Written by: Matt Kluchenek, Patricia McDonald & Michael Sefton, Baker&McKenzie
If you've been thinking about starting a hedge fund, you've likely encountered a byzantine array of options and requirements. Sorting through these options and requirements can be overwhelming. However, planning ahead and identifying key issues can clear a path and help you efficiently achieve your goal. In this article, we identify 10 of the most common considerations that arise for emerging fund managers.
- The Approach: Fund or Managed Account? Initially, most traders focus on forming a fund simply because it is the most common investment vehicle. That often makes sense. However, an alternative is to offer a managed account program. In a managed account program, the client gives a limited power of attorney to the manager to manage an account in the client's name. There are pros and cons associated with both funds and managed account programs. A managed account program can be established more quickly and is typically less expensive than forming a fund. Another benefit of a managed account program is that, at least with respect to commodity futures, a client can use "notional funds" (essentially, leverage) to trade a greater amount. On the other hand, funds also provide a wide range of benefits, including limited liability for investors and the aggregation of capital, which might be essential to the trading strategy and reducing certain costs.
- The Investment Objective. Regardless of whether you decide to form a fund or offer a managed account program, you'll need to define the investment objectives of your trading strategy. Aside from "seeking capital appreciation," what will your trading strategy offer investors? Is your trading strategy based on fundamental analysis or technical analysis? Does your trading strategy focus on one market, or are the markets diversified? Addressing these types of questions is important and should be drafted in a way not to disclose trade secrets or proprietary methods. In addition, you should also plan on addressing risk management and inform investors about the steps you will take if the market moves against you. Overall, investors should have enough information to determine whether the trading strategy fits well within, or complements, their overall portfolio.
- Control (Class Structures). Assuming you go the fund route, you'll need to form an entity to serve as the fund manager and an entity that will be the fund. Structuring funds as well as management companies can be complex. Nonetheless, a structure commonly used is for the fund to be a limited partnership or limited liability company, and the fund manager to be the general partner or manager, respectively, of the fund. Additionally, depending on whether you may offer different fee structures, redemption rights, different trading levels or other rights to your investors, you may want to consider offering separate classes or series of interest in your fund.
- US. Tax Considerations. You may wish to market your fund to U.S. investors and/or non-U.S. investors. The manner in which you structure your fund should take into account the types of investors that may invest in the fund and the general tax sensitivities of these investors. For example, U.S. tax-exempt investors are often sensitive to deriving "unrelated business taxable income" (or UBTI), because they are subject to U.S. tax (at corporate income tax rates) on such income. Non-U.S. investors are often sensitive to deriving "effectively connected income" (or ECI) because they are taxed on such income and are subject to U.S. filing requirements with respect to such income. UBTI-sensitive U.S. tax-exempt investors and ECI-sensitive non-U.S. investors typically invest through the use of "blocker" entities that are treated as corporations for U.S. tax purposes. Such blocker entities protect investors from U.S. tax payment exposure and/or U.S. tax filing exposure that arises from UBTI-generating and ECI-generating investments, because the blocker entities (as opposed to the investors) are the persons that receive, and are taxed on, any UBTI or ECI from underlying investments. In structuring your fund, you should consider whether to offer blocker protections to investors. If you decide to offer such protections, you should determine how your fund structure will incorporate blocker entities. There are a number of alternatives to achieve this, including, but not limited to, the use of (i) "feeder funds" treated as corporations for U.S. tax purposes and through which sensitive investors indirectly invest in the fund; or (ii) "alternative investment vehicles," which are typically established as partnerships but which form blocker entities through which sensitive investors may invest in the underlying investments. The structure of your fund (including any use of blocker entities) and the associated material U.S. tax considerations (including such tax considerations as may be impacted by any U.S. tax reform that may be passed by the Trump administration) will need to be disclosed in the fund's offering documents (see #7 below). Notwithstanding the inclusion of tax disclosures, however, the offering documents should make it clear that the disclosures are general information only and not legal or tax advice, and that each investor should consult with such investor's independent tax advisors as to the tax considerations to the investors of an investment in the fund, in light of the investors' particular circumstances.
- Eligible Investors. Depending on what types of instruments that the fund will trade, there may be additional suitability requirements for investors. Most prospective investors are familiar with the concept of an "accredited investor" used to satisfy private placement requirements, but funds trading securities may also need to ensure that their investors are "qualified clients" or "qualified purchasers." For those funds trading commodity futures, investors may need to be "qualified eligible persons." Additionally, there may be limitations as to the number of investors that the fund may accept.
