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Foundations often invest in hedge funds by hiring consultants to aid in determining a portfolio strategy

Restrictions on Retirement Fund Investing

First, as mentioned earlier, the owner of the IRA must be eligible to invest in the hedge fund. Second, the owner of the retirement assets must find a way to effect the investment. For example, an IRA investor must find a trustee willing to let the owner make a hedge fund investment and must have the balance in a self-directed account. A 401(k) investor must work for a company that is willing to add one or more hedge funds to the list of eligible assets.

Third, the investor must cope with a hedge fund industry that is hesitant about taking retirement money into their funds. IRA accounts, Keogh funds, and other self-directed retirement plans are all considered benefit plan investors under the Employee Retirement Income Security Act of 1974 (ERISA; see Chapter 8). Hedge funds almost universally limit plan assets to less than 25 percent of the fund to avoid being regulated as a pension fund. Some funds of funds have recently started turning down investments from retirement accounts, including the self-directed plans described here.

Nonaccredited Investors

Hedge funds sold under the private placement rules in the United States may admit up to 35 nonaccredited investors in addition to an unlimited number of employees, although having nonaccredited investors puts additional restrictions on the fund. These investors may not have sufficient income or net worth to be accredited but should be knowledgeable investors. Because of the potential for litigation if the fund loses money, often hedge funds accept no investments from nonaccredited investors.

Nonaccredited investors can be valuable to a hedge fund start-up because the additional investors demonstrate confidence in the manager. Even small investments might be helpful to hedge funds starting with limited assets under management. However, a large fund would get little benefit from a small increase in assets under management. The administrative burdens of carrying small investors may be unprofitable. Also, if a fund is nearing the maximum number of permitted investors (either 99 or 500 for U.S. unregistered funds), it may be better to turn away potential new investors unless they can invest substantial sums.

Nonaccredited investors get the same benefits from hedge fund ownership as do other types of investors. The nonaccredited investor may be seeking higher returns, lower risk, or lower correlation to other assets. Likewise, the management company may get benefits from having employees carry an investment in the fund they manage to motivate good behaviors.


A family office is a group of investors who hire investment advisers, tax and accounting advisers, estate planners, and legal advisers. Family offices have existed for over a century to handle the affairs of the children or grandchildren of very wealthy individuals. Family offices may have additional responsibilities to oversee closely held assets and provide for succession of control. Family offices typically are formed to serve related individuals, but a family office may be created for any group of individuals having certain common interests.

Although the members of this investment group may form a business unit to hire a staff and provide office space, the investment funds are generally not commingled into this business or any other. Often, however, the investors own many of the same assets, including a family business, limited partnerships, and investment positions in public company shares.

Family office investment offices may act as the gatekeeper for the investment assets that might be invested in hedge funds. The investors who make up a family office are generally high-net-worth individuals and, by virtue of the expert advice provided by the office employees, are sophisticated investors.

It would be wrong to assume that all the investors in the office are ideal candidates to make hedge fund investments. The office may assist investors of two or even three generations. Various factions have more or less wealth, differing risk tolerance, and different tax sensitivities. However, it is the responsibility of the family office employees to deal with these differences. To the hedge fund, the family office represents a particularly sophisticated high-net-worth individual. However, getting an investment from the family office may mean getting separate, sizable investments from several family members.

Although family offices may invest in any kind of hedge fund, the advisers often place less priority on very high returns and more priority in balancing the expected returns against the risks assumed by investing. Similarly, the advisers generally favor strategies with low correlation to traditional investments. Family office advisers may invest indirectly in hedge funds by investing in a fund of funds to take advantage of the specialized hedge fund knowledge that may exist in those funds. Alternatively, the family office may invest in two or more funds to diversify the hedge fund returns. Finally, the advisers may blend the hedge fund into portfolios that arent well-diversified as when family members own large positions in closely held firms. They are more concerned with the risk and return of the portfolio including the hedge fund and less concerned with the performance of the hedge fund as a stand-alone investment.


Foundations are generally managed to escape income tax on investment returns. Because they arent penalized by high tax rates on ordinary income and short-term capital gains, they have been early investors in hedge funds.

