Monthly Archives: August 2008

Five Challenges to Raising Institutional Assets

SEI White Paper: Maturing Hedge Fund Industry Must Shift Gears to Grow Institutional Business

Paper Identifies Five Challenges for Hedge Funds Trying to Attract Institutional Assets

OAKS, Pa., Feb. 11 /PRNewswire-FirstCall/ — As hedge funds increasingly look to the institutional market for asset growth, they must equip themselves to fit the high expectations and conservative attitudes characterizing institutional investors, concludes a white paper released today by SEI (Nasdaq: SEIC), titled “Five Critical Challenges for Hedge Funds Taking Aim at the Institutional Market.”

Hedge fund assets under management have been growing at a compound annual rate of 26% since 1990, reports the SEI analysis, with much of that growth coming from the institutional market. “To maintain that growth trajectory, the hedge fund industry will need to branch out from its traditional high-net- worth, foundation, and endowment clientele to serve the broader institutional market,” said Paul Schaeffer, Managing Director of Strategy and Innovation for SEI’s Investment Manager Services division. “But to compete for those assets, the industry must recognize that large institutions have a distinct set of demands concerning issues such as the quality of infrastructure, transparency, and risk.”

Based partly on a survey of more than 100 institutional investors by SEI and the research firm of Infovest21, the SEI analysis details growing institutional acceptance of hedge fund investing. Forty-seven percent of the institutions surveyed said they already invest in hedge funds. Within that group, 73% of pension plans and 55% of institutions overall said they had increased hedge fund allocations over the last several years. Portfolio allocations to hedge funds averaged 30% for endowments, 13% for pension funds, and 24% for institutions.

At the same time, institutions expressed continued concerns with hedge fund investing. “Headline risk” was named by 37% of survey respondents as their biggest worry, followed by lack of transparency (19%) and poor performance (15%). Institutions also remain cautious in selecting hedge funds, the survey found, devoting an average of seven months to due diligence and 12 additional weeks to approval.

In the paper, SEI identifies five challenges hedge funds should address in order to attract more institutional assets:

1) Demonstrate institutional-quality infrastructure and operations. Infrastructure was ranked the number-one criterion in hedge fund selection, with 46% of those surveyed naming it most important. Of those who responded this way, 54% said it was because “better managed firms produce better returns.” The quality of fund administration was a prime concern. Of those respondents most concerned with infrastructure, two- thirds said it is unacceptable for funds to handle their own administration internally, and half demand a “big-name” administrator; 81% said they take steps to verify that hedge fund investments are valued independently.

2) Meet investor demands for reporting and transparency. The lack of transparency was the second most commonly cited worry with hedge fund investing, with 19% of institutions ranking it number one. This concern was greatest at the strategy level, with 85% of respondents saying they would not invest in a strategy they do not fully understand. More than half said they seek portfolio transparency at the industry or sector level, and one-third were most concerned with transparency of the investment process. Only 11% said they seek transparency of specific investment positions.

3) Build stable management teams with a full range of skill sets. Interviewees ranked “people at the firm” as the third most important factor in hedge fund selection, surpassed only by “firm infrastructure” and “performance.” Other survey responses revealed that investor concerns with hedge funds’ organizational stability and staffing are not confined to those making investment decisions, but cut across all key management and support positions.

4) Shift focus from performance to investment disciplines. Institutions are as concerned with investment process and risk profile as they are with the level of absolute returns, the survey revealed. Interviewees ranked “consistent, stable returns,” “uncorrelated returns,” and “high risk- adjusted returns” as more important objectives than “high absolute returns.” Seventy-two percent of interviewees said the investment strategy, rather than performance, is their starting point for hedge fund selection.

5) Keep abreast of public policy and regulatory trends. Citing ongoing deliberations over hedge-fund-related regulation, tax policies, and accounting rules and investor concerns with “headline risk,” the paper urges the industry to “commit whatever resources are needed to ensure that hedge fund managers meet the highest possible standards for their overall compliance and general business practices.”

“The take-away message is that institutions clearly prefer to do business with institutional-style organizations,” concluded Schaeffer. “For hedge funds, the challenge will be to fit the profile of an institutional-quality fund while preserving the performance attributes that attracted major investors in the first place.”

The white paper is published by the SEI Knowledge Partnership, which provides ongoing business intelligence to SEI’s investment manager clients. To request a copy of the white paper, please visit www.seic.com/ims/General_5challenges.asp.

Filing Form D

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While hedge funds are not generally “regulated,” they are subject to the requirements of the Securities Act of 1933 (and potentially Regulation D). Generally this will mean that each hedge fund will have to file a Form D with (1) the SEC and (2) each state in which the fund has an investor. Form D must be filed with the SEC within 15 days of the first sale to the investor, each state will have different requirements.

