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Hedge funds may be organized as corporations, especially outside the United States
Types of Accounts
Hedge funds use the same categories of accounts as other types of businesses: assets, liabilities, equity, revenues, and expenses. The assets, liabilities, and other accounts differ markedly from those of a manufacturing or service company because a hedge fund is little more than a legal wrapper around a pool of investment assets. Because the fund contracts the management duties to a separately organized management company, the fund generally has no employees. A hedge fund has no physical plant and may have no office equipment and supplies.
On the income side, a hedge fund has no cost of goods sold. Interest expense may be large. Realized gains and losses may show no pattern from month to month and may not relate closely to investment performance.
Assets The assets of a hedge fund are primarily investments plus cash balances. In particular, the fund will carry long positions in stocks, bonds, and commodities as assets, predominately long-term assets. In addition, the asset section of the balance sheet will contain financing transactions as short-term assets. The mechanism of financing a levered long position is described in Chapter 6.
Suppose a hedge fund started with $100 million cash at inception. At that point, the fund would have short-term assets of $100 million and the same amount of equity or partnership capital. If the fund buys $80 million in stocks, the short-term asset (cash) goes down by that amount, to be replaced by an equal amount in a long-term stock investment.
Suppose, too, that the fund sells short another issue for $70 million. The proceeds of the sale generate $70 million in cash. However, the only way to settle the short sale is to borrow the shares to make the delivery. The fund posts $75 million in collateral, receives the shares, and makes the delivery. After all this has settled, the fund has $15 million in cash ($100 million minus $80 million paid for stock plus $70 million proceeds from a short sale less $75 million in collateral). The fund also has a short-term, interest-bearing asset of $75 million (the collateral) and $80 million in stock. The fund has a reserve of cash plus $5 million in collateral in excess of the value of the short positions.
This example does not include other assets that might appear on a hedge fund balance sheet. These assets are likely not large, compared to the assets described. If the fund buys bonds, part of the value of the position will appear as accrued interest. The fund may also have margin on deposit at futures brokers. The fund may invest the excess cash balances in money market instruments. The fund may also have receivables reflecting dividends declared but not paid or funds deposited by partners awaiting investment. The fund may also carry past expenditures (professional fees, for example) as assets to delay recognizing the expense.
Liabilities If a hedge fund carries short positions, those positions show up as liabilities. It may seem counterintuitive to classify a short as a liability instead of a negative asset, but accountants go to great lengths to avoid showing negative values in any account. In fact, a short sale of a bond looks very much like a loan, which is clearly a liability. In both cases, the lender gives the fund a loan balance (also described as the proceeds of the short sale). In both cases, the hedge fund makes periodic interest payments to the other party. Finally, the loan repayment of principal corresponds with buying back the bond.
A short sale of a stock doesnt correspond with a conventional liability but represents a liability all the same. Because the short represents a future obligation to pay out cash (buy back the position), it is carried as a liability even though common stock would clearly be considered an asset out of the context of levered trading.
The short sale of $70 million worth of stock in the previous example would appear as a liability on the books of the hedge fund. The fund could also create leverage by borrowing against the long position. Suppose, to extend the example, the hedge fund pledges $80 million worth of stock and borrows $50 million. The $50 million would show up as a higher cash balance and also as a short-term liability because the loan balance would need to be repaid at the end of the financing term.
In this example, the hedge fund would no longer possess the $80 in common stock because it is delivered to the lending counterparty. However, the lender only holds the collateral (stock) to assure repayment of the loan and must return the shares to the hedge fund when the loan is repaid. In other words, the hedge fund still owns the stock even though it is being held by the lender. As a result, the lending trade does not reduce the size of the long-term assets. Similarly, the fund continues to show a short position of $70 million in the second issue after making delivery on the sale because the financing trades do not affect the number of shares the fund must buy in the future.
Equity The accountants use the word equity to describe the third category of balance sheet accounts. Hedge fund investors call it capital. In both cases, it is the value of the fund assets in excess of the fund liabilities. It is also called net asset value (NAV) but shouldnt be confused with assets.
Hedge funds may be organized as corporations, especially outside the United States (see Chapter 5). The equity or NAV of a hedge fund organized as a corporation is common stock. Practitioners generally think of NAV more like net liquidating value in a margin account at a broker. It is possible to have more than one class of common stock, which creates the opportunity to treat investors differently (different fees, for example).
