1. Starting a Hedge Fund in 2009
Bart Mallon, Esq.

2. 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
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3. Initial Items to Consider
Who will be your investors?
How will you get to where you want to go?
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4. Hedge Fund Characteristics
Trading Strategies
Traditional
Non-Traditional
Other Pooled Investment Vehicles
Fees
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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
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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
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12. 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
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13. 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
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14. 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.
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15. 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
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16. 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
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17. 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.
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18.
Please send questions, comments or suggestions to
Bart Mallon at ©