Hedge Fund IPOs Swathed in Sunshine
June 4, 2007
When hedge funds, long known for their exclusivity and secret-sauce approach to investing, go public, it takes a lot of planning and some cultural adjustment, too, according to a web-based presentation hosted by Deloitte & Touche last week.
First and foremost, outcome-oriented investment companies accustomed to light regulation must be prepared to handle intense scrutiny, adopt steadfast processes and dive into a veritable alphabet soup of filings and regulatory agencies.
But the shift in mindset can't stop there. The procedure of going public permeates every aspect of operating a fund, from employee compensation, to valuation, to the way performance fees are accounted for, panelists said.
"You need to reprioritize pretty much everything going on at your firm that is not deal-related," said Will Tarry, a principal with Deloitte Consulting in New York. "And all this needs to be done while maintaining business as usual."
The list of public hedge funds is short, led by London-based Man Group, which has been traded in the United Kingdom for a while, and now crossing the pond to be listed on the New York Stock Exchange. The most notable public offering of a hedge fund in the U.S. may be that of New York-based Fortress, which went public in February.
Whether private investment pools going public is a trend, it's too early to tell, said Houman B. Shadab, senior research fellow at the Mercatus Center at George Mason University in Fairfax, Va. Still, going public may have advantages.
For one thing, although their individual funds are not, publicly traded companies are subject to uniform public filings submitted to regulators. "This indirect' scrutiny might help attract institutional investors to hedge funds in that they will feel that the managers/sponsors will not put their business reputations at risk or risk regulatory actions," said Herb Chain, a partner with Deloitte, and moderator of the panel.
More importantly, selling shares allows Fortress to generate capital without relying on banks or securities firms. "This means that it can avoid a fire sale of its positions to cover margin loans if the price of its investments [temporarily] decreases," Shadab wrote in a seperate e-mail.
But it also means a lot of legal maneuvering, corporate restructuring and time.
Perhaps the most obvious adjustment is adapting to the financial reporting requirements. Many hedge funds, renown for operating off of spreadsheet models, may lack the very infrastructure to manage reporting requirements, said Joe Matrullo, a principal with Deloitte Consulting. The Securities and Exchange Commission expects uniform reports, generated regularly. Be prepared for annual reports that are usually 30 pages or less to swell to over 150. Accounting should adhere to Generally Accepted Accounting Principles, or GAAP. Standardizing the process may mean hiring dedicated staff to manage it, and certainly means adopting standard policies and procedures to follow, and adherence to the myriad rules laid out in the Sarbanes-Oxley Act. There should be an audit committee, and independent directors.
"This gives you credibility, and it is worth dollars when it comes to stock prices," he said.
Adhering to Sarbanes-Oxley means quarterly 302 and annual form 404 filings, which cover financial reports and internal controls, respectively, but those are just the beginning, said Rick Borelli, a partner with Deloitte. Firms must be aware of and examine potential conflicts of interest, codes of ethics and auditing procedures. Most importantly, senior financial officers who are required to sign these attestation forms must remember that they are legally liable for their accuracy. Anti-fraud procedures must also be in place.
Going public also means reexamining how employees get paid, said Martin Somelofske, a principal with Deloitte Consulting. Hedge funds typically offer a base salary plus leveraged incentive plans, with a limited number of principals having equity. Public companies can offer restricted stock, or stock options as part of a compensatory package, but companies should be mindful of how to best structure those plans so that employees don't leave in favor of a company that offers wads of cash upfront.
When executives sell their shares, that means another SEC report, Somelofske noted. As directors and top-level executives, principals' pay packages will become open to public scrutiny. "These are difficult decisions you have to live with for a number of years," he said.
Valuation of stock is also a difficult task, said Dan Knappenberger, a principal with Deloitte FAS. "The intrinsic value method is no longer acceptable," he said. Companies must disclose how they value stock, and accounting for the value of shares must adhere to generally accepted standards.
Hedge funds, especially, face special tax considerations when they go public, said Ted Dougherty, a partner with Deloitte Tax. Performance fees levied by individual funds are considered income in public fund companies and must, therefore, be passed through to investors.
Most alternative managers create PTPs, or pass-through-partnerships, to address these requirements. Dividends, real property, interest, capital gains and the like are all considered "good income," and can be passed through easily. But performance and management fees are not. Most companies, therefore, set up "blocker" corporations, which capture this "bad income," which is taxed at a different rate. Companies should consider adding blockers outside of the U.S. for clients who live offshore and invest, so that those performance fees are not subject to U.S. federal taxes.
Shadab said there is no evidence that this transparency will pressure managers to adjust fees, especially if it means lowering them.
Taxes get even trickier when it comes to deferred compensation plans, distributions and the treatment of legacy owners, he said.
"The difficulty of recordkeeping should not be underestimated," Dougherty noted.
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