Three Embarcadero Center

Seventh Floor
San Francisco, CA 94111-4065
Telephone 415.434.1600
www.howardrice.com

SOME CONSIDERATIONS IN SETTING

UP A HEDGE FUND

Howard Rice’s investment management practice has long included setting up

private 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 “hedge
fund” 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.

WHAT EXACTLY IS A HEDGE FUND?

The term “hedge fund” is used loosely to include any privately-offered
investment pool that trades or invests in securities and other financial
instruments, for the most part in public markets. It generally does not include
fixed-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 in
the new millennium, short selling and other market-hedging techniques have
been important attractions for, in particular, institutional investors. Increasingly,
the term “alternative investment” is used to describe hedge funds, together with
private 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 to
help the fund’s investment manager or promoter perfect exemptions from a
variety of regulatory requirements and limitations. Two themes underlie most
of 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 organized
and offers its interests outside the United States. Hedge funds also seek, in their
structures (if not their operations) to minimize the effective taxes paid both at
the 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.

WHY FORM A HEDGE FUND?

For a startup money manager, a hedge fund can be an inexpensive, efficient and
potentially very profitable way to enter the investment management business.
For an established institutional manager, it can be a low-cost way to
accommodate investors who do not satisfy minimum account size requirements
and to add to profitability through a participation in the results of good
performance. Particular advantages:

The manager can pool assets from many investors, allowing it to manage a
single portfolio efficiently; and

The manager can minimize regulatory overhead and restrictions by

avoiding regulation as a mutual fund. Unlike a mutual fund, a private
fund may, among other things:

ƒ sell short without limit (except as imposed by lending brokers);

ƒ buy on margin without limit (except as imposed by lending brokers);
ƒ take extremely concentrated positions;
ƒ flexibly deploy creative options, futures and other derivatives
strategies; and
ƒ share the fund’s profits (generally called a “performance fee,”
although it is usually an allocation of profits, not a fee) with the
manager.

BASIC STRUCTURE FOR A DOMESTIC FUND

A management company manages the Fund’s portfolio and otherwise operates
the Fund. For funds organized as limited partnerships, the investment manager
often acts as the general partner, but some Funds separate the function of
general partner from that of investment manager. Sometimes this is done to
address tax issues specific to the organization and activities; sometimes it is
because the sponsor of the Fund is not the investment manager; sometimes it is
for reasons related to compensation arrangements for particular personnel
involved in the fund’s management.1

¾ Note: The money manager is distinct from the “hedge fund.” The
manager does not “own” the Fund—the investors do, and the

1This is discussed below. For most purposes in this outline, the general partner and investment

adviser 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 in

the Fund’s agreement of limited partnership or similar constitutional
document.

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. Its
income, 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’s
debts. 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 Fund
creditors.

These attributes mean the Fund will be either a limited partnership (of which
the management company or a related entity is the general partner) or a limited
liability company (“LLC”) of which the management company or a related
entity is the “managing member”)2 Here is a pictorial view of the simplest (and
very common) structure:

O w ner #1 O w ner #2
C a p . C o n tr ib ., M em ber
M em ber S e rv ic e s I n te r e s t C a p . C o n tr ib .,
In te re s t S e rv ic e s

A B C In v e stm e n t
M anagem ent L L C
(I n v e s tm e n t A d v is e r )
(D e l L L C )

G P In te re s t;
In v esto r s 2 0 % In c e n tiv e
(L im ite d P a r tn e r s ) A llo c a tio n
(1 0 0 , if 3 (c )(1 ); 4 9 9 if o f P r o fits; 1 %
3 (c )(7 )) M g t. F e e
C a p ita l
C o n t r i b 's ; M g t .
C a p ita l S e rv ic e s
LP
C o n t r i b 's
In te re s ts

F e r o c io u s A n im a l F u n d , L P
(F u n d )
(D e l L td . P tn rs h ip )

I n v e s tm e n t P o r tfo lio

2An LLC that is centrally managed, like a Fund would be, has a “manager” or “managing member” that

plays the same role as a general partner. But the management company is not liable for the debts of the
fund, like a true general partner would be.
 December 2009 Considerations For Hedge Fund Startups
Page 4

Other characteristics. Most funds share the following traits:

ƒ Investors share in profits, losses, etc. based on their respective

investment account balances from period to period, subject to the
management company’s performance allocation.
ƒ The management company has almost complete authority to run the
Fund.
ƒ The management company is an investor, or its owners are investors,
in the Fund.
ƒ New investments are accepted periodically (usually quarterly).
ƒ Investors typically may withdraw quarterly (often after a lockup
period, which the management company may waive).
ƒ The portfolio is marked to market every time an investor comes in or
out, and the investors’ sharing ratios are based on current values,
including unrealized gains and losses.

¾ Caveat: Keep it Simple!! Partnership (or LLC) format provides almost

unlimited flexibility to structure the deal between the general partner and
the investors. Partnerships are inherently complicated, ironically because
they are so flexible. Most investors won’t understand—or spend time
trying to understand—new structures or subtle distinctions.

STRUCTURE OF THE MANAGEMENT COMPANY

Type of entity. In deciding what type of entity a management company should
be, the two principal considerations are much the same as those for selecting the
entity for the Fund:

Tax pass-through status is extremely desirable to avoid double taxation and

preserve for owners capital gains treatment of amounts allocated to the
management company.

Liability of the management company’s owners should be limited to their

investment in the management company.

