100 The Investment Game

Investment Game!!!!!!
Operations
The Investment Game:

An Overview of the Hedge Fund Industry
Last Updated: Aug 2010

Training Hedge Fund Overview
Table of Contents
INTRODUCTION ................................................................................................................................... 3
THE INVESTMENT GAME .................................................................................................................. 3
INVESTMENT FUNDS ......................................................................................................................... 3
INVESTMENT TYPES .......................................................................................................................... 3

- EQUITIES....................................................................................................................................... 3
- DEBT ............................................................................................................................................. 4
- DERIVATIVES ................................................................................................................................ 4
INVESTMENT TECHNIQUES ............................................................................................................. 4
- “GOING LONG” ............................................................................................................................ 4
- “GOING SHORT” .......................................................................................................................... 4
- LEVERAGE .................................................................................................................................... 5
- HEDGING....................................................................................................................................... 5
RISK ........................................................................................................................................................ 7
- DIVERSIFIABLE RISK .................................................................................................................... 7
- NON-DIVERSIFIABLE RISK ........................................................................................................... 7
INTRODUCTION TO HEDGE FUNDS ............................................................................................... 8
- HISTORY ....................................................................................................................................... 8
- WHAT IS A HEDGE FUND? ........................................................................................................... 8
- STARTING A HEDGE FUND ......................................................................................................... 10
- HEDGE FUND CHARACTERISTICS .............................................................................................. 10
- MUTUAL FUNDS VS. HEDGE FUNDS .......................................................................................... 12
- REGISTRATION & REGULATION ................................................................................................. 13
HEDGE FUND ORGANIZATION ...................................................................................................... 15
- CITI HEDGE FUND SERVICES (THE ADMINISTRATOR) .............................................................. 16
- FUND SPONSOR ......................................................................................................................... 17
- GENERAL PARTNER/BOARD OF DIRECTORS ............................................................................ 17
- INVESTMENT ADVISOR/M ANAGER ............................................................................................. 17
- DISTRIBUTOR .............................................................................................................................. 17
- PRIME BROKER .......................................................................................................................... 17
- EXTERNAL AUDITORS ................................................................................................................ 17
HEDGE FUND ENTITY TYPES ........................................................................................................ 17
- ONSHORE VS. OFFSHORE .......................................................................................................... 18
- CORPORATIONS (INC. / LTD.) .................................................................................................... 19
- PARTNERSHIPS (LP) .................................................................................................................. 19
- LIMITED LIABILITY COMPANIES (LLC) ...................................................................................... 20
- UNIT TRUSTS .............................................................................................................................. 20
HEDGE FUND STRUCTURES ......................................................................................................... 21
- STAND ALONE FUND .................................................................................................................. 21
- MULTIPLE CLASS FUND ............................................................................................................. 21
- MULTIPLE SERIES FUND ............................................................................................................ 22
- M ASTER/FEEDER FUNDS ........................................................................................................... 22
- FUND OF FUNDS ......................................................................................................................... 23
- MULTI M ANAGED FUND ............................................................................................................. 23
GLOSSARY.......................................................................................................................................... 25
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Introduction
The purpose of this document is to provide Administrators with an overview of the
Investments industry and, ultimately, the theory, aims, structure and terminology of a
Hedge Fund.
The Investment Game

First of all, an „Investment‟ is the purchase of an asset with a primary view to their
financial return, either as income (where the asset generates cash) or capital gain
(where the asset appreciates in value over time).
A „Security‟ is a financial asset/product which can create a financial return via either
income or capital gain, or both. Obviously, these securities can fail to generate any
financial return (and potentially incur a loss) if the underlying asset, in which the
investment is in, depreciates (e.g. A company stock decreasing).
The security itself is not necessarily a physical asset, but

rather a financial asset whose value is often linked to the
price of an under-lying asset (e.g. commodity, company
share price, etc).
The oldest maxim of the investment industry is “Buy low,

