x long position weighting) - (beta of short positions x short position weighting). Gross market exposure: long exposure + (absolute value of) short exposure. Long/short positions. ratio: total long positions relative to short
Net market exposure: long exposure - short exposure Prime broker: refers to a broker offering professional services specifically aimed at hedge funds and other large institutional clients. The prime broker clears the trades, custodies the securities, provides margin financing, lends stock to cover short sales, and provides cash and position reports. When a hedge fund designates a prime broker, it instructs all executing brokers to settle its trades for cash with a single firm. After the fund executes a trade, it reports the details to its prime broker. Sharpe Ratio: a ratio based on the first two moments of the return distribution (ie, the mean and the variance), calculated as the ratio of the mean return minus the risk-free rate (excess return) to the standard deviation. The higher the Sharpe Ratio, the more favourable the risk/reward trade-off. Short interest: short position in a particular percentage of the total shares outstanding. stock as a
Notes to AlMA strategy paper series:

Educational materials: this document is designed solely for information and educational purposes. The examples used have generally been simplified in order to convey the key concepts of the hedge fund trading strategy. Hedge fund strategy performance data: the statistical data on the hedge fund strategy presented in this paper is both end-date sensitive and period sensitive. We have used the period and end date in this paper, as it reflects the overall performance of the hedge fund strategy for the longest period to date (at the time of writing), based on available data from Hedge Fund Research Inc. (HFRI). Different periods and end dates may result in different conclusions.
88
Starting a
Long/Short Equity Strategy Hedge Fund - a Canadian Perspective
Past and future performance: past performance is not necessarily indicative of future results. Certain information contained herein has been obtained from third··parties, ·Whijesucl"iinformationis··believedtobe reliable, AlMA Canada assumes no responsibility for such information. Disclaimer: none of AlMA, AlMA Canada, its officers, employees or agents make any representation or warranty, express or implied, as to the adequacy, completeness or correctness of this strategy paper. No liability whatsoever is accepted by AlMA or AlMA Canada, its officers, employees or agents for any loss arising from any use of this strategy paper, or otherwise arising in connection with the issues addressed in this strategy paper.
Colin Stewart JCClark cstewart@jcclark.com
4163611279
Keith Tomlinson Arrow Hedge Partners ktomlinson@arrowhedge.com
4163230477
Reviewed by Tom Schenkel, Epic Capital Management Inc.
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