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415.434.1600
www.howardrice.com
S
OME
C
ONSIDERATIONS IN
S
ETTING
UP A
H
EDGE
F
UND
Howard Rice’s investment management practice has long included setting upprivate investment funds for both U.S. and offshore investors and, equally important, counseling fund managers and sponsors in all manner of challenging situations. Some of the most commonly asked questions regarding “hedgefund” startups are discussed below. For further information, contact Mark Whatley, André Brewster, Anita Krug, Ellen Fleishhacker, David Tang, Gary Kaplan, Ben Berk, or Charlotte Saxon.
W
HAT EXACTLY IS A
H
EDGE
F
UND
?
The term “hedge fund” is used loosely to include any privately-offeredinvestment pool that trades or invests in securities and other financialinstruments, for the most part in public markets. It generally does not includefixed-duration, “closed-end” pools like venture capital funds and private equity or leveraged buyout funds (although many hedge funds engage in limited venture capital and private equity investing). “Hedging” is neither the defining nor even an essential characteristic of a hedge fund’s activities, although so far inthe new millennium, short selling and other market-hedging techniques havebeen important attractions for, in particular, institutional investors. Increasingly,the term “alternative investment” is used to describe hedge funds, together withprivate equity and “hybrid” funds.Hedge funds are typically organized to minimize the amount of regulation to which they and their managers are subject. Thus, a lot of the lawyer’s role is tohelp the fund’s investment manager or promoter perfect exemptions from a variety of regulatory requirements and limitations. Two themes underlie mostof those exemptions: (i) interests in the fund are available only on a limited,private basis to wealthy, sophisticated investors and/or (ii) the fund is organizedand offers its interests outside the United States. Hedge funds also seek, in theirstructures (if not their operations) to minimize the effective taxes paid both atthe entity level and at the investor level – and for the manager and its owners.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
hedge fund world is through a privately placed domestic fund. Accordingly,most the discussion below is of considerations in forming a domestic fund.Some special considerations for offshore funds are discussed at the end.
W
HY
F
ORM A
H
EDGE
F
UND
?
For a startup money manager, a hedge fund can be an inexpensive, efficient andpotentially very profitable way to enter the investment management business.For an established institutional manager, it can be a low-cost way toaccommodate investors who do not satisfy minimum account size requirementsand to add to profitability through a participation in the results of goodperformance. Particular advantages: The manager can pool assets from many investors, allowing it to manage asingle portfolio efficiently; and The manager can minimize regulatory overhead and restrictions by avoiding regulation as a mutual fund. Unlike a mutual fund, a privatefund may, among other things:
sell short without limit (except as imposed by lending brokers);
buy on margin without limit (except as imposed by lending brokers);
take extremely concentrated positions;
flexibly deploy creative options, futures and other derivativesstrategies; and
share the fund’s profits (generally called a “performance fee,”although it is usually an allocation of profits,
not
a fee) with themanager.
B
ASIC
S
TRUCTURE FOR A
D
OMESTIC
F
UND
A management company manages the Fund’s portfolio and otherwise operatesthe Fund. For funds organized as limited partnerships, the investment manageroften acts as the general partner, but some Funds separate the function of general partner from that of investment manager. Sometimes this is done toaddress tax issues specific to the organization and activities; sometimes it isbecause the sponsor of the Fund is not the investment manager; sometimes it isfor reasons related to compensation arrangements for particular personnelinvolved in the fund’s management.
1
Note:
The money manager is distinct from the “hedge fund.” Themanager does not “own” the Fund—the investors do, and the
1
This is discussed below. For most purposes in this outline, the general partner and investmentadviser are referred to collectively as the “management company.”
December 2009 Considerations For Hedge Fund Startups
Page 3
management company owes them a fiduciary duty, generally as defined inthe Fund’s agreement of limited partnership or similar constitutionaldocument.
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. Itsincome, 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’sdebts. 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 Fundcreditors. These attributes mean the Fund will be either a
limited partnership
(of whichthe management company or a related entity is the general partner) or a
limited liability company
(“
LLC
”) of which the management company or a relatedentity is the “managing member”)
2
Here is a pictorial view of the simplest (and very common) structure:
Ferocious Animal Fund, LP
(Fund)
(Del Ltd. Ptnrship)
Investors
(Limited Partners)
(100, if 3(c)(1); 499 if 3(c)(7))CapitalContrib'sLPInterestsGP Interest;20% IncentiveAllocationof Profits; 1%Mgt. FeeCapitalContrib's; Mgt.Services
Investment PortfolioOwner #1
Cap. Contrib.,Services
Owner #2
MemberInterest
MemberInterestCap. Contrib.,Services
ABC InvestmentManagement LLC(Investment Adviser)
(Del LLC)
2
An LLC that is centrally managed, like a Fund would be, has a “manager” or “managing member” thatplays the same role as a general partner. But the management company is
not
liable for the debts of thefund, like a true general partner would be.
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