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hFMWeek

S P E C I A L r E P O r T

h o w t o s ta r t a h e d g e fund in the us 2011


DistributeD with hfMweek

LAUNCHES

All the essential information for first-time fund managers

REGULATION

Updates on federal and state legislation covering hedge funds

RESPONSIBILITY

The widening spectrum of administrative services

featuring Concept Capital // ifna // Sadis & Goldberg LLP // SS&C // US Bancorp // VITEOS

NG ITI C EX

EW N

T UC D OD E PR NCH U LA

... at a fraction of the normal cost of a traditional Fund.

Start your own Professional Investment Fund . . .

This complete solution is supported by trusted, internationally recognised institutions and is available at an all inclusive cost. Please visit www.primarydevelopmentfund.com or www.ifina.com for further information.

SOLOMON HARRIS
CAY MAN I SL AND S ATTOR NE YS - AT- L AW

H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 1

T
REPORT EDITOR

he hedge fund sector evolves quickly. Fortunately so do its service providers. Since 2008s market meltdown, increasingly high calibre teams of administrators, lawyers, prime brokers and auditors have emerged to solve the day-to-day demands of managers, investors and regulators. The successful launch of a new fund, whether it is domestic or offshore, or indeed both, is dependent on selecting the appropriate structure and complying with ever-changing federal and state regulations. A manager will need more layers of support if a launch, or running an existing business, is to be successful. The sectors service providers consistently excel at this. Increased regulatory restrictions, and nervous investors, are making fund launches more difficult. The heavy push on independent administrators, seen in the wake of the Madoff scandal, is also likely to continue. While administrators, prime brokers and legal counsel will all share the burden of implementing regulatory requirements proposed by Dodd Frank and Basel III. The year ahead will be a challenging time for first time fund managers looking to launch under pressurised market conditions. Actively engaging in understanding what the best practices are in managing and running the operations of hedge funds, and keeping abreast of industry regulations will secure the greatest possible future for funds. Recruiting the right service provider remains essential to this process.

Annie Roberts

HFMWEEK
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HEDGEFUNDMANAGER

REPORT EDITOR Annie Roberts T: +44 (0)20 7029 4061 a.roberts@pageantmedia.com HFMWEEK EDITOR Gwyn Roberts T: +44 (0)20 7029 4057 g.roberts@pageantmedia.com PRODUCTION EDITOR Claudia Honerjager SUB-EDITOR Rachel Kurzfield DESIGNER Matt McLean OPERATIONS DIRECTOR Sebastian Timpson CHIEF EXECUTIVE Charlie Kerr COMMERCIAL MANAGER Lucy Guest T: +44 (0)20 7029 4052 l.guest@ hfmweek .com PUBLISHING ACCOUNT MANAGER Richard Mason T: +44 (0)20 7029 4054 r.mason@hfmweek . com PUBLISHING ACCOUNT MANAGER Matthew Rudd T: +44 (0)20 7029 4053 m.rudd@hfmweek .com SUBSCRIPTIONS Raheem Salami T: +44 (0)207 029 4056 r.salami@hfmweek .com CIRCULATION MANAGER Fay Muddle T: +44 (0)20 7029 4084 f.muddle@pageantmedia.com
HFMWeek is published weekly by Pageant Media Ltd, a certified member of the PPA ISSN 1748-5894 Printed by Wyndeham Grange 2011 all rights reserved. No part of this publication may be reproduced or used without the prior permission from the publisher

H F M W E E K . CO M 3

H O W TO S Ta r T a H E D G E F U N D I N T H E U S 2 0 1 1

contents

06

administration

providing the works

16

administration

for first-time fund managers looking to set up in the Us, william c stone of ss&c believes choosing the right administrator means choosing one that can provide a fully comprehensive service, owns its own technology and knows the Us market

francis Rainsford of Viteos looks at the back office and key considerations in building best practice

a Back-up plan For the industry

19

service provider

09

administration

Derak Adler of ifina talks to hfmweek about how the primary development fund provides a fast, simple and cost-effective solution for fund managers

the complete package

christine waldron of Bancorp fund services highlights what to consider when launching an alternative investment product

investor transparency

21

legal

12

prime Brokerage

frank L napolitani, of concept capital, gives fund managers a stepby-step guide to setting up a fund in the year ahead

ready to launch

George mazin of Dechert LLPs financial services group outlines the questions hedge fund managers must ask when selecting which law firm to work with

Fund counsel: what you need to know

14

legal

structuring success

Ron s Geffner of sadis & Goldberg provides in-depth advice on how to launch and structure a successful hedge fund within the Us

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FINANCIAL SERVICES

A top-ranked legal advisor to the investing world.

For more information, please contact: Robert W. Helm +1 202 261 3356 robert.helm@dechert.com Richard Horowitz +1 212 698 3525 richard.horowitz@dechert.com George J. Mazin +1 212 698 3570 george.mazin@dechert.com Kevin P Scanlan . +1 212 649 8716 kevin.scanlan@dechert.com M. Holland West +1 212 698 3527 holland.west@dechert.com

With approximately 140 financial services lawyers in the United States, Europe and Asia, our top-ranked team has the reach, resources and experience to provide comprehensive, cross-border services to the worlds largest hedge fund and emerging fund managers. Dechert has hedge fund work down to a fine art Chambers UK A powerhouse hedge funds practice The American Lawyer This firm has a peerless global footprint in the hedge funds space Chambers Global Dechert is for many the first port of call for hedge fund advice The Legal 500 (UK) One of the top three onshore legal advisors globally serving hedge funds CogentHedge.com

dechert.com
U.S. Austin Boston Charlotte Hartford New York Orange County Philadelphia Princeton San Francisco Silicon Valley Washington, D.C. EUROPE Brussels Dublin London Luxembourg Moscow Munich Paris ASIA Beijing Hong Kong

H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 1

p rovidin g t h e w o r k s
for first-time fund mAnAgers looking to set up in the us, william c stone of ss&c believes choosing the right AdministrAtor meAns choosing one thAt cAn provide A fully comprehensive service, owns its own technology And knows the us mArket
or first-time fund managers, ownership and control, as well as speed of customisation and commercial availability, are critical considerations when launching a fund. There is no shortage of administrators who claim they can meet the firsttime fund managers every need, but SS&C is one of the few that provide a truly independent, comprehensive service. William C. Stone of SS&C talks to HFMWeek about the business model that has taken his organisation from strength to strength and the technological developments that will see it through the coming year. HFMWeek (HFM): What services do you offer to fund managers? William C. Stone (WCS): We are a leading provider of investment management software and offer a full range of financial and outsourcing services. The range of solutions we provide includes: fund administration, execution and trade order management, portfolio accounting and reporting as well as a large fixed network for order and post-trade communication.

founded ss&c in 1986 and has served as ceo and chairman of its board of directors. before launching ss&c, mr stone directed the financial services consulting practice of kpmg llp, an accounting firm, in hartford, connecticut, and was vicepresident of administration and special investment services at Advest inc., a financial services company. he also serves on the board of directors of openlink financial, inc.

