Author Archives: Hedge Fund Lawyer

Question: I wanted to inquire as to legalities for a new hedge fund formation. My question is can I get by the limit of 500 investors and qualification requirements. I mean is there another type of fund to start with same freedom and lack of regulation with breadth of trading types, but that can accept investors with net worth under $250,000…and more than 500 of them?

Answer: Let’s break down your question first:

“…can I get by the limit of 499 investors and qualification requirements”

A little preliminary background on hedge fund laws may be helpful. Hedge funds are investment vehicles which, by definition, would be subject to the registration requirements of the federal Investment Company Act of 1940. This means that, absent an exemption from registration, these funds would need to be regulated as mutual funds under the ICA. Many funds do not want to be registered as such because the regulations under the ICA are extremely onerous.

Luckily, the ICA contains two different exemptions for hedge funds – the Section 3(c)(1) exemption and the Section 3(c)(7) exemption. Under the 3(c)(1) exemption a hedge fund manager can accept investments from up to 99 outside investors. Generally these investors will need to be “accredited investors” and may also need to be “qualified clients” (these requirements come from other federal securies acts, and state laws, as appropriate). Under the 3(c)(7) exemption, a hedge fund manager can accept investments from an unlimited amount of “qualified purchasers.” A “qualified purchaser” is a very high net worth individual or institution (generally those persons who own $5 million in “investable” assets, which does not include a person residence). Because of other federal rules, a 3(c)(7) fund will often limit the amount of qualified purchaser investors to 500. Because many beginning hedge fund managers do not have a rolodex filled with “qualified purchaser” contacts, many of these start-up managers will initially begin a 3(c)(1) fund.

To your question, assuming you run a 3(c)(7) fund, you can “get by” the 499 investor limit but you would be subject to other federal laws. The 499 investor limit is in place because of the Securities Exchange Act of 1934 (“34 Act”). While most hedge funds do not need to register their securities because of the private offering exemption (Regulation D) under the Secutities Act of 1933, the hedge fund would still potentially be subject to registration under the 34 Act. The 34 Act requires an issuer (the hedge fund) to register its securities if (1) it has $10 million or more in total assets as of the end of a fiscal year and (2) has a class of equity interests which are owned by 500 or more persons. Generally a 3(c)(7) fund will have no problem meeting the first requirement and therefore the limit to 499 investors keeps such a fund from the registration provisions of the 34 Act.

So the answer to the first part of the question is yes – if you want to register your fund under the 1934 Act.

The second part of the question is no – unless you want to register under the ICA.

The next question you asked was:

I mean is there another type of fund to start with same freedom and lack of regulation with breadth of trading types, but that can accept investors with net worth under $250,000…and more than 500 of them?

Yes, you can start a registered fund – either (1) a mutual fund or (2) a fund registered under the 1933 Act. As noted above mutual funds are very highly regulated and a hedge fund manager probably does not want to start a mutual fund. The considerations involved in starting a mutual fund are considerable, and the legal costs to establish a mutual fund will be anywhere from about $50,000 to $150,000, whereas the legal costs to establish a hedge fund will be anywhere from $15,000 – $45,000 depending on the strategy. When establishing a mutual fund there are other considerations such as distribution and administration which can quickly escalate all costs.

If you only trade forex and certain types of futures, you may be able to do a registered fund (under the 1933 Act), but that is a longer and more expensive process than a traditional hedge fund. The legal costs to establish a fund registered under the 1933 act will be similar to the costs to establish the mutual fund. Additionally, the distribution and administration costs will need to be considered.

Please feel free to email any hedge fund questions you have through our contacts page. I will attempt to answer all questions and may post yours on this site.

Hedge Fund Seeder to Go Public

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Two hedge fund groups, Tuckerbrook Alternative Investments and HARDT Group Advisors, are joining forces to create HT Capital Corporation, a hedge fund seeder/incubator which will seek to go public with a $300 million offering of it securities. The IPO will be underwritten by Jeffries and Company, will be listed on the NYSE, and go by the symbol “HTG.”

