Ten things Institutional Investors need to know about investing in Hedge Funds

As institutional investors continue to seek diversification and absolute returns in varied market conditions, the role of hedge funds as an integral part of proper portfolio construction becomes increasingly greater. The inflows of capital come from a diverse group of investors and is further invested across a mix of strategies and jurisdictions. Combined with the emergence of novel asset classes such as cryptocurrencies and exotic financial products, and an everchanging compendium of tax law, managers are faced with a myriad of tax issues around which they need to navigate. Well informed investors that understand what to expect from their managers and what can be done to structure around gaps and inefficiencies are best positioned for success.

1. Managers often must balance the needs of a diverse investor base. Many fund structures combine a diverse group of investors with varied tax interests. Domestic investors, foreign investors, tax exempts, sovereigns, and “super-tax exempt” investors all may have disparate tax considerations. Qualification for potential treaty benefits and the diverse nature of bilateral treaties may add further complication. Depending on the strategy, these issues may become more prevalent. Institutional investors that find themselves disadvantaged by these potential conflicts might consider structures such as separate managed accounts and funds of one, or parallel structures where the investor base is more homogeneous.

2. Even well-established structures carry tax risk. While some managers may be more aggressive in their tax planning, many managers operate using well established structures, vetted by their tax and legal advisors. Nevertheless, structuring is typically being conducted under “should” (70% or greater likelihood of success) or “more likely than not” (50+% or greater likelihood of success) levels of opinion, and in many cases, these opinion levels vary between advisors. Thus, despite receiving advice of counsel, structures may be subjected to scrutiny from various tax authorities. 

3. Managers should have a developed infrastructure for effectively developing tax policies and monitoring compliance. Practitioners will frequently cite an old adage that “the only thing worse than not having a tax policy is having one with which you don’t comply”. Investors should make certain that managers have processes in place to monitor practices and ensure that they are aligned with the assumptions underpinning their tax advice. Changing market practices, strain on the business operations, administrative difficulties, inadequate procedures, or disconnects between the front office and tax function can create unanticipated exposure for investors. Proper governance and procedures are considered best practices in minimizing tax risk.

4. Well established and legally sound structures and transactions may still be susceptible to reputational risk. While managers may often be able to manage tax risk, there may still be reputational risk associated with even iron clad planning. Both public and regulatory scrutiny over investing through pooling vehicles organized in low tax jurisdictions, complex holding company structures (often having nothing to do with tax), government granted tax incentives and preferential rates, and the like may create additional complexities for investor stakeholders, investment committees, and shareholders. Otherwise commonplace strategies may not be well understood by those less familiar with the alternatives investment industry.

5. ESG (Environmental, Social and Governance) is a novel concept which is not uniform across the investor base. As ESG is an emerging concept, many managers are just now beginning to understand what is expected by ESG sensitive investors. Whether, and to what extent, this is meant to address tax planning activities at the manager, fund or portfolio level is unclear and the relative weighting and transparency considerations versus non-tax issues are also not uniform and may vary by region. (e.g. moving operations to a developing market may generate substantial economic benefit to the region, but may also lower tax costs, leaving one to speculate on the overall result to ESG scoring). ESG sensitive investors should have a mutual understanding with managers over what is expected as part of a sound ESG policy, including compliance with relevant ESG standards and regulations, - e.g., EU Sustainable Finance Disclosure Regulation (SFDR) which imposes mandatory ESG disclosure obligations for asset managers and other financial markets participants.

6. Tax rules many vary across jurisdictions. Tax laws are not uniform across jurisdictions, and accordingly structures that provide benefits in some jurisdictions may result in very different treatment in others. Factors such as physical presence may be the most significant factor in some jurisdictions, while the location of investors, board members or management and control may be more dispositive in others. These differences have traditionally presented both the opportunity for tax arbitrage, as well as the necessity to negotiate the potential pitfalls that could come with strategies that span jurisdictions. In addition, emerging markets may present further complications, as they often lack the framework needed to bring clarity as to the tax treatment. Mangers and investors should understand the disparate tax treatment to make certain that their chosen structures meet their needs across all jurisdictions in which they are involved, and that managers employ best practices in making certain that proper procedures are in place to sustain the intended tax result . In some cases, tax efficiency is optimized by using sperate structures for specific transactions and/or jurisdictions. 

