Starting a Hedge Fund in 2009 Bart Mallon, Esq. www.hedgefundlawblog.com

Overview Initial Considerations Fund Characteristics Basic Structure Structural Issues Laws Regulation D Investors Registration Service Providers Timeline Offering Documents Costs Raising Capital Other Issues Disclaimer 2 of 18 © www.hedgefundlawblog.com

Initial Items to Consider Who will be your investors? How will you get to where you want to go? 3 of 18

Hedge Fund Characteristics Trading Strategies Traditional Non-Traditional Other Pooled Investment Vehicles Fees 2 and 20 Taxation “pass-through” taxation tax benefit of “allocation” of performance fees Hedge funds defined by a few major things - thier trading strategies, What is a hedge fund? Hedge funds, contrary to their name, do not always have hedged investment programs. A good general definition of a hedge fund is any sort of pooled investment vehicle where a management company makes the investment decisions on behalf of the fund Different funds have different types of trading stragies Traditional Long/short equity, Market Neutral, Biased (short or long), Macro, Sector, Convertible Bond and Convertible Arbitrage, Event-Driven Strategies, Distressed Assets, Emerging Markets and Managed Futures Non-Traditional Forex, Life Settlement Funds, Asset Based Lending Funds, Green Funds, Horse Racing Funds, Gambling Funds, Sports Betting Funds, and Charitable Funds Other Pooled Investment Vehicles Real Estate, Private Equity, VC, Fund of Funds, and Hybrid Fees Management Fees and Performance Fees Historical “2 and 20” fee structure Taxation no “double taxation” like in a corporation Fund Manager receives tax benefit of “allocation” of performance fees allowing manager to be taxed on this income pursuant to the underlying tax attributes of the income (long term or short term capital gain) as opposed to simple ordinary fee income 4 of 18

Basic Fund Structure Fees Allocations Management Movement of money Investors make investment in the Fund, payment to the Fund’s bank account* Manager wires money to the Fund’s brokerage account* Fund is managed by the Management Company Fund makes investments Fund pays Management Company a management fee (or may be paid from brokerage account)* Fund allocates Management Company a performance allocation If Investors make withdrawals, the Fund will make a distribution to investors* * Indicate where there would likely be wire fees Hedge Fund Investors (Limited Partners) Management Company (LLC) 1. 5. 6. 7. Hedge Fund (LP) (Bank Account) 3. 2. 7. Fees Allocations Management Movement of money Withdrawal Hedge Fund (LP) (Brokerage Account) 4. Investments 5 of 18

Structural Issues Fund structure/ Investors Minimum Investments Initial, Subsequent, In-kind, Maximum Withdrawal and Contribution Periods Monthly, Quarterly, Yearly; Lock-up; Gate Provision; In-kind; Distributions Fees Management and Performance; High Watermark; Hurdle Rate Management registration status Reports to investors Selling commissions Expenses Asset valuation practices 6 of 18

Hedge Fund Laws Securities Act of 1933 Interest in a fund are “securities” Regulation D “safe harbor” Securities Exchange Act of 1934 Funds with 500 investors and $10 million in equity must register Investment Company Act of 1940 Hedge funds exempted under Section 3(c)(1) and Section 3(c)(7) Investment Advisers Act of 1940 Requires investment advisers to register with the SEC Exemption under Section 203(b)(3) for advisers who have less than 15 clients over a 12 month period Commodities Exchange Act CPO and CTA Registration Other Laws Internal Revenue Code of 1986 “Blue Sky” Laws There are six basic groups of laws which apply to hedge funds in one respect or another. Fund managers should be aware of the major ways in which these groups affect the structure and operations of hedge funds. Securities Act of 1933 Interest in a fund are “securities” Regulation D “safe harbor” Securities Exchange Act of 1934 B/Ds must be registered with SEC Requires issuers with 500 shareholders and $10 million in equity to register as a “reporting company” Investment Company Act of 1940 Requires mutual funds to register (very onerous) Hedge funds exempted from definition of mutual fund under Section 3(c)(1) and Section 3(c)(7) Investment Advisers Act of 1940 Requires investment advisers to register with the SEC State vs. Federal jurisdiction Exemption under Section 203(b)(3) for advisers who have less than 15 clients over a 12 month period Commodities Exchange Act Regulates commodities and futures trading Requires managers trading commodities and futures to register with the CFTC as Commodity Pool Operators Internal Revenue Code of 1986 US tax laws Long term capital gains taxed at a rate lower than the ordinary income rate “Blue Sky” Laws State laws which may apply to hedge fund managers in certain circumstances 7 of 18