ƒ This protection will be significantly less complete for owners who are
active portfolio managers and otherwise active in running the
management company because of special provisions of federal
securities laws that impose liability for certain acts directly on “control
persons.”
ƒ But even control persons can be protected from some liabilities, and
any passive or noncontrolling owners can receive fuller protection.
 December 2009 Considerations For Hedge Fund Startups
Page 5

This means the management company will probably be one of the following:

ƒ LLC—current favorite. It’s flexible, tax-efficient, and doesn’t require

that anyone be generally liable for the company’s obligations.
ƒ Limited Partnership—essentially same tax efficiency and flexibility as
LLC. Can have some self-employment tax advantages. Usually
requires an additional entity to act as its general partner.
ƒ S-Corporation—less flexible but simpler to put together and offers
good tax efficiency. May have some quirky tax characteristics under
some circumstances.
ƒ Sole Proprietorship—least likely choice. Single owner, simple, tax-
efficient. But the owner is generally liable for the company’s (and the
Fund’s) obligations and cannot share equity with others.
Single vs. multiple entities. For domestic funds, the management company’s
organization typically receives three distinct types of value: (a) fees for services
provided; (b) a share as a “partner” (“member” in an LLC) in the profits (and
losses) of the Fund, based on the organization’s investment in the Fund
(basically on the same terms as outside investors, but generally without
reduction for management fees or carried interest); and (c) a “carried interest”—
“incentive” or “performance” profit participation. It is important, from a tax
point of view, to preserve the distinction between the fees for services and the
profit participation. In some circumstances, it may be appropriate to structure
the arrangement so that these two sources of value go to separate entities.
Thus, the Fund’s general partner may be an entity separate from the entity that
receives the management fee.

ƒ Some tax practitioners believe this may improve the position under
federal income tax law that the carried interest should be entitled to
treatment as a profit allocation rather than a fee for services. For
investment managers located in New York City, a similar analysis is
common in order to avoid subjecting the carried interest to an
Unincorporated Business Tax.
ƒ Separate entities can facilitate sharing the two sources of value among
the various participants in a hedge fund startup (and their employees)
in different ways. This may be particularly useful for tax planning
purposes and/or where the hedge fund project is a joint venture
between different organizations and people.
ƒ Some practitioners believe that separating the investment
management function from the “general partner” function may
enhance the limitation of liability of owners of the two entities.

Here is a diagram of one multiple-entity structure (with an offshore fund added,

to show the different relationship the management company has to such an
entity):
 December 2009 Considerations For Hedge Fund Startups
Page 6

Owner #1 Owner #2
Member Member
(ownership) (ownership)
Interests Interests

US Tax-Exempt
Investors
(Shareholders)
U.S.
ABC Asset
ABC Holdings LLC Management LLC OFFSHORE
(Del LLC) (Del LLC)
Non-US
US Taxable Purchase Investors
Investors GP Interest, Price (Shareholders)
(Limited Partners) 20% Incentive 1.5% Mgt. Fee
Allocation Investment
AND
Mgt. Services
20% Performance Fee
1.5% Mgt. Fee Purchase
Capital Shares Price
Contribution Investment
Mgt. Services Shares
Capital
Contributions
Ferocious Animal Ferocious Animal Offshore
LP Interests
Partners, LP Fund, Ltd.
(Domestic Fund) (Offshore Fund)
(Del Ltd Prtnrship) (Cayman Company)

OFFSHORE
U.S.

Investment Portfolio
Investment Portfolio

Financing. Hedge fund management is not particularly capital intensive. But

at the beginning there are working capital needs. The Fund’s organization
expenses must be paid, the Fund must be marketed to investors, and you must
keep the lights on during the initial period. Some basic questions:

How much working capital will the management company need? Factors include:

ƒ Personal cash flow needs of founders;

ƒ How much the Fund can raise right away and how much it will cost to
raise that;
ƒ What expenses can be paid, and what should be paid, with “soft
dollars.” Don’t count on a lot.

Who will provide it?

ƒ Founders.
ƒ Passive financial investors.

How much dilution? How much of the upside should the Founders sell and how
much control should they cede to outside investors?
 December 2009 Considerations For Hedge Fund Startups
Page 7

Other ownership issues.

Multiple founders. If there are multiple founders of the management company,

structuring the deal among them deserves careful thought at the front end.
Some considerations:

ƒ Who makes what decisions? How are deadlocks broken?

ƒ If some founders are able to contribute more capital than others,
should profit-sharing percentages vary from capital contributions?
How?
ƒ What happens to a member’s interest if s/he leaves the firm? E.g.,
buyout? Call? Put?

Employees and consultants. Particularly as an organization matures, attracting

talented analysts, traders, and portfolio managers may require giving them equity
or equity-like packages. These interests may be distinguished from “founders”
interests in aspects such as rights to participate in management, other voting
rights, rights or obligations if the employee leaves the company, and
participation in any profits from a sale of the company. They can be structured
as “profits” interests for which the employee need not “buy-in” (contribute
capital) at the same price as founders or financial members (if at all), and profit
participation can even be varied by the Founders from period to period.

Special features for financial investors. In an LLC or limited partnership, passive

members who provide working capital as a financial investment can have
preferred returns, limits on their profit participation, and “sunset” or buyout
features to their investment.

“Anchor tenant” investors in Fund. Some large investors may be willing to “seed” a
new Fund in exchange for a participation in the management company’s
profits—sometimes relating only to the Fund, sometimes to all the company’s
investment activities. This interest can be limited in duration and/or subject to
a “buyout” right.

MANAGEMENT COMPANY COMPENSATION

Most funds provide some combination of an asset-based fee and a participation
in the fund’s profits. Each of these components has its own characteristics and
issues.