sell high”. This is the basic idea behind investment theory.
The skill involved in playing the „Investment Game‟ is to be able to anticipate when a
security will rise in value, and when it will drop - A skilful investor can make money
from either movement.
Investment Funds
An investment fund is a pool of investors and investments. They are created primarily
to raise monies from investors to invest in securities or other financial instruments.
They are created to allow investors to:
- Pool Funds
- Utilize professional management
- Diversify investment risk
- Share profit and losses among investors
Examples of investment funds are: mutual funds, partnerships, pooled funds, hedge
funds, ucits, unit trusts, qualified investment funds etc.
Investment Types
From an investment point of view, Securities can generally be classed as equities,
debt or derivatives.
- Equities
An Equity security is an ordinary share in a company. The holder of an equity
security is a shareholder, owning a share, or fractional part of the issuer.i In the event
of a company going into liquidation, the shareholders are entitled to share out the
remaining assets, after all creditors have been paid off. These shares can be traded
and profit is made due to any capital growth in the share.
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- Debt
The holder of a debt security, typically a bond, has effectively taken over a
company‟s debt and is entitled to the repayment of the principal amount plus interest,
together with other personal rights under the terms of the issue, such as the right to
receive certain information. Debt securities are generally issued for a fixed term and
redeemable by the issuer at the end of that term.1 Bonds are the main example of
debt finance, and are often referred to as a „Fixed Income Security‟ as a dividend is
paid out to holders at certain intervals by the issuer.
- Derivatives
A Derivative is a security whose price is dependent upon or derived from one or more
underlying assets. The derivative itself is merely a contract between two or more
parties. Its value is determined by fluctuations in the underlying asset. The most
common underlying assets include stocks, bonds, commodities, currencies, interest
rates and market indexes. Futures contracts, forward contracts, options and
swaps are the most common types of derivatives (See Glossary for definitions).
Because derivatives are simply contracts, almost anything can be used as an
underlying asset. There are even derivatives based on variations in weather data,
such as the amount of rain or the number of sunny days in a particular region.1
Investment Techniques
In addition to the various forms of investments available, an investment manager can
adopt various techniques to create a profit from market movements. An investment
manager can take a long position or a short position on an investment.
- “Going Long”
This is the basic method whereby an investor purchases an
investment which he/she believes is going to increase in
value in the future. The investor would therefore have the
intention of selling the investment on at a time if/when they
believe the price has peaked and profit has maximized. This
technique allows investors to make money from a security
increasing in value.
An investor who expects prices to rise is described as a
Bull, or „bullish‟. Similarly, a Bull Market is one in which prices are rising or expected
to rise and, as a result, there are likely to be more buyers than sellers. For this
reason, a long position is sometimes referred to as a Bull Position, as there is the
expectation that prices are going to increase.
- “Going Short”
This technique is slightly more complex although it is a fundamental technique in the
investment industry as it allows an investor to profit from a price decrease. A short
position is one in which the investor sells an investment which they do not yet own,
at the current price of the investment in the market. Once the sell has been made the
investor therefore has to close (or cover) the trade by buying the investments on the
market. The aim, therefore, is to wait for the prices to fall. If/when the prices fall, as
the investor expected, he/she will buy the investment and pass them over to the
investor for the previously agreed price. The difference between the agreed price
between the investors and the market price, at the time the investment was actually
purchased, is profit.
An investor who expects prices to fall is described as a
Bear, or „bearish‟. In contrast to a Bull Market, a Bear
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Market is one in which prices are falling, or are expected to fall and, as a result, there
are more sellers than buyers. Because a Short Position demonstrates the
assumption that prices are going to fall, it is often described as a Bear Position.
Example:
- Mary is a Bear (she believes the price of Apple shares is going to drop).
- Paul is a Bull (he believes the price of Apple shares is going to rise).
- Mary sells short 100 Apple shares at $1. She has borrowed the shares for
Paul through their broker.
- Mary, since she does not actually own the 100 shares she will have to go
onto the market to buy the shares in order to cover the position she has taken
with Paul. Mary, however, believes the price is going to fall and so she waits.
- As expected, and contrary to Paul‟s expectation, the price of Apple shares

falls. The price drops to 80c per share; a price which Mary believes is as low
as it is going to go. Mary buys the 100 shares at a price of $80.
- Mary then transfers the shares over to Paul. Mary has made a profit of $20
($100 - $80).
- Leverage
In Hedge Funds leveraging simply refers to the use of debt to fund an investment or
project. It provides the IM with another method of increasing value for
shareholders. This would be worthwhile if the investment manager believed that the
financial benefits of the investment will outweigh the cost of the debt (interest rates,
dividend payments etc).
A non Hedge Fund example of leverage is the issue of bonds. As we discussed