In addition to the Form D, each state will generally require the partnership to submit a Form U-2 and the payment of an administrative fee. These administrative fees can range from $75 to $500; a few states may charge more. (Note: the fund itself, not the management company, will typically pay for this expense.) These items will generally need to be submitted to each state within 15 days of the date of the first sale in each state (note: New York requires its Form 99 to be filed prior to a first subscription from a New York resident).

The firm which submits these filings on your behalf will typically need the following information for each subscription:

Residence of investor
Amount of subscription
Whether the investor is “accredited” or not

Hedge fund hurdle rate

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When a manager decides on an investment program and how he will be able to sell his program to investors (whether institutional or otherwise), a potentially attractive part to the program would be a hurdle rate. This basically limits the performance allocation to the general partner. It is a way for the manager to make sure that the investor is compensated before the manager takes his allocation. The hurdle rate used to be a more prevalent feature of hedge funds. In the past couple of years, I’ve seen the use of the hurdle rate decline…but in the past six to eight months I’ve seen a resurgence of the use of the hurdle rate, especially with regard to groups that plan to court institutional investors in the near future.

The two major considerations for the manager with the hurdle rate is:

What should the rate be?
How will the rate be calculated?

What should the rate be?

Obviously the named hurdle rate is a business point, not a legal point. The manager should consider who his potential investors would be and what they would like to see. Also, the rate should relate, if applicable, to the investment program. If you have a bond program and your investment objective is to exceed the lehman aggregate bond index, a natural hurdle rate would be that index. For funds with a blue chip bias, a hurdle might be the return of the S&P 500 or the DJIA. However, in these instances it is more likely to see something like LIBOR or LIBOR plus one or two percent as the hurdle rate.

How will the rate be calculated?

There are three ways to calculate the hurdle rate: a hard hurdle, a soft hurdle or a blended hurdle.

The hard hurdle – the hard hurdle is calculated on all profits above the hurdle rate. The hard hurdle is the most investor-friendly of the three and provides the manager with limited upside.
The soft hurdle – the soft hurdle is calculated on all profits IF the hurdle is achieved. In this instance, in certain situations, if the hurdle rate is achieve, the investor actually would have a higher return if the partnership had a lower return. The soft hurdle is the least investor-friendly.
The blended hurdle – the blended hurdle is calculated on all profits if the hurdle is achieved; however, if the hurdle rate is achieved, the return to investors cannot dip below the hurdle rate. The blended hurdle rate has the upside of the soft hurdle (see difference below if a 10% return is achieved) but protects the investor from the undesirable consequences, in certain instances, of the soft hurdle (see 9% return for the soft hurdle).

The chart below shows the mechanical application of the hurdle rate at various return levels. It contemplates a yearly application of a 20% performance allocation and a 8% hurdle rate.

Return	Hard hurdle		Soft hurdle		Blended hurdle
Return	Investors	GP	Investors	GP	Investors	GP
8	8	0	8	0	8	0
9	8.8	0.2	7.2	1.8	8	1
10	9.6	0.4	8	2	8	2

The negative hurdle rate

In addition to the hurdle rates named above, a fund might also have a negative hurdle rate. The negative hurdle rate comes into play when the hurdle rate is actually below zero. Say for instance if the S&P is down 10% for the year and the fund returns 0%, the manager would actually earn a 2% performance allocation, even though the fund did not return anything. For various reasons, the negative hurdle rate is rarely done. There are plenty of issues with this type of hurdle rate, the most important being the fact that it is going to be hard to tell investors that the fund lost money and owes a performance allocation. In practice, funds with the negative hurdle rates have tended, over time, to drop this provision.

Questions: hedge fund structure

Question: Why is a hedge fund structured as a LP or a LLC instead of a corporation?

Answer: The short answer is that corporations are subject to double taxation (at the entity and investor levels) and that LPs and LLCs can be taxed as partnerships which are taxed only once (as the investor level).

Question: Should a hedge fund be structured as a LP or as a LLC?

Answer: When hedge funds first started out, they were established as limited partnerships. The purpose of forming the fund as a partnership is so that all of the investors and the manager will be subject to partnership taxation. When LLCs became a more prevalent structure in the 80s, there was not a huge rush to form the funds as LLCs. The central reason is that, as a newly formed entity, the law firms were not sure how the courts would view the statutory liability protections of these new entities. As general case law developed, practitioners became more and more comfortable with the LLC as a practicle entity from a liability protection standpoint. However, it was during this time also that many states either developed LLC applicable tax laws or realized that existing laws applied to LLCs.

