As an investment manager looking into starting a hedge fund, you know that a successful launch is critical to standing out in the increasingly competitive investment management business. If you want to attract capital from the right investors, you must put the right team and structure for your new fund in place. Discounting the legal and regulatory complexity involved with forming a hedge fund or trying to wear too many hats could lead to early mistakes that stifle momentum and are expensive to fix. This post describes some key considerations for aspiring hedge fund managers contemplating forming a new fund.
Assembling Your Team
As with any successful business venture, you must surround yourself with the right experts and service providers. The key members of your team should include:
- The Attorney. An attorney who is experienced in hedge fund formation is necessary to establish the appropriate structure, form the entities, and draft your initial fund documents (discussed below) in accordance with the law. Your attorney can also be a resource for finding other service providers that will make up your team.
- The Prime Broker. The prime broker is typically an investment bank that facilitates and coordinates all your trades and serves as a centralized manager for your investments worldwide. Like your lawyer, your prime broker is a good source for identifying other service providers your fund will need.
- The CPA. Every hedge fund needs a CPA to review the fund’s tax obligations, prepare the necessary returns, handle audits, and work with your attorney on other tax-related issues.
- The Fund Administrator. The administrator’s job is to assist the fund manager with back office services, including accounting, bookkeeping, secretarial, and transfer agent services. The administrator may also serve as a “second signer” on any transfers or withdrawals, if necessary.
Offering Documents
The documents below are the initial documents that every hedge fund should have to form the right structure for the fund in compliance with various state and federal regulations.
- The Limited Partnership Agreement. Domestic hedge funds are typically organized as Delaware limited partnerships with the fund manager as the general partner (usually an LLC) and the investors as the limited partners. The limited partnership agreement governs the relationship between the general and limited partners and lays out key terms like the management powers of the general partner, restrictions on transfers of partnership interests, admission of additional partners, voting rights of the partners, fees owed to the general partner, asset valuation, and much more.
- The Private Placement Memorandum. This disclosure document provides information to prospective investors regarding the identity of the fund’s principals and service providers, the terms of the offering, the fund’s investment strategy, risks of investing, fees, valuation procedures, and tax disclosures.
- The Subscription Agreement. All investors must execute a subscription agreement, which governs the purchase of an interest in the fund. The subscription agreement also requires investors to acknowledge that they understand the risks of the offering and are properly qualified to make the investment.
SEC or State Investment Adviser Registration
Depending upon the state you are located in, the amount of money you manage, and whether you have clients outside of your fund, you may have to register as an investment adviser with the state securities authority where your principal business is located and be required to pass the Series 65 examination. Some states have adopted exemptions to state registration requirement for those who advise only private investment funds (like most hedge fund managers) while others require registration only after a fund has accumulated a certain amount of assets or number of clients. Additionally, depending on the amount of assets under management in your fund and the type of clients you provide investment advisory services to, you may be required to obtain a federal registration with the Securities and Exchange Commission (SEC).
Securities Compliance
Federal securities laws also govern the type of investors you can have in your fund, the information you must provide those investors, and the way you can market the offering. Below are three noteworthy federal securities rules that every hedge fund manager should be aware of:
- Accredited Investor Rule. Under federal law, an offering of securities (i.e., limited partnership interests) to investors must either be registered with the SEC or exempt from federal registration. The most commonly used federal exemption is Rule 506 under Regulation D, which preempts state securities registrations and allows the fund to raise an unlimited amount of money. Although technically, Rule 506 allows for up to 35 non-accredited investors, this is not practical or cost-effective because of the increased disclosure requirements applicable to non-accredited investors (read more about this here). Therefore, the offering should be limited to accredited investors – i.e., individuals with a net worth of over 1 million dollars excluding their primary residence or an annual income of $200,000 ($300,000 if married) for each of the last two years and a reasonable expectation of achieving the same in the current year.
- No General Solicitation. Until recently, Rule 506 prevented issuers from utilizing “general solicitation” (i.e., advertising) of the offering to potential investors, which required issuers to have a pre-existing relationship with its investors. A benefit of this rule (now called “Rule 506(b)”) is that it allows a business to sell exempt securities to accredited investors without verifying their accredited status so long as it does not engage in general solicitation. However, in 2013, the SEC implemented Rule 506(c), which permits general solicitation of an offering as long as it is 1) limited to accredited investors and 2) the issuer takes “reasonable steps to verify” that investors are accredited. Although this new rule allows issuers to solicit investors outside of their preexisting contacts, Rule 506(b) continues to be the more popular exemption for private funds for the time being due to the increased compliance burden of ensuring accredited investor status.
- Form D and State Filings. Anyone offering exempt securities under Rule 506(b) or Rule 506(c) should file a Form D notifying the SEC that unregistered securities have been sold. Form D provides information about the issuer, its management, and the offering itself and must be filed within 15 days after the offering’s first sale of a security. The issuer must also file a notice with the relevant securities authorities of any states where exempt securities are sold.
Plan Ahead
A key component to your success as a hedge fund manager, especially starting out, will be your ability to assemble a team experienced in forming hedge funds that can guide you through each step of the process. It’s never too early to get key service providers in place.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