What is a Foundation ?

A foundation is a pool of money and a group of employees to invest that money and to distribute part of the pool to activities and organizations consistent with a set of objectives. The money donated to the foundation is treated as a charitable donation for income tax purposes. Subject to some exceptions, the investment return of the foundation is exempt from federal income taxation.

Foundations are often established to maintain voting control of a closely held company. A foundation may play a role in corporate governance. The foundation may also control management succession, particularly when a family, together with the foundation, controls a voting block of stock in a publicly traded company.

According to federal tax law, at least 5 percent of the foundation must be distributed each year to retain the tax-free status of the foundation. Although the investment returns of a foundation are not taxed, a foundation would be taxed on the returns of a business if it operates a business. The returns on such a business are unrelated taxable income. Unfortunately, income from highly leveraged hedge funds may be classified as unrelated taxable income if the fund borrows money and distributes significant interest expenses to the foundation. See Chapter 10.

Foundations may invest in offshore hedge funds organized as corporations. As described in Chapter 5, hedge funds domiciled in low- or no-tax areas are usually organized as corporations. These offshore corporate funds are not flow-through tax entities, so a foundation would not be allocated interest expense from a hedge fund.

Why Foundations Invest in Hedge Funds

Foundations invest in hedge funds for many of the same reasons that other types of investors incorporate hedge funds into their portfolios. A foundation that earns high returns can increase the funding of projects consistent with its objectives. Because of the 5 percent distribution requirement, a foundation needs to earn a substantial real return to preserve the size of the foundation relative to inflation.

A foundation may also invest in hedge funds to get the benefit of lower risk, either by incorporating hedge funds with low volatility of returns or by investing in hedge funds with low correlation to other assets in the foundation portfolio. All investors like to lower the risk in their portfolios if this is possible with little reduction in expected return. Foundations may be particularly sensitive to the effects of a short-term loss in a portfolio because the combination of the loss and the commitments the foundation has made to make distributions may shrink the size of the foundation and limit its ability to achieve its objectives in future years.

Foundations as Hedge Fund Investors

A foundation usually seeks to pursue long-term objectives. Perhaps as a consequence, foundations take a fairly long-term perspective on investment decisions. Foundations are not greatly bothered by lockup provisions, especially if the funds can justify a reason for a lockup period, based on the underlying assets held by the funds.

Because of the threat of unrelated business income tax (UBIT), foundations tend to avoid investing in highly leveraged hedge funds. As a result, foundations are less likely to invest in convertible bond strategies and fixed income arbitrage strategies, which can have leverage of 6:1 up to 40:1, unless the hedge fund is located offshore and organized as a corporation so that the foundation is not allocated significant interest expenses.

Foundations often invest in hedge funds by hiring consultants to aid in determining a portfolio strategy, suggest individual funds within a strategy, and perform due diligence analysis of alternatives. Foundations may also invest in funds of hedge funds and rely on the fund of funds manager for asset allocation, due diligence, and so on.


Endowments also consist of pools of funds used to support certain projects or satisfy objectives. However, an endowment is usually affiliated with a particular philanthropic organization and the endowment is created to fund a portion of the expenses in that organization.

Why Endowments Invest in Hedge Funds

Many endowments have been long-term investors in alternative assets, including real estate, venture capital, and hedge funds. Endowments may be motivated by higher returns, lower risk, or low correlations, much like other investors. The endowments of Harvard University and Yale University along with other prominent university endowments have earned spectacular returns from these alternative assets. Other endowments may feel a degree of peer pressure to include some alternative assets in their portfolios.

Endowments as Hedge Fund Investors

Endowments behave much like foundations in the way they regard hedge fund investments. Endowments usually make longer and firmer funding commitments than foundations make so are somewhat risk-averse on their investments. Endowments have had good luck using hedge funds to diversify the returns on their portfolios, so their commitment to hedge funds remains stronger than ever.