- Fees. Historically, most fund managers received a management fee equal to 2% of the fund's net asset value per annum, and 20% of the fund's net profits as an incentive allocation or a "carried interest". The idea was that the 2% management fee would cover the fund manager's expenses and the 20% of net profits would be the fund manager's profits. Today, however, fewer investors are willing to pay a 2% management fee, especially to an unproven fund manager. As a result, many new fund managers do not charge a management fee, or at most charge a management fee of 1%. Another option if the manager is able, is to forego a management fee, and instead, pass on certain expenses of the manager to the fund. With regards to incentive allocations or carried interest, managers are also including "hurdle rates" where the incentive allocation may become a greater percentage as the fund's profits increase. As you can see, fund managers have a wide range of latitude and flexibility when determining the appropriate fee structure for their fund. The key with any fee structure is ensuring that the fees are adequately disclosed up front to investors.
- Documentation—PPM, Organizational Documents and Subscription Documents. Once you have determined most of the material terms of offering interests in your fund, you are most likely ready to begin preparing your offering documents. These documents include the private placement memorandum or "PPM", a limited partnership agreement/operating agreement governing the fund and the subscription documents. The PPM is a key document which is used to disclose all of the material terms and risks associated with an investment in the fund. This is the document that if an investor has a question regarding the fund structure (including the use of blocker entities), the fee structure, the investment strategy, risks associated with an investment, or any other issue, the investor should be able to find an answer in the PPM. The limited partnership agreement (in the case of a limited partnership) or the operating agreement (in the case of a limited liability company) is similar to a corporation's bylaws, and is the document that governs the fund. The subscription documents, which include the subscription agreement, are the documents that investors complete when they are ready to invest in the fund. The subscription documents require that investors provide necessary information related to suitability, anti-money laundering, and other regulatory requirements.
- Securities Offering and Regulatory Requirements. Because fund interests are considered "securities," you will need to comply with federal and state securities laws. Many fund managers rely upon the "issuer's exemption" which permits officers of the company to engage in selling efforts provided they have other more significant responsibilities and satisfy other regulatory requirements. Many times, fund managers are required to rely upon the efforts of a third party marketer. If the third party marketer is engaged in selling fund interests, it needs to be registered a "broker-dealer." As a result of the JOBS Act, funds relying upon private placement exemptions may now engage in "general solicitation" to find investors. Additionally, fund managers trading securities may be required to register either with the SEC or a particular state's securities commission as an "investment adviser." Whether an investment adviser must register at the federal or state level may depend upon the amount of assets under management as well as a variety of other factors. Additionally, exemptions from registration such as the "Private Fund Adviser" exemption may apply as well other exemptions based on state law. Managers of funds trading commodity futures may also be required to register with the CFTC as "commodity pool operators." Again, exemptions may apply depending on factors such as investor suitability and why the fund is trading commodity futures.
- Service Providers. Managing a successful fund takes a lot of resources and fund managers cannot do everything on their own. In addition, certain service providers are required regardless of expense. Funds will need to establish brokerage accounts regardless of whether they are trading securities or commodity futures and thus, a broker will be required. Additionally, most investors will expect that the fund's financials are audited by an auditor, and depending on applicable law, audited financials may even be required. An administrator, typically an accounting firm, can calculate the fund's net asset value on a monthly basis as well as process new subscriptions and redemptions. Finally, attorneys will be necessary to form the fund as well as advise the fund manager on an ongoing basis.
- Risks. Today, more than ever, fund managers face significant risks. While a PPM can disclose many material risks associated with an investment in a fund, a PPM cannot disclose every risk. Situations will arise from time to time when a fund manager will need to rely upon the advice of others, including counsel. Whether facing a regulatory-related issue or a matter of possible civil liability, fund managers cannot operate alone or make decisions in a vacuum. Finally, compliance manuals are a necessity and can provide a road map for fund managers to ensure they are complying with applicable law, including federal and state law, the rules of self-regulatory organizations and exchanges.
If you'd like to discuss any of these considerations with us, please feel free to give any of us a call. We would welcome the opportunity to speak with you.
Matt Kluckenek
312.861.8803
matt.kluckenek@bakermckenzie.com
Patricia McDonald
312.861.7595
patricia.mcdonald@bakermckenzie.com
Michael Sefton
312.861.2884
michael.sefton@bakermckenzie.com