earlier, Bonds are debts which belong to a company (for example) but are paid by the
bond holders. In return, the company pays the bond holders a dividend to reward the
bond holder. Most companies use debt to finance operations. By
doing so, a company increases its leverage because it can
invest in business operations without increasing its equity. For
example, if a company formed with an investment of $5 million
from investors, the equity in the company is $5 million - this is
the money the company uses to operate. If the company uses
debt financing by borrowing $20 million, the company now has
$25 million to invest in business operations.
An investor or investment fund may use leverage through options, futures and other
financial instruments. Leverage, however, comes with greater risk. If an investor uses
leverage to make an investment and the investment moves against the
investor, his/her loss is much greater than it would've been if the investment had not
been leveraged - leverage magnifies both gains and losses.ii
- Hedging
This is the name given to the practice of diversifying risk. A
hedger is concerned with the adverse movements in a securities
price or with increases in volatility, which increases the overall
risk. For example, if an individual has a long position in cash
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market securities, he/she will be concerned about the prices of those securities falling
and may want to protect against this possibility. Similarly, if an individual has a short
position in cash market securities, he will be concerned about rising prices and may
want to protect against this possibility.
In order to hedge successfully and so transfer the risk, the hedger must select a
suitable instrument. A „suitable instrument‟ would be one with price movements that
closely mirror those of the original cash market security. „The perfect hedge‟ is a
situation whereby the market movement of one position is perfectly negatively
correlated (mirrored) to that of another position. As such, the perfect hedge is rarely
found.
Example 1:
- Mary holds stock in The Coca-Cola Company, priced at 120p per share.
- She fears that the price may drop, so she sells a futures contract to Paul stating
that she will sell her stock at 140p per share in, say, 10 months.
- The price is now set at the agreed price and Mary does not have to worry about
market fluctuations. She has hedged the risk.
Example 2:
- Paul holds a long position on oil (i.e. He has the intention of selling the oil when
the price increases).
- Due to economic/political/other reasons, Paul‟s bullish opinion of oil changes and
decides to hedge the risk that he will not be able to sell the oil for a higher price
than he bought it.
- Paul hedges the risk of the long position by taking a short position on oil (ie. If the
price of oil falls, he will make a profit).
- The price of oil drops.
- The loss/risk on the long position is counter-balanced by the short position.
It is important to note that, although the loss in the long position was offset by the
short position, a gain in the long position would have been offset also. In the first
example, the market could have up-turned and the price could have risen higher than
that agreed in the Futures contract. Therefore, Mary would have missed out.
Hedging diversifies risk, although it is the risk which is reflected by the financial
returns. If the risk is diversified, so too is the potential financial return. For this
reason, hedging is not a technique which is adopted and used constantly by a fund or
investor; it is merely used at certain times when it will be of benefit to the
investor/fund (this will be discussed later).
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Risk
The investments and techniques discussed so far may suggest that the stock market
and the investment industry is a simple, money making process;
you put $80 in, you get $100 out. This, however, is certainly not
the case. Buying a share in a company, for example, could seem
like a quick and easy way to make money; but what if the
company goes bust? Similarly, what if you take a short position
on oil and, contrary to what you expected, the price of oil
increases? Richard Branson, head of Virgin Atlantic, once said;
“The safest way to become a millionaire is to start as a billionaire and invest in the
airline industry”
This is the inherent nature of the investment game. „Risk‟, however, can be
managed, to a certain degree.
There are 2 types of risk; Diversifiable and Non-diversifiable.
- Diversifiable Risk
This type of risk is often referred to as „Specific‟ or „Non-systematic‟ risk. This is risk
associated specifically with each individual investment. This risk can be eliminated by
maintaining a diversified portfolio (ie. not “putting all your eggs in one basket”).
- Non-Diversifiable Risk
This type of risk is often referred to as general, residual or Systematic risk. This risk
is associated with the market and cannot be reduced by diversification. It is the risk
which is inherent to the associated market or class. Unlike diversifiable risk, which an
investor is expected to eliminate by his/her skill & knowledge, Systematic risk is
compensated for by the Risk Premium. Non-diversifiable risk can be eliminated by
hedging.
Higher risk, however, does mean potentially higher financial returns. This is because
a rational, risk averse investor must be compensated for taking a risk. For example, a
US Treasury bond is deemed to be the safest investment because the US
government are unlikely to default on payment (if they started running out of money,
they would just print more!). The financial returns, however, reflect this lack of risk. A
corporate bond (a bond issued by a company), however, involves a lot more risk
because a company can go into liquidation and default on payments. Again, because
financial returns reflect the risk, the potential financial gains are higher. This balance
of risk and return is known as the „Risk/Return Payoff‟. This ratio differs for different
investors, depending on their level of risk tolerance/aversion.
Market/investment risk is quantified by the deviation (standard deviation) of the

market/investment. Hedging is the elimination of market fluctuations (or deviations).
In light of the risk/return payoff; if risk is eliminated, so too is the payoff! For this
reason, as discussed before, „the perfect hedge‟ is not attractive in the long run, in
terms of financial returns.
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Introduction to Hedge Funds
- History
Alfred Winslow Jones is said to have set up the first hedge fund. In
1949 he set up a private partnership that invested in equities, but also
used leverage and short selling to “hedge” the portfolio‟s exposure to
the movements of equity markets. Jones‟s premise was that it was
impossible to forecast the direction of the stock market with any
consistency. His idea was to eliminate market risk. He used
borrowing to enhance returns, but took actions to hedge out the effect
of market movements. He picked undervalued stocks, which he would buy, and
overvalued stocks, which he would sell short.
- What is a Hedge Fund?
General Definition:
“An open ended fund established for institutional and high net
worth investors in an onshore or offshore jurisdiction which uses
the services of a prime broker and invests (including on a
leveraged basis) in both long and short securities/investments,
e.g. equities and debt securities (both listed and unlisted),
currencies, commodities and derivatives.”
It is an entity that holds a pool of securities and other assets whose

