- March 6, 2017
- Posted by: Vincent Sarullo
- Category: Fund Administration, Hedge Funds
We see that most funds launch with initial capital coming from the fund manager and his/her closest friends and family. Family members commonly have a significant amount of their savings and investments held in their Individual Retirement Accounts (IRAs). Since hedge funds are viewed as a longer-horizon investment, using their IRA funds makes sense for investing.
Before the scandals and fund blowups in the early 2000s, it was easy to invest your IRA in alternative funds. All the large retail brokerage firms had a simplified process to let their clients invest, subject to a review of the fund’s documents and a nominal annual fee. That has drastically changed. Unless you have significant assets with the brokerage firm, they have all but closed the door on customers’ ability to invest in alternative funds for fear of getting dragged into litigation or bad press if a fund goes south. To fill this gap, several trust companies have created programs that allow investors to transfer their IRAs (or portions thereof) to them in order to make the investments.
Not all fund strategies are right for IRA investors. There are issues you and the fund manager need to consider before IRA money comes into the fund. By law, IRAs are not permitted to invest in certain instruments and by leverage of the manager are subject to tax of certain incomes through unrelated business taxable income (UBTI). There is also a laundry list of prohibited transactions the fund manager can’t enter into, but in my experience, I have not seen a hedge fund involved with them.
The most common concern of fund managers is having the fund become “plan assets” under the ERISA laws. ERISA stands for the Employee Retirement Income Security Act of 1974, which is governed by the Department of Labor. The key focus for the fund manager is whether or not the investors in his fund that are pension plans and IRAs make up 25% or more of the fund’s capital. Depending on the fund’s structure, this calculation can be a bit complicated and confusing.
For instance, the manager and any related accounts are excluded from the ratio calculation and the test needs to be done on a class by class basis in the fund if more than one class exists. To alleviate your stress over tracking this and wondering if it’s worth taking Uncle Jack’s IRA into your fund, know that IRAs alone will not cause your fund to fall into the plan asset category under ERISA. You can have 100% of your capital in the fund come from IRAs and there is no issue. The pitfall is that if at any time even $1 of pension money comes into the fund, all the IRA accounts get drawn into determining if you’ve gone over the 25% threshold.
What if you’ve gone over 25% or a significant prospect with a pension plan will put you over the threshold? Step off the ledge; the world isn’t over. Being in this situation and now being subject to the ERISA rules is not as onerous as you think. The impact to you is that you will need to be a registered investment advisor with the SEC or a state securities commission (which you probably are already). You will need to get a fidelity bond, which costs a couple thousand dollars a year, and you must be aware of some restricted transactions (most of which won’t concern you). Outside of some simple information reporting and records retention requirements you should be handling already, there isn’t much more of an impact on you and your fund.