William C Stone

one of the only administrators who own all of our technology, so we never have to wait in line. We own and control our data centres, so as soon as the initial offering documents are signed and funds are approved we can start the next day. A brand new fund with capital and trading approval can be up and running within 24 hours. We provide start-up funds with a full portfolio of cash management, risk reporting, investor and client reporting, web delivery, portfolio analytics, multiprime capability and compliance. HFM: What are the latest systems and technology that you have in place? What will you be bringing to the market in 2011? WCS: We have a full range of trading systems from equities and derivatives to fixed income, which are processed and delivered to a very efficient net asset value (NAV) calculation. In general, the most sophisticated funds NAV are struck very shortly after period end because of our efficiency. There are some very exciting technological developments we are working on and will be launching this year, including a number of web portals and mobile delivery platforms. We are well placed to be the first to market with these applications. HFM: How does the size of your organisation help to provide these services? WCS: SS&C is registered in the US with the Securities and Exchange Commission and we are trading on the NASDAQ (SSNC) and have a market capitalisation of $1.4bn. We are a strong company, with offices all over the world, which allows our clients to be able to choose their domiciles. A smaller provider may not have the numbers we do, whereas a larger provider, such as a bank, will not have as strong a strategic focus on fund administration. SS&C has 700 staff committed to the outsourcing business, whose talent has grown from within the organisation and through acquisition. This gives us a diversity and depth of ex-

HFM: What help do you give to start-ups? WCS: We offer particular guidance to first-time fund managers in the initial stages of drafting their offering documents, which we then review, and work together with them and their lawyers and accountants to enable the fund to get up and running. Access to expertise in the form of our senior people is the key. First-time fund managers understandably have a lot of questions and they need to be able to communicate with people with the necessary knowledge and experience of similar structures, products and tax issues. HFM: What can you offer in terms of speed of launch for fund managers? WCS: The main attraction of our business is we are
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A smAller provider mAy not hAve the numbers we do, whereAs A lArger provider, such As A bAnk, will not hAve As strong A strAtegic focus on fund AdministrAtion

a d m i n i s t r at i o n

pertise, which I believe is unmatched in the industry. Now, more than ever, fund managers seek out established administrators with successful track records and reputations and SS&C is well positioned. HFM: What makes your services unique in the fund administration space? WCS: With the breadth and depth of our technology, combined with our 250 software engineers, we are able to customise our solutions to meet the unique needs of high-end money managers looking for returns all over the world who dont want to be restricted by systems or expertise. At SS&C we have expertise across a range of asset classes and different types of vehicles fund managers use to invest in those assets. Institutional providers who offer services to smaller funds are few and far between and fund managers require the ability to grow as the fund grows. We believe SS&Cs conversion expertise and methodology are particularly attractive. HFM: What do you expect to happen in terms of funds outsourcing middle- and back-office functions this year? WCS: I believe outsourcing will continue to accelerate throughout 2011. There was a heavy push on adminis-

trators, in the wake of the Madoff scandal, to take on more responsibility but this seems to have slowed. I believe that the hedge fund model and the outsourcing of administrative responsibilities is a positive, as large institutions have a difficult time cost effectively managing technology, investment operations and accounting. Recently we converted three fund managers middle- and back-office processes to SS&Cs fund administration platform. They required several deliverables, including web-based fund and investor reporting, proven ability to scale, reliable staff and an impeccable corporate reputation. SS&C met and exceeded each of these criteria. HFM: What new challenges will regulatory changes bring to fund administrators in 2011? WCS: Recent legislation, such as Dodd Frank and Basel III, are calling for a number of study groups in order to define what are going to be the specific requirements. The Securities Exchange Commission and the Commodity Futures Trading Commission, in the US, aim to define joint reporting. This reduces the burden on the fund industry. Capital, position limits and stress testing will become the norm. SS&C will be in good shape to help our clients implement all the regulatory requirements. n

h f m w e e k . co m 7

THE ONE

YOU CAN TRUST

BES T T H I N K I NG . BEST PRACTICE.

www.viteos.c om

H o W t o s tA r t A H e D g e F u n D i n t H e u s 2 0 1 1

a d m i n i s t r at i o n

The co m p l e T e pac k ag e
derak adler of ifina talks to hfmweek about how the Primary develoPment fund Provides a fast, simPle and cost-effective solution for fund managers

T
Derek Adler acsi is
domiciled in the uk and during his career in the city of london has been regulated by the fsa and nfa. educated in england and switzerland, he is a director and founding member of ifina, a fully licensed fund administrator.

he journey from start-up to becoming a well established and recognised fund can be a long and challenging process. Increased regulatory restrictions and reluctant investors are making fund launches harder than ever for emerging managers. HFMWeek talks to Derek Adler of ifina about the launch of its new product, Primary Development Fund, and how this aims to provide a complete service package that can give start-up funds a competitive advantage with minimal costs involved. HFMWeek (HFM): Can you tell me about the new product you are launching? Derek Adler (DA): We are offering a new service in the form of Primary Development Fund (PDF) in Cayman, which will provide fund managers with administration, auditing, director and legal functions as part of a complete service package. The underlying value of PDF is to provide a fast, simple, effective solution for managers in a regulated market and this umbrella fund platform is ideally created for managers in startup situations or emerging investment managers with very low assets under management. It provides a low-cost solution by avoiding the higher fees of the traditional standalone funds and is ideally suited for fund assets of between $1m and $10m, uncapped. This cost-effective start-up solution, which provides competitive ongoing annual operating costs to assist the manager, will include monthly administration, valuation and share registry services, as well as directional services and an annual audit. It will work out of the Cayman Islands as the primary offshore jurisdiction, which will be regulated by the Cayman Islands Monetary Authority but can work across other jurisdictions depending on the needs of the investment manager. HFM: How exactly will it work and how will it help new launches? DA: A fund will be established as a segregated sub-fund of Primary Development Fund Ltd. Managers will be charged

