Private Equity and Hedge and Law
- What is the definition of finance? Why do lawyers need to know finance? How does law affect finance from both an investment and legal perspective
Finance entails the allocation of liabilities and assets over a given period of time under uncertain and certain conditions. Lawyers need to be conversant with finance so that they can possess the knowledge needed to better understand financial decision-making which their corporate clients are involved in (Berezin 2005). In addition, such knowledge of finance will enable them to communicate effectively when involved in integrated teams of accountants, lawyers, and investment bankers. Law affect finance from both an investment and legal perspective through corporate restructuring transactions like takeovers, mergers, or joint ventures, where legal advice is needed (Mclean, Zhnag & Zhao 316). In addition, law aids in the drafting of contracts and in negotiations of investment transactions.
- Is performance the best way to judge the quality of a fund? Please explain yes or no and if you do not think so please provide another framework(s) for judging the quality of a fund.
Yes. The quality of a fund is best judged by evaluating its performance periodically for instance over a period of three to six months. The quality is also judged by benchmarking its returns with that of an industry index and also evaluating performance parameters such as variance of returns and standard deviation (Crary n.p.).
- What is the definition of a hedge fund? What are the major sub categories? How are the sub categories the same/different in terms of returns, investment styles, compensation of management, time horizon, structure, management style etc?
A hedge fund refers to the pooling of funds by a limited partnership of investors. It utilises high risk strategies (for example, investing borrowed money) with a view to earning huge capital gains (Philips 5). The four major sub categories of hedge funds are:
Equity hedge fund: these funds go long on or buy stocks that are deemed to appreciate in value, according to the fund manager. Likewise, shorting or selling of stocks that are deemed to depreciate in value by the fund manager also occurs.
Global macro funds: These are funds often interested in securities of different countries (for example, the United States) on the basis of macroeconomic conditions. The fund manager adopts tactical asset allocation (Philips 6). They also utilise purchase derivative securities (e.g. futures, swaps, and options) and leverage to enhance the effect of market moves. Market timing funds is an example of a global macro fund
Relative value funds: The construction of these funds depends on variations in market values between related investments (arbitrage). It consists of such sub categories as fixed income arbitrage funds, and convertible arbitrage funds.
Event-driven funds: These types of funds endeavour to profit from such significant market events as acquisitions or mergers, of companies. Managers purchase securities at huge discounts owing to specific company distress (Philips 8). Examples of sub categories are distressed stock funds, and distressed debt funds.
- What is the definition of private equity? What are the major subcategories? How are the subcategories the same/different in terms of returns, investment styles, compensation of management, time horizon, structure, management style etc.?
Private equity refers to an asset category made up of debt and equity securities in operating firms whose stock is not publicly traded (Kellog 3). A private equity investment consists of a venture capital firm and a private equity firm.
Venture capital (VC): Venture investments typically occur in companies without any, or those with little, debt. Venture capital investing is both high-reward and high-risk and is common in the early stage companies. Investment styles in VC include traditional, seed capital, and growth (Kellog 3).
Buy out: Common in profitable companies characterised by significant free cash flow. Buyout firms assume a majority position. In order to generate refunds, buy out firms require more aggressive capital structure (Kellog 4).
Mezzanine: This type of financing offers debt capital. It is usually used alongside a leveraged buyout. Equity participation varies significantly (Kellog 6).
Distressed: This kind of investing endeavours to buy debt of distressed firms. It involves the purchase of more senior capital structure, such as senior debt, bank loans, or senior subordinated debt (Kellog7).
- Describe the style and organization of private funds (i.e. limited partnership, onshore vs offshore fund, offering memorandum, etc), and reasons for various structures/documents?