interests are not sold in a registered public offering and is not registered as an investment
company under the Investment Company Act.
To say that a hedge fund has the sole objective of hedging risk is inaccurate, as not all
funds maintain an explicit hedge on their portfolio investments. In fact, because hedge fund
managers make speculative investments (investments chosen purely for their potential
financial growth), these funds can carry more risk than the market itself! The name „Hedge
Fund‟ is mostly historical as the first hedge funds were set up as a reaction to a particularly
bearish market. The name „Absolute Return Fund‟ would be more fitting due to the many
strategies and techniques employed with the main goal being maximisation of return.
The point which defines a hedge fund from any other fund type is its lack of regulation and
its ability (legally) to use high levels of leverage in order to maximise returns. This point is
discussed in the next section.
Hedge Funds are typically setup as Limited Partnerships, Corporations or Unit Trusts. The
majority are open-ended which allow investors to subscribe and
redeem on a regular basis.
The Hedge Fund industry has grown at a ferocious pace in the last
decade, from as few as 300 funds in 1990 to more than 9,000 in
2007. The funds have become highly visible in markets and press,
and are today estimated to manage up to 1.3 trillion in capital.
Hedge Funds have gone through some turbulence in the last few
years due to the recent financial downturn in the global market.
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For further information on the impact of this downturn please see Side Pocket Training. Also
please see the tables below which show positive trends in 2010.
www.hedgefund.net
www.barclayhedge.com
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Starting a Hedge Fund

The following outlines the basic steps in starting a new fund:
1. The Investment Manager or Sponsor engages counsel and public accountants

2. The “team” drafts the Private Placement Memorandum (“PPM”)/Confidential Offering
Memorandum (“COM”)/ Prospectus
3. The prime broker and administrators are hired and administration agreements are
signed
4. All parties review the PPM to ensure what is documented can be performed
5. Offering documents are finalized
6. Offering documents are sent to potential investors
7. Bank accounts are opened and directors are established
- Hedge Fund Characteristics
Private:
Hedge funds are not a registered public offering and are not registered as
an investment company under the Investment Company Act. They are
private placements and most provide all investors with a Private
Placement Memorandum (PPM) stating the Funds objectives, disclosing
fund strategies and all operational aspects of the fund. A PPM is also
known as a „Prospectus‟, „Confidential Explanatory Memorandum‟, and „Offering
Memorandum.‟ The private offering exemption prohibits Hedge Funds from making any
public offering. Therefore, hedge funds are prohibited from general advertising and
generally secure investors through word of mouth, registered representatives, brokers or
investment advisors.
Fee Structure:
Another characteristic of a hedge fund is the fee structure as the
Investment Manager will typically receive compensation from the fund
(management fee) plus an incentive/performance fee of 10% - 30% per
annum.
The underlying principle of the incentive/performance fee is that the

Investment Manager is rewarded for his performance. Effectively the
premium is paid by shareholders/partners for the superior returns and
management of risk. Generally it is based on an actual increase in the net asset value per
share of the fund over specified performance periods up to 12 months. The incentive fee
serves to align the objectives of managers and investors; the nature of the relationship is
one of true partnership.
Regulation:
Due to the private nature of hedge funds (as discussed above) hedge funds have a
reputation as being under very little regulation. A hedge fund, unlike a mutual fund, is not
limited in the techniques or strategies which it adopts or in the investments which it
purchases. We will go into the greater detail of the regulation later.
Investment Strategies:
Due to the lack of regulation, as discussed above, Hedge Funds can adopt a wide range of
strategies, such as short selling and leverage.
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Higher risks:
Some of the risks associated with hedge funds are: high valuation
fluctuations, higher risk strategies, and longer lock up periods.
Investors:
European investors were among the first to see the opportunities
presented in hedge funds. The three primary centres of hedge fund accounting in Europe
are Switzerland, The UK and France, but there are significant investors throughout the
continent. The largest provider of hedge fund capital is the US. Both Institutions and
Individuals in the US are becoming increasingly comfortable with hedge fund investing.
Investor Types are as follows:
Private Investors
Fund of Funds
Private Banks
Institutional Investors
Endowments and Foundations
Pension Funds
Insurance Companies
Commercial & Investment Banks
Corporations
Open Ended:
A hedge fund will typically be open-ended, allowing investors to
subscribe and redeem their investments at a net asset value (NAV) on
a regular basis. There are two exceptions:
Soft Closed Funds:

- The Investment Manager would officially announce the
Fund is closed to new money, but are still open to high quality investors.
Closed Funds:
- New money/investment is not permitted in the Fund
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- Mutual Funds vs. Hedge Funds

Hedge funds are primarily organized as private partnerships in the US
and corporations in offshore jurisdictions to provide maximum flexibility
in constructing a portfolio. Hedge funds can take both long and short
positions, use leverage, use derivatives, and invest in many markets.
This is in sharp contrast to mutual funds, which are highly regulated and
do not have the same breadth of investment instruments at their
disposal.
Mutual Funds Hedge Funds
Strict Regulations - A mutual Lightly Regulated – Private

funds structure and operation is investment pools subject to the
subject to strict regulation under terms of an investment
the federal laws: The Securities agreement entered into by the
Act of 1933 and must register sponsor of and the investors in
with the SECiii. the hedge fund.
Management Fees Management and Performance

Fees
Use debt to provide short term Ability to trade short and leverage
liquidity for withdrawals. the fund.
Can trade derivatives but not to
create leverage.
Performance is measured in Performance is measured in

relative terms, compared to a absolute terms, expected to make
relevant index e.g. S&P 500. a return when relative indices are
down.
Investing Public High Net Worth Individuals and

