NAVENDU P. VASAVADA, PHD, has held the positions of investment manager of large institutional investors, manager of private hedge funds, an economic analyst, and writer-at-large. He was formerly a senior investment manager at Aetna Inc. for over a decade, serving as head of quantitative research, risk manager, mortgage securities analyst, and equity/fixed income derivatives quant. He holds a PhD from Wharton, preceded by an engineering MS from the University of Pennsylvania and PGDBA from IIM-A, India.

• Preface xiiiChapter 1 The Arcane World of Hedge Funds and Investment Partnerships 1What Is a “Hedge Fund”? 1U.S. Venture Partnerships 3Types of U.S. Hedge Fund Entities and the U.S. Tax Code 4Organizing a Typical U.S. Hedge Fund 6Investor Clienteles in Hedge Funds 10Foreign Investors in a U.S. Hedge Fund 14Offshore Funds 14U.S. Investors in Offshore Funds 17U.S. Investors in Swiss Bank Accounts 19U.S. Investors in Madoff-Like Managed U.S. Trading Accounts 23Size of the Global Hedge Fund Industry 25Fund-of-Funds 28Incentives of the Hedge Fund Manager and Investors 30Valuation of a Hedge Fund Management Company 31Economies of Scale in Hedge Funds 33Chapter 2 The Structure of Hedge Funds 35Organizing a Typical Offshore Hedge Fund 35Master-Feeder Structuring of Onshore/Offshore Arms: Organizing a Hedge Fund for Clienteles 39U.S. Withholding Agent for U.S. Withholding Taxes on Foreign Investors 44Chapter 3 Hedge Fund Fees 47Starting Point: The Partnership Agreement 47Fund Valuation at Discrete Opening Time Points 48Calculation of Fixed Fees 49Calculation of Performance Fees 55Claw-Back Provision: Performance Fee Returned to Limited Partners 66Representation of a Fund’s Net Asset Value (NAV) per Share 71Black-Scholes Formula Valuation of Performance Fees 74Chapter 4 Hedge Fund Accounting and Tax Filing 79Partnership Accounting for U.S. Funds 79IRS Tax Return Filings for U.S. Hedge Funds 80Financial Statements for Hedge Funds and Venture Funds 85Interim Valuation: The Core of a Hedge Fund’s Accounting Operation 93Books of Account and Financial Statements for Hedge Funds 96Audit of an Offshore Fund 97Audit of a U.S. Fund 98Capital Account Audit for Both Offshore and U.S. Funds 99Chapter 5 Partner Tax Allocations in U.S. Partnerships 101U.S. Tax Allocation Rules Governing U.S. Partnerships 101Tax Components of U.S. Investment Partnership Income 103Fixed Fees: Income to the General Partner and Expense to the Limited Partners 107Generalizing the Allocation Formula to Other Components of Income 108Tax Basis of Partner’s Investment in a U.S. Partnership 109Accountants’ Terminology 113Tax Allocations of Realized and Unrealized Income to Partners 113The Tax Allocation Method of Layering 115Tax Allocation of Interest 118Tax-Exempt Interest Income, Line 18a 120Similar Calculation for Tax Allocation of Dividends, Investment Expense, Foreign Tax Paid 121Tax Allocation of Fixed Fees Paid by Limited Partners 121Tax Allocation of Guaranteed Payments (of Fixed Fees) to the General Partner 122Reporting Subcomponents of Interest Income and Dividends 122Tax Consequences of Shorting 123Short Positions: Tax Treatment of Equity Dividends or Bond Coupons Claimed as Interest Expense 123Distributions from Partnerships Owned 124Chapter 6 Tax Allocations of Realized Gains by Layering 127Tax Allocation of Unrealized and Realized Capital Gains Using