Below is a question we received through the comment portion of this blog:
A fund we participate in converted in mid-2007 from a 3(c)(1) fund to a 3(c)(7) fund. Upon receipt of the K-1 for the year, there was a large realized short-term capital gain realized with a large corresponding unrealized capital loss. When I asked about what triggered the short-term gain, I was told that it related to the conversion to 3(c)(7) status. Is there anything within the conversion process which would inherently trigger recognition of a capital gain, especially short-term? Thanks for any insight you may be able to share with me on this.
First, let’s examine what it means to “convert” from a 3(c)(1) hedge fund to a 3(c)(7) hedge fund. There is no form that a hedge fund submits to the government or any agency which declares whether they are a 3(c)(1) hedge fund or a 3(c)(7) hedge fund. There is no sort of internal declaration like with certain IRS rules.
The 3(c)(1) structure limits the number of investors to 99, the 3(c)(7) structure does not limit the number of investors, but limits the type of investors. So, to “convert,” a hedge fund would just make sure that all of its investors were qualified purchasers and then have more than 99 of them. Therefore, when a hedge fund “converts” from a 3(c)(1) hedge fund to a 3(c)(7) hedge fund, the fund is basically informing investors that the number and “type” of investor in the hedge fund (a limited partnership or limited liability company) will be changing. (Please also note that a 3(c)(7) hedge fund with 99 or less investors would also be exempt from registration under the Investment Company Act as a 3(c)(1) hedge fund. )
When the conversion takes place, the fund would redeem those investors who are not qualified purchasers (the offering documents will typically provide managers with this unilateral authority). In order to have the cash on hand to mandatorily redeem the investors, the fund may have to liquidate some underlying positions. Based on the holding period of the underlying positions, the gain or loss may be long-term or short-term gain or loss, each of which has different tax consequences to investors in the hedge fund.
At the end of the year, the hedge fund accountant will prepare K-1s for all investors in the partnership which will include each investors allocation of gains and losses (realized and unrealized) during the year. The manner in which these gains and losses are allocated is generally dictated by the hedge fund’s offering documents, which generally allow the manager wide latitude in how to make allocations.
With regard to the specific situation above, I cannot answer this question because it depends on the facts. One thing an investor in this situation may want to do is review the audited financial statements from the hedge fund and then determine if an allocation was made which was incorrect – an accountant should be able to do this. If there is still a question on the allocation, the investor should discuss the issue with the hedge fund manager in conjunction with the manager’s auditor or accountant. From there the investor should be able to get further clarity on the issue.