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For many successful managers, a significant part, if not most, of the assets they
manage are held in offshore vehicles. But many managers’ first entry into the
December 2009 Considerations For Hedge Fund Startups
Page 2
The manager can pool assets from many investors, allowing it to manage a
single portfolio efficiently; and
¾ Note: The money manager is distinct from the “hedge fund.” The
manager does not “own” the Fund—the investors do, and the
1This is discussed below. For most purposes in this outline, the general partner and investment
Choice of entity for Fund. The following attributes are so desirable as to be,
as a practical matter, “required”:
“Pass-through” taxation. The Fund itself shouldn’t pay income taxes. Its
income, gains, losses, deductions should all “pass through” to investors,
who take them directly on their own tax returns.
Limited liability. Investors should not be personally liable for the Fund’s
debts. They can lose what they invested, but, e.g., if the Fund is leveraged,
they should not have to make additional contributions or answer to Fund
creditors.
These attributes mean the Fund will be either a limited partnership (of which
the management company or a related entity is the general partner) or a limited
liability company (“LLC”) of which the management company or a related
entity is the “managing member”)2 Here is a pictorial view of the simplest (and
very common) structure:
O w ner #1 O w ner #2
C a p . C o n tr ib ., M em ber
M em ber S e rv ic e s I n te r e s t C a p . C o n tr ib .,
In te re s t S e rv ic e s
A B C In v e stm e n t
M anagem ent L L C
(I n v e s tm e n t A d v is e r )
(D e l L L C )
G P In te re s t;
In v esto r s 2 0 % In c e n tiv e
(L im ite d P a r tn e r s ) A llo c a tio n
(1 0 0 , if 3 (c )(1 ); 4 9 9 if o f P r o fits; 1 %
3 (c )(7 )) M g t. F e e
C a p ita l
C o n t r i b 's ; M g t .
C a p ita l S e rv ic e s
LP
C o n t r i b 's
In te re s ts
F e r o c io u s A n im a l F u n d , L P
(F u n d )
(D e l L td . P tn rs h ip )
I n v e s tm e n t P o r tfo lio
2An LLC that is centrally managed, like a Fund would be, has a “manager” or “managing member” that
plays the same role as a general partner. But the management company is not liable for the debts of the
fund, like a true general partner would be.
December 2009 Considerations For Hedge Fund Startups
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This protection will be significantly less complete for owners who are
active portfolio managers and otherwise active in running the
management company because of special provisions of federal
securities laws that impose liability for certain acts directly on “control
persons.”
But even control persons can be protected from some liabilities, and
any passive or noncontrolling owners can receive fuller protection.
December 2009 Considerations For Hedge Fund Startups
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This means the management company will probably be one of the following:
Some tax practitioners believe this may improve the position under
federal income tax law that the carried interest should be entitled to
treatment as a profit allocation rather than a fee for services. For
investment managers located in New York City, a similar analysis is
common in order to avoid subjecting the carried interest to an
Unincorporated Business Tax.
Separate entities can facilitate sharing the two sources of value among
the various participants in a hedge fund startup (and their employees)
in different ways. This may be particularly useful for tax planning
purposes and/or where the hedge fund project is a joint venture
between different organizations and people.
Some practitioners believe that separating the investment
management function from the “general partner” function may
enhance the limitation of liability of owners of the two entities.
Owner #1 Owner #2
Member Member
(ownership) (ownership)
Interests Interests
US Tax-Exempt
Investors
(Shareholders)
U.S.
ABC Asset
ABC Holdings LLC Management LLC OFFSHORE
(Del LLC) (Del LLC)
Non-US
US Taxable Purchase Investors
Investors GP Interest, Price (Shareholders)
(Limited Partners) 20% Incentive 1.5% Mgt. Fee
Allocation Investment
AND
Mgt. Services
20% Performance Fee
1.5% Mgt. Fee Purchase
Capital Shares Price
Contribution Investment
Mgt. Services Shares
Capital
Contributions
Ferocious Animal Ferocious Animal Offshore
LP Interests
Partners, LP Fund, Ltd.
(Domestic Fund) (Offshore Fund)
(Del Ltd Prtnrship) (Cayman Company)
OFFSHORE
U.S.
Investment Portfolio
Investment Portfolio
How much working capital will the management company need? Factors include:
Founders.
Passive financial investors.
How much dilution? How much of the upside should the Founders sell and how
much control should they cede to outside investors?
December 2009 Considerations For Hedge Fund Startups
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“Anchor tenant” investors in Fund. Some large investors may be willing to “seed” a
new Fund in exchange for a participation in the management company’s
profits—sometimes relating only to the Fund, sometimes to all the company’s
investment activities. This interest can be limited in duration and/or subject to
a “buyout” right.