Management fee.

ƒ Typically 1.5% to 2% of assets, paid quarterly or monthly.

ƒ Separately calculated for each investor, to permit customized fee
arrangements, waivers.
ƒ In advance vs. arrears
 December 2009 Considerations For Hedge Fund Startups
Page 8

“Performance” or “Incentive” allocation (“carried interest”).

ƒ It is not a “fee,” it is an allocation of fund profits to the management

company, in the management company’s capacity as a partner or
“member” in the fund. This has valuable tax implications.
° Timing of realization of taxable income. The allocation is based on
unrealized as well as realized gains and losses. At the end of the
year (or shorter allocation), the management company’s capital
account is increased by 20% (or other amount) of these gains,
increasing its “investment” in the fund and its percentage
ownership. To the extent the fund’s gains were unrealized, this
occurs without tax to the management company. If the same
amount were paid as a fee, the management company would pay
tax on the entire amount when accrued or paid. (Of course if the
management company makes a withdrawal, gain will be triggered.)
° Capital gains treatment. The portion of the allocation that represents
realized gains has the same tax character for the management
company as it has for the Fund. So to the extent the allocation is
based on long-term capital gains, the management company is
allocated capital gains. If the same amount were paid as a fee, the
entire amount would be ordinary income to the management
company.
° Potential advantage for investors. The allocation reduces the amount of
gains and profits allocated to the investors. If it were a fee, they
would have more gains allocated to them, to be offset by a
deduction for the fee. The deductibility of the fee could be
subject to limitations for some investors.
° BUT Congress is considering legislation that would change the
tax treatment for recipients (the management company) – would
treat incentive allocations as ordinary income paid for services.
ƒ High water mark. In virtually every fund, the management company
will receive an incentive allocation for a period only to the extent
profits in that period exceed previously allocated but unrecovered
losses. That is, if a fund has suffered losses, the management
company will not be rewarded simply for restoring those losses—for
bringing investors back to their “high water mark.” Some funds
provide that losses incurred more than one or two years earlier need
not be restored before the management company can receive an
incentive allocation—they “reset” the high water mark to eliminate
older losses.
ƒ Hurdle rates and fancy footwork. Particularly where a fund’s objectives
and style are similar to those offered by public funds or other
investment vehicles, investors may want to be subject to the incentive
allocation only when their profits exceed those they could earn in an
alternative investment. Some variations on this theme:
 December 2009 Considerations For Hedge Fund Startups
Page 9

° “Hard” hurdle—Incentive Allocation is made only on amount by

which investor’s return exceeds the hurdle rate.
° “Soft” hurdle—Incentive Allocation is made on all profits (not
just excess over the hurdle rate), but only if the net return exceeds
the hurdle rate.
° Cumulative hurdle vs. year-by-year
° Hurdles such as S&P 500 or Russell 2000, which can be negative
for a period, could result in an Incentive Allocation when the
investor loses money.
ƒ Individualization. The incentive allocation and high water mark are
calculated separately for each investor. If an investor makes a partial
withdrawal when he has an unrecouped loss, the dollar amount of
losses that must be restored before the management company may
receive an incentive allocation is proportionately lowered.
Individualization also allows waivers and special deals for particular
investors.

¾ Caveat redux: Keep it simple!!!! You may be tempted to distinguish your

fund from others by providing a slightly better, more clever deal on the
Incentive Allocation. And some special-purpose, limited distribution
funds have some very imaginative, highly negotiated (with anchor
investors) terms. But complexity is generally a negative in marketing.
Many investors won’t understand the details and the explanation may
divert their attention from the important point: the management
company’s investment skill. Complexity also costs money and bogs the
formation process down.

Regulatory limits on performance allocation.

An SEC rule (Rule 205-3) provides that an SEC-registered management

company (see discussion below) may collect performance-based compensation
only from persons who either have a net worth of at least $1.5 million or have at
least $750,000 under the management company’s management. Many states,
including Washington, Oregon and California, impose similar limitations, either
by reference to Rule 205-3 or through their own, similarly constructed rule.

REGISTRATION (OR NOT) OF THE FUND

Fundamental goal: Avoid regulation as an “investment company” (mutual
fund). A fund will be considered an “investment company” (mutual fund)
under the federal Investment Company Act of 1940, if it does not qualify for an
exclusion from regulation. This would dramatically increase the fund’s and the
management company’s regulatory burden and limit the fund’s freedom to
operate.
 December 2009 Considerations For Hedge Fund Startups
Page 10

3(c)(1) Funds. Most funds rely on the Section 3(c)(1) exclusion:

ƒ Fund may not make a public offering of its interests. Satisfying the
“private placement” exemption described below will satisfy this
requirement; and
ƒ Fund may not have more than 100 “beneficial owners” at any time.

!!!! Beware!! Rules for counting up to 100 are complex and unclear. For
example:

ƒ If another 3(c)(1) fund (e.g. “fund of funds”) holds more than 10% of
interests, Fund generally must “look through” that fund and count
each of its investors as filling a “slot.” This rule also applies to
investments by mutual funds and 3(c)(7) funds (discussed below).
ƒ Even if below 10%, if a partnership, LLC, corporation or other entity
is formed for the purpose of investing in the fund, must look through
and allocate a slot to each of that entity’s owners. If more than 40%
of the entity’s assets are invested in the fund, that entity is presumed
to have been formed for the purpose of investing in the Fund.
ƒ If a management company operates multiple funds, unless there are
sufficient differences in investment objectives and eligibility
requirements, they may be “integrated” and considered to have only
100 available slots among them.