One of the defining style of a private fund is limited partnership structure. According to Day Pitney, “a hedge fund is usually formed as a limited partnership with a separate limited liability company [“LLC”] serving as its general partner [“GP]” (2). In case the fund entity has been structured in the mould of a limited partnership, investors can not only buy limited partnership interests but the money that they have contributed adds towards the capital of such a fund entity. An onshore fund is one in which a significant number of potential investors to whom the fund founders have access to, are to be found within a given country, such as the United States, On the other hand, in case majority of such potential investors are to be found outside a given country like the U.S., then this is described as an offshore fund. On the other hand, an offering memorandum refers to a legal document that describes the risks, terms and objectives of investment within a private placement. This entails such items as management biographies, financial statements, et cetera.
- What are the major regulatory Acts affecting private funds? What are the major exemptions for private funds from those regulatory Acts? How would falling under each of the regulatory Acts affect the private funds (i.e. in terms of investment, size, etc? What are the major penalties for violating any of the respective regulatory Acts?
The Dodd-Frank Act and Consumer Protection Act are two of the major regulatory Acts affecting private funds. According to the Dodd-Frank Act, “all hedge fund advisers above $ 150 million to register with SEC” (Brown, Lynch and Petajisto n.p.). The Act was enacted into law in 2010. It alters several areas of private funds, such as regulatory swaps, and novel reporting requirement that fund managers are expected to fulfil (Gale and Lynam 24). On the other hand, the Consumer Protection Act endeavours to limit the “retailization of private investment funds by increasing the net worth requirements for investors in these funds” (Paulhastings 2).
- How do the major regulatory Acts limit/enable private funds compared to their public counterparts in terms of investment styles, funding, flexibility etc? Please be specific to the regulatory Act as well as the type of public/private fund
Most private equity funds only manage 14 funds as compared to the public funds. As a result, private equities have less regulatory acts imposed on them by SEC under the Investment Advisors Act of 1940. However, the Dodd-Frank Act eliminates these on private equities that manage funds worth more than $150 million and hence there are required to register with SEC (Stowell 401). Moreover, The Securities Act of 1933 limits the U.S private equity funds by the fact that they are only allowed to be sold through private placement as compared to public funds.
- What does the future hold for the private fund universe in a legal context and investment context?
With the financial crisis slowly fading away, the future of the private fund universe is sure. The private fund universe is an arena for individuals who are ready to take risks no matter what and that is the reason behind that the fund universe has produced some of the richest people in the U.S. with the future being sure, law firms will be partakers of the good performance since contracts, negotiation of agreements, mergers, takeovers and even law suits are expected to increase (Yale School of Management n.p.).
Berezin, Mabel. “Emotions and the Economy” in Smelser, N.J. and R. Swedberg (eds.)
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Brown, Stephen, Anthony Lynch, and Antti Petajisto. Hedge Funds after Dodd-Frank. 2010. Web. 30 April 2015. http://w4.stern.nyu.edu/blogs/regulatingwallstreet/2010/07/hedge-funds-after-doddfrank.html
Crary, Mindy. How To Evaluate Performance of Your Mutual Fund. 2012. Web. 30 April 2015. http://www.forbes.com/fdc/welcome_mjx.shtml
Fevurly, Keith. The Handbook of Professionally Managed Assets: A Definitive Guide to Profiting from Alternative Investments. Apress, 2013. Print.
Gale, Adam and Garrett Lynam. “Dodd-Frank Act Changes Affecting Private Fund Managers and Other Investment Advisers”. NYSBA Inside, 29.3(2011): 24-29.
Kellog, Nat. Private Equity Position Paper. March 2011. Web. 30 April 2015.
Mclean, David, Tenyu Zhang and Mengxin Zhao, M. (2012). Why Does the Law Matter? Investor Protection and Its Effects on Investments, Finance, and Growth. The Journal of Finance, 67.1(2012): 314-339.
Paulhastings. A New Era in the Regulation of Private Investment Funds. July 2010. Web. 30 April 2015. http://www.paulhastings.com/assets/publications/1687.pdf
Philips, Christopher. Understanding Alternative Investments: A Primer on Hedge Fund Evaluation. 2005. Web. 30 April 2015.