the Method of Layering 127Ignoring Ambiguity #1 with Layering 132Work-Around to Fix Ambiguity #2, the Fatal Flaw with Layering 133Chapter 7 Partial and Full Netting Methods 137The Methods of Aggregation or Netting 137Partial Netting 138Full Netting 141Measures of Book-Tax Disparity across Partners 142Formulating the Problem for Optimal Partner Tax Allocations under Full Netting 143Formulating the Problem for Optimal Partner Tax Allocations under Partial Netting 146Solving the Convex Optimization Problem of Tax Allocation 148Chapter 8 Comparative Tax Consequences of Layering and Netting Methods 153Which Is the Better Method for Allocation of Realized Gains: Layering, Full Netting, or Partial Netting? 153Layering Examples Showing Earlier Tax Payment 154Full Netting Examples Showing Tax Postponement 158Chapter 9 Tax Efficiency of Hedge Funds 161Tax Efficiency Considerations for Offshore Hedge Funds 161Tax Preference Ordering for U.S. Investors 163More Attractive Tax Items to U.S. Investors 167Less Attractive Tax Items to U.S. Investors 169An Exception: Special Tax Preference for Gains from U.S. Exchange-Traded Futures Contracts 170Ambiguities in Tax Preference 170Tax Efficiency Steps for U.S. Hedge Funds 170A Structure for Tax-Exempt U.S. Entities to Recover Foreign Taxes 173Chapter 10 Hedge Fund Performance and Risk Presentation 175Performance Presentation: CFA Institute GIPS Verification 175Calculation of Hedge Fund Returns for Performance Presentation 179Facilitating Historical Risk and Return Review for Investors Using GIPS Guidelines 183Chapter 11 Mutual Funds and Venture Funds Compared to Hedge Funds 191Tax Return Filing of U.S. Partnerships Is an Involved Task 191Comparison with Tax Allocations Made by Mutual Funds 191U.S. Venture Partnerships (Silicon Valley Venture Funds) 196Chapter 12 Epilogue 203Economic Accounting Is a Common Denominator for U.S. and Offshore Funds 203Tax Return Filing of U.S. Partnerships Is an Involved Task 204Calculating Partner Allocations Is Most of a U.S. Partnership’s Tax Accounting Effort 204Layering and Netting Methodologies for Tax Allocation of Capital Gains 205Example of Tax Allocation of Capital Gains by Full and Partial Netting in a 100-Partner Setting 205Tilting Tax Allocations According to Tax Preferences 206The Crown Jewel: Automated Tax Allocation of All Items of Income 206The End of an Era of Layering 207Appendix 1 Excerpts of Key U.S. Statutes Discussed in Chapter 1 That Govern U.S. and Offshore Hedge Funds Venture Funds 209Appendix 2 Methodology and Implementation Example of Full Netting 229Appendix 3 Methodology and Implementation Example of Partial Netting 253Appendix 4 Nonabusive Tilting of Tax Allocations According to Tax Preferences 259Appendix 5 Eliminating Layering Entirely, by Allocating Dividends, Interest, Capital Gains, and Expenses in One Step 267Index 277

NAVENDU P. VASAVADA, PHD, has held the positions of investment manager of large institutional investors, manager of private hedge funds, an economic analyst, and writer-at-large. He was formerly a senior investment manager at Aetna Inc. for over a decade, serving as head of quantitative research, risk manager, mortgage securities analyst, and equity/fixed income derivatives quant. He holds a PhD from Wharton, preceded by an engineering MS from the University of Pennsylvania and PGDBA from IIM-A, India.