the Primary develoPment fund Provides the manager with the oPPortunity to build a track record whilst the fund becomes established, which will also enable further caPital to be raised

approximately 50% of the normal rate for establishing the fund. The individually tailored and regulated Segregated Portfolio/Sub Fund will provide managers with the ability to select their own named fund as well as the opportunity for non-regulated managers to act as investment manager to their fund. This does not prevent the sub-fund launching in its own right and breaking away from the umbrella structure at any point in the future. Therefore, not only are there substantial savings in the initial launch stages of the fund and with the ongoing charges but there is also the flexibility to convert to a standalone fund in the future if the manager wishes. The PDF and its low-cost basis provide the manager with the opportunity to build a track record while the fund becomes established, which will also enable further capital to be raised. This process also minimises the problem of major investors wishing to invest only in well-established funds. The costs involved in this product are really the main advantage for emerging managers as normal operational costs can be a big deterrence for managers considering the launch of their own fund, due to a lack of initial seed capital. Even once the fund has been launched, delays in raising further assets can also hinder the success of the fund. To minimise the burden of setting up the fund, all the manager needs to decide is the choice of jurisdiction. This new service will be offered to clients on a global basis and while available in a number of regulated jurisdictions, the initial focus will be in Cayman, although a BVI structure is already underway. Other jurisdictions such as Malta are also available but more expensive and additionally with some restrictions. The advantage of being established in Cayman is that this service can be offered to managers who have not yet become regulated and therefore the conditions for this product are extremely favourable for investments managers looking to expand. HFM: Who else is involved and what do they contribute to the platform?
h f m w e e k . co m 9

h o w t o s ta r t a h e d g e f u n d i n t h e u s 2 0 1 1

a d m i n i s t r at i o n

da: The platform is supported by trusted, internationally recognised institutions and is available at an all inclusive cost. We offer a complete package whereby ifina group will be the administrator partnered with Barclays Bank (Isle of Man) as the bank account, MF Global Direct as the broker account, Baker Tilly (Cayman) Limited as the auditor and Solomon Harris as the law firm. The affiliation with these companies will also give managers the advantage of reduced fees across the board, due to economies of scale. hfM: have you had much interest from us managers in the platform and how can it be of particular use to them? da: Yes, the PDF has attracted attention from even more managers in the US seeking such a product for start-up funds. We are looking to launch a US version onshore very soon to accommodate the interest we have received.

key to the business model is the fact that in cayman, fund managers do not have to be regulated, as the regulatory burden is placed on the funds administrator

in the same jurisdiction. However, the PDF product is cheaper than its rivals because its cost base is cheaper, partly because the Cayman Islands is less expensive than Luxembourg and also because its partner companies have agreed to provide their services at a substantial discount. The set-up charge is around 40% to 50% cheaper than would typically be the case if ifina were to set up a standalone Cayman fund for a client, while the auditors and directors fees being provided to PDF clients are 50% lower than they would be on the open market. Key to the business model is the fact that in Cayman, fund managers do not have to be regulated, as the regulatory burden is placed on the funds administrator, which in the case of sub-funds of the PDF would fall to ifina.

hfM: what makes ifinas new structure unique in this space? da: The concept is not unique but the choice of jurisdictions is. We offer the PDF out of BVI, Malta and Cayman which I believe is unusual. In addition, we propose a very competitive pricing structure and a complete package of top institutional contributors to the platform. This enables emerging managers to start their own fund in a regulated and controlled environment, which is unique. The PDF concept is similar to one used by other operators such as KMG Sicav-SIF SA, based in Luxembourg, which involves the creation of a fund platform that enables third parties to launch their own funds quickly, cheaply and with less attention to regulation than if they were to do so directly
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hfM: what new challenges will current regulatory changes bring to fund administrators in 2011? da: Many of the changes that have been made and many of the new rules that have been introduced are more likely to affect the larger hedge funds and fund of funds. This is not the case relating to smaller funds, particularly those trading derivatives and start ups, which the PDF will cater to, focusing on the needs of traders with relatively small amounts of capital. The PDF exists to provide a cost-effective structure that permits traders to have the opportunity to have a controlled and regulated environment in which to manage money, without having to worry themselves about such burdensome regulatory details as capital adequacy requirements, or having to fill out thousands of forms. The PDF gives investors a structure thats fully regulated, in which they can build up a track record as a money manager. n

independent

Free from the influence, guidance, or control of others.

deFinition:

Recognized as the source for independent fund accounting and administration for hedge funds, fund of funds and private equity.

SS&C Fund ServiCeS

Visit ssctech.com/fundservices or call +1-800-234-0556 to learn more.

H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 1

RE ADY TO L AU N C H
Frank l napoliTani, of concepT capiTal, gives fund managers a step-by-step guide to setting up a fund in the year ahead
e have seen a steady increase in new launch prospects in the past six months. We feel this is due to a combination of factors including: improved returns in global equity markets, increased risk appetite from global investors, portfolio managers from larger hedge funds leaving to start their own businesses, and the disbanding of proprietary trading desks at major banks. The calibre of the teams we are seeing is increasingly of higher quality than before the 2008 market meltdown, and we view this as a direct result of allocators only seeding/ incubating top investment teams that possess the pedigree, process and past performance to build a sustainable business. We touch on several new launch topics below and hopefully provide some insight into what managers need to consider as they prepare to launch a fund in 2011/12. Develop a Business plan It is imperative to develop a business plan describing why you (and your partners) have the ability to start and grow a successful alternative asset management firm. With the continued institutionalisation of the industry, simply taking a cottage industry approach wont cut it in the current environment if your goal is to attract institutional capital and grow a scalable business. In your business plan, you should touch on the following items: Executive summary General company description Products and services Marketing plan Operational plan Management and organisation Financial plan Start-up expenses and capitalisation As a start-up business, managers should look to get as much bang for their buck as they can and look to align with service providers that have this mindset and business model. Knowing who those service providers are and forging a partnership is often key to a fund managers success as he or she attempts to launch. picking primary FunD service proviDers Like any important business decision, you will want to work with service providers who understand your business plan and investment strategy, and a group that you
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feel comfortable working with. Before picking any service provider, you will want to make sure the firm has name brand recognition within the hedge fund community and confirm their expertise in dealing with hedge funds and the specific asset class and structure you intend to manage. The key service providers you will need to engage are legal, accountant/auditor, fund administration and prime brokerage. legal fund legal structure Fees Lockups Additions/redemptions US-only or onshore/offshore, master feeder firm legal documents File necessary entities in proper jurisdictions (such as Delaware, Caymans/BVI) Draft operating agreements for GP and investment management company entities Draft employee contracts Draft compliance manual Draft business continuity and disaster recovery plan fund offering documents Offering memorandum, agreement of limited partnership and subscription documents Review marketing documents for accuracy against the PPM Review any tax or ERISA issues accounTanT/auDiTor Annual audit Investor tax statements Tax preparation Certify the performance of the fund for investors FunD aDminisTraTion Portfolio reporting Record keeping for the fund MTD, QTD, YTD performance Liaise with auditors for audit Fund books and records prime Broker/cusToDian Multi-asset class, multi-currency, multi-custodian platform Stock loan Trading technology

