When investors hold shares in private hedge or venture funds, they may indirectly have unrealized profits in specific stocks in the fund portfolios.  In this situation, the hedge or venture fund investor cannot actually sell the specific stock.  However, a passive investor may enter into completely separate personal investments to protect his or her share of a fund’s profitable position. This strict separation of the two holdings has interesting tax implications.

Completely Separate Personal Investments

Passive investors in private hedge and venture funds usually cannot make investment decisions for the funds.  As a result, they may believe that there is no way to protect their unrealized gains.  In most situations, however, it is possible for investors in collective vehicles to create hedges that protect gains in specific stocks.

One possible hedge would involve short sales. A short sale is a sale of a stock the investor does not own. If the stock goes down, the short seller will make money, and if the stock goes up, the short seller will lose. Therefore, a short sale combined with the indirect ownership should create an economic situation that is similar to a “regular” sale.  From a tax perspective, this approach might appear problematic, because when a fund investor does a personal short sale of a fund holding, the combination of the personal hedge and the holding in the collective investment will include all the elements of a short against the box.  A short against the box often constitutes a constructive sale.  In this situation, however, if the investor has no control over the disposition of the long stock in the fund, and if the short position is kept strictly separate from the fund, then the combined holdings should not constitute a constructive sale for tax purposes.

Certain regulatory caveats apply to this approach. The investor can’t directly or indirectly own more than 50% of the fund; otherwise, the combined positions will constitute a constructive sale.  Moreover, the strategy is only available to investors whose role in the fund is strictly passive; if an investor has control over fund decisions, then the strategy might constitute a constructive sale.  Finally, this strategy requires collateral.

Investors who use this approach should take steps to apprise themselves of the fund’s investment decisions.  In particular, they need to know if the fund sells the stock that they have shorted. If this should happen, the investor can undo the potential risks of the short sale by purchasing the stock.

A Complex Analysis

The hedging of collective vehicle components can be somewhat complicated. Investors need to apprise themselves carefully of the effects of potential hedging transactions before they proceed.  In many situations, however, a viable hedge can be constructed to protect an underlying stock holding without triggering any tax.

For an interactive overview of hedging and monetizing possibilities for different types of appreciated securities, investors can consult Twenty-First Securities 'hedging low-basis stock decision tree'.

This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein.   Purchasers of hedge funds, including hedge fund of funds, should carefully review the fund's offering materials.  Hedge funds and hedge fund of funds have a high degree of risk, including, without limitation, that these funds typically employ leverage and other speculative investment practices, that the ability to make withdrawals typically is very limited, that these funds are not subject to the same regulatory requirements as mutual funds, and that an investor can lose all or a substantial amount of his investment.