Hedge funds are unregulated investment vehicles available to sophisticated investors, including accredited institutions and people with substantial assets. Hedge funds share similarities with mutual funds—they both pool investors’ capital and attempt to generate a return on those assets.
However, hedge funds typically have a greater degree of flexibility in terms of what can be invested in, have higher fees and are less liquid. For instance, hedge funds invest in stocks, bonds and real estate, but the approach is different than traditional mutual funds.
Many hedge funds use what is known as long/short strategies. The “long” portion involves buying stocks. The “short” portion includes selling stocks with borrowed money, then buying them back when the price falls. As a result, hedge funds are assets that can be very difficult to divide during a divorce.
When deciding what to do about hedge funds during a divorce, there are three key considerations: liquidity, taxes and strategy.
1. Hedge Funds Lock up Liquidity
Some hedge funds cannot be sold quickly, thereby complicating the potential division of assets. For example, some hedge funds have multiyear lockup periods, meaning the investors will not be allowed to sell or redeem their shares during that period. Other funds have annual liquidity (i.e. an investor can only take money out on a specific date each year).
Consequently, when evaluating hedge-fund assets as part of a property division, it is critical to understand the timing and feasibility of transferring a hedge fund to a spouse.
Confounding the matter even further, transferring ownership in hedge funds is not always a straightforward task. Some funds prevent transfers entirely, while others may require right of first refusals. The bottom line: transferring a hedge fund investment can be a very complex legal endeavor. (For related reading see: Taking a Look Behind Hedge Funds.)
2. Hedge Fund Tax Treatment
Tax filing for hedge funds is different from most other investments. A hedge fund is a form of pass-through entity that allows the fund itself to operate tax-free. When the funds are distributed to the partners, the gains and losses are then taxed at the individual level.
Thus, hedge-fund investors receive a Form K-1, which reports the investor’s share of the hedge fund’s income, deductions and credits. A Form K-1 can add a layer of complexity to an individual’s tax filings. It usually necessitates filing for an extension and having higher accounting expenses. For this reason alone, a spouse may not want to keep a hedge fund.
Ultimately, it is imperative to know the tax treatment for earnings and any distribution rights. Then you can pay the resulting tax, should you receive a hedge fund.
3. A Satisfactory Hedge Fund Strategy
A final consideration is the hedge-fund strategy. Hedge funds are typically a blend of publicly traded and closely held securities, which makes placing value on them an extremely difficult task. Is it a hedge fund worth keeping on the merits of the investment? Will it generate a satisfactory return on investment? Are the fund’s securities valued by an independent source? (For related reading, see: The Multiple Strategies of Hedge Funds.)
There are many factors that go into determining whether a hedge fund is an asset you may want to keep as part of your property settlement. Without knowing the fund’s investment strategy in-depth, it may be a poor financial decision to accept some hedge funds as part of a property settlement.
Get Extra Help
With the intricacies involved, it is necessary to hire a financial specialist to evaluate hedge-fund assets as part of a divorce. By carefully evaluating hedge fund assets, you can decide whether they are worth keeping or if you should consider taking other assets as part of the divorce. By informing yourself of the liquidity, taxes and strategy, you can make the best decision for you during this difficult time.
(For more from this author, see: 3 Steps to Separate Your Finances During Divorce.)