Institutions
Daily dealing More commonly

quarterly/monthly/weekly dealing,
but daily funds exist.
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- Registration & Regulation

Hedge Funds tend to avoid registering under the Investment Company Act of 1940. The
reasons for doing so include:
Limitations on the ability of the fund to borrow or

otherwise leverage portfolio
Corporate governance requirements
Restrictions on transactions with affiliates
Periodic SEC filling requirements
To avoid registration and substantial regulation, hedge funds must use available exemptions
from the definition of an “investment company” in the Investment Company Act. The two
most commonly used exemptions are „Section 3(c) 1‟ and „Section 3(c) 7‟.
Section 3(c) 1
The fund must restrict its offering to „Accredited Investors‟ and is limited to taking 100
shareholders. Entities must have $5 million in assets and Individuals must have $1 million in
assets or income in access of $200,000 in each proceeding two years.
An "accredited investor" is deemed to include, in part:
A natural person with an individual net worth, or joint net worth with his or her
spouse, at the time of purchase in excess of $1,000,000;
A natural person with an individual income in

excess of $200,000, or in excess of $300,000 with
his or her spouse, in each of the two most recent
years and who has a reasonable expectation of an
income in excess of $200,000 individually, or in
excess of $300,000 with his or her spouse, in the
current year;
Any executive officer, director or general partner of the issuer of the securities
offered;
An employee benefit plan within the meaning of Title I of the Employee Retirement
Income Security Act of 1974, as amended ("ERISA"), (a) whose investment
decisions are made by a plan fiduciary, as defined in Section 3(21) of ERISA, which
is either a bank, insurance company or registered investment adviser; or (b) having
total assets in excess of $5,000,000; or (c) if self-directed, the investment decisions
are made solely by persons that are accredited investors;
A trust, with total assets in excess of $5,000,000 which was not formed for the
specific purpose of acquiring an interest in the hedge fund, whose purchase is
directed by a sophisticated investor; and
An entity in which each of the equity owners are accredited investors.
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Section 3(c) 7
The fund must restrict the offering of its securities to Qualified Purchasers and can have an
unlimited number of investorsiv. Entities must have $25 million in qualifiedv investments and
an Individual must have $5 million in qualified investments.
The Investment Company Act of 1996 stipulates there is no numerical limit on the number of
investors. The size and nature of the investments of the individual are in question, and
investors in funds that utilize the section 3(c) 7 exemption under most circumstances must
be a "qualified purchaser." Qualified purchasers are by definition, high net worth individuals
with certain specified investments in excess of $5 million, as well as qualified institutional
investors. The premise behind 3(c) 7 is that affluent investors inherently should understand
the risk and do not need the full protection of the federal and state securities laws.
Qualified Purchasers
In general there are five categories of qualified purchasers:
1) Natural persons owning "investments" of at least $5 million;
2) Family owned companies owning not less than $5 million in

investments;
3) Trusts whose trustees or equivalent decision makers and

whose settlers or other asset contributors are all qualified
purchasers described in (1) and (2) above;
4) Institutional investors, acting for their own accounts or for other qualified purchasers,
that own and invest on a discretionary basis "investments" of at least $25 million,
including employee benefit plans that are not participant-directed; and
5) Certain qualified institutional buyers ("QIBs") acting for their own accounts or for
other QIBs or qualified purchasers.
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Hedge Fund Organization
Potential Investors
Investors/Limited Partners
Distributor/Agent
The Fund /
Limited Partnership/etc
Citi Hedge Fund Services
Investment Manager
Fund Sponsor
F.A. S.S.G. A.M.L.
Corp Sec TACM
Board of Directors/General Partner
External Legal Councel

External Auditors
Prime Broker/Custodian
Investment Vehicles
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- Citi Hedge Fund Services (The Administrator)

Fund Setup
Provide advice and assistance relating to fund structures, domiciles and operations. Our
legal and operational staff review all setup and offering documents and liaise between
onshore and offshore legal counsel.
Accounting and Valuations

The Fund Accounting department (FA) provide fund valuation services using independent
pricing sources and oversee the day-to-day operations of the fund.
Key FA Responsibilities -
° Maintain financial records of the fund (general ledgervi and a TB)

° Responsible for the calculation of the net asset value (NAV)
° Coordinate annual audit (Prepares initial draft package for auditors)
° Process trades and value assets
° Reconcile portfolio positions to prime broker/custodian
° Reconcile cash positions to prime broker/custodian
° Accrue and pay expenses
° Accrue income
° Process capital activity
Investor Relations
Shareholder Services (SSG) administrators maintain share, partnership, and unit-holder
registers for our fund clients and are experts in products such as investor eligibility, anti-
money laundering restrictions, new issues, ERISA etc.
Key SSG Responsibilities -
° Review subscription/ redemption docs to ensure completeness and validity

° Accepts cash for subscriptions or authorises disbursement of cash for
redemptions;
° Respond to investor requests/inquiries;
° Coordinates distributions to investors;
° Performs anti-money laundering checks; and
° Sends information to shareholders on weekly/ monthly/ quarterly basis.
Corporate Secretarial Services

