By Joshua Glikman, Esq., Sabari Bagchi, Esq., and Emily Collins, Intern
- Introduction; General Description
This article provides a general introduction and summary of matters relating to the formation and structuring of hedge funds. Hedge funds are privately offered and professionally managed pooled investment vehicles. Ownership interests in hedge funds are generally sold in private offerings to institutional investors and wealthy sophisticated individuals
A domestic U.S. hedge fund is formed as a limited partnership (LP) or limited liability company (LLC) under the laws of Delaware or another U.S. state. These domestic funds are typically aimed at U.S. citizens who are taxable investors.
The term “hedge fund” has no legal definition, although these funds typically engage in sophisticated investment techniques, including hedging against market risk.
Hedge funds typically invest in liquid securities, which are most often publicly traded common stocks or other equity securities. As a general matter, a hedge fund will exist indefinitely with investors and portfolio investments entering and leaving the fund from time to time. Hedge funds typically restrict withdrawals by investors during an initial “lock-up” or holding period of up to one (1) year following investment after which time investors may periodically withdraw capital from the fund, subject to certain limitations and procedures.
Hedge funds and “private equity funds” are the most common types of private funds. Like hedge funds, private equity funds sell their ownership interests in private offerings to sophisticated investors. There are, however, significant differences between hedge funds and private equity funds.
Unlike hedge funds, private equity funds typically make long-term illiquid investments. Unlike hedge funds, private equity funds have a specified term (which may usually be extended). Also, an investor in a hedge fund will invest all of its committed capital on an immediate up-front basis, while investments in private equity funds are typically funded by capital calls periodically made on investors. Furthermore, hedge funds tend to allocate profits and losses based on realized and unrealized gains, while private equity funds allocate profits and losses based on realized gains.
Please also note that matters relating to “offshore funds” are outside the scope of this summary. Offshore funds are typically organized in the Cayman Islands or other foreign jurisdictions with favorable tax treatment. These offshore funds are aimed primarily at U. S. tax-exempt investors (including charitable foundations and pensions) and/or foreign investors and may operate on a side-by-side basis with a domestic U.S. fund or otherwise operate within different master-feeder structures.
- Fund Structure
The structure of a hedge fund typically involves the following principal entities:
Fund: The hedge fund will generally be organized as an LP, but may be organized as an LLC. The fund entity will consist of a general partner (GP) and investors as limited partners who are passive investors with limited liability. If, however, the fund is organized as an LLC, then the fund will consist of a managing member and investors as members. The fund will be a “pass through” entity which is not subject to federal income tax at the fund level. The income and gains will flow through to the investors, and each investor reports its share of the profit or loss on its own tax return.
General Partner: The GP (or managing member) entity, which will typically be an LLC itself, has broad management authority to control and administer the fund and to take actions on the fund’s behalf.
Management Company (Investment Manager): The GP (or managing member) will also typically establish an affiliated management company or investment manager entity which will act as the fund’s investment adviser. The fund and/or GP will usually enter into an investment management agreement providing that the fund will pay a management fee (see “Asset-Based Management Fee” below) in exchange for the management company’s services relating to employment of investment professionals, evaluation of investment opportunities and providing services regarding investment advisory activities.
- Fees; Expenses
The investment manager of a hedge fund will typically receive the following fees as compensation:
Asset-Based Management Fee: Hedge funds generally charge investors with an asset based management fee (regardless of performance), with a typical annual rate of 2%. The management fee is generally payable monthly or quarterly based upon an investor’s capital account balance at the beginning (if payable in advance) or end (in arrears) of the month or quarter.
Performance-Based Compensation: Performance-based compensation arrangements aim to reward good performance by allocating to the investment manager a percentage of the investor’s profits, with 20% being the most common percentage. This compensation is based upon an investor’s net realized and unrealized profits or “net capital appreciation” over a specified measurement period, which is most often a full year. The manager will also charge performance-based compensation upon an investor’s withdrawal during a measurement period as to the amount withdrawn.
Fund Expenses: The fund will typically bear the fees, costs and expenses relating to the operation of the fund, including the management fees, investment expense (including brokerage commissions, clearing and custodial expenses and interest expenses), accounting and auditing fees, legal fees, taxes, insurance and litigation expenses. The investment manager will, however, bear the cost of its own ordinary administrative and overhead expenses incurred in managing the fund. The fund will also generally pay the organizational expenses relating to establishing the fund (although these organizational expenses may sometimes be paid for by the manager).
- Regulatory Matters
The ownership interests in a hedge fund are “securities” under the Securities Act of 1933. Accordingly, the offer and sale of these fund interests must be registered under the Securities Act unless an exemption from registration is available. Since the registration process for securities is costly and time consuming, hedge funds do not elect to register their offerings.