Frank L Napolitani
is managing director, prime services group, concept capital market LLc

prime broker age

Middle/back office support Portfolio and risk reporting Infrastructure (such as office space and IT) Capital introduction services Key Components of Running youR fund multi-custodial platform: A key advantage of using a boutique prime brokerage service provider like Concept Capital Markets LLC is the multi-custodial platform we provide to clients. We work with several of the most reputable global custodian banks, which provides our clients the ability to multi-prime across various custodians while having to deal with a single support team at Concept. global trading capabilities: Concept Capital Markets LLC serves its clients with a high-touch, multi-asset class, complete global outsourced trading solution. We serve as a one-stop shop for execution of global equities, ETFs, options, futures, fixed income and forex. In addition to highquality trade execution, we support our clients with experienced traders to provide continuity, while acting as your partner who is focused on your needs. Our agency-only model aligns our interest with our clients. risk management and advisory: Our Risk Analytics Team* provides outsourced risk analytics and management services to more than 60 hedge funds, which oversee $50bn+ assets under management (AUM) across all strategies.

The groups goal is to identify the relationship between units of risk and units of return in both normal and extreme market environments. The team provides the following customised analytics to its clients: Exposure reporting Stress testing/scenario analysis VaR Risk budget/volatility sizing Limit exception monitoring P&L time series and attribution analysis Capital allocation simulations Investment strategy allocation middle/back office support*: In addition to the multi-prime/ multi-custodian capabilities we provide to fund managers, Concept can also serve as a funds outsourced middle and back office and facilitate aggregated portfolio reporting. This service provides fund managers with significant cost savings and the ability to allocate all of its resources to the investment process. Concept is one of the few boutique prime brokerage service providers that made the investment in Advent Geneva early on and has gained substantial proficiency in this state-of-the-art system. While expensive and elaborate, Concept foresaw the value of the implementation of Advent Geneva and its ability to provide more robust reporting not readily available to small-to-medium size hedge funds. With Advent Geneva, we provide our clients with multi-custodial, multi-asset class, multi-currency reporting through one aggregated set of reports. We currently work with approximately 15 custodians and provide an aggregated reporting package to our clients each morning. infrastructure support and start-up services+: Having assisted a large number of investment teams launch funds since the mid-1990s, our relationship managers in the Prime Services Group at Concept Capital often act as hedge fund consultants to our clients during the pre-launch stage by helping them budget their pre-launch and first-year expenses, choosing service providers (legal, audit, fund administration and outsourced compliance services for example), general infrastructure items (such as office space and IT), and developing marketing materials to present to prospective investors. After launch, we continue to work closely with our clients as they tackle the ongoing issues of running a business, not just running a portfolio. outsourced iT services+: Concept provides a significant number of our hedge fund clients with outsourced IT services, including: Managing and hosting domain services including file sharing, e-mail communications, network communications, server maintenance, network maintenance, and firewall protection. Providing VolP phone service and high speed internet connectivity. Assist in drafting and implementing an IT business continuity and disaster recovery plan integration of various trading systems based on manager preference.
+

*Affiliate company, Concept Capital Fund Services, LLC Affiliate company, Concept Capital Administration, LLC
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sT ruc Tu r i n g s u cc ess
ron S geffner of SadiS & goldberg provides in-depth advice on how to launch and structure a successful hedge fund within the us

T
Ron S Geffner
is a member of sadis & goldberg llp and oversees the financial services group. he regularly structures, organises and counsels private investment vehicles, investment advisory organisations, broker-dealers, commodity pool operators and other investment fiduciaries.

he hedge fund industry has matured over the last ten years. Investors and regulators continue to evolve, becoming more sophisticated and asking more probing questions than the previous year. Now more than ever, the successful launch of a hedge fund is dependent upon selecting the proper structure and complying with the ever-changing federal and state regulations governing hedge funds. Structuring a hedge fund involves both the creation of one or more entities through which investments will be made (domestic and offshore hedge funds), as well as the management entities through which the advisory services will be provided to the hedge funds (the general partner and/or the investment manager). The structure and domicile of the hedge fund is primarily dependent upon two variables: (i) the nature and demographics of the prospective investors, and (ii) the investment strategy employed by the investment manager. The structure and domicile of the investment manager is determined by the citizenship and tax considerations of its owners, as well as the regulatory regime of the domicile. Structuring the hedge fund Investors can be divided into three classes: (i) US taxable investors, (ii) US tax-exempt investors, and (iii) non-US persons. In the majority of circumstances, if the investors are US taxable investors, the fund will be formed as a US limited partnership or limited liability company. The US fund is often referred to as a domestic fund. Most domestic funds are organised in Delaware. If the investors are US tax-exempt investors or non-US persons, the fund generally will be formed in a jurisdiction outside of the US as a corporation (or other analogous entity). The non-US entity is often referred to as an offshore fund. Most offshore hedge funds organised on behalf of US-based investment managers are organised in Bermuda, the British Virgin Islands and the Cayman Islands. US tax-exempt investors typically prefer to invest in an offshore fund set up as a corporation because if the offshore fund purchases securities on margin (often re-

ferred to as leverage), an offshore fund which is set up as a corporation blocks the unrelated business taxable income (UBTI) that would otherwise be taxable to the US tax-exempt investor. economic analySiS In determining whether to form both a domestic and an offshore hedge fund, it is imperative to determine the amount of anticipated assets that will be invested in the hedge funds at, or shortly after the launch of the funds. In short, the anticipated aggregate investment at, or shortly after the launch of the business may not justify the creation of both a domestic fund and an offshore fund and to create both would impair the investment managers ability to survive due to the organisational expenses and the costs of maintaining both domestic and offshore hedge funds. With early-stage managers, cash-burn is often overlooked and can be critical to the survival of the newly formed asset management firm. The manager must have an opportunity to establish a proven track record.