The corporate secretarial department maintain minute books and
statutory records for fund entities, providing experienced personnel to
act as company secretaries to fund structures. Ensuring all regulatory
and stock exchange filings and fees are dealt with in a timely basis and
advise our clients of relevant legal and regulatory developments which
affect the fund industry.
In-house Legal Counsel

Responsible for drafting and reviewing documents and ensuring CHFS‟s role
is properly defined. Our in-house legal counsel cannot give legal advice to
fund managers or investors.
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- Fund Sponsor
This is the entity that starts the fund. The sponsor may or may not „manage‟ the fund, but
they are responsible for researching the needs in the marketplace prior to the introduction of
the fund to the marketplace, deciding on the structure of the fund, and marketing the fund
(i.e. obtaining partners/shareholders for the fund).
- General Partner/Board of Directors
Responsible for all aspects of the fund, delegates day-to-day operations to

the administrator and has fiduciary responsibility to the
shareholders/partners.
- Investment Advisor/Manager
The Investment Manager (IM) provides investment advice, research services and certain
administrative services for a fee. Responsible for making investment decisions while
implementing the fund‟s policy and objective.
- Distributor
The distributor acts as sales agent for the Fund.
- Prime Broker
The prime broker gives the fund access to financing and stock loans which enables the
funds to follow their investment strategy with the use of leverage and short selling. They
also provide the following services:
Clearing;
Custody;
Margin financing
Reporting.
- External Auditors
They conduct the Independent Audit of the Funds Financial Statements on a yearly basis.
Hedge Fund Entity Types
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The following will be covered in this section:

Onshore vs. Offshore Funds
Corporations
Partnerships (LP‟s & Limited Liability Companies)
Unit Trusts
- Onshore vs. Offshore
Onshore Funds
Domiciled in the United States, typically Delaware; these funds are usually
organized as limited partnerships to accommodate investors subject to US
income taxation. US taxpayers generally prefer to be in a domestically organized vehicle
that is a flow-through entity for tax purposes, such as a limited partnership or a limited
liability corporation. Over 50% of US publicly traded corporations and 60% of the Fortune
500 companies are incorporated in Delaware vii; the state's attractiveness as a corporate
haven is largely because of its business-friendly corporation lawviii.
Offshore Funds
These types of funds offer securities primarily to non-US investors and to US
tax-exemptix investors. Advisors/ managers who have significant potential
investors outside the United States typically create offshore hedge funds that
are:
Domiciled outside the United States (usually a low or no tax jurisdiction such as Cayman
Islands, Bermuda, BVI, Guernsey, Luxembourg, Ireland);
Typically subject to less regulation than their counterparts in the countries in which they
are distributed;
Offers advantages in terms of taxation for their shareholders
Can be any type of legal entity (e.g. partnership, LLC, Ltd or Inc.)
Many offshore centers are keen to encourage the establishment of hedge funds. To do this
they offer some combination of professional services, a favorable tax environment, and
business-friendly regulation. The Cayman Islands have been estimated to be home to about
75% of world‟s hedge funds, with nearly half the industry's estimated $1.225 trillion AUM.x
Offshore Onshore
Domiciled outside the United States (usually Domiciled in the US, typically Delaware.
a low or no tax jurisdictions such as
Cayman, BVI, or Bermuda).
Non-US or US tax-exempt investors US Taxpayers
PPM/COM & Articles of Association Prospectus & Limited Partnership

Agreement
Board of Directors – oversees day to day General Partner – oversees day to day
investments activities and operation of the investments activities and operation of the
fund. (The board consists of directors from fund.
both Citi and the Investment Managers firm.) Limited Partners
Shareholders
Any type of legal entity Limited partnership or a limited liability

corporation
Updated: Aug 2010

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- Corporations (Inc. / Ltd.)

Corporations are the most common entity type for offshore hedge funds. The corporation
generally issues shares representing limited liability with a stated par value (e.g. $100,
$1,000 etc.) These entities may or may not pay dividends or distributions to shareholders
and are easy to operate.
- Partnerships (LP)
Onshore Hedge funds are typically formed as limited partnerships and most will be
registered in Delaware for tax reasons. Each partnership has a general partner (GP) or
partners and raises money from investors who become limited partners (LP). The general
partner is responsible for running the fund, including building a staff and investing the fund‟s
assets, and can be held personally responsible for any debts the partnership incurs. Limited
partners, in contrast, have no responsibility for making investment or management
decisions and they‟re not liable for partnership debts. The most they can lose is the amount
they invest.
Partnerships are generally used for US shareholders for the tax benefits, and are created to
provide tax transparency to its investors. Partners are able to carry through the “character”
of the profit/losses of the partnership which is important because “income” and “gains” are
taxed at different rates. Interests in partnerships are issued as follows: Each investor has a
capital account that captures the partner‟s activity and profits / losses „allocated‟ to them.
Partnerships have:
 A General Partner (GP) that is usually affiliated with the Investment Advisor.
° The general partner oversees all activities of the fund;
° Has unlimited liability for the repayment and discharge of all debts and
obligations of the partnership;
° Can have little to no investment;
° Usually a vehicle created to receive incentive fees; and
° May or may not receive a share of the profits of the partnership.
 Limited Partners (LP) are investors in the fund.
° The liability is limited by the amount invested in by the investors;
° Limited partnership are governed by the LP Agreement which outlines all

legal, structural, operational and accounting guidelines; and
° The LP will also have a PPM.
IMPORTANT! If there are any inconsistencies in the two documents (PPM & LP
Agreement), the LP Agreement is the governing legal document.
Updated: Aug 2010