Regulation D Rule 506 Definition of “accredited investor” No limit on amount of sales Generally only sold to “accredited investors” Can have up to 35 non- “accredited investors” Definition of “accredited investor” $1 Million Net Worth $200,000 in income in last 2 years No General Advertising No newspaper ads No radio shows File Form D with SEC within 15 days of sale 8 of 18

Hedge Fund Investors Section 3(c)(1) Funds Section 3(c)(7) Funds Limited to 99 investors Accredited Investor Qualified Client Natural person with a net worth of $1,500,000 Note: may be dependant on state law Limited to 499 investors Qualified Purchaser Natural person with a liquid net worth of $5,000,000 9 of 18

Registration Investment Advisor Registration CTA or CPO Registration State vs. Federal Under $25 million – State only $25 - $30 million – SEC or State Over $30 million – SEC SEC Section 203(b)(3) exemption Generally 2-4 weeks Compliance manual State Exemption depends on state laws Generally 2-8 weeks Series 65 Potential net capital requirements Compliance procedures including potentially a compliance manual CTA or CPO Registration Registration with CFTC through the NFA Potential CTA and CPO Exemptions (but potential state issues) Series 3 Various compliance requirements Investment Advisor Registration State vs. Federal SEC Section 203(b)(3) exemption Generally 2-4 weeks Compliance manual State Exemption depends on state laws Generally 2-8 weeks Series 65 Potential net capital requirements Compliance procedures including potentially a compliance manual CTA or CPO Registration CFTC and NFA Potential CTA and CPO Exemptions Series 3 Various compliance requirements 10 of 18

Hedge Fund Service Providers Lawyer drafts offering documents; entity formation; registration; strategic and legal advice Administrator provides fund NAV calculation; fee calculations; investor reporting; etc. Auditor/ Accountant provides yearly fund audit; prepares tax forms for the manager and investors Prime Broker provides execution and/or clearing services for trades; custodian of assets Consultant provides consulting services to management company re: fund raising, marketing, operational guidance etc 11 of 18

Hedge Fund Timeline Week 1 Week 2 Week 3 Week 4 discuss fund structure in depth, organize legal entities (management company, fund), begin talking with outside service providers Week 2 receive draft of offering documents, begin thinking about operational issues which may arise – are your computers ready, is office space secured? Week 3 discussion and revision of offering documents with attorney, begin finalizing outside service provider contracts, establish bank account, establish brokerage account Week 4 tie up loose ends, finalize offering documents, begin to get ready for trading or selling interests in your fund IA registration and CTA/ CPO registration will affect this timeline – usually add about 2-4 weeks to the schedule assuming that the principals have all required regulatory exams and also provided that there are no prior regulatory actions 12 of 18

Offering Documents Private Placement Memorandum (PPM) Similar to mutual fund prospectus Discussion of important structural terms Discussion of investment program Information on management company and managers Limited Partnership Agreement (LPA) Governing legal document Subscription Documents Subscription agreement Investor suitability questions 13 of 18

Costs to Start a Fund Lawyer Administration Audit Prime Broker Range from $15,000 (boutique) to $30,000 (BigLaw) for a basic domestic long-short fund; registration extra My firm will be about $10,000 for a basic domestic long-short fund; registration from $2,000 if necessary Administration Range from $750 - $1,500 per month; Initial one time set-up fees range from $500 - $1,500 Larger funds may also pay a fee (x bps) on AUM Audit Audit: $5,000 – 15,000 depending on a number of factors including Audit firm Tax Prep: $4,000 - $10,000 depending on a number of factors including number of investors and the Audit firm Prime Broker Varies depending on strategy, investments, trading volume Business Expenses – office rent, compliance costs, telephones, computers and IT, office equipment, staff salary, etc. 14 of 18

Raising Capital Must be done pursuant to Regulation D Who Friends and Family Institutional Investors Marketing Materials Powerpoint Pitchbooks One Page Tearsheets Appropriate Disclosures/ Disclaimers Outside Marketing Hedge Fund Databases Hedge Fund Industry Events Capital Introduction Services Third Party Marketers 15 of 18

Other Issues “Incubator” hedge funds Offshore hedge funds Taxation ERISA and IRA investments “New Issues” Rule Soft Dollars Side Letters Due Diligence Blue Sky Filings 16 of 18

Disclaimer This presentation was made for informational purposes only. I am not providing legal advice to any user. I am not providing tax advice. Presentation is subject to the Circular 230 Notice on the disclaimer portion of my blog. This presentation does not establish an attorney-client relationship between myself and the user. Any discussion herein is not a substitute for seeking actual legal advice from a licensed attorney with knowledge of the rules and regulations governing the industry. I make no representations, guarantees, or warranties as to the accuracy, completeness, currency, or suitability of the information provided via this presentation. This may be considered to be “attorney advertising” in some jurisdictions. 17 of 18

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