Hedge funds and ERISA

Hedge fund managers have to be especially aware of the ERISA rules with regard to their hedge fund and the investors in the fund. ERISA stands for the Employee Retirement Income Security Act of 1974 and it governs, among other things, pension investments into hedge funds.  The Department of Labor is the governmental agency which is in charge of promulgating regulations regarding ERISA.

There are many items to be aware of with regard to ERISA. The most important item for a hedge fund manager is the 25% ERISA threshold limitation for “benefit plans.” If investments into a hedge fund by “benefit plans” exceed the 25% threshold then the manager will become subject to certain ERISA rules. For these purposes the term “benefit plan” means both traditional pension plans and also Individual Retirement Accounts (IRAs).

Requirements for hedge fund managers subject to ERISA

The hedge fund manager who is subject to the ERISA rules will, most importantly, need to (i) be registered as an investment adviser with either the SEC or the state securities commission and (ii) maintain a fidelity bond (which usually costs a few thousand dollars a year).

Additionally, there are many other issues the hedge fund manager will need to be aware of and which he should discuss with his attorney including:

  • Performance Fees
  • Soft dollars and brokerage
  • Dealing with “Parties in interest”
  • Use of Affiliated Brokers
  • Cross Trades
  • Principal Transactions
  • Expenses
  • Information reporting and side-letters
  • Record retention

The 25% threshold

There are many intricacies to the 25% threshold and if you have any questions you should speak further with an attorney regarding the specific facts of you situation.  A couple of items to note about the 25% rule:

1. Investments by the manager and affiliates do not count toward determining the 25% threshold.

For example, if a hedge fund has shares outstanding with a total net asset value of $100M and the fund manager and its affiliates (e.g., portfolio managers, employees, etc.) hold a $20M investment in the fund, the 25% threshold would be 25% of $80M (i.e., $20M), rather than 25% of $100M (i.e., $25M).

2. You will need to test on a class basis.

For example if a hedge fund has two classes of interests, you will need to determine the 25% threshold for each class of interests. If Class A has $90M in assets and no “benefit plan” investments and Class B has $10M in assets and has a $5M investment by benefit plans, then the whole fund, not just the Class B, will be subject to ERISA because of the Class B investment.

Additionally, with the advent of new structures such as the Delaware Series LLC and the offshore Segregated Portfolio Company, the application of the test is likely to be at the series of segregated portfolio level, and not simply at the fund level. The last time we researched this question the issue was not definitively decided, but there may have been some definitive guidance since that time. If you are contemplating one of these structures you should discuss this issue with legal counsel. Also, the calculations may get a little get a little difficult with an offshore master-feeder structure.

3. Continuously monitor the 25% threshold.

Because hedge funds typically will allow additional capital contributions as well as withdrawals at regular intervals, the percentage of fund’s investments by benefit plans will change. If, because of a redemption of another investor, the 25% threshold is reached, the hedge fund manager will be subject to ERISA.

Only IRA investments – still subject to ERISA?

One items that always comes up is what happens if the fund exceeds the 25% threshold but only has IRA investments.  Although a fund which exceeds the 25% threshold will generally be subject to the ERISA rules, those rules only will apply to the pension plans and not the IRAs (although the manager will need to make sure to conform all actions to certain IRS requirements).  In this way a hedge fund manager which exceeds the 25% threshold and only has IRA money will not be subject to the registration and bonding requirements.  Many of our clients fall within this category.

Conclusion

ERISA is one of the more specialized parts of hedge fund law. If a manager is thinking of potentially being subject to ERISA the manager should thouroughly discuss the possibility with his hedge fund counsel. The manager should always make sure that the law firm he works with has an attorney which specializes in ERISA or works with an outside ERISA counsel on all ERISA issues.

While many managers will make sure that their fund is never subject to ERISA, I have seen many managers who have become subject to ERISA because of a significant investment by certain pension plans. Indeed in many situations it will make a lot of sense to become subject to ERISA and start up hedge fund managers should not automatically reject potential investments because they may become subject to ERISA. Our firm has worked with many managers who becomes subject to ERISA and it has worked out well – one suggestion I would make is to start the process early because investment advisor registration will be necessary.

12 thoughts on “Hedge funds and ERISA

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  4. Fred

    Bart -I have a question regarding ERISA. I’m a start up hedge fund manager. I have significant Roth IRA assets that I would like to invest in the “fund” which would make my Roth IRA a significant majority partner in the fund.

    However, I’m the sole member/owner of the general partner. Is this ok under ERISA? If so, can the Roth IRA be charged management & performance fees? How about start up cost allocations like legal etc.?

    1. Hedge Fund Lawyer Post author

      Fred,

      You can invest in the fund with your Roth IRA, but there are a number of issues that need to be discussed before. Also, there are likely to be issues with the actual investment of the assets into the fund – your IRA’s custodian will need you to make a number of representations and legal counsel may need to be involved. For many of our clients in this situation, it may take some time to get the IRA custodian comfortable with the investment (even if they allow self-directed investments into private placements/hedge funds). It will depend on the practices of each individual custodian.

      Hope this helps and please feel free to contact us to discuss in greater depth. Please also see our disclaimer on this website.

      Regards,
      Bart

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  8. Chimborazo

    Can you elaborate on your section in the article “Only IRA investments – still subject to ERISA?”. Are you saying that if the only retirement funds invested are IRA funds (and no pension funds) and such IRA funds comprise, say, 40% of the total dollars in the fund, then the Asset Plan Rule is not violated? Do you have a source for this?

    Our registered investment adviser has formed a special purpose vehicle (SPV) which will, in turn, invest into an operating company. More than 25% but less than 100% of the funds in the SPV are from IRAs and there are no pension funds.

    Thank you.

  9. Josh

    I’m looking for an exception to the 25% threshold if only IRA investments are contained within a private investment fund. Where did the authority come from for your statement:

    “Only IRA investments – still subject to ERISA?

    One items that always comes up is what happens if the fund exceeds the 25% threshold but only has IRA investments. Although a fund which exceeds the 25% threshold will generally be subject to the ERISA rules, those rules only will apply to the pension plans and not the IRAs (although the manager will need to make sure to conform all actions to certain IRS requirements). In this way a hedge fund manager which exceeds the 25% threshold and only has IRA money will not be subject to the registration and bonding requirements. Many of our clients fall within this category.”

    Thanks!

    1. Hedge Fund Lawyer Post author

      Josh,

      Thanks for the question. There is no specific law or regulation I can point to – it is a statement that I made based on my understanding of how the ERISA laws and regulations work in conjunction with the Internal Revenue Code. Unfortunately, the ERISA laws, as they apply to hedge funds and other private funds, are harder to understand with respect to certain discreet questions than the securities laws are. This is because the ERISA laws were written broadly to apply to a number of different situations whereas the securities laws are more focused.

      Hope this helps.

      Best,
      Bart

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