3(c)(7) Funds. Section 3(c)(7) of the Investment Company Act provides an

alternative to Section 3(c)(1), without the 100-investor limit.

ƒ Fund may not make a public offering of its interests. Same test as for
3(c)(1) funds.
ƒ Fund is not limited to 100 beneficial owners, but may be owned only
by “Qualified Purchasers” and “knowledgeable employees” of the
management company or the fund.
ƒ Qualified Purchasers are:
° Individuals and certain family companies that own at least
$5 million of “investments.” Entities that have “control” over
$25 million of “investments.” Controlled investments include the
entity’s own investments and assets held by other Qualified
Purchasers over which the company exercises investment
discretion; Entities that are themselves owned only by Qualified
Purchasers; and “Qualified Institutional Buyers” under Rule 144A.
ƒ Calculation of $5 million or $ 25 million of “investments” is complex.
° Must exclude value of securities of certain privately held
companies.
° Real estate may be included, but only if held for investment—i.e.,
not for personal or business—purposes.
 December 2009 Considerations For Hedge Fund Startups
Page 11

° Commodity interests, commodities, cash, and financial contracts

may be included, if held for investment.
° Net of outstanding indebtedness incurred to acquire investments.
ƒ “Knowledgeable employees” include: executive officers and directors
of the Fund or of an affiliate of the Fund that manages the Fund (e.g.,
the management company); any employee of the Fund, the
management company, or one of its affiliates, who participates in
investment activities and has done so for at least 12 months.

Another fundamental goal: Avoid “public offering” registration of

interests in the Fund. When a fund accepts an investor’s assets, it sells a
security. Federal and most states’ laws require that all securities be registered or
“qualified” for sale. This means creating a full-blown prospectus and filing it,
together with additional detailed information, with the SEC. Unless an
exemption is available.

Almost all Funds rely on “private placement” exemption from federal

registration (Rule 506 of Regulation D). Basic requirements:

ƒ No advertising or “general solicitation.”

!!!! Beware!!— articles, interviews, internet websites and listing in
hedge-fund databases can violate this requirement.
ƒ Most investors must be “accredited” (see “Who Can Invest,” below)
and all should be “sophisticated”—with sufficient knowledge and
experience in business and investments to permit them to evaluate the
merits and risks of an investment.
ƒ May have up to 35 non-”accredited” investors, but —
° Requirements for disclosure document are somewhat more
formal.
° This does not mean 35 nonaccredited investors in the Fund at any
one time. If Fund offers interests continuously (almost all do)
redemption by a nonaccredited investor does not free up another
non-accredited “slot.”
° Investment adviser laws applicable to the management company
may prevent the management company from receiving a
performance allocation on nonaccredited investors’ profits.
ƒ No particular form of disclosure/offering document is required, but:
° Full disclosure is critical to protect the management company.
Must include fund structure, the management company’s identity
and background, investment program (the management
company’s complete investment discretion and/or limits on
investments), overview of risks, conflicts of interest, tax
characteristics of Fund;
 December 2009 Considerations For Hedge Fund Startups
Page 12

° If nonaccredited persons may invest, disclosure document must

include all the material information that would be included in an
SEC registration statement;
° If Fund invests in commodity options or futures, depending on
the level of investment and/or the types of investors in the Fund,
specific disclosure may be required by CFTC, including
performance and risk disclosure.
ƒ Notice filing (Form D) required by SEC within 15 days after first sale.

“Blue Sky.” State (“blue sky”) registration is not required—nor is compliance

with state-specific exemption conditions— if the fund’s offering of interests is
exempt under SEC Rule 506 (Part of Regulation D). But filings—and filing
fees—are required in most states. A “notice” filing generally must be made
within 15 days after first sale in the state. This area is subject to change, as
states are still adapting to federal legislation adopted in 1996.

WHO CAN INVEST?

This depends on the fund and the management company, including:

ƒ what exemption the fund seeks from regulation as a mutual fund—

3(c)(1) vs. 3(c)(7);
ƒ whether Fund invests in commodity options or futures and wants to
qualify for a “QEP” exemption from the full disclosure and CFTC
review requirements;3
ƒ whether the management company is SEC-registered or, if not, what
state’s laws, if any, it is registered under (because of performance
compensation rules);
ƒ whether the fund invests in futures contracts.

Financial qualifications. Most funds impose a two-part requirement: investor

must be “accredited” under Regulation D and must have a net worth of at least
$1.5 million.4

3Other exemptions are available for 3(c)(7) funds and funds that limit their investment in futures to

specified levels.
4For investors in Funds based on the west coast, it is generally not enough simply to be an accredited

investor. Accredited investors include individuals with a net worth of at least $1 million, individuals with
incomes of at least $200,000 for certain periods, individuals whose joint income with spouse for certain
periods was at least $300,000, and certain corporations with assets of at least $5 million. The SEC’s Rule
205-3, precludes an SEC-registered adviser from receiving a performance allocation as to an investor
that does not have a $1.5 million net worth or have at least $750,000 under the Management Company’s
management. California, Washington, and Oregon law governing investment advisers contain similar
requirements, in various states of evolution to conform to Rule 205-3.
 December 2009 Considerations For Hedge Fund Startups
Page 13

ƒ A fund of funds that invests must show that each of its investors
meets the net worth test.
ƒ The management company may make some exceptions. E.g., a 3(c)(1)
fund that does not invest in futures or commodity options may admit
a limited number of nonaccredited investors if the management
company waives the performance allocation for them.