Corporations (including U.S. companies and foreign businesses) invest in hedge funds for a variety of reasons. For example, some corporations invest in hedge funds with low-volatility, nondirectional strategies to improve the return on cash balances that arent required for the companys cash management needs. Other corporations invest in hedge funds to increase the company return on assets or to reduce the companys sensitivity to volatile operating results.

Corporations pay corporate income tax on hedge fund returns. When these returns are eventually distributed to shareholders as dividends, shareholders pay ordinary income tax on the same returns. It would seem to make more sense for such cash-rich companies to distribute cash to shareholders, who could decide to invest the cash in hedge funds or other financial assets or reinvest the dividends back in the company by buying more shares. The situation is complicated because any distribution to shareholders would likely be taxed as a dividend, so shareholders would have less money after-tax to invest in hedge funds than if the company made the investment in lieu of a dividend. In addition, not all shareholders could qualify to invest in hedge funds or come up with the minimum investment amount.


Pension funds or retirement funds include a wide variety of structures created by Congress to encourage U.S. taxpayers to save for retirement. As mentioned earlier, ERISA (see Chapter 8) governs IRAs, 401(k) plans, Keoghs, plus defined benefit plans and defined contribution plans. The individually directed plans are discussed earlier in this chapter along with other types of individual investments in hedge funds. This section discusses traditional company-sponsored pension plans.

A defined contribution plan is a pension plan where the employer or employee makes contributions to the pension accounts of eligible workers. Workers may have some input as to how the pension balance is invested. More importantly, the worker bears all of the investment risk, enjoying a growing account balance when returns are good and suffering losses when performance is bad. Importantly, the employer makes no commitment to that worker that the pension benefit will be of any particular amount.

Like the IRA and Keogh plan, it makes sense for highly taxed workers who can qualify based on their incomes, net worth, and investment knowledge to invest their defined contribution balances in hedge funds. These investments would benefit from the tax deferral on the investment returns of the hedge funds. However, individuals can elect to invest in hedge funds only if the plan sponsor (usually the employer) offers that as an option. Yet most group defined contribution plans have been replaced by individually directed 401(k) plans, so company defined contribution plans are not a source of funding for hedge funds.

In a defined benefit plan, an employer makes a commitment to fund a retirement benefit at a particular level. It is typical to guarantee some percent of salary upon retirement (often with several strings attached). The company funds the plan but also bears the risk of shortfall if the contributions and investment returns fall short of providing for the promised benefits. Similarly, if the pension returns are high, the company can reduce its own contributions to the plan. Because the corporation bears all the investment risk, it is not important that many of the plan beneficiaries would not qualify to invest in hedge funds.

Pension funds have been slow to invest in hedge funds. Lately, their allocation to hedge funds has accelerated. Pension assets allocated to hedge funds have more than doubled in two years, from $30 billion in 2001 to $70 billion in 2003.9 With trillions of dollars under management, pension funds have the potential to be sizable hedge fund investors. As discussed in Chapter 8, hedge funds are not prepared to accept large increases in funds from pensions for fear of falling under the regulations of ERISA.

Pension funds have traditionally been cost-conscious investors. The size of fees often determines the relative performance of traditional fund managers. That is, the managers that charge the lowest fees often generate the highest net return. Not surprisingly, pension funds, which have been able to negotiate low management fees for traditional portfolio management, were initially reluctant to pay the higher management and incentive fees charged by hedge funds.

Pension fund investors have also been risk-averse investors. In moving assets into hedge funds, pension fund trustees have relied on consultants to aid in selecting and monitoring hedge fund investments. Pension funds are also likely to invest in funds of hedge funds, to get the benefits of both the diversification in a fund of funds and the expertise in reviewing and monitoring hedge fund investments. Pension funds have discovered that in the world of hedge funds, the managers that produce the best returns often charge higher fees, but the net performance on these funds is still higher than hedge funds with lower gross returns.

Like other tax-exempt hedge fund investors, pension funds may be charged UBIT on hedge fund returns if interest expenses are high. As a result, pension funds generally avoid investing in hedge funds that have high leverage. They also are reluctant to invest in most arbitrage strategies, even though the risk/reward characteristics of these strategies would appeal to the trustees.

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