• Preface xiiiChapter 1 The Arcane World of Hedge Funds and Investment Partnerships 1What Is a “Hedge Fund”? 1U.S. Venture Partnerships 3Types of U.S. Hedge Fund Entities and the U.S. Tax Code 4Organizing a Typical U.S. Hedge Fund 6Investor Clienteles in Hedge Funds 10Foreign Investors in a U.S. Hedge Fund 14Offshore Funds 14U.S. Investors in Offshore Funds 17U.S. Investors in Swiss Bank Accounts 19U.S. Investors in Madoff-Like Managed U.S. Trading Accounts 23Size of the Global Hedge Fund Industry 25Fund-of-Funds 28Incentives of the Hedge Fund Manager and Investors 30Valuation of a Hedge Fund Management Company 31Economies of Scale in Hedge Funds 33Chapter 2 The Structure of Hedge Funds 35Organizing a Typical Offshore Hedge Fund 35Master-Feeder Structuring of Onshore/Offshore Arms: Organizing a Hedge Fund for Clienteles 39U.S. Withholding Agent for U.S. Withholding Taxes on Foreign Investors 44Chapter 3 Hedge Fund Fees 47Starting Point: The Partnership Agreement 47Fund Valuation at Discrete Opening Time Points 48Calculation of Fixed Fees 49Calculation of Performance Fees 55Claw-Back Provision: Performance Fee Returned to Limited Partners 66Representation of a Fund’s Net Asset Value (NAV) per Share 71Black-Scholes Formula Valuation of Performance Fees 74Chapter 4 Hedge Fund Accounting and Tax Filing 79Partnership Accounting for U.S. Funds 79IRS Tax Return Filings for U.S. Hedge Funds 80Financial Statements for Hedge Funds and Venture Funds 85Interim Valuation: The Core of a Hedge Fund’s Accounting Operation 93Books of Account and Financial Statements for Hedge Funds 96Audit of an Offshore Fund 97Audit of a U.S. Fund 98Capital Account Audit for Both Offshore and U.S. Funds 99Chapter 5 Partner Tax Allocations in U.S. Partnerships 101U.S. Tax Allocation Rules Governing U.S. Partnerships 101Tax Components of U.S. Investment Partnership Income 103Fixed Fees: Income to the General Partner and Expense to the Limited Partners 107Generalizing the Allocation Formula to Other Components of Income 108Tax Basis of Partner’s Investment in a U.S. Partnership 109Accountants’ Terminology 113Tax Allocations of Realized and Unrealized Income to Partners 113The Tax Allocation Method of Layering 115Tax Allocation of Interest 118Tax-Exempt Interest Income, Line 18a 120Similar Calculation for Tax Allocation of Dividends, Investment Expense, Foreign Tax Paid 121Tax Allocation of Fixed Fees Paid by Limited Partners 121Tax Allocation of Guaranteed Payments (of Fixed Fees) to the General Partner 122Reporting Subcomponents of Interest Income and Dividends 122Tax Consequences of Shorting 123Short Positions: Tax Treatment of Equity Dividends or Bond Coupons Claimed as Interest Expense 123Distributions from Partnerships Owned 124Chapter 6 Tax Allocations of Realized Gains by Layering 127Tax Allocation of Unrealized and Realized Capital Gains Using the Method of Layering 127Ignoring Ambiguity #1 with Layering 132Work-Around to Fix Ambiguity #2, the Fatal Flaw with Layering 133Chapter 7 Partial and Full Netting Methods 137The Methods of Aggregation or Netting 137Partial Netting 138Full Netting 141Measures of Book-Tax Disparity across Partners 142Formulating the Problem for Optimal Partner Tax Allocations under Full Netting 143Formulating the Problem for Optimal Partner Tax Allocations under Partial Netting 146Solving the Convex Optimization Problem of Tax Allocation 148Chapter 8 Comparative Tax Consequences of Layering and Netting Methods 153Which Is the Better Method for Allocation of Realized Gains: Layering, Full Netting, or Partial Netting? 