Certain Initial Considerations Associated With Forming a Hedge Fund Management Business

In connection with the establishment of a hedge fund management enterprise and one or more hedge funds, there are common issues that the hedge fund manager must confront early on in the development of his or her business. This article briefly examines several of the most important initial issues a hedge fund manager should seek to resolve as soon as possible in the process. It is very helpful to involve legal counsel early on to help identify and resolve these matters.

Implications of the Investment Strategy

The hedge fund manager must first identify whether the hedge fund’s strategy would generate certain types of income that may require some additional structuring. For instance, if the strategy will generate any U.S. effectively connected income such as a loan origination strategy, it would be important to modify the fund structure to accommodate non-U.S. investors if the fund manager expects to target such investors. In addition, if the fund will employ leverage in connection with its investment strategy, the fund structure should include an offshore blocker entity if U.S. tax-exempt investors are part of the contemplated investor base. The use of an offshore blocker will avoid the receipt of unrelated business taxable income by any such investors since some of them may be sensitive to the receipt of such income.

Jurisdiction of Establishment

For both onshore and offshore funds, the regulatory environment of the chosen jurisdiction will impact the timing of formation, the cost of establishment and the continuing obligations associated with operating the fund. In the U.S., Delaware has established itself as the jurisdiction of choice for the majority of managers establishing onshore hedge funds due to its convenience, flexibility and tax advantages. The decision on where to domicile an offshore hedge fund will be guided by a number of considerations, including, without limitation, the location of the investor base, the tax treatment of the fund entity and the investors, the regulatory regime, the availability of high-quality service providers and how business-friendly the environment is in such jurisdiction. The Cayman Islands, Bermuda, the British Virgin Islands, Luxembourg and Ireland are among the preferred locations for managers establishing hedge funds outside the U.S.

Key Terms

Prior to launching a fund, a manager must determine a number of key items, including the level of management fees and performance fees/allocations (and the ability to allow reductions, waivers or rebates of such fees), the base currency (including the ability to issue classes in currencies other than the base currency, if applicable), the use of hedging, minimum investment and/or holding amounts, and liquidity terms. The liquidity terms will encompass a broad range of considerations, including the frequency of withdrawals, notice periods for withdrawals, the use of a lock-up (which may be a specified lock-up period with no withdrawals or a specified lock-up period with withdrawals permitted subject to the imposition of a withdrawal fee), the use of a gate (which may be imposed on either a fund-wide basis or on an investor-by-investor basis), the suspension of withdrawals or the payment of withdrawal proceeds under certain circumstances and the ability of the fund or the manager to cause an investor to mandatorily withdraw from the fund. The offering documents should include a detailed description of all fees and expenses that the fund will bear. If the fund or the manager would like to retain the flexibility to deviate from the terms of the fund with respect to one or more investors, the potential use of side letters should be disclosed.

Potential Investor Base

In tandem with considering the issues identified above, the hedge fund manager needs to marry those considerations with the types of investors the hedge fund manager is seeking to solicit for the hedge fund. Often the preferences of U.S. taxable investors are in conflict with the preferences of U.S. tax-exempt and non-U.S. investors. As a result, it is ideal to segregate these classes of investors into separate investment funds that may invest in parallel or may participate through a shared investment vehicle commonly referred to as a master fund. In addition, will the fund include investors that are subject to the U.S. Bank Holding Company Act or that are registered investment companies? If so, the hedge fund manager should ensure that the fund documents provide the flexibility to issue non-voting interests. Finally, will the fund include investors that are subject to ERISA? When ERISA plans invest in a vehicle, that vehicle’s assets will not be deemed to include plan assets if “benefit plan investors” do not own 25% or more of the value of any class of equity interests in the vehicle. If the hedge fund’s assets are deemed to include plan assets, the fund and the fund manager will become subject to various rules and regulations of the U.S. Department of Labor in respect of the fund. Accordingly, the manager should decide in advance whether it will stay below the 25% threshold and should monitor compliance on an ongoing basis.

Distribution Effort

Now that the fund has been structured and the considerations triggered by the contemplated investors and investment strategy have been resolved, the hedge fund manager needs to consider how he or she will market the fund. In this regard, the hedge fund manager should ensure that his or her marketing activities do not violate the private placement exemption on which the fund will rely to issue its interests, and should consider whether to engage a placement agent to assist with the marketing effort. It can be quite advantageous to employ a placement agent in order to utilize the placement agent’s list of potential investors. However, a placement agent, as an agent of the hedge fund, can cause the fund to violate the private placement exemption and, as a result, care should be taken in the placement agent agreement to ensure there are appropriate undertakings by the placement agent to avoid the violation of this exemption. In addition, to the extent the hedge fund manager seeks to solicit investors outside of the United States, consideration needs to be given to the requirements of the laws and regulations of those jurisdictions.

Another aspect of the marketing effort involves determining whether the fund will offer founders’ share classes (i.e., share classes that generally provide for reduced fee rates for the initial investors) or whether the fund manager is interested in permitting an anchor investor to take a significant stake in the fund manager’s business through an ownership interest or revenue share in the fund manager’s business. These approaches can accelerate the growth of the fund manager’s business but at a cost of some reduction in revenue received by the firm’s principals and control over their business.

Regulatory / Compliance Matters

As part of the roll-out of the fund manager’s business, the fund manager must confront issues such as whether the fund manager’s business might require registration as (i) an investment adviser with the Securities and Exchange Commission (SEC) or any state regulatory authority or (ii) a commodity pool operator and/or commodity trading adviser with the Commodity Futures Trading Commission. For example, to the extent the hedge fund management enterprise has “Regulatory Assets Under Management” (as defined on SEC Form ADV) of less than $150 million and its only clients are private funds (as defined in SEC guidance), the hedge fund manager will be able to rely upon an exemption from registration with the SEC. However, the fund manager will need to ensure it is not otherwise required to register with any state in which it conducts its advisory activities.

Relationship Among the Principals

Finally, the hedge fund manager will need to determine how the partners of the firm will organize their relationship with each other and with their employees as part of the governing documentation of the fund manager and/or employment agreements. In this regard, some items that are typically debated among the principals are (i) whether there will be vesting provisions associated with the receipt of the carried interest or performance allocation, (ii) what happens in the event of the departure of a member where such departure is voluntary, involuntary (including for cause or not for cause) or due to death or permanent disability and (iii) whether the governing documentation of the hedge fund manager will impose non-competition and non-solicitation provisions.