Unrelated business taxable income (“UBTI”) may make an investment in many

funds inappropriate or undesirable for tax-exempt investors such as IRAs,
employee benefit plans, foundations.

ƒ Created by leverage—margin borrowing—but not by most short

selling;
ƒ Calculating how much of a fund’s taxable income and gains are UBTI
is complex;
ƒ Some types of tax-exempts may be willing simply to pay taxes on
UBTI allocated to them; however, for others (e.g., charitable
remainder trusts) the income tax consequences are more severe, in
that the UBTI they are allocated is subject to a 100% tax.

Retirement plan investors may be undesirable for the management company. If

25% or more of any class of a fund’s securities (usually limited partner interests)
are held by “plan investors,” the management company will be subject to
additional duties under ERISA that can’t be waived or varied by plan investors:

ƒ Additional fiduciary duties;

ƒ Several types of transactions may become “prohibited,” including
many soft-dollar practices;
ƒ Plan investors’ other fiduciaries may become liable for the
management company’s actions in managing the fund, and the
management company could become liable for those other fiduciaries’
misdeeds;
ƒ The management company must obtain a bond;
ƒ Performance allocation may become subject to additional limitations.

¾ Note! Calculation of 25% can be tricky.

ƒ Must include not only “true” ERISA plans, but also IRAs and Keoghs
and certain other types of plans.
ƒ Must exclude the management company’s (and its owners’) capital
account(s) from both numerator and denominator.
 December 2009 Considerations For Hedge Fund Startups
Page 14

PORTFOLIO INVESTING ISSUES

Generally, there are very few externally-imposed legal restrictions on how a
Fund may or may not invest or trade. If disclosure is adequate, the fund can invest
in almost anything or engage in almost any trading activity. Some activities that
require special disclosure:

ƒ futures or commodities interests

ƒ investing in private placements or other restricted securities
ƒ use of soft dollars for other than “research”
ƒ trading through broker-dealer affiliated with the management
company
ƒ crossing transactions with other advisory or brokerage clients of the
management company or its affiliates
ƒ coinvesting with the management company

If the fund’s Offering Memorandum describes any limits on the investing and
trading activities the fund will engage in (e.g., “the Fund will not buy a security if
after doing so the security would comprise more than 10% of the Fund’s
assets”; other concentration characteristics; focus on small-capitalization
equities; no margin; no options), the management company must stick to them.
Some of these may be unclear. Requires care in drafting Memorandum.

Restricted securities—be careful!!! Offering Memorandum and Partnership

Agreement should expressly permit investment in private placements and other
restricted securities. But these investments bring significant valuation and
liquidity risks.

Concentrated positions—Extremely concentrated positions can subject a fund to

serious performance and liquidity risks, particularly if a number of investors try
to withdraw at the same time.

REGISTRATION AND REGULATION OF MANAGEMENT COMPANY

SEC registration.

Under federal law, managing an investment limited partnership makes a

management company an “investment adviser.” Most states’ laws are similar.
So the management company must either register as an investment adviser or
find an exemption. A Manager generally is not allowed to register with the SEC
unless it has at least $25 million under management.5 So for many startup

5A Management Company with between $25 million and $30 million is permitted to register with the

SEC, but is not required to as long as it complies with state registration requirements or is eligible for
the private adviser exemption from SEC registration. Congress is considering legislation that could raise
this limit to $100 million.
 December 2009 Considerations For Hedge Fund Startups
Page 15

managers, state registration issues are more relevant at the outset. But growth
brings SEC considerations.

Many management companies with more than $25 million under management
qualify for a “private adviser” exemption from SEC registration:

ƒ Fewer than 15 clients (fund generally counts as one “client”); AND

ƒ The management company does not “hold itself out to the public” as
an investment adviser. This requirement makes the exemption very
fragile. Publicity, including articles, interviews, internet websites, and
presence in databases and directories can violate this requirement. So
can listing as an investment adviser in yellow pages or even in a
building directory.
¾ Note! Congress is considering legislation that would eliminate this
exemption entirely – at least for managers who manage $100 million (or,
in one bill, $150 million) or more.

State registration.

If the management company is SEC registered, states cannot require registration

or impose substantive regulations on the management company itself, although
they may require “notice” copies of filings with the SEC and fees.

If the management company has less than $30 million under management or is
relying on the “private adviser” exemption from SEC registration, states may
require registration and subject the management company to substantive
regulation, such as net capital requirements, rules governing contracts, and rules
governing performance-based compensation.

ƒ Washington, Oregon and California have investment adviser laws

similar, but not identical, to the federal regime.
ƒ California has a “private adviser” exemption similar to the SEC
exemption described above, but it is available only for management
companies with more than $25 million under management.
¾ Note! These laws would probably change if currently pending Federal
legislation is passed.

Commodity Futures Trading Commission.

If a fund invests in futures contracts or other commodity interests (or in other

funds that do), the management company may have to register with the CFTC
as a “commodity pool operator” (“CPO”) and become a member of the
National Futures Association (“NFA”). It may also have to register as a
Commodity Trading Adviser (“CTA”) if it gives advice about futures contracts
or other commodity interests to clients other than the Fund.
 December 2009 Considerations For Hedge Fund Startups
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There are exemptions from CPO and CTA regulation for managers of (i) 3(c)(7)
funds and (ii) 3(c)(1) funds that, among other things, are not marketed as
commodity pools and limit their futures and commodities activities so that
(a) the aggregate initial margin and premiums required to establish commodity
interest positions (determined as of the most recent time a position is
established) does not exceed 5% of the fund’s liquidation value or (b) the
aggregate net notional value of the fund’s commodity interest positions
(determined as of the most recent time a position is established) does not exceed
100% of the fund’s liquidation value.

