The Canadian Hedge Fund Ecosystem Described

A new handbook from AIMA Canada portrays the “afterglow” of that country’s strong banking industry, its success in coming through recent global crises unscathed, as a comparative advantage for the nation’s hedge fund managers.

AIMA Canada, a national group under the umbrella of the Alternative Investment Management Association, focuses in its handbook mostly on regulation, compliance, structuring, and the raising of capital. But the book’s early materials, which put the hedge fund industry in context, have their own fascination.

The handbook tells us, for example, that the bulk of Canada’s hedge fund managers will be found in Toronto, in the province of Ontario, where one can find “a growing and exceptionally dynamic hedge fund and alternative investment ‘ecosystem’ with new players constantly entering the market as spinoffs from local trading desks, traditional investment managers and other hedge funds.”

The handbook also gives a shout-out to Calgary, a city whose economy is largely driven by the energy sector, but which also has a promising financial services presence dedicated to “managing and diversifying the great wealth created by [the energy sector] and its participants.”

Canadians are justly proud of their banking sector, which has endured through the global credit crises of recent years with barely a murmur. AIMA Canada credits its stability in part to capitalization. Canadian banks “greatly exceed the guidelines set by the Bank of International Settlements” on this matter.

Indeed, the handbook credits this fact, the “positive afterglow” of a strong banking industry, as one of the factors that has stimulated the growth of fund administrators, especially in Toronto. These administrators are expanding “their service offerings to enable managers to outsource more processes than ever before.”

Regulation and Compliance

But on to the meat of the book … there are three different sorts of registration requirement with which the hedge fund industry has to contend in Canada: registration for dealers, advisers, and investment fund managers.

Hedge funds often respond to the dealer registration requirement by registering as an exempt market dealer rather than as an investment dealer. EMDs can trade only in securities distributed under a prospectus exemption or with people or companies to whom a security might be distributed under such an exemption.

Given the times in which we live, it is unsurprising that hedge funds in Canada are subject to anti-money laundering and anti-terrorist financing legislation. This entails for example reporting, filing, and client identification mandates.

There is also privacy legislation, which makes a registered firm responsible for the information it collects from individuals, and the way it stores or discloses that information to third parties.

Investors have statutory rights of action for rescission or damages if an offering memorandum contains a misrepresentation, inclusive of a material omission, and an offering memorandum must itself contain a description of those statutory rights.

Further, a copy of any offering memorandum, or any amendment thereto, must be filed with the securities regulatory authority in the jurisdictions where are located the purchasers of securities in that foreign fund.

Separately, subscription materials for investment in a foreign fund must be customized. Usually a schedule or addendum is added “to ensure that the distribution of the securities of the Foreign Fund may occur in Canada on a basis which is exempt from the requirement for the Foreign Fund to file and clear a prospectus in Canada.”

Structure

Hedge funds in Canada are unlikely to be corporate in character. They are more likely to be limited partnerships or unit trusts, or a hybrid of the two.

If they are LPs, they may use traditional capital accounting, or they may be unitized. In a unitized LP, a limited partner’s interest is described as a distinct number of units, which themselves may be distinguished by class or series. In either case, as the Handbook says “a limited partnership allows fees to be charged at the series or investor level, and allows income or losses to be allocated most fairly.”

There are drawbacks to the LP structure though. For example, registered retirement plans are not allowed to invest in LPs, so hedge funds with this structure lose out on that source of capital.

A unit trust, then, deserves consideration from would-be hedge fund managers who want to offer their fund “to foundations, pension plans, registered retirement savings plans and other non-taxable investors.”

Hybridization of the two structures is possible. Managers might create a “top trust,” with access to registered plan money, which then invests in an underlying LP which manages a portfolio.

Canadian hedge funds often offer monthly redemptions, though as elsewhere funds that have relatively illiquid portfolios “or that wish to minimize portfolio disruption and cash-drag may only offer quarterly or even yearly redemptions.”

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