The central argument for structuring new funds as LLCs is that at the LLC level, there is no liability. In addition to this, the management company will itself be structured as a LLC which provides very strong liability protection for the managers of the management company. At the entity level, the general partner of a limited partnership is potentially subject to unlimited liability; although the fact that the general partner is itself structured as an LLC should provide managers with ample protection. Even so, it is recommended that when a manager is investing in his own fund, he do so as a limited partner. The idea is to keep the management company sufficiently, but not overly, capitalized.

Monthly Feature: Hedge fund offering documents

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The central reason that beginning hedge fund managers need a lawyer is that the lawyer will prepare the offering documents for the fund. The offering documents are designed to comply with the requirements of the federal securities laws as interests in the fund (whether the fund is a limited partnership or a limited liability company). Specifically the offering documents will most likely be drafted to conform to the requirements of Rule 506 of Regulation D under the Securities Act of 1933.

The offering documents are the necessary paperwork that the manager must give to prospective investors. The offering documents will look very similar to a mutual fund prospectus. The three parts of the offering documents are:

The private placement memorandum (also sometimes called the offering memorandum). The private placement memorandum (also known as the “PPM”), is the main offering document. It provides the prospective investor with information on the structural and business aspects of the fund.
The limited partnership agreement (or, if the fund is an LLC, the operating agreement). The limited partnership agreement (also known as the “LPA”), is the actual governing legal document. It provides a description of the rights of the investors and the manager. When an investor becomes a “partner” in the fund, the investor is executing the limited partnership agreement.
The subscription documents. The subscription documents are the documents which provide the manager with background information on the investor. These documents include assurance and warranties by the potential investor that the potential investor is qualified to invest in the offering. These documements usually include the signature page to the LPA.

A more in depth description of the potential parts of the offering documents follows:

Private Placement Memorandum

While each law firm’s general PPM template is different, they all share many of the same items of information which are included. Below is a non-exhaustive list of some of the major sections of the PPM which you are likely to find in all offering documents.

Coverage
Legends and securities laws notices
Table of contents
Summary
Use of proceeds
Investment Program
Risk factors
Description of the management company and managers
Discussion of fees (Management fees, Performance fees)
Manner of valuing the investments
Discussion of conflicts of interest
Discussion of brokerage
Discussion of litigation of the investment manager
Discussion of financial statements of the fund
A summary of the LPA or Operating Agreement
Discussion of service providers
Tax disclosures
ERISA disclosures
Other notices (privacy notice, definition of investors qualified to invest, disclosure on the lack of transferability, etc.)

Limited Partnership Agreement

Like the PPM, each law firm has a different way to draft the LPA. For instance, some law firms will craft a lengthy definition section at the very beginning, other law firms will have definitions attached as an appendix, other firms will define specific terms throughout the document. A very rough guideline of the items which are in the LPA include:

Coverpage
Table of contents
Preamble
Defintions
Information on formation (business office, registered agent, length of fund, etc.)
Capitalization structure (initially and on a going-forward basis)
Manner of allocation of profits and losses (including the various tax allocation provisions)
Manner of distributions and withdrawals
Rights and duties of the management company
Rights and duties of the investors
Information on accounting, books and records
Transfer rights
Dissolution of the partnership; winding up
Manner of final distributions
Grant of power of attorney
Miscellaneous provisions (headings, amendments, applicable law, jurisdiction)

Subscription Documents

The subscription documents from one firm to another may differ fairly substantially. Some firms have separate subscription documents for individual investors and for institutional investors. Some firms include the necessary representations with the actual subscription agreement. The basic information included in the subscription documents includes:

Coverpage with certain legal disclaimers
Directions on how to complete the subscription documents
Subscription agreement (including certain acknowledgements, representations and warranties)
Investor suitability questions (may be embedded in the subscription agreement) – generally accredited investor, qualified client, or qualified purchaser status
LPA investor signature page

If a fund accepts non-accredited investors, the manager will need to make sure that the non-accredited investor meets certain that the non-accredited investor, together if applicable with their purchaser representative, is sufficiently sophisticated to understand the risks of making an investment in the fund. These supplemental representations can be made either in the subscription documents or in a supplement to the subscription documents.

Hedge fund to satisfy redemptions in “installments”

SEC Release 2008-167: New SEC Commissioner Sworn In

Start-up hedge fund timeline | How to Start a Hedge Fund

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Starting a Hedge Fund Timeline

Many prospective hedge fund managers know that they would like to start a hedge fund but have not gone through the process necessary to understand what the process is like or how long it will take. For some managers the process is painless, for others the process is more time consuming and frustrating than they would like. Unfortunately, the timing of an actual fund launch cannot usually be determined with absolute certainty and will depend upon, in large part, your program and your service providers.