Even if a management company does not qualify for those exemptions and
must register as a CPO, it may qualify for an exemption from CTA registration
under a “private adviser” exemption similar to the SEC exemption.

If registered as a CPO, a management company will have to be sure that the

fund’s offering materials include specific types of disclosure about the futures
and commodities activities.

ƒ If the fund is available only to “Qualified Eligible Participants”

(“QEPs”), no special disclosure (beyond a legend) is required and the
offering materials need not be submitted for regulatory review.
Generally, an individual is a QEP if he or she is an “accredited
investor” (see discussion below) and has at least $2 million in
investments or at least $200,000 on deposit with a futures commission
merchant. Entities must satisfy other eligibility requirements.
ƒ If the fund does not limit its offering or activities in the ways
described above, the offering materials must include detailed
disclosure, including performance- and risk-related information, that
must be reviewed by the NFA. This is a time-consuming and arduous
process.

A registered CPO or CTA must also be careful that investors that are
themselves pooled investment vehicles (e.g., funds of funds) are managed by
entities that are either registered as commodity pool operators or commodity
trading advisers (and members of the NFA) or exempt from such registration
and membership.

Licensing and examination requirements for individuals.

The management company’s portfolio managers are not themselves “investment

advisers.” But they may need to have certain credentials in order to be
employed by and act on behalf of the management company.

ƒ The SEC imposes no examination or licensing requirements on a

management company’s personnel. But a state may require licensure
(including exams) for an “investment adviser representative” of an
SEC-registered management company, including a solicitor, if more
than 10% of the representative’s clients in that state are “retail”
 December 2009 Considerations For Hedge Fund Startups
Page 17

clients. A fund is a single “client.” Retail clients exclude any

individual that meets the standard for paying performance-based
compensation.
ƒ Many states, including Washington and California, require at least
investment-level personnel to have passed examinations, such as the
Series 65, administered by the NASD. And some (such as
Washington) require a management company to have a “principal”
who has passed the Series 24 “supervisor’s” exam. Some states
permit experience-based exemptions from these requirements.
ƒ Certain principals other employees of registered CPOs and CTAs
must pass certain examinations administered by the NFA.

Substantive rules applicable to the management company.

Fiduciary Duties. Regardless of whether SEC-registered, CFTC-registered, state-

registered or unregistered, the management company is a fiduciary. This brings
duties that regulators and private litigants take seriously. Some particular
considerations:

ƒ Fiduciary duties can generally be defined and limited by contract (i.e.,

the fund’s Partnership Agreement). In the absence of very explicit
agreements, presumption is that investors’ interests must always come
before the management company’s. So Partnership Agreements (and
other investment management agreements) should specifically address
certain issues such as the management company’s ability to invest
outside of the fund and conduct other business activities.
ƒ Use of soft dollars involves a conflict of interest, but is permissible
within limits and if disclosure and authorization are adequate.
° Buying “research” and “brokerage” products and services are
protected by a federal statute, if procedures are followed.
° Paying fund expenses is generally permissible, as it does not
involve the same kind of conflicts of interest as other
expenditures.
° Buying other products and services for the management company
is not necessarily prohibited, but does involve conflicts and must
be fully and very carefully disclosed. Also not permitted for funds
that consist of ERISA “plan assets” (a very technical definition):
• management company overhead
• Investor referrals
° Technically there is no difference between SEC-registered and
state-registered management companies.
ƒ Personal trading activities by the management company and its
personnel can involve conflicts of interest and should be governed by
well thought out policies. SEC-registered investment advisers are
 December 2009 Considerations For Hedge Fund Startups
Page 18

required to have a “code of ethics” that expressly deals with these

issues.

Insider trading. Most management companies must have a written set of policies
and procedures to detect and prevent insider trading (often integrated with their
“codes of ethics”). Some unregistered management companies may not be
specifically required to have such a policy, but as a matter of prudence and
practice they should. The substantive insider trading laws apply to all market
participants.

Compliance programs, generally. SEC-registered management companies must have

a comprehensive compliance program reasonably designed to ensure
compliance with all applicable laws. As part of that program, they must formally
designate a Chief Compliance Officer. State-registered advisers may not be
subject to this requirement. But, again, prudence dictates some procedures to
stay on top of compliance with those requirements that do apply.

Recordkeeping. SEC- and state-registered management companies are required to

keep detailed records of their business. Most required records are things a
prudent, well-organized business would keep, regardless of whether or not
regulated. However, some items, such as support for performance quotations in
marketing materials, must be kept for specified periods and in specified forms.
Retention of email communications and instant messages is the subject of
significant debate; advisers should probably expect to be required, to retain
essentially all email communication.

Performance-compensation rules. The SEC and most states permit management

companies to accept performance-based compensation only from investors that
have net worths of at least $1.5 million. Funds of funds and other entity
investors may have to be “looked through,”—all of their underlying owners may
have to satisfy that test as well.

State net capital requirements. The SEC does not require registered management
companies to maintain any particular level of capitalization, but many states do.
The substantive requirements are generally easy to meet, but management
companies must maintain records demonstrating compliance.