while managing cashburn is critical for a new manager, the quality of the firms infrastructure cannot be sacrificed

Side-by-Side, maSter feeder and mini-maSter StructureS Managers seeking to launch both domestic and offshore funds have several options available in structuring. The three most common structures are side-by-side, master feeder and mini-master. In a side-by-side structure, the domestic fund and the offshore fund make direct investments pursuant to the investment strategy, and the prime broker typically allocates trade tickets between the domestic fund and the offshore fund. In a master feeder structure, a third entity is created (the master fund) and the domestic fund and the offshore fund, rather than making direct investments, invest their assets into the master fund and in turn, the master fund makes the investments on behalf of the domestic fund and the offshore fund (often referred to as the domestic feeder and offshore feeder). The mini-master structure generally is comprised of two entities: an offshore feeder and a master entity. While the offshore feeder is taxed as a corporation to benefit US taxexempt investors and block UBTI, the master entity may

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legal

be structured for tax purposes as a partnership. Rather than the US-based manager receiving its incentive as a fee from the offshore fund and being subject to ordinary income tax, the US-based manager may receive the incentive as an allocation from the master entity, in an attempt to benefit from capital gains tax treatment. There are many legal and commercial drivers in determining the ideal structure. For example, if the strategy calls for significant investment in illiquid or thinly traded positions, which are difficult to allocate among two brokerage accounts, a master feeder structure may be preferred as the investments will be allocated on a pro rata basis at the master fund yet only require the investment manager to purchase and sell the positions through one brokerage account. Also, in many transactions involving early stage or seed investment, if the seeder is located offshore, it may prefer a master feeder structure so that all fees and allocations may be taken at the master fund and thus avoid the US tax regime. Conversely, employing a tax-efficient strategy for US taxable investors may be of little benefit or detrimental to US tax-exempt investors and non-US persons. Thus, a side-by-side structure allows the investment manager the ability to employ tax efficiency with the domestic fund, while maximising the entry and exit points of securities positions without regard to long-term tax gains for the offshore fund. Structuring the inveStment manager The structure and domicile of the investment manager is primarily determined by the citizenship and tax considerations of its owners. Empirical evidence suggests that the super majority of hedge funds are managed by USdomiciled entities structured as either limited liability

companies or limited partnerships which are taxed as flow-through vehicles (rather than as corporations). In circumstances involving non-US persons, if the non-US persons own the majority of equity in the investment manager and their interests are controlling, the investment manager may be organised in an offshore jurisdiction to accommodate the needs of the non-US persons. State regulation often impacts the location at which the investment manager will maintain its office. Certain states, such as California, Colorado, Connecticut and Texas, have compulsory registration requirements which require an investment manager with an office in their state to register as an investment adviser prior to the launch of the hedge fund. Many managers choose to maintain offices in neighboring states, which do not have compulsory registration requirements so as to avoid having to register as an investment adviser. While managing cash-burn is critical for a new manager, the quality of the firms infrastructure cannot be sacrificed. Having spent approximately two decades practicing law in this industry, both as an enforcement attorney with the US Securities & Exchange Commission and in a private practice, I have had the benefit of witnessing many successes and failures. It is important to use service providers who have corporate, tax and regulatory experience in connection with structuring hedge funds. Failure to properly structure your firm will have material opportunity costs. A firm with structural issues is less likely to attract investment and more likely to be plagued with investor litigation, regulatory prosecution, limitation on capital resources and reputational damage. The costs associated with fixing a problem far exceed the costs of doing the job correctly at the outset. n
h f m w e e k . c o m 15

H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 1

a b ack u p p l a n fo r the in d u st ry
francis rainsford of viteos looks at the back office and key considerations in building best practice

W
Francis Rainsford
is executive vice president of viteos and has 25 years of experience servicing the alternative investment industry. as global head of client relationship, he advises clients in areas of fund structuring, valuation of investments, back office operations, tax and regulatory compliance.

hen hedge funds are starting up, accountants, lawyers, prime brokers and fund administrators are the first service providers that are hired by the fund manager. It is a perception that once this selection process is finalised the hedge fund has all the tools it needs to manage a successful fund. However, critical to the success of startups is building a robust back office around their specific needs for post trade processing, portfolio management and compliance/risk reporting. Hiring practices in Hedge fund back offices To the surprise of none, there is a growing change within the hedge fund industry to hire an individual who possesses skills more aligned with a COO than what is typically defined as a CFO. Historically, US hedge fund back offices were financial reporting and investor servicing centric, due to self administration. This trend is not expected to continue, as investors look to have the roles of financial reporting and investor servicing outsourced to a third party. In fact this is a US centric phenomenon. By contrast, in Europe and Asia fund managers have long adopted an approach that their back offices be portfolio management centric. Their hedge funds are domiciled in jurisdictions with favorable tax treaties, and those jurisdictions generally require the financial reporting and investor servicing be done by licensed administrators. With new regulations in the US, fund managers conclude that best practices will require them to adopt a more European/ Asian-style back office that is focused on portfolio management. This change will call for US fund managers to hire an individual or to develop internally an individual that possess broad skill sets. Among these skill sets are a legal understanding of contracts, regulatory reporting and compliance; technical ability in implementing and managing software solutions to portfolio, risk and compliance management; accounting for financial and tax reporting and the ability to communicate all these