153Layering Examples Showing Earlier Tax Payment 154Full Netting Examples Showing Tax Postponement 158Chapter 9 Tax Efficiency of Hedge Funds 161Tax Efficiency Considerations for Offshore Hedge Funds 161Tax Preference Ordering for U.S. Investors 163More Attractive Tax Items to U.S. Investors 167Less Attractive Tax Items to U.S. Investors 169An Exception: Special Tax Preference for Gains from U.S. Exchange-Traded Futures Contracts 170Ambiguities in Tax Preference 170Tax Efficiency Steps for U.S. Hedge Funds 170A Structure for Tax-Exempt U.S. Entities to Recover Foreign Taxes 173Chapter 10 Hedge Fund Performance and Risk Presentation 175Performance Presentation: CFA Institute GIPS Verification 175Calculation of Hedge Fund Returns for Performance Presentation 179Facilitating Historical Risk and Return Review for Investors Using GIPS Guidelines 183Chapter 11 Mutual Funds and Venture Funds Compared to Hedge Funds 191Tax Return Filing of U.S. Partnerships Is an Involved Task 191Comparison with Tax Allocations Made by Mutual Funds 191U.S. Venture Partnerships (Silicon Valley Venture Funds) 196Chapter 12 Epilogue 203Economic Accounting Is a Common Denominator for U.S. and Offshore Funds 203Tax Return Filing of U.S. Partnerships Is an Involved Task 204Calculating Partner Allocations Is Most of a U.S. Partnership’s Tax Accounting Effort 204Layering and Netting Methodologies for Tax Allocation of Capital Gains 205Example of Tax Allocation of Capital Gains by Full and Partial Netting in a 100-Partner Setting 205Tilting Tax Allocations According to Tax Preferences 206The Crown Jewel: Automated Tax Allocation of All Items of Income 206The End of an Era of Layering 207Appendix 1 Excerpts of Key U.S. Statutes Discussed in Chapter 1 That Govern U.S. and Offshore Hedge Funds Venture Funds 209Appendix 2 Methodology and Implementation Example of Full Netting 229Appendix 3 Methodology and Implementation Example of Partial Netting 253Appendix 4 Nonabusive Tilting of Tax Allocations According to Tax Preferences 259Appendix 5 Eliminating Layering Entirely, by Allocating Dividends, Interest, Capital Gains, and Expenses in One Step 267Index 277

NAVENDU P. VASAVADA, PHD, has held the positions of investment manager of large institutional investors, manager of private hedge funds, an economic analyst, and writer-at-large. He was formerly a senior investment manager at Aetna Inc. for over a decade, serving as head of quantitative research, risk manager, mortgage securities analyst, and equity/fixed income derivatives quant. He holds a PhD from Wharton, preceded by an engineering MS from the University of Pennsylvania and PGDBA from IIM-A, India.

• Preface xiiiChapter 1 The Arcane World of Hedge Funds and Investment Partnerships 1What Is a “Hedge Fund”? 1U.S. Venture Partnerships 3Types of U.S. Hedge Fund Entities and the U.S. Tax Code 4Organizing a Typical U.S. Hedge Fund 6Investor Clienteles in Hedge Funds 10Foreign Investors in a U.S. Hedge Fund 14Offshore Funds 14U.S. Investors in Offshore Funds 17U.S. Investors in Swiss Bank Accounts 19U.S. Investors in Madoff-Like Managed U.S. Trading Accounts 23Size of the Global Hedge Fund Industry 25Fund-of-Funds 28Incentives of the Hedge Fund Manager and Investors 30Valuation of a Hedge Fund Management Company 31Economies of Scale in Hedge Funds 33Chapter 2 The Structure of Hedge Funds 35Organizing a Typical Offshore Hedge Fund 35Master-Feeder Structuring of Onshore/Offshore Arms: Organizing a Hedge Fund for Clienteles 39U.S. Withholding Agent for U.S. Withholding Taxes on Foreign Investors 44Chapter 3 Hedge Fund Fees 47Starting Point: The Partnership Agreement 47Fund Valuation at Discrete Opening Time Points 48Calculation of Fixed Fees 49Calculation of Performance Fees 55Claw-Back Provision: Performance Fee Returned to Limited Partners 66Representation of a Fund’s Net Asset Value (NAV) per Share 71Black-Scholes Formula Valuation of Performance Fees 74Chapter 4 Hedge Fund Accounting and Tax Filing 79Partnership Accounting for U.S. Funds 79IRS Tax Return Filings for U.S. Hedge Funds 80Financial Statements for Hedge Funds and Venture Funds 85Interim Valuation: The Core of a Hedge Fund’s Accounting Operation 93Books of Account and Financial Statements for Hedge Funds 96Audit of an Offshore Fund 97Audit of a U.S. Fund 98Capital Account Audit for Both Offshore and U.S. Funds 99Chapter 5 Partner Tax Allocations in