Hedge funds organized within the United States are often organized as limited partnerships. Capital is called partnership capital and the fund distinguishes between general partners capital and limited partners capital. The rights of the two classes of partner are laid out in the partnership agreement. If identical fees are assessed for limited partners capital as for general partners capital, the return on the two types of capital would generally be equal. Because limited partners cannot lose more than their committed capital, it is possible for the general partners to lose more than the limited partners lose. The general partners may have a prior claim on performance when recovering from a loss if the general partners have lost more than their committed investment.
Revenue The revenue of a hedge fund includes dividend income and coupon income on long positions. The revenue for a particular period includes income accrued but not yet paid. For example, suppose a fund holds 10,000 shares of stock in a company that declares a quarterly dividend of $1 per share. In particular, on March 20 the company announces that the dividend will be paid to the shareholders registered as owners on March 25 but will not be paid until March 30. Assuming the fund still owns the position on March 25, it will receive dividend income of $10,000, which is included in revenue in calculating net income. Even if the payment date was April 2, the entire amount of revenue is recognized in March and benefits the owners of the fund in March. However, none of the dividend income is accrued for the benefit of investors of the fund for January or February, even if the income could be predicted accurately.
The revenue is handled differently if the fund also owns a bond that pays interest semiannually at the end of March and September. The fund must prorate (i.e., accrue) the coupon to the investors in each statement period. As a result, the fund would recognize roughly the same income in March whether the coupon is paid on March 30 or April 2.2
Much of the return to hedge fund investors may come in the form of gains. Individual gains are classified as short-term and long-term and accumulated in separate accounts. Gains on futures and commodities are tallied separately from gains on securities. These gains, called Section 1256 gains, are taxed at a blended rate as if 60 percent of the results was long-term and 40 percent was short-term. The fund must report these gains to investors, who in turn include this income on their tax forms. The mechanics of this tax reporting are described.
Expenses Hedge funds pay commissions to execute trades. The fund is also charged management and incentive fees that are included as expenses on the income statement. The interest paid to finance a leveraged position is a typical expense for a hedge fund. Note that a corporation does not deduct the dividends it declares and pays to its shareholders, but a hedge fund includes payments paid for dividends declared by other companies if the hedge fund carries a short position in a security that pays a dividend (this is the scenario posed by question 6.13). The hedge fund must make substitute dividend and interest payments on all short positions in stocks and bonds, which are reported as expenses.
Hedge funds accumulate short-term losses, long-term losses, and Section 1256 losses. These losses are included on the hedge fund income statement. The losses are also reported to investors, who include the amounts on their individual or corporate income tax forms. The losses reduce income and usually reduce the taxes investors must pay. Chapter 10 includes a brief description of these tax rules related to gains and losses.
Hedge funds accrue many accounts to fairly allocate investment returns and expenses to investors.
Interest on Bonds Hedge funds accrue income on bonds exactly the same way corporations and unleveraged portfolios accrue income. However, hedge funds may carry either long or short positions, so accruals on individual positions may be treated as either an asset or a liability.
Hedge funds generally dont report accrued interest as an individual item on the balance sheet. Frequently, the value of the accrued interest on long positions is included in the market value of the long positions and the accrued interest on short positions is included in the market value of the short positions. The net amount carried in accrued interest may also appear either as an asset (when the sum of accruals on long positions exceeds accrued interest on short positions) or a liability (when the sum of accruals on short positions exceeds accruals on long positions).
If a hedge fund buys $10 million face value of a bond with a 6 percent semiannual coupon, the total paid for the position must reflect both the price paid for the face value plus accrued interest. Assume for this example that the bond maturing on May 15, 2009, was purchased to settle on February 15, 2004, at a price of $103 (or 103 percent of face value). The principal amount of the trade is $10,300,000 (103% $10 million). The accrued interest would be approximately $151,648.3 The following entries might be used to book the purchase:
At the end of the month, the accrued income would rise by $23,077.4 The increase in the value of the asset on the balance sheet would show up as income and be included on the income statement.
February Month-End Journal Entries
As a result, investors would get credit for the income, even though no cash flow was received during the month.
A slightly more complicated set of transactions is required when a bond actually pays a coupon. The fund would continue to recognize income and increase the accrued interest. On April 30, 2004, the balance sheet would reflect $275,275 for the bond and the fund would have recognized income of $51,099 in March and $49,451 in April.5 On May 15, 2004, the fund receives a semiannual interest payment of $300,000 ($10 million 6%/2). The fund must now journal the incremental $24,7256 of income:
After these entries, this bond will show no accrued interest on the balance sheet and the fund will have recognized income on the position for half the month. On May 31, if the fund still carries the position, it recognizes $26,0877 in income, reflecting 16 more days of income at a new accrual rate.