Additional requirements for management companies that have “custody” of client

assets

ƒ Higher net capital (if state-registered), audit of the management

company’s books, surprise examination of client securities, additional
recordkeeping.
ƒ A general partner of a partnership is generally considered to have
custody of all the partnership’s assets.
ƒ A state-registered management company may avoid the custody-
related requirements if the fund enters into an agreement with its
 December 2009 Considerations For Hedge Fund Startups
Page 19

Prime Broker (all custodians) requiring a letter from an independent

accountant confirming performance of certain procedures as to
disbursements to the general partner (e.g., payment of management
fee, withdrawals from General Partner capital account, reimbursement
of expenses).
ƒ An SEC-registered management company may avoid the custody-
related requirements if the fund provides GAAP-basis audited
financial statements by a PCAOB-registered and inspected accounting
firm within a specified time frame.

PUTTING THE FUND TOGETHER—MECHANICS AND DOCUMENTS

Many, but not all, tasks proceed on roughly parallel paths.

Engage professional team. Prime brokerage, legal, accounting. Do this first.

Form the Management Company. At least the minimal act of formation

must be accomplished before application to register as investment adviser may
be filed.

Register the management company as an investment adviser.

Form fund entity (Limited Partnership or LLC).

Draft Offering Documents.

ƒ Offering Memorandum
° Does double duty: marketing document as well as protection
against investor claims that they were misled.
° Must disclose details of structure, identity of the management
company, investment program and restrictions, compensation and
economic interest of the management company, overview of risks,
conflicts of interest of the management company, overview of tax
characteristics of fund, terms on which interests are offered.
° If fund invests in futures and other commodity interests may need
to include detailed disclosure imposed by CFTC.
ƒ Fund Partnership Agreement (“Operating Agreement” for LLC)
° Contains details of deal among investors and the management
company, including: grant of authority to the management
company; performance allocation; management fee; withdrawal
(redemption) rights; who bears what expenses; “carveout”
arrangements for new issues; voting and amendment rights.
° Should give the management company broad authority to invest,
authorize the management company to force withdrawals, limit
impact of fiduciary duties on other management company
 December 2009 Considerations For Hedge Fund Startups
Page 20

activities, and maximize flexibility to amend to adapt to changes in

regulatory environment and applicable partnership law.
ƒ Subscription Documents
° Investor questionnaire has competing goals. It should both:
• Elicit detailed information from investors sufficient to perfect
the regulatory exemptions described above and comply with
laws; and
• Be friendly and decipherable for both investor and the
management company.
° Subscription agreement specifies terms on which investor offers
to buy an interest, includes investment-related and investor-
specific representations to protect the management company in
the offering process, and binds investor to the Partnership
Agreement.

Open prime brokerage account.

For state-registered management companies, enter into custody/

disbursements agreement with Prime Broker (with input from outside
accountant).

Begin offering.

Review investors’ completed subscription documents carefully for

completeness and compliance with terms of the offering

Make post-sale filings to perfect securities registration exemptions

Provide new issue documentation to brokers who might sell new issues to
Fund.6

FUND RAISING
No general solicitation or advertising.

ƒ Rule of thumb: sell to those with whom the management company or

its agents has sufficient pre-existing business or personal relationship
to permit confidence that the investor meets the fund’s qualification
requirements.
ƒ Areas of concern:

6NASD regulations require brokers to have documentation demonstrating that sales of “new issues”

are not made to accounts in which “restricted persons” have beneficial interests. Many funds use
“carve out”” accounts to allocate profits from new issues away from restricted persons. These
regulations are complex and managers face choices in how to comply.
 December 2009 Considerations For Hedge Fund Startups
Page 21

° Publicly available directories or databases

° Internet websites
° Interviews and articles in which the management company
cooperates
° Mass mailing

Stick to the script—don’t make statements that aren’t in the formal offering
documents or in supplemental materials that have been reviewed carefully for
consistency with the formal documents. In particular, statements about limits
on portfolio activities (e.g., concentration limits, limits on margin or short
activity) can come back to haunt.

Use of soft dollars to reward referrals. If the management company will

consider referrals of prospective investors when deciding what brokers to use,
then, among other things, the practice must be fully disclosed and should be
consistent with best execution.

Paying hard dollars for sales

ƒ Fund typically does not pay commissions for subscriptions.

ƒ Payments by the management company may make the recipient a
“broker” who must register with the SEC and state regulators and
become a member of the NASD.
ƒ May need to comply, at least in substance, with SEC rule governing
investment advisers’ payment for soliciting advisory clients.

OFFSHORE FUNDS
Reasons for setting up separate offshore fund.

Historically, the reasons are US income tax-based: if a foreign person

invested in a U.S. partnership that was a “trader,” capital gains (principal source
of profits) would be subject to U.S. taxation.

A 1997 tax act (repeal of so-called “Ten Commandments”) changed that. Now,
foreign investors are subject to tax only on dividend and certain interest income.

But some reasons remain:

ƒ Foreign investors’ desire for anonymity. A U.S. partnership would file

Schedules K-1 with the IRS for foreign investors, even though they
won’t be subject to tax on capital gains.
ƒ Foreign investors could be subject to U.S. estate tax on ownership
interest in a U.S. partnership.
ƒ U.S. tax-exempt investors do not face UBTI from an offshore fund
organized as a corporation, even if the Fund uses margin extensively.
 December 2009 Considerations For Hedge Fund Startups
Page 22

ƒ IF offshore fund is available only to foreign investors and U.S. tax-

exempt investors, under most circumstances U.S. tax-exempt
investors can be directed to the offshore fund and free up “slots” for
U.S. taxable investors in a “sister” domestic 3(c)(1) partnership.

Structure.