U.S. Partnerships 101U.S. Tax Allocation Rules Governing U.S. Partnerships 101Tax Components of U.S. Investment Partnership Income 103Fixed Fees: Income to the General Partner and Expense to the Limited Partners 107Generalizing the Allocation Formula to Other Components of Income 108Tax Basis of Partner’s Investment in a U.S. Partnership 109Accountants’ Terminology 113Tax Allocations of Realized and Unrealized Income to Partners 113The Tax Allocation Method of Layering 115Tax Allocation of Interest 118Tax-Exempt Interest Income, Line 18a 120Similar Calculation for Tax Allocation of Dividends, Investment Expense, Foreign Tax Paid 121Tax Allocation of Fixed Fees Paid by Limited Partners 121Tax Allocation of Guaranteed Payments (of Fixed Fees) to the General Partner 122Reporting Subcomponents of Interest Income and Dividends 122Tax Consequences of Shorting 123Short Positions: Tax Treatment of Equity Dividends or Bond Coupons Claimed as Interest Expense 123Distributions from Partnerships Owned 124Chapter 6 Tax Allocations of Realized Gains by Layering 127Tax Allocation of Unrealized and Realized Capital Gains Using the Method of Layering 127Ignoring Ambiguity #1 with Layering 132Work-Around to Fix Ambiguity #2, the Fatal Flaw with Layering 133Chapter 7 Partial and Full Netting Methods 137The Methods of Aggregation or Netting 137Partial Netting 138Full Netting 141Measures of Book-Tax Disparity across Partners 142Formulating the Problem for Optimal Partner Tax Allocations under Full Netting 143Formulating the Problem for Optimal Partner Tax Allocations under Partial Netting 146Solving the Convex Optimization Problem of Tax Allocation 148Chapter 8 Comparative Tax Consequences of Layering and Netting Methods 153Which Is the Better Method for Allocation of Realized Gains: Layering, Full Netting, or Partial Netting? 153Layering Examples Showing Earlier Tax Payment 154Full Netting Examples Showing Tax Postponement 158Chapter 9 Tax Efficiency of Hedge Funds 161Tax Efficiency Considerations for Offshore Hedge Funds 161Tax Preference Ordering for U.S. Investors 163More Attractive Tax Items to U.S. Investors 167Less Attractive Tax Items to U.S. Investors 169An Exception: Special Tax Preference for Gains from U.S. Exchange-Traded Futures Contracts 170Ambiguities in Tax Preference 170Tax Efficiency Steps for U.S. Hedge Funds 170A Structure for Tax-Exempt U.S. Entities to Recover Foreign Taxes 173Chapter 10 Hedge Fund Performance and Risk Presentation 175Performance Presentation: CFA Institute GIPS Verification 175Calculation of Hedge Fund Returns for Performance Presentation 179Facilitating Historical Risk and Return Review for Investors Using GIPS Guidelines 183Chapter 11 Mutual Funds and Venture Funds Compared to Hedge Funds 191Tax Return Filing of U.S. Partnerships Is an Involved Task 191Comparison with Tax Allocations Made by Mutual Funds 191U.S. Venture Partnerships (Silicon Valley Venture Funds) 196Chapter 12 Epilogue 203Economic Accounting Is a Common Denominator for U.S. and Offshore Funds 203Tax Return Filing of U.S. Partnerships Is an Involved Task 204Calculating Partner Allocations Is Most of a U.S. Partnership’s Tax Accounting Effort 204Layering and Netting Methodologies for Tax Allocation of Capital Gains 205Example of Tax Allocation of Capital Gains by Full and Partial Netting in a 100-Partner Setting 205Tilting Tax Allocations According to Tax Preferences 206The Crown Jewel: Automated Tax Allocation of All Items of Income 206The End of an Era of Layering 207Appendix 1 Excerpts of Key U.S. Statutes Discussed in Chapter 1 That Govern U.S. and Offshore Hedge Funds Venture Funds 209Appendix 2 Methodology and Implementation Example of Full Netting 229Appendix 3 Methodology and Implementation Example of Partial Netting 253Appendix 4 Nonabusive Tilting of Tax Allocations According to Tax Preferences 259Appendix 5 Eliminating Layering Entirely, by Allocating Dividends, Interest, Capital Gains, and Expenses in One Step 267Index 277