Suppose the fund sells the bond at 104.375 on June 15. The fund must book an additional 15 days worth of income totaling $24,4578. The fund must also journal a gain of $137,500 (1.375 percent of $10 million) and remove the position from the balance sheet.
Notice that the asset account for the bond is credited (reduced) by exactly the amount debited when the position was established, not the current value. This accounting differs from when the position was established so that the asset account is reset to zero. The difference between that cost amount and the sale price is entered as the gain. Notice, too, that the accrued interest amount as of May 31, 2004, is credited to remove this amount from the balance sheet. The accrual from May 31, 2004, through June 15, 2004, is booked as income at the time of sale.
Interest on short bond positions is accrued the same way as long positions. However, the initial interest on the bond at the time of sale is a liability, not an asset. Also, the interest in each accounting period is recognized as an expense, not as revenue. The expense debited is booked against an equal credit to the accrued interest liability each period.
Dividends on Stock Positions Stock dividends are not accrued, even if the timing and the amount of the dividend are predictable. Instead, the entire amount of the dividend is booked as revenue for long positions or as expense for short positions after the dividend is declared, probably on the record date.
Interest on Financing The hedge fund accrues the interest expense paid to borrow money and the interest income received on the collateral supporting borrowed securities. Most financing transactions are short-term. These trades originate and end within a single accounting period. The fund should monitor those items daily but there is no need to accrue the interest on these positions.
Generally, the journal entries to establish a financing trade are created when the financing is created. For simplicity and to increase the verifiability of the accounting records, the income and the termination entries are created at the same time. These entries must be created in light of the dates financial statements are produced.
Consider the financing trade related to the bond purchase described earlier. Recall that a long position was purchased for $10,451,648, including principal and accrued interest. Suppose the hedge fund agreed to borrow $10 million secured by this position. The hedge fund must deliver the position to the lender on February 15, 2004, and receives the loan amount of $10 million on that date. If the lender agrees to lend the funds for 30 days at 5 percent, the fund would book the interest expense at the time of the trade.
These journal entries would be perfectly adequate for a hedge fund that publishes financial statements quarterly. However, if the fund produces statements at each month-end, it should accrue the expense incurred but not yet paid. To recognize 14 days worth of interest expense in February, the fund could substitute a more complicated accrual of the interest expense:
Accruing Management Fees Management fees accrue steadily on the assets under management. Hedge funds need to accrue management fees to reflect this progressive expense. This accrual is not generally necessary at the end of each accounting period because a prorated amount of the annual management expense is journaled each accounting period.
However, most hedge funds calculate their net asset value (NAV) much more frequently than they publish formal financial statements. Because the NAV is little more than a simple balance sheet, it is necessary to accrue management fees whenever NAV is calculated.
Hedge funds can produce the standard collection of accounting statements that are used by nonfinancial businesses. Usually, the hedge fund discloses the balance sheet to trading and financial counterparties. The hedge fund generally discloses the income statement and balance sheet to investors. Other statements such as the statement of cash flow are less useful to hedge fund investors.
Balance Sheet The balance sheet or statement of financial positions lists the assets and liabilities of the fund. This is the only financial statement routinely published and shared with investors and creditors. The balance sheet can be used to determine the sizes of positions carried by the hedge fund. The statement does not review specific positions because the assets and liabilities are aggregated to obscure the details of the hedge funds positions.
Income Statement An income statement lists the types of revenues and expenses that make up net income. It is generally not possible for analysts to extrapolate income accounts into the future. Dividends and interest income reflect the particular positions held by the fund and are subject to change. A major component of performance is unrealized gains and losses, which are particularly difficult to extrapolate.
If the income statement includes unrecognized gains and losses on securities positions in addition to recognized gains, losses, revenues, and expenses, it would be possible to derive performance from the income statement. In practice, because much of the investment community does not see the income statement, investors calculate performance from the NAV, based on the balance sheet for the fund.
Statement of Cash Flow Generally accepted accounting practice requires a hedge fund to produce a statement of cash flow that reconciles the change in cash or cash equivalents to the accounts in the income statement and balance sheet. Hedge funds may not circulate the statement of cash flows. The statement can be useful to the fund manager to track how cash is being used in its various strategies and to measure the adequacy of liquid cash balances.
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