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- Limited Liability Companies (LLC)

This entity fits somewhere between a partnership and a corporation providing similar
advantages, such as tax transparency to investors. For example, like a partnership LLC
partners report business profits on their personal income tax returns, however they are
protected from personal liability for business debts and claims such monies owed and
lawsuits. Like a corporation only the business assets are at risk, creditors cannot reach the
personal assets of the LLC owners, such as a house or a car. An LLC combines the best
features of both the partnership and corporate business structures.
- Unit Trusts
These are trusts in which investors purchase redeemable trust certificates. The money
raised is used by the trustees to buy such securities as bonds, which are usually held until
they mature. Usually both the number of certificates issued and investments held remain
unchanged during the life of the trust, but the certificates can be sold back to the trustees at
any time. Since the portfolio composition is fixed trusts are referred to as unmanaged,
hence the management fees can be less than those of managed funds.
Updated: Aug 2010

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Hedge Fund Structures

The following are common Hedge Fund structures:
Stand Alone Fund

Multi-Class or Multi Series Funds
Master/Feeder Fund
Fund of Funds
Multi-Managed Funds
- Stand Alone Fund

A stand alone fund has one legal entity with one portfolio of investments. Onshore funds will
generally be partnerships and offshore funds will be setup as a corporation.
ABC Training Fund

(One Portfolio)
Investors
- Multiple Class Fund

A multiple class fund has only one legal entity with one portfolio of investments. Since every
shareholder in the same class must be treated equitably, a multiple class fund allows
different „types‟ of investors to subscribe into the same fund, and thus the same portfolio.
Each class of share/partner may have a different fee or expense structure to accommodate
different types of investors. Investors may also have different subscription/ redemption
requirements, lock up periods, „new issue‟ eligibility, and investing currency.
ABC Training Fund

(One Portfolio)
Investors Investors Investors

Class A Class B Class C
Updated: Aug 2010

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- Multiple Series Fund

A multiple series fund has only one legal entity with one portfolio of investments. Each time
there is a fund offering, a new series of shares may be issued to allow for ease in the
incentive fee calculation. This type of structure will not be used for investors that want one
net asset value per share.
ABC Training Fund

(One Portfolio)
Class A
SERIES 1 SERIES 2 SERIES 3
- Master/Feeder Funds
This structure was modelled after the Hub and Spoke model. This structure allows
shareholder/partners (Feeders) to invest in the same portfolio (Master). This allows the
investors to share in the economies of scale by investing in one portfolio.
The master and the feeder are separate legal entities. The master usually is an offshore
corporation but reports as a partnership under the US tax rules. In today‟s environment,
there are generally two feeders: an offshore corporation (i.e., Cayman) and a US limited
partnership.
Advantages
Allows many investors to share in the same portfolio which decreases custody and
administration fees. It is less expensive to run a portfolio if larger.
The investment manager, prior to the structure, created multiple funds with the same
objectives. This structure is easier for them as they do not need to “split tickets”.
Disadvantages
Creates conflict in trading strategies because of tax rate differential in long-term and
short-term capital gain rates for US investors and possible withholding tax related
issues for non-US investors.
May lose tax treaty benefit flow-through.
For certain segments of non-US investors, having a US tax reporting master may be
perceived as negative even though the investment is in a direct offshore corporation.
Updated: Aug 2010
- 22 -
ABC Training Fund LDC

Offshore LLC - Master
ABC Training Fund LP ABC Training Fund Ltd.

Onshore LP - Feeder Offshore LLC - Feeder
- Fund of Funds
These products are offered by sponsors that invest in many different funds which allows for
diversification. A fund of funds invests its pooled capital in other hedge funds and
establishes a diversified portfolio at a substantially lower minimum investment than
accessing each of the portfolio managers separately. Sponsors must perform very detailed
initial and ongoing due diligence of the underlying funds prior to investing.
Risks: Delay in receiving NAV‟s of the underlying funds and there may be restrictions on
timing of redemptions due to requirements in underlying funds.
Investors
ABC Training Fund

No Portfolio
DEF Training Fund GHI Training Fund JKL Training Fund
- Multi Managed Fund

A fund sponsor allocates investor monies to multiple investment managers. A multi-advisor
fund tends to have a very specific international focus; for example, a fund may invest in
Updated: Aug 2010

