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“Hedge Fund” is a generic term for a pooled investment vehicle that can undertake a wide range of investment and trading activities. A hedge fund is usually organized as a limited partnership, Limited Liability Company (LLC) or Limited Liability Partnership (LLP). A key characteristic of a hedge fund is that only certain investors may invest. These investors are typically institutions, such as pension funds, university endowments and foundations, or high net worth individuals. Individual investors must certify that they are “accredited” investors at the time they invest. The term “accredited investor” is defined by SEC regulations and requires a certain minimum net worth and an attestation that the investor has the necessary experience to evaluate the investment. When making an initial hedge fund investment, the investor is asked to complete and sign a subscription agreement. This important document asks for information to establish that the investor is “accredited.” The other important document you should receive prior to making a hedge fund investment is a Private Placement Memorandum (PPM). The PPM should disclose investment strategies, management fees, the fund manager’s performance history and any other material facts about the fund and its manager.

In general, hedge funds invest in a diverse range of assets, but most commonly trade liquid securities on public markets. Many hedge funds also invest in restricted securities, derivatives and private placements. (See article on ” Private Placements.”) They often employ well-defined investment strategies, and make use of techniques such as short selling and leverage. What hedge funds offer investors is the opportunity to achieve above market returns. The cost to investors, as is true with any investment that seeks above market returns, is a higher risk of large capital losses.

Hedge funds are usually open-ended, meaning investors can invest and withdraw money at regular, specified intervals, usually once or twice annually. However, most hedge funds have an initial lock-up period, in most cases one year, in which withdrawals of principal are prohibited. Unlike an investment in common stock or a mutual fund, hedge funds are illiquid meaning that should you need your money back quickly, or if the hedge fund is declining in value rapidly, you may be unable to redeem your investment immediately. The current value of an investment in a hedge fund is calculated as a percentage of the fund’s net asset value (“NAV”).

A hedge fund typically pays its investment manager a management fee, which is a percentage of the fund’s NAV, and a performance fee if the fund’s NAV increases during a year. The standard performance fee is 20% of the fund’s increase in NAV over a year. These performance fees are usually subject to a “high water mark” so that if the fund’s NAV declines in value during a year the performance fee will not be paid again until the fund’s NAV exceeds the previous high water mark. As of 2009, hedge funds represented 1.1% of the total assets held by financial institutions. The estimated investment in hedge funds worldwide is $1.9 trillion. In addition to standard hedge funds with a single investment manager, some funds are called Funds of Funds. In a Fund of Funds, the investment manager does not select the specific investments but chooses a number of individual hedge funds to invest monies raised in a Fund of Funds offering.

In July 2010, Congress passed the Dodd-Frank Wall Street Reform Act for the purpose of improving the regulation of financial companies, including hedge funds, following the financial crisis of 2008. The Act requires advisers with private pools of capital exceeding $150 million or more in assets to register with the SEC as investment advisers and become subject to all rules which apply to registered advisers by July 21, 2011. Previous exemptions from registration provided under the Investment Advisers Act of 1940 no longer apply to most hedge fund advisers. Under Dodd-Frank, hedge fund managers with less than $100 million in assets under management are overseen by the state where the manager is domiciled and are subject to state regulation. Overseas-based hedge funds with more than 15 U.S. domiciled investors and managing more than $25 million for those investors also have to register with the SEC by July 21, 2011.

Investor claims that may arise from a hedge fund investment are as varied as the type of funds that exist. Misrepresentations or omissions of material facts in a hedge fund’s offering materials can include the prior performance of the investment manager, misstating the fund’s investment strategy or not disclosing known risks about that strategy. Claims can also arise from the post-offering operations of the fund, for instance where the manager deviates from a stated investment strategy or pays fees and expenses in a manner that violates the fund’s organizational agreement.

If you have questions about a hedge fund investment you are considering or suspect something amiss with an existing hedge fund investment, please contact Pearson Warshaw, LLP’s by e-mail at [email protected] or by telephone at (818) 788-8300.

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