Management fee.
Fund may not make a public offering of its interests. Satisfying the
“private placement” exemption described below will satisfy this
requirement; and
Fund may not have more than 100 “beneficial owners” at any time.
!!!! Beware!! Rules for counting up to 100 are complex and unclear. For
example:
If another 3(c)(1) fund (e.g. “fund of funds”) holds more than 10% of
interests, Fund generally must “look through” that fund and count
each of its investors as filling a “slot.” This rule also applies to
investments by mutual funds and 3(c)(7) funds (discussed below).
Even if below 10%, if a partnership, LLC, corporation or other entity
is formed for the purpose of investing in the fund, must look through
and allocate a slot to each of that entity’s owners. If more than 40%
of the entity’s assets are invested in the fund, that entity is presumed
to have been formed for the purpose of investing in the Fund.
If a management company operates multiple funds, unless there are
sufficient differences in investment objectives and eligibility
requirements, they may be “integrated” and considered to have only
100 available slots among them.
Fund may not make a public offering of its interests. Same test as for
3(c)(1) funds.
Fund is not limited to 100 beneficial owners, but may be owned only
by “Qualified Purchasers” and “knowledgeable employees” of the
management company or the fund.
Qualified Purchasers are:
° Individuals and certain family companies that own at least
$5 million of “investments.” Entities that have “control” over
$25 million of “investments.” Controlled investments include the
entity’s own investments and assets held by other Qualified
Purchasers over which the company exercises investment
discretion; Entities that are themselves owned only by Qualified
Purchasers; and “Qualified Institutional Buyers” under Rule 144A.
Calculation of $5 million or $ 25 million of “investments” is complex.
° Must exclude value of securities of certain privately held
companies.
° Real estate may be included, but only if held for investment—i.e.,
not for personal or business—purposes.
December 2009 Considerations For Hedge Fund Startups
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3Other exemptions are available for 3(c)(7) funds and funds that limit their investment in futures to
specified levels.
4For investors in Funds based on the west coast, it is generally not enough simply to be an accredited
investor. Accredited investors include individuals with a net worth of at least $1 million, individuals with
incomes of at least $200,000 for certain periods, individuals whose joint income with spouse for certain
periods was at least $300,000, and certain corporations with assets of at least $5 million. The SEC’s Rule
205-3, precludes an SEC-registered adviser from receiving a performance allocation as to an investor
that does not have a $1.5 million net worth or have at least $750,000 under the Management Company’s
management. California, Washington, and Oregon law governing investment advisers contain similar
requirements, in various states of evolution to conform to Rule 205-3.
December 2009 Considerations For Hedge Fund Startups
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A fund of funds that invests must show that each of its investors
meets the net worth test.
The management company may make some exceptions. E.g., a 3(c)(1)
fund that does not invest in futures or commodity options may admit
a limited number of nonaccredited investors if the management
company waives the performance allocation for them.
Must include not only “true” ERISA plans, but also IRAs and Keoghs
and certain other types of plans.
Must exclude the management company’s (and its owners’) capital
account(s) from both numerator and denominator.
December 2009 Considerations For Hedge Fund Startups
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If the fund’s Offering Memorandum describes any limits on the investing and
trading activities the fund will engage in (e.g., “the Fund will not buy a security if
after doing so the security would comprise more than 10% of the Fund’s
assets”; other concentration characteristics; focus on small-capitalization
equities; no margin; no options), the management company must stick to them.
Some of these may be unclear. Requires care in drafting Memorandum.
5A Management Company with between $25 million and $30 million is permitted to register with the
SEC, but is not required to as long as it complies with state registration requirements or is eligible for
the private adviser exemption from SEC registration. Congress is considering legislation that could raise
this limit to $100 million.
December 2009 Considerations For Hedge Fund Startups
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managers, state registration issues are more relevant at the outset. But growth
brings SEC considerations.
Many management companies with more than $25 million under management
qualify for a “private adviser” exemption from SEC registration:
State registration.
If the management company has less than $30 million under management or is
relying on the “private adviser” exemption from SEC registration, states may
require registration and subject the management company to substantive
regulation, such as net capital requirements, rules governing contracts, and rules
governing performance-based compensation.
There are exemptions from CPO and CTA regulation for managers of (i) 3(c)(7)
funds and (ii) 3(c)(1) funds that, among other things, are not marketed as
commodity pools and limit their futures and commodities activities so that
(a) the aggregate initial margin and premiums required to establish commodity
interest positions (determined as of the most recent time a position is
established) does not exceed 5% of the fund’s liquidation value or (b) the
aggregate net notional value of the fund’s commodity interest positions
(determined as of the most recent time a position is established) does not exceed
100% of the fund’s liquidation value.