- 23 -
South American debt, Asian Equities and Global Real Estate, with one manager responsible
for each investment component.xi
A sponsor may provide many investment Managers with a certain allocation of

monies to be managed.
These differ from fund of funds in that they are not separate legal entities but
“managed accounts”.
For financial statement purposes, there is only one “portfolio” as there is only one
legal structure.
These entities create economies of scales in administration.
Would normally require a separate set of books and records for each managed
accounts.
Disadvantages
They may create administrative complexities if each managed account needs to be

separately tracked by the administrator.
There may be risks associated with these types of entities as funds often have
restrictions outlined in their PPM. With many „hands in the pot”, it makes it difficult to
monitor the funds activities.
Investors
Fund Sponsor
ABC Training Fund
$ $ $ $
$ $
I.M. I.M. I.M.
Global Real Estate Asian Equities South American Debt
Updated: Aug 2010

- 24 -
GLOSSARY
Future Contract –
A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset),
such as a physical commodity or a financial instrument, at a predetermined future date and
price.
Forward Contract –
A cash market transaction in which delivery of the commodity is deferred until after the
contract has been made. Although the delivery is made in the future, the price is
determined on the initial trade date.
Option –
A privilege sold by one party to another that offers the buyer the right, but not the obligation,
to buy (call) or sell (put) a security at an agreed-upon price during a certain period of time or
on a specific date.
Swaps –
The exchange of one security for another to change the maturity (bonds), quality of issues
(stocks or bonds), or because investment objectives have changed. Recently, swaps have
grown to include currency swaps and interest rate swaps.
i
www.investopedia.com
ii
http://www.investopedia.com/terms/l/leverage.asp
iii
Source: Securities and Exchanges Commission – www.sec.gov
iv
Most funds relying on Section 3(c)(7) have no more than 499 investors in order to avoid registration and reporting
requirements of the Securities Exchange Act of 1934. – Implications of the Growth of Hedge Funds. US SEC Staff Report
September 2003.
v Qualifying investments include: securities, real estate, commodities and cash.
vi A summary of the general ledger is broken down by capital, income statement and balance sheet.
vii Delaware 2007 Fiscal Notebook - State General Fund Revenues by Category (F.Y. 2002 - F.Y. 2005)
viii Tax Justice Network (2009-11-01). "Financial Secrecy Index"
ix Offshore funds are attractive to US tax-exempt organizations as a method of avoiding unrelated business taxable income.
x
Institutional Investor, May 15, 2006, Article Link, although statistics in the Hedge Fund industry are notoriously
speculative
xi ‘Oxford Dictionary of Finance and Banking’ – 3rd Edition - 2005
Updated: Aug 2010

- 25 -

100 The Investment Game

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Investment Game!!!!!!

The Investment Game:

Last Updated: Aug 2010

THE INVESTMENT GAME .................................................................................................................. 3

INVESTMENT FUNDS ......................................................................................................................... 3

INVESTMENT TYPES .......................................................................................................................... 3

Updated: Aug 2010

The Investment Game

The security itself is not necessarily a physical asset, but

The oldest maxim of the investment industry is “Buy low,

Updated: Aug 2010

Updated: Aug 2010

- As expected, and contrary to Paul‟s expectation, the price of Apple shares

A non Hedge Fund example of leverage is the issue of bonds. As we discussed

Updated: Aug 2010

There are 2 types of risk; Diversifiable and Non-diversifiable.

Market/investment risk is quantified by the deviation (standard deviation) of the

Updated: Aug 2010

Introduction to Hedge Funds

- What is a Hedge Fund?

It is an entity that holds a pool of securities and other assets whose

Updated: Aug 2010

Updated: Aug 2010

Starting a Hedge Fund

1. The Investment Manager or Sponsor engages counsel and public accountants

- Hedge Fund Characteristics

The underlying principle of the incentive/performance fee is that the

Updated: Aug 2010

Investor Types are as follows:

Soft Closed Funds:

Updated: Aug 2010

- Mutual Funds vs. Hedge Funds

Mutual Funds Hedge Funds

Strict Regulations - A mutual Lightly Regulated – Private

Management Fees Management and Performance

Performance is measured in Performance is measured in

Investing Public High Net Worth Individuals and

Daily dealing More commonly

Updated: Aug 2010

- Registration & Regulation

Limitations on the ability of the fund to borrow or

An "accredited investor" is deemed to include, in part:

A natural person with an individual income in

An entity in which each of the equity owners are accredited investors.

Updated: Aug 2010

1) Natural persons owning "investments" of at least $5 million;

2) Family owned companies owning not less than $5 million in

3) Trusts whose trustees or equivalent decision makers and

Updated: Aug 2010

Hedge Fund Organization

Citi Hedge Fund Services

External Legal Councel

Updated: Aug 2010

- Citi Hedge Fund Services (The Administrator)

Accounting and Valuations

° Maintain financial records of the fund (general ledgervi and a TB)

Key SSG Responsibilities -

° Review subscription/ redemption docs to ensure completeness and validity

Corporate Secretarial Services

In-house Legal Counsel

Updated: Aug 2010

- General Partner/Board of Directors