Hedge Fund FormationAs a result of state and federal regulatory issues, Hedge Fund Formation has become more complex over the years. Going back just 10 years, most of the investing public knew very little about hedge funds. Now, with the internet, as well as heightened interest on the subject, anyone can find large amounts of information on these once secretive investment vehicles.
Forming a hedge fund takes careful planning, as well as a strong understanding of the regulatory issues involved both at the state and federal level. With good legal advice in combination with a knowledgeable CPA in the hedge fund field a hedge fund can be formed to suit the specific needs of the hedge fund manager or management team. When looking for a Hedge Fund Attorney to advise you, keep in mind that you need to specify what services you are looking for, which will affect the involved and the fee you will be charged. Also, just like most things, whether it be a fee charged for accounting work, carpentry work or consulting work, legal fees are not all the same. Some larger New York firms will charge much more that smaller firms in other parts of the country for the same work. Make sure, however, that whatever attorney you use, he or she is experienced and has formed several hedge funds and advised them as clients. Also, you should get a retainer agreement in writing form the attorney. That retainer agreement should specify the legal work that will be performed and even the legal work that will not be performed. Hedge Fund Attorneys should be knowledgeable on all aspects of hedge fund formation including such issues as state and federal law exemptions for the investment manager, filing of Form D and state blue sky filings, broker-dealer exemptions relative to capital raising efforts, preparation of the offering memorandum, SEC view on proper hedge fund website setup, and advising the client on the choice of a prime broker, administrator and auditor. Hedge funds can be broken down into two categories: (1) domestic and (2) offshore. There is a great difference between the domestic and offshore fund and it is important to fully understand both structures and the reasons for each. It is not simply the domestic fund takes in US investors and the offshore takes in non-US investors. Be wary of any businesses or consulting firms that make it sound easy and for a low flat fee are willing to provide you with an offering memorandum (also known as a PPM) and all the tools you need to set up an offshore fund or domestic fund. DOMESTIC State Law Issues. One of the first things I discuss with clients are the state and federal securities laws and how they will affect my client's business. Depending on the state in which the hedge fund manager (also known as an investment manager under state and federal regulations) will operate, there may be a registration requirement. Connecticut, for instance, requires all hedge fund managers/investment advisers to be registered. The registration application process is lengthy and requires the submission of a financial statement, a copy of your offering memorandum, work experience, and lengthy questionnaire. Connecticut regulations provide that investment advisers who have no place of business in Connecticut and who, during the preceding twelve months, have had no more than five clients who are residents of Connecticut are exempt from registration in Connecticut. Many small funds have elected not to have an office in Connecticut because the regulatory requirements and compliance requirements are too costly and time consuming. Here is a full list of the Requirements for Connecticut Investment Adviser Registration. New York on the other hand makes it easier to navigate their regulatory framework and therefore New York is favored for hedge fund formation by many small hedge fund managers, as well as larger funds, when they start the hedge fund formation process. Limited Partnership Structure. As I mentioned above, most hedge funds that are formed in the United States are set up as limited partnerships so that the investors become limited partners with limited liability. The limited partnership is most often formed as a Delaware Limited Partnership because of its favorable regulatory framework and reputation. If your office will not be located in Delaware, however, you will need to get a certificate of good standing from the Delaware Secretary of State, file it in the state where your office will be located and file a form with your state that allows you to do business there even though that is not the state in which your limited partnership was formed. The general partner is usually set up as a corporation or limited liability company. I usually choose to form the general partner as a limited liability company in the state where the hedge fund manager will be located. If you decide to chose setting up a Delaware Limited Liability Company in Delaware or another state that is not the state in which your office is located, then you will need to get a certificate of good standing from the Delaware Secretary of State, file it in the state where your office will be located and file a form with your state that allows you to do business there even though that is not the state in which your limited liability company was formed. This takes extra time, so add about two more weeks to the hedge fund formation process and it will probably cost you another $500 in filing fees. As you probably already know, Hedge Fund Regulation is just around the corner. The SEC is looking at several proposals by Congress. Some of the main issues being discussed are the following: OFFSHORE It is not uncommon for newspapers, even small local papers, to carry at least one article that mentions something about a hedge fund. Large amounts of capital fund these investment vehicles. Investors include wealthy individuals, trusts, institutions and pensions. It is estimated that over one trillion dollars is now managed by hedge funds. Although the current economic crisis may reduce that number it is very likely that once the economy settles down again, assets will again flow into hedge funds in large amounts and hedge fund formation will again pick up. A PIPE Fund has become a fairly well-known type of fund that invests mainly in microcap companies. It may grow in popularity as bank financing and funding from private lenders becomes harder to obtain. You can find more information here on Hedge Fund Formation and Hedge Fund Start-Up For some more background information that might be helpful check out Hedge Fund Formation - How to Define a Hedge Fund. Hedge Fund formation documents usually contain language that the fund manager is required to return to the investors 75% of the amount being redeemed within 60 calendar days following the redemption notice. The balance of 25% is to be sent to the investor within thirty (30) calendar days after the annual audit is completed. There are, however, numerous variations in the terms and conditions set forth in hedge fund offering documents. For instance, one common clause I have used in documents drafted for my clients states,“The Investment Manager shall not be required to liquidate positions in order to meet withdrawals of the limited partners, if to do so would have a negative effect on the funds performance.” This clause actually protects all the limited partners in the fund, including those that are sending in the redemption notices. Assets or stock positions that must be quickly sold in a “fire sale” will greatly reduce the funds return and hurt redeeming as well as non-redeeming limited partners. What happened with the recent economic meltdown, however, was that fund managers were blatantly issuing unilateral decisions to suspend all withdrawals and redemptions by investors. It would seem that these large multi-billion dollar funds, that have become a Hedge Fund Armada, were simply trying to preserve their assets under management. When a fund manager makes a 2% management fee on a billion dollars (or more) under management, he tends to be protective of his assets, maybe overly protective. It is likely these managers will lose considerable assets and credibility, which will affect them for years to come. Small brokerage firms and hedge funds are starting to pop-up now that the dust has settled from the Bear Stearns, Lehman Brothers and Madoff debacles. Wall Street and the rest of the financial services industry are starting to rebuild themselves and boutique firms that have good management teams and access to investors will be carving their niche. During the next few years it will be interesting to see which new firms are successful and become well-known in the industry. Hedge Fund Formation is starting to pick-up steam once again and while there is talk of new or revised regulations, most people in the industry agree that it will do little to impede hedge fund formation and money management in general. Please contact me with any questions or comments. Private Placement Funding. Tips on Raising Capital. Reverse Merger Funding.
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I have helped clients with Hedge Fund Formation for domestic, offshore and master feeder structures. Setting up domestic and offshore hedge funds for clients includes advising them on many regulatory, structural and procedural matters. There are many issues you may not have considered that can simplify your fund launch. Contact me if you are considering setting up a hedge fund. 