Offshore funds typically are not partnerships.7 Instead, they are “companies,”
like corporations, that issue shares. They typically have a board of directors and
the management company usually is not an investor. Instead, it has an
investment management contract with the fund. Many funds use a “master-
feeder” structure in which the assets of the offshore fund and a “sister”
domestic fund are pooled into a single portfolio. Whether this is advantageous
depends on a number of factors particular to the funds’ investment activities
(tax considerations are important) and the number and types of potential
investors.

Management Company Compensation.

ƒ Management Fee is sometimes higher—2% rather than 1.5%.

ƒ Performance Fee is often a true fee, not an allocation (assuming
company structure).
° This means it is ordinary income to the management company
when it is paid (assuming the management company is cash
basis—when earned if accrual basis).
° Many management companies enter into deferral arrangements
under which, before the beginning of a year, the management
company agrees to defer some or all of the fees for a specified
period. Amount payable at the end of the deferral period may
reflect simple interest, but more often is calculated as if the
amount were actually invested in the Fund. If done correctly, fees
are not taxable to the management company until actually paid.
They will be ordinary income then. Deferred fees are a liability of
the Fund, must remain unsecured, and are subject to the claims of
the Fund’s creditors.
ƒ An alternative structure involves causing the Fund to invest in a
“portfolio company” or a master fund that is treated as a partnership
for US tax purposes. Management company is a “partner” in that
entity and receives a performance allocation, taxed in the same way as
in a domestic fund.

7Limited partnerships and LLCs may be appropriate for some types of funds As with domestic
funds, such a structure would have the advantage of permitting investor-level accounting and
structure of performance allocation in same manner as domestic fund. This could be more
hospitable to U.S. taxable investors. However, none of this would be appropriate if exchange listing
or publication of net asset value is desirable.
 December 2009 Considerations For Hedge Fund Startups
Page 23

ƒ Performance fee is generally based on performance of fund as a

whole, not individual investors’ capital accounts.
° This can cause anomalies for investors who come in midyear or at
a time when the fund has a loss carryforward (i.e., is below its high
water mark).
° Several mechanisms are used to simulate investor-by-investor high
water marks. They are complex, difficult for investors to
understand, and create potential for errors in NAV calculation.

Jurisdiction of formation.

Criteria:

ƒ No local tax on the fund. Some jurisdictions give guarantees that

changes in their tax laws won’t affect the fund for specified periods.
ƒ Limited local regulation of investment funds.
ƒ Good local service providers—primarily attorneys. Administrators
and, for most jurisdictions, accountants need not be located in the
jurisdiction.
ƒ Credibility with prospective investors.
ƒ Appropriate regulatory structure for types of investors and offering
intended. Some countries’ securities regulators will not allow a Fund’s
securities to be registered for sale to the public if the jurisdiction of
formation does not have a regulatory structure adequately comparable
to that of the offeree country.

Low-cost, low regulation jurisdictions—Cayman Islands, British Virgin Islands,

Netherlands Antilles.

Mid-range jurisdictions—Bermuda, Isle of Man, Channel Islands.

High-end—Ireland, Luxembourg.

Expenses; mechanics.

Formation is typically significantly more expensive than for domestic fund. In part
because, although U.S. counsel must remain involved and will generally take
laboring oar in drafting disclosure documents and coordinating formation, also
need offshore counsel for the formation documents and local registration.

Registration fees and setup fees for offshore service providers add to the
expense.

Formation also takes longer, again due to increased number of players,

coordination requirements, and local filings.
 December 2009 Considerations For Hedge Fund Startups
Page 24

Ongoing administrative expenses are higher.

ƒ Historically many functions, including calculation of net asset value

and communications with investors, had to be performed outside the
U.S. in order to prevent the fund from being subject to U.S. taxes.
These functions were typically performed by an “administrator”
located offshore who charged the Fund a fee.
ƒ Those functions are no longer required under U.S. tax laws to be
performed outside the U.S., so less need will be done by offshore
administrators.

Accounting/auditing. As with administration, accounting functions

previously had to take place offshore. That increased audit expense. Many of
these functions may now be performed in the U.S., allowing more efficiency,
coordination with accounting and auditing for domestic funds.

Offering of shares/interests

Generally offer only to non-U.S. investors (this term has a technical definition)
and up to 100 U.S. tax-exempt investors (more if limit these to Qualified
Purchasers who could invest in a 3(c)(7) fund).

ƒ U.S. taxable investors may be exposed to adverse tax consequences.

ƒ Permitting them to invest increases risk of “integration” of offshore
fund with domestic fund for purposes of counting “slots” for the
3(c)(1) exclusion from U.S. mutual fund regulation.
For sales to non-U.S. investors, typically must satisfy requirements of
Regulation S for ensuring that the sales are truly offshore transactions.

For sales to U.S. investors, comply with the “private placement” exemption.

Distribution/placement agents are used more often to sell shares offshore than
domestically. They increase cost to the management company, often taking a
piece of the management company’s compensation. And they may even charge
commissions on sales.

Subadvisory and other strategic arrangements.

Several offshore organizations regularly form offshore funds to be run by

selected management companies. They take care of organization,
administration, and distribution. They subcontract with a domestic adviser to
run the fund, putting the management company’s name on the front.

Less complete “sponsorship” arrangements also exist.

In addition to providing administrative benefits, these types of arrangements can

ease the process of listing on foreign exchanges, such as the Irish Stock
 December 2009 Considerations For Hedge Fund Startups
Page 25

Exchange, which may be desirable for sales to certain types of foreign

institutional investors.

They typically involve the “sponsor’s” participation in both management and

performance fees and often include exclusivity and/or noncompetition
requirements.
 December 2009 Considerations For Hedge Fund Startups
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