7. Pay careful attention to the investment strategy. Certain strategies may carry more tax risk and/or require more tax structuring than others, and investors may find that this also varies from jurisdiction to jurisdiction. Many jurisdictions have favorable rules and safe harbors encouraging foreign investment for minority stakes in exchange traded products, but those rules may not extend to private offerings, real estate holding companies or stakes in excess of certain thresholds. Lending strategies often require structuring in ways that exchange traded equity trading does not, and novel strategies such as cryptocurrencies, litigation finance, leasing and trading of exotics may not have established authority for tax treatment across jurisdictions. As rules can vary significantly across jurisdictions, investors should carefully evaluate the strategies, structures and jurisdictions in which their capital is being deployed.

8. Treaty benefits may depend on the status of other investors in the fund. As many treaty benefits are dependent on the overall fund makeup, institutional investors may need to consider how the manager will source qualified investors, validate their status (both initially and going forward), and manage the possibility of exiting investors. The tax risk of an adverse investor base may necessitate special undertakings from the manager on certain tax matters such as US “check the box” elections, tax reporting information, and managing investor profiles.

9. Structures that work with some large managers may not work with some smaller managers. Mangers and investors will typically navigate against the former being viewed as an agent of the later, which would result in the fund, and in some cases its investors, being deemed to have a permanent establishment based on the activities of the manager. This issue is generally avoided by creating an “independent agent” relationship between manager and investor, where the focus is typically based on the legal relationship between the respective parties. However, based on a theory of “economic independence”, if an investor represents a significant amount of the manager’s AUM (e.g. 25% or more), the investor may be viewed as having such economic significance to the manager, that they are de facto viewed as not independent. This can mean that structures with a smaller manager may have a different result than the same structure with a larger manager where the investor represents a lesser share of the manager’s AUM.

10. Managers should be prepared to address shifting tax landscapes. Whether by means of legislative reforms, regulatory guidance or a constant flow of case law, tax laws are in a constant state of flux. Initiatives such as BEPS have caused managers and investors to reevaluate their practices, and well-established practices such as the use of low-tax investment jurisdictions have been called into question. And as new jurisdictions continue to create favorable tax and regulatory environments in an effort to attract capital and promote their respective locations as financial centers, even more change can be expected. Managers and investors should have a process in place for monitoring tax law developments both in their respective home jurisdictions, as well as jurisdictions in which they invest, and should be prepared to adapt their planning accordingly. Requiring the annual preparation of assessments of these risks (under ASC 740 or IFRIC23 accounting rules) may help identify any potentially controversial positions.

By garnering an understanding of the hedge fund industry and the tax issues that surround it, Institutional Investors can be better positioned to more effectively perform due diligence in choosing a manager and strategy that best suits their needs – in some cases being able to use bespoke structuring to better address their unique situations. Being able to predict after-tax returns that may be distinct to the particular investor and not reflected in a manager’s track record allows investors to make more educated decisions with respect to their deployment of capital. And by understanding the potential pitfalls and reputational issues that may surround various investments, investors can further risk adjust their decisions.

KPMG firms have a dedicated practice that work with the top Institutional Investors and leading hedge fund managers across the all geographies and all strategies. KPMG professionals can help provide insights and advice on market leading practices to accommodate all parties to a transaction.

Jay Freedman, Principal, Global Lead, Hedge Fund Tax, KPMG in the US

Gareth Bryan, Partner, KPMG in Ireland

Darren Bowdern, Partner, Head of Alternative Investments, KPMG in Hong Kong (SAR)