Even if a management company does not qualify for those exemptions and
must register as a CPO, it may qualify for an exemption from CTA registration
under a “private adviser” exemption similar to the SEC exemption.
A registered CPO or CTA must also be careful that investors that are
themselves pooled investment vehicles (e.g., funds of funds) are managed by
entities that are either registered as commodity pool operators or commodity
trading advisers (and members of the NFA) or exempt from such registration
and membership.
Insider trading. Most management companies must have a written set of policies
and procedures to detect and prevent insider trading (often integrated with their
“codes of ethics”). Some unregistered management companies may not be
specifically required to have such a policy, but as a matter of prudence and
practice they should. The substantive insider trading laws apply to all market
participants.
State net capital requirements. The SEC does not require registered management
companies to maintain any particular level of capitalization, but many states do.
The substantive requirements are generally easy to meet, but management
companies must maintain records demonstrating compliance.
Offering Memorandum
° Does double duty: marketing document as well as protection
against investor claims that they were misled.
° Must disclose details of structure, identity of the management
company, investment program and restrictions, compensation and
economic interest of the management company, overview of risks,
conflicts of interest of the management company, overview of tax
characteristics of fund, terms on which interests are offered.
° If fund invests in futures and other commodity interests may need
to include detailed disclosure imposed by CFTC.
Fund Partnership Agreement (“Operating Agreement” for LLC)
° Contains details of deal among investors and the management
company, including: grant of authority to the management
company; performance allocation; management fee; withdrawal
(redemption) rights; who bears what expenses; “carveout”
arrangements for new issues; voting and amendment rights.
° Should give the management company broad authority to invest,
authorize the management company to force withdrawals, limit
impact of fiduciary duties on other management company
December 2009 Considerations For Hedge Fund Startups
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Begin offering.
Provide new issue documentation to brokers who might sell new issues to
Fund.6
FUND RAISING
No general solicitation or advertising.
6NASD regulations require brokers to have documentation demonstrating that sales of “new issues”
are not made to accounts in which “restricted persons” have beneficial interests. Many funds use
“carve out”” accounts to allocate profits from new issues away from restricted persons. These
regulations are complex and managers face choices in how to comply.
December 2009 Considerations For Hedge Fund Startups
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Stick to the script—don’t make statements that aren’t in the formal offering
documents or in supplemental materials that have been reviewed carefully for
consistency with the formal documents. In particular, statements about limits
on portfolio activities (e.g., concentration limits, limits on margin or short
activity) can come back to haunt.
OFFSHORE FUNDS
Reasons for setting up separate offshore fund.
A 1997 tax act (repeal of so-called “Ten Commandments”) changed that. Now,
foreign investors are subject to tax only on dividend and certain interest income.
Structure.
Offshore funds typically are not partnerships.7 Instead, they are “companies,”
like corporations, that issue shares. They typically have a board of directors and
the management company usually is not an investor. Instead, it has an
investment management contract with the fund. Many funds use a “master-
feeder” structure in which the assets of the offshore fund and a “sister”
domestic fund are pooled into a single portfolio. Whether this is advantageous
depends on a number of factors particular to the funds’ investment activities
(tax considerations are important) and the number and types of potential
investors.
7Limited partnerships and LLCs may be appropriate for some types of funds As with domestic
funds, such a structure would have the advantage of permitting investor-level accounting and
structure of performance allocation in same manner as domestic fund. This could be more
hospitable to U.S. taxable investors. However, none of this would be appropriate if exchange listing
or publication of net asset value is desirable.
December 2009 Considerations For Hedge Fund Startups
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Jurisdiction of formation.
Criteria:
High-end—Ireland, Luxembourg.
Expenses; mechanics.
Formation is typically significantly more expensive than for domestic fund. In part
because, although U.S. counsel must remain involved and will generally take
laboring oar in drafting disclosure documents and coordinating formation, also
need offshore counsel for the formation documents and local registration.
Registration fees and setup fees for offshore service providers add to the
expense.
Offering of shares/interests
Generally offer only to non-U.S. investors (this term has a technical definition)
and up to 100 U.S. tax-exempt investors (more if limit these to Qualified
Purchasers who could invest in a 3(c)(7) fund).
For sales to U.S. investors, comply with the “private placement” exemption.
Distribution/placement agents are used more often to sell shares offshore than
domestically. They increase cost to the management company, often taking a
piece of the management company’s compensation. And they may even charge
commissions on sales.
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