matters with investors. Ideally these roles would be met by having a COO, CFO, IR, CIO, CCO, CRO and general counsel; however it is not practical to hire all these individuals in a market that is difficult to raise capital. To address this need, many new service providers are coming to market offering for hire outsourced solutions. Fund managers understand that generating alpha is their primary job; hiring the right person to oversee these relationships becomes a mission-critical internal function of their back office. tHe role of us regulations in How a fund manager builds tHeir back office In the past, hedge fund back offices in the US have been financial reporting and investor servicing focused, mainly due to self administration of the US-domiciled hedge fund. US regulations do not require a US-domiciled hedge fund or any commingled pool of assets to engage a thirdparty administrator, the reason being that the regulators could not delineate hedge funds from family offices and investment clubs. Just imagine how surprised a college investment club or family would feel to learn a byproduct of pooling their money together to invest, is they are now subject to having to hire an independent third party to provide financial reporting and investor servicing. It is interesting to note that with all the regulatory changes the industry has seen in recent years, a safeguard that was overlooked by US regulators is a requirement that US funds be administered by a third party. A commonality among frauds committed by fund managers, who desired to do so over the past 20 years, is their ability to control the information that is disseminated to the investors. Understanding systemic risk is important to the regulatory agencies and the ability to mitigate another financial collapse is of the upmost importance to Congress and the American people, but when it comes to the operations of hedge funds it has been left to the investors to drive the conversation about what are best practices. The old adage of buyers beware best summarises the view the

fund managers understand that generating alpha is their primary job; hiring the right person to oversee these relationships becomes a mission-critical internal function

16 h f m w e e k . co m

a d m i n i s t r at i o n

government has taken to hedge fund back offices and self administration. Best practices Being adapted By fund managers Today fund managers are actively engaged in reviewing their back office needs and understanding what the best practices are in managing and running the operations of hedge funds. The following are several best practices seen in the industry: Engaging a third party to administer the domestic domiciled funds. It is not a question of if only a question of when this will be commonplace in the industry. Purchasing or outsourcing portfolio management software. There is a trend to avoid reliance on portfolio data and reports from prime brokers, because of the inherent risk that should a fund manager change prime brokers or use multiprimes the information, including historical data, needed to manage the portfolio may no longer exist. Fund managers have several options available whether its buying and building the infrastructure, engaging a hosting partner or outsourcing the back office in its entirety or pieces of it to a service provider. Seamless integration of software systems and processes. For too long the industry has relied on fragmented systems and processes to meet the needs of trading, portfolio, risk, compliance and financial management of the fund. Investors are quick to point out these deficiencies when performing due diligence so fund managers will need to demonstrate that their processes and systems are seamless. Maintaining a redundant set of books and records. Fund managers are increasingly concerned that to safeguard everything done within their back office there needs to be a second redundant process in place, often referred to as shadow accounting. shadow accounting Shadow accounting has been around for some time and gained traction during the financial collapse. The premise behind it is providing an additional layer of comfort to the fund managers and investors that a second set of books and records are being maintained for the hedge fund. In cases where the hedge fund books are self administered, the fund manager will engage a third party, usually an administrator, to prepare a second set of financial reports for the hedge funds. Or, in instances where there are concerns around the post trade processing and reconciliation, there is another redundant service being performed, to insure trade breaks are identified, margin calls are correct, and valuations of hard to value assets are verified. It is difficult for some to understand the benefits of this need for redundancy, applying the analogy that should the wheels fall off the bus; there is a second bus directly behind the first that can carry the passengers to their destination. There are critical and tangible benefits to this approach as no fund manager wants to see

the success of the fund should be based on performance and mitigating risk, no fund manager wants their success to be decimated or hindered by the inability of their back office

their business fail due to operations. The risk of a bad NAV, inaccurate investor allocations of income/expenses, restatements or poor investment decisions resulting from inaccurate valuation of assets, and unresolved trade breaks easily offsets the additional cost to the fund or management company.

the Question of outsourcing The hedge fund industry is comprised of a large number of fund managers, all working towards a common goal of creating alpha for their investors. The success of the fund should be based on performance and mitigating risk, no fund manager wants their success to be decimated or hindered by the inability of their back office to keep pace with the demands of the portfolio management team. Fund managers are engaging in a conversation around outsourcing into their overall back office operations for three reasons: Outsourcing selective back office functions such as trade reconciliation, software management and operating software programmes, frees up existing staff and provides a cost-effective solution to hiring internal staff and building infrastructure. Outsourcing provides greater flexibility and faster execution of a business plan. Enabling a fund manager to utilise a system or processes that have already met the proof of concept and thereby demonstrates best practices in the industry. Outsourcing creates bandwidth for fund managers; the ability to have a proven solution that can grow with their business. To conclude, structuring a robust back office that optimises investment decisions and safeguards the capital invested in the hedge fund is no longer a nice-tohave but rather a need-to-have for todays hedge fund managers. n
h f m w e e k . c o m 17

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F O R M O R E I N F O R M AT I O N P L E A S E CO N TA C T

v Raheem Olaitan Salami a +44 (0)207 029 4063 OR email r.salami@pageantmedia.com

O R V I S I T H F M W E E K . CO M FO R D E TA I L S

H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 1

SeRVIce PRoVIDeR

ChrIstIne waldron of banCorP Fund servICes hIghlIghtS what to conSIDeR when launchIng an alteRnatIVe InVeStment PRoDuct

in v esto r tr an s pa r e n c Y
our products shape the industrys future, but creativity can get stifled with increasing regulations, investor scrutiny, and institutionalisation. Generate synergy between vision and operations by relying on a third-party service provider to take the complexity out of launching funds, supporting your investors, and managing risk. This article provides a perspective and several tools to understand the infrastructure advisers need to help them demonstrate transparency and attract investors across the globe. Industry trends The volatility in the market has brought fund operations into the limelight and caused increased requirements by the government regulators as well as the investor community for heightened transparency, risk management and compliance. With investor due diligence sharpened around fund processes and reporting, investors expect advisers to evolve their processes, reporting and fund structures to ensure they are adjusting to regulatory changes and challenges while still providing excellent performance returns. Increasingly, investors, particularly institutional investors, are conducting formal due diligence assessments of operations prior to placing assets with funds. To prepare and capitalise on these evaluations, management companies must augment their focus from purely asset management to include comprehensive compliance programmes and defined operational procedures. They must be aware of all red flags, including perceived conflicts of interest associated with internal administration services, adviser provided valuations and affiliated prime brokerage arrangements. Any single area of perceived administration risk can create enough concern to drive investors to different advisers. In an economic environment that encourages increased regulations, leaner busi-