Most funds rely on the exemption from federal registration of securities pursuant to Rule 506 of Regulation D under the Securities Act. Under this exemption, the fund will typically offer its interests only to “accredited investors”. Accredited investors include: (i) individuals (either alone or together with spouse) having a net worth, excluding primary residence, of $1 million; (ii) individuals with annual income of $200,000 (or $300,000 jointly with spouse) for the two (2) most recent years and a reasonable expectation of such income in the current year; (iii) a trust with total assets in excess of $5 million; and (iv) an entity owned exclusively by accredited investors.
Investment Company Act
The Investment Company Act regulates funds and other companies that primarily engage in investing and trading in securities and offer their own interests to investors by requiring these funds to either register as an investment company with the Securities Exchange Commission (SEC) or qualify for an exemption from registration. Registration as an investment company involves substantial additional regulatory compliance obligations and disclosure requirements. Accordingly, hedge funds typically rely on the following exemptions from registration under the Investment Company Act:
Section 3(c)(1): exempts a fund that is not making a public offering and its interests are beneficially owned by no more than 100 persons. Special counting rules or “look-through” rules may operate to increase or decrease the number of beneficial owners of such 3(c)(1) fund.
Section 3(c)(7): exempts a fund that is not making a public offering and is beneficially owned only by “qualified purchasers”. A qualified purchaser is generally a person owning $5 million or more of investments (broadly defined) or an institutional investor entity owning $25 million or more of such investments.
Investment Advisers Act
The Investment Advisers Act generally regulates fund managers who, for compensation, furnish advice to other parties relating to securities, by requiring them to register as an investment adviser with the SEC unless an exemption is available. As a general matter, fund managers with assets under management (AUM) of $150 million or more (with fund clients only) will be required to register as an investment adviser with the SEC. Fund managers who are small advisers or mid-sized advisers may be required to register as an investment adviser on the state level. Advisers required to register under the Advisers Act have additional recordkeeping and reporting requirements as well as examination and audit obligations.
If a fund manager is required to be registered under the Advisers Act, then an investor may be charged performance-based compensation only if that investor is a “qualified client”. A qualified client is an investor who (either alone or together with spouse) has a net worth, excluding primary residence, of $2,100,000 (which is approximately twice the net worth amount required for accredited investors).
- Investor Eligibility Requirements
An investor must satisfy all of the eligibility requirements for suitable investment set forth in the principal fund documents which will generally include the following:
Accredited Investor: applicable to all investors-see “Securities Act” above.
Qualified Client: applicable if the investment manager is required to be registered under the Advisers Act and in order to enable the manager to receive performance-based compensation-see “Advisers Act” above.
Qualified Purchaser: applicable to all investors in a 3(c)(7) fund-see “Investment Company Act” above.
- Principal Documents
The key documents typically prepared by legal counsel in connection with hedge fund formation include the following:
Fund Operating Agreement: The operating agreement of the fund (limited partnership agreement for LPs or LLC agreement for LLCs) is entered into between the GP (or managing member) and investors. This document governs the relationship and arrangements among the GP (managing member) and investors. The operating agreement typically includes provisions regarding the following matters: objectives of the fund; limitation on liability; management of the fund; management fees and performance-based compensation; capital accounts; allocations; withdrawals and distributions; valuation of assets; accounting and reports; tax matters; amendments; and transfers.
Private Placement Memorandum: The private placement memorandum (PPM) is a disclosure document providing key information regarding the fund. The PPM is generally furnished by the fund to all prospective investors and is the primary document through which the fund markets its ownership interests to such investors. The PPM typically includes information regarding the following matters: investment strategy of the fund; risk factors; conflicts of interest; business experience of the management company and GP; management fees and performance-based compensation; other fees and expenses; summary of fund operating agreement (including matters relating to withdrawal and transfer restrictions, valuation procedures and profit and loss allocations); investor suitability requirements; and tax matters.
Subscription Documents: An investor subscribes to a hedge fund as a limited partner or member by executing a subscription agreement which provides for the investor’s capital commitment to the fund. The subscription agreement also generally includes certain representations and acknowledgments by the investor and indemnification provisions. An investor is also typically required to complete a questionnaire confirming his suitability to invest under the fund’s eligibility requirements (see “Investor Eligibility Requirements” above).
Investment Management Agreement: The management company and the fund or GP (managing member) will also typically enter into a separate investment management agreement setting forth the general terms under which the management company is authorized to act as the fund’s investment manager in connection with fund investments in exchange for the management fee (see “Management Company” above).
The information in this article is for general education purposes only and should not be taken as specific legal advice.