Structural And Operational Hedge Fund Issues

What Legal Structure Should I Use?
Most domestic hedge funds are organized as limited partnerships with the general partner organized as a limited liability company. Additional entities may be needed in certain jurisdictions for tax reasons.

How Do I "Seed" A Hedge Fund?
Managers will seed a fund by first investing their own money in a limited partnership fund vehicle for several months to establish a track record.

Do I Need A Prime Broker?
Prime brokerage arrangements are common in the hedge fund industry. Start-up or smaller managers often employ introducing brokers to facilitate entering into a relationship with a prime broker. Prime brokers generally provide custody, back office support and other services. In the wake of the Madoff scandal, many investors are more closely scrutinizing a fund’s custody arrangements.

Do I Need An Administrator?
Many funds hire a third party to provide administrative services to the fund. Among the services administrators may provide are the following: operating the fund’s bank account; issuing payment instructions; providing net asset calculations; and, calculating management, performance, and other fees. Costs for administration services vary significantly depending on the scope of services provided and the size of the firm providing services. Fees vary widely. Some firms charge a fixed monthly fee, Others charge based on assets under management with a fixed minimum. In our experience, $500 a month would be on the low side.

Do I Need An Audit?
Although generally not required by law, most domestic and offshore funds provide investors with annual financial statements audited by an independent accounting firm. Investors generally are reluctant to invest in a fund that does not undergo an annual audit and provide these financial statements. Costs for audit services vary significantly depending on the complexity of the fund’s investment program and the size of the accounting. As more and more managers become registered as investment advisers with the SEC (and with legislation pending that will even increase this number), an annual audit is necessary in order to comply with the collective investment vehicle exemption to the SEC’s investment adviser custody rule. In addition, the states may enact legislation requiring hedge funds domiciled in such states to have an annual audit.

What Is a Typical Fee Structure For a Hedge Fund?
Hedge fund investors typically pay a management fee and some form of performance compensation (generally structured as a partnership allocation in a domestic fund). The management fee is paid either monthly or quarterly and generally ranges form 1% to 2% of the funds assets under management on an annual basis. Performance compensation is paid either quarterly or annually in an amount equal to 20% of the fund’s realized and unrealized net capital appreciation (subject to a "high water mark").

How Do I Raise Capital For The Fund?
Start-up funds may be marketed initially through the manager’s personal network and often through friends and family. It is also possible to raise capital from seed investors who usually require reduced fees, equity in the management company or both in consideration of the seed investment. Hedge funds may also be sold by distributors, who should be registered broker-dealers.

Can Interests In The Fund Be Offered To Non-Accredited Investors?
A hedge fund may have up to 35 non-accredited investors and still remain within the SEC’s "safe harbor" under Regulation D which governs private placements. While technically allowed, the better practice is to restrict the offering to accredited investors.

How Should the Fund Be Marketed?
Interests in a hedge fund are generally sold pursuant to a private placement exemption and must be marketed very carefully, without using any general advertising or general solicitation. The manager should have a pre-existing relationship with everyone who is offered interests in the fund. Furthermore, to remain exempt from registration as an investment advisor at the state or federal level, a manager cannot hold himself out to the public as an investment advisor. Promotional activities involving websites and providing information to organizations that track hedge funds should not be engaged in without the advice of counsel.

Can Third Parties Raise Capital For The Fund?
As noted above, third parties may be used to raise capital. However, anyone who sells interest in the fund and receives a commission (or any kind of compensation) must be affiliated with a registered broker-dealer. The compensation paid to third party marketers varies widely. A typical arrangement would pay the marketer 20% of the management and performance compensation allocable to the capital raised by the marketer for either a set period of time or for as long as such capital remains invested in the fund. Obviously, start-up funds may have to pay a higher rate or provide an equity kicker to obtain the services of a marketer. This is a complex area and counsel should be consulted before entering into any such arrangement.

Can The Past Performance Of Another Account Or Back Tested Results Be Used To Market The Fund?
Prior performance is often used in the marketing of hedge funds. However, such prior performance must be presented in a fair manner and contain the proper disclosures and disclaimers.

Can Pensions And IRAs Invest In The Fund?
Pensions and IRAs may invest in a fund. The typical practice is to restrict investments by ERISA plans, IRAs, 401(k) plans or other employee benefit plans to no more that 25% of the value of the fund. A fund which exceeds such limitation would itself become a plan asset and subject the fund’s manager to the ERISA prohibited transaction rules and potential limits on the ability to charge performance compensation.

Are Any Registrations Or Licenses Needed To Operate A Fund?
There is currently momentum to require fund managers to register as investment advisers. A fund manager should consider whether it has to register as an investment adviser in the state in which it has its principal office. Larger managers may have to register as investment advisers with the SEC. We can assist with these issues and with the registration process itself, should it prove necessary. In the case of state registration, principals of the manager and other key employees may have to pass the Series 65 exam.

May Commodity Futures Be Traded In The Fund?
If a hedge fund trades in futures contracts or options thereon, the fund would likely be considered a commodity pool under the Commodity Exchange Act. In that event, the manager of the fund would have to register with the Commodity Futures Trading commission as a commodity pool operator or qualify for an exemption from such registration. If registration is required, the principals of the fund manager would have to pass the Series 3 exam administered by the National Futures Association.

When Should I Form An Offshore Fund?
Fund managers establish offshore funds when they have a significant potential to attract non-United States investors into the fund. In offshore funds are attractive to U.S. tax-exempt investors as a means of avoiding taxation of Unrelated Business Taxable Income (UBTI). Offshore funds are typically sited in the Caribbean (the Cayman Islands and BVI) although a European jurisdiction, such as Ireland, may be more appropriate if a significant number of European investors are involved. Based on the operations of the fund, consideration should be given to structuring the offshore fund as a mirror fund or as part of a master-feeder structure.

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