Christine Waldron

serves as senior vicepresident for uS Bancorp fund Services and manages the companys alternative Investment Products division, which specialises in the unique servicing needs of alternative and private investment products such as hedge funds, offshore funds, and distressed assets.

wIth InVeStoR Due DIlIgence ShaRPeneD aRounD funD PRoceSSeS anD RePoRtIng, InVeStoRS exPect aDVISeRS to eVolVe theIR PRoceSSeS, RePoRtIng anD funD StRuctuReS to enSuRe they aRe aDjuStIng to RegulatoRy changeS anD challengeS whIle StIll PRoVIDIng excellent RetuRnS

ness practices, greater transparency and more sophisticated reporting, advisers must take into account the entirety of their fund administration and develop an infrastructure to anticipate and prepare for investor due diligence. In addition to the importance being placed on the operations and transparent reporting, investors are putting a greater emphasis on the structure the fund establishes. Investors are demanding products that provide the comfort of a regulated entity, but also have the exposure and returns of an alternative investment vehicle. These include business development companies, closed-end funds, hybrid-registered hedge funds and hybrid-registered fund of funds. Aside from the investor demand, these structures are also gaining popularity among advisers who are interested in tapping into the Employee Retirement Income Security Act (ERISA) market without triggering the ERISA ownership percentage monitoring requirement. Advisers opting to go with a traditional unregistered product are evaluating master-feeder structures versus side-by-side structures. While the master-feeder structure provides greater operational efficiency and enhanced leverage abilities, the side-by-side structure allows for more investors if the fund is relying on Section 3(c)(1) of the Investment Company Act of 1940 and greater US tax efficiency. ConsultIng and ProaCtIve suPPort For you What does this mean for you, the adviser? It means that when selecting a third-party administrator, your administrators business model should be consultative and they should share their industry experience to assist with any aspect of launching a product from design to daily operations. This should include: 1. Fund Launch Consulting. Will it provide a fund expense projection and help with expense modelling based on your requirements? Will it provide industry benchmarking
h f m w e e k . c o m 19

H O W T O S TA R T A H E D G E F U N D I N T H E U S 2 0 1 1

SeRVIce PRoVIDeR

analysis for liquidity terms, management fees, performance fees, carried interest calculations or total expense ratios? Will it assist with fund infrastructure implementation for special purpose vehicles such as side-pocket investments, registered office and board of director selection? Will it provide the support and resources to assist with independent legal and audit firm search/selection? What about helping with operations procedures and policies, such as valuation policies and investment guidelines? 2. Product Design. Will your administrators legal, compliance, and tax teams support your investment strategy guidelines by offering insight into possible investment product construction, diversification, valuation procedures and disclosures? 3. Regulatory Consulting. Will its legal and tax teams help interpret and describe both the regulatory requirements as well as the operational impact to the funds general partner and adviser? What is its take on how to implement successful compliance programmes? Will it provide assistance with adviser registration for the new SEC requirements? 4. Partnership. Will your administrator leverage its existing relationships with industry contacts? Can you work with its experts from an oversight capacity on even more granular market, investment, and regulatory issues? Advisers should also complete a thorough assessment of the administrators servicing team, including industry and specific product service abilities, certifications and biographies. Responses should focus on the specific product requirements related to the fund with respect to staff sourcing, efficiency and the administrators capacity for training and development. In addition, advisers should consider the administrators technology platforms and flexibility to support custom solutions. In order to ensure your administrator can not only help you meet these demands, but also give you the consultative model you need to capitalize on your investment strategies, your biggest question should be: can, and will, your prospective administrator be your servicing partner? The administrators talent and expertise is the most important element of providing successful due diligence responses to your investors. Your investors require comfort that you, and your providers fund administration team, possess the vision, authority, skills and accountability to the fund and investors to fulfil the role of independent compliance oversight. Consulting and ProaCtive suPPort For Your investors It is vital for advisers to treat investor due diligence processes as they would any external audit, business risk assessment, or procurement process. By taking the time to fully understand each investors requirements, advisers will be able to prepare information and responses in advance of formal on-site due diligence and demonstrate full transparency of operations, procedures and the control environment. In our experience, proactive responses highlight the advisers commitment to the investor by taking into consideration the nature and depth of information they require. A proactive approach also allows advisers to use investor due diligence as an opportunity to strengthen their relationships and provide investor education, which in our experience,
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enhances investor loyalty. Typical investor due diligence we have seen is a combination of questionnaires, site visits and detailed calls covering the following areas: Firm overview with specific questions on administrators industry experience, tenure, turnover, commitment to hiring and retaining qualified personnel, insurance carried, internal and regulatory audit and exam history, risk management controls, business continuity and disaster recovery processes, Anti-Money Laundering programme, SAS 70s, financials, references, and technology reinvestment with questions asking for commentary on commitment to innovation. Accounting overview with questions on trading, valuation, reconciliation, pricing, technology platforms, quality assurance and financial reporting for the fund. Compliance and regulatory overview with questions on oversight capabilities, filings, ability to stay up to date with legislation, compliance checks and tax reporting. Investor services overview with questions on operating systems, online access to reports and data, print/mail service, anti-money laundering procedures, processing and correspondence. Net Asset Value (NAV delivery) with the ability to provide enhanced NAV certifications, which are included with an investors statement and highlight details regarding counterparty/custody exposure, valuation policies compliance, percentage of valuations obtained independently, independent verification of the existence of cash, investments and OTC transactions with third-parties and procedures performed around the calculation of management, performance fees, and investor account balances. Custody overview with questions on service model, technology, treasury and lending services, and segregation of duties for operational functions as well as a review and approval process surrounding cash movements. Fees with requests for fee schedules, a projection of expenses, and sample contracts. Above all, the single most important aspect of investor due diligence is ensuring your administrator can provide accurate and timely investor reporting. This is one of the biggest concerns we are seeing from an investor perspective. Investors want complete confidence and transparency in the funds underlying portfolio holdings, including industry exposure, credit rating and yield distribution, and individual issue exposure on a monthly basis. Your administrator should support you in all of these areas and provide examples of other due diligence audits and visits theyve experienced across their client footprint. Parting thoughts The alternative investments industry is driving investors to perform risk assessments of administration support. Innovative product structures, along with a superior infrastructure that supports investor due diligence, gives you an opportunity to showcase your operations, demonstrate transparency, create investor confidence in your investment practices and administration, and above all, secure additional assets. So, go aheadinnovate. n