A good rule of thumb (for managers who do not need to register as investment advisers with their states) is that the fund formation process should take about 2 months. Often a fund can be up in running in a month or less, but to be on the safe side, I recommend 2 months.* If you need to register with a state, you are going to want to add anywhere from 3 – 6 weeks to the process.**

* It is not unheard of to have funds up and running in a couple of weeks. I’ve had a fund up and running in 4 days. If I need to work with a manager on an extremely tight deadline, this can probably be done in 2 to 3 days, depending on the availability of outside service providers.

** States like California will be closer to 3 weeks (UPDATE: CA is now taking two months to register investment advisers 08-18-09); states like Texas are going to be closer to 6 weeks.

In general the timeline might look like this:

Day 1 – Discussion with legal counsel regarding the structure of your fund (fees, contribution provisions, withdrawal provisions, other items to be included in the legal documents). During this time you will also discuss your investment program and your background.

Day 7-10 – Delivery of offering documents. During this time your legal team should respond to you with your legal documents. Your hedge fund’s legal documents will include the following:

Private placement memorandum
Limited partnership agreement (or limited liability company operating agreement)
Subscription documents

Don’t be scared when you first review these offering documents – they will usually be around 100 pages. Some very large fund offering documents might be up to 200 page or more in length.

Day 10-14 – Review of your offering documents. During this time you should be reviewing the offering documents and familiarizing yourself with their provisions. You will need to understand what all of the legal provisions in your documents mean. If you don’t understand a concept or phrase – mark it down and be sure to ask your attorney. Remember, these are your legal documents and you paid very good money for them – you should know what they say.

Day 17 – Discussion with legal counsel regarding offering documents. You should take about an hour (sometimes it is more or less) to discuss the key points of your offering documents with your legal counsel. You should bring up items which you have questions on and your lawyer should run down the key points of the offering documents with you.

Day 24 – Delivery of revised offering documents. Your legal team should be able to deliver you revised offering documents within about a week. At this time the offering documents are very close to being complete. You should review the documents to make sure that all your questions have been addressed and your changes incorporated. If the revised wording does not make sense, let your attorney know as soon as possible.

At this point these offering documents are in good enough shape to send to your administrator and your auditor (if you decide to name an auditor in the offering documents). In addition, you should begin the account application process with your broker or prime broker.

Day 24-30 – Begin finalizing service provider contracts and make sure all service providers are on the same page. The brokerage account application can potentially be a stumbling block in the process. Certain brokers have certain due diligence requirements which must be met before the account will be ready for live trading. You might not know of these requirements beforehand or the broker’s compliance department may come back with extra requirements – you never know what might be required. For example: one fund was not allowed to have the word “Fund” in their name if they started with less than $2 million in AUM. Another fund was not allowed to clear through a certain prime broker because the managing member of the management company did not have enough experience in the eyes of the clearing broker. While stories like this are the exception rather than the rule, the brokerage account opening process is the most uncertain in terms of time.

Day 30-45 – Last minute prep work with lawyers and service providers. The auditors or administrators may have some minor comments for the lawyers on the offering documents. Some of these service providers may require certain disclaiming language regarding the services which will be provided. It is not uncommon for these requested modifications to be passed on directly to the attorney, sometimes these requests will go through you. Your lawyer will send you finalized offering documents during this time.

Day 46-60 – Begin getting ready for trading. You should make sure that everything is in place for a smooth first day – make sure you know when and how you will be doing your trading. Make sure you will have assets in the brokerage account on Day 1. Make sure your computers will be working.

Keys to remember during the process

Start early. Give yourself too much time.
Be responsive to all emails and phone calls.
Keep the lines of communication open with your service providers. This is your fund and you are paying your service providers good money. They should be responsive to you and should answer all of your questions. If you do not get the response you would like it is your responsibility to discuss this with your service providers.
Be patient.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. has written most all of the articles which appear on the Hedge Fund Law Blog. Mr. Mallon’s legal practice, Cole-Frieman & Mallon LLP, is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Question: hedge fund manager and registration

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Question: I am a investment adviser registered in Texas and I want to start a hedge fund – do I have to register in each state which I have investors?

Answer: Generally no. If you are a Texas-registered investment adviser (note: to be distinguished from an SEC-registered investment adviser), and you have no place of business in another state, you will not have to register in any other states. However, please note that if you sell interests in your hedge fund, you will need to make sure you comply with all of the “blue sky” laws with regard to the state in which the interests are sold. This will generally entail making a Form D filing for states where the investor resides. Your law firm will be able to make this Form D filing for you on your behalf.

BVI FSC may request additional information for hedge fund “recognition”