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LEGAL

FUND COU N S E L : W H AT YOU NE E D TO K N O W


george mazin of dechert llps financial services group outLinEs thE quEstions hEdGE fund mAnAGErs must Ask whEn sELEctinG which L Aw firm to work with

O
george Mazin
is a partner in dechert LLPs financial services group. he advises clients on the structuring and restructuring of domestic and offshore private funds, private placements of securities, structured products, private equity investing, and brokerdealer and investment adviser compliance.

ne of the early decisions that hedge fund managers must make when they decide to launch a fund is to select a law firm to prepare the funds offering documents. Despite the importance of this decision, many managers are inexperienced in selecting counsel. Here are some of the factors that should be considered when making a decision: Experience how extensive is the firms experience in organising private funds? How deep is the bench and which lawyers will be doing the work? Market intelligence does the firm know what current terms are for competitive funds? Compliance expertise in an industry that is increasingly becoming subject to greater regulation, does the firm have the requisite experience in compliance matters? Geographic coverage many funds invest globally and seek to raise capital from investors around the world. Does the law firm have the necessary geographic footprint to address these needs? Ancillary services in addition to fund formation and compliance expertise, managers will require advice in a broad array of areas, including tax, ERISA, derivatives, intellectual property and employment law. Does the law firm have expertise in each of the areas required by the manager? While it is relatively easy to diligence these areas, there are several other considerations that are at least as important, but are perhaps more difficult to assess. These include the following: Is the proposed attorney an effective business adviser, or merely a legal technician? Is the attorney able to establish a good rapport with you? How responsive will the firm be in meeting deadlines and answering questions? Will services be provided in a timely and efficient manner? Higher hourly rates need not mean that the cost of delivering services will be higher than lower cost by less experienced firms. Experienced

firms can often do the work more efficiently than a firm that is learning on your nickel. While fees are important, managers should take a longer view and select a firm that will provide value and be an effective partner with the manager in building a business. Also, in comparing fee quotes from competing firms, make sure you are comparing apples to apples. Do both quotes cover the same scope of work? What do l aW yers do? Often the perception of the manager, as a prospective client, is that offering documents are simply boiler plate, and preparing a set of documents requires little more than filling in the blanks. While the need to deliver legal services as efficiently as possible requires attorneys to strive to create more standardised documents, one size does not fit all. Fund documents must be carefully tailored to fit the investment strategy that will be employed by the manager. Liquidity terms must match the duration of the assets in the portfolio and risk factors must be drafted in a manner which highlights the most relevant risks and eliminates those that are of limited relevance to the strategy. Before the drafting begins, time must be spent developing the optimal fund structure. Many factors should be taken into account in doing so, including the desire to achieve the greatest tax efficiency, considering the proposed investment strategy and its impact on fund structure, regulatory considerations and the needs and requirements of investors. de veloping fund ter ms Once the basic fund structure has been developed, the remaining fund terms must be established. Space does not permit an exhaustive description of all issues which must be evaluated. However, the following are some of the more important considerations: Parallel vs master/feeder structure: there are advantages and disadvantages to each approach.
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whiLE thE nEEd to dELivEr LEGAL sErvicEs rEquirEs AttornEys to strivE to crEAtE morE stAndArdisEd documEnts, onE sizE doEs not fit ALL

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A master/feeder structure is often favoured to simplify trade allocation and to be able to publish consistent returns for both the domestic and offshore feeders. Offshore fund: is there a need for an offshore fund and in which jurisdiction should the offshore fund be formed? Non-US investors and US tax exempt investors still prefer offshore vehicles. While Cayman is still the jurisdiction of choice for most US managers, it is not the only option and the European Alternative Investment Fund Managers Directive is causing many managers to consider other jurisdictions, including Ireland and Luxembourg. Regulatory exemptions: consideration must be given to navigating the exemptions available under the Investment Company Act, Securities Act and Commodity Exchange Act. Management fees: the rate at which fees will be charged must be determined as well as the frequency of payment. Incentive fees: will a standard 20% incentive fee arrangement be used, or will the incentive fees reflect some new terms emerging in the market?

EmErging tEr ms Use of hurdle rate. Multi-year performance period with clawback. Modified high-water mark. Reduced fee for longer term lock-up. Expenses. Certain expenses (such as legal fees, fees payable to the administrator, audit fees and trading expenses) are almost always charged to the fund. Other types of expenses are up for grabs. How aggressive does the manager wish to be in shifting expenses to the fund. Possible categories of expenses that might be charged to the fund (if properly disclosed) include risk management and order management software, insurance premiums, travel and marketing expenses and compliance expenses. Liquidity decisions concerning the restrictions that will be imposed on investors who wish to withdraw their investment from the fund have become the most contentious part of negotiating offering documents with investors. Consideration must be given to the following: How frequently will investors be able to withdraw their capital? Will there be a lock-up period during which withdrawals are prohibited? Will withdrawals be permitted during the lock-up period upon the payment of a fee (soft lock up)? Should the amount of capital that may be withdrawn on any withdrawal date be limited by the im22 h f m w e e k . co m

in comparing fee quotes from competing firms, make sure you are comparing apples to apples
position of a gate. If so, should the gate be a fund gate or an investor level gate? Should the manager have the ability to fund withdrawals through distributions of securities? If securities cannot be readily distributed, should the manager have the ability to create an SPV or liquidating share class? Should the manager have the ability to suspend withdrawals, and if so, under what circumstances? Investment limitations; purchase of illiquid assets. While fund managers seek maximum flexibility to modify their investment strategy to take advantage of market opportunities, investors are increasingly seeking to constrain this flexibility. Similarly, investors are reluctant to give the manager carte blanche to purchase private or illiquid securities, and have a strong negative reaction to the use of side-pockets to manage the funds exposure to illiquid securities. Transparency; reporting. With investors demanding a high level of transparency, managers must determine the policies they will employ in providing portfolio information and disclosing those polices to investors. The advice provided by counsel to managers is critical in helping them make sound decisions in developing the terms for their fund. Counsel will explain legal requirements, liability issues and market practice. The goal should be to create a set of documents for a fund that will be viewed favourably by investors, while still appropriately protecting the manager. n

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