HT Capital Corporation plans to use approximately $200 million to seed/incubate an initial stable of 8 promising hedge fund managers. The company will then seed an additional 10 managers within the 12 months after the IPO with proceeds from the IPO as well as a credit facility. HT Capital Corp. will invest in emerging managers through senior loans to the management company and participating interest (equity) investments in the hedge fund management company. These two types of investments are expected to produce four different revenue streams:

1. an 8.5% quarterly cash interest payment on the senior loan

2. a share of the management company’s management fees (expected to grow as AUM grow)

3. a share of the management company’s performance allocation (with the potential for such performance allocation to increase as AUM grow)

4. a stake in any sale of the hedge fund management company

The company will invest in emerging hedge fund management companies; the below statement comes from their N-2 filing with the SEC:

We plan to diversify across the following three distinct stages of emerging management companies:

“Incubation-stage” management companies, which will generally have few or no assets under management at the time of our investment, but may have, for example, an investment manager who recently came from the trading desk of a larger firm or established an investment track record in another firm’s name. We generally expect to provide incubation-stage management companies with between $5 million and $10 million of senior loans and a participating interests investment of typically about $1 million.

“Early-stage” management companies, which will generally have an investment track record of between 6 months and 24 months and between $5 million and $25 million of assets under management at the time of our investment. We generally expect to provide early-stage management companies with between $10 million and $25 million of senior loans and a participating interests investment of typically between $1 million and $2 million.

Acceleration-stage” management companies, which will generally have an investment track record of between two and three years and between $25 million and $100 million of assets under management at the time of our investment. We generally expect to provide acceleration-stage management companies with between $25 million and $50 million of senior loans and a participating interests investment of typically between $1 million and $2 million.

Hedge fund incubation platforms are becoming more and more popular as reports indicate that small and emerging managers present larger investors with the greatest opportunity for the most attractive returns. By participating in an incubation program as well, the investor will have the opportunity to allocate more assets to the manager in the future – a potentially valuable future right.

The Series 65 Exam

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If you are a hedge fund manager in certain states (California and Texas are two prominent examples) then your management firm will need to be registered as an investment adviser with your state’s Securities Commission. In all states, the prerequisite for such registration is that the firm have at least one investment adviser representative who has passed certain qualifying exams (the Series 65 exam or the Series 7 and Series 66) or have certain designations (CFA, CFP, etc).

This post intends to give you an overview of the Series 65 exam and some thoughts on taking and passing this exam.

The Series 65 basics

What: a three-hour (maximum) 140 question computer based exam which focuses on the following topic areas: economics and analysis; investment vehicles; investment recommendations and strategies; and legal and regulatory guidelines, including prohibition on unethical business practices. The exam features 10 ungraded questions (which can appear anywhere within the test) and an examinee needs to correctly answer 89 of 130 graded questions (70%).

Where: you will take the exam at either a Pearson-Vue or Prometric testing station.

When: you will sign up to take the exam at a time of your choosing on either the Pearson or Prometric website. It is recommended you schedule the exam at least a week prior to the date you plan to take it.

Why: it is required for a person to become registered as an investment adviser representative.

How to sign up

You will typically register for the Series 65 by submitting a Form U-4 through the IARD system or by submitting a Form U-10 online. Your law firm or your compliance consultant can help steer you through this process. Also feel free to contact us if you have any questions.

The cost to take the exam is $120. There may also be some state and IARD fees if you are signing up for the exam through the Form U-4 process.

How to study for the exam

I recommend to all of my clients that they put a pretty good effort into studying. I have seen a good portion of very smart hedge fund managers fail the exam on the first try. The central reason, in my opinion, is lack of a diligent study program. While the Series 65 is not a college chemistry exam, it still covers a lot of information which is probably new to the manager. Accordingly, I recommend that a manager set aside at least 40 hours to prepare for the exam. During the preparation phase, I recommend the following:

Get a study guide and read the guide from front to back. I read my study guide from front to back while I actively created notecards as I read each chapter. Doing so takes much longer, but afterward I was able to keep the notecards in my pocket and review them whenever I had free time, which kept the material fresh in my mind.

I used the Kaplan study guide. I am partial to the Kaplan study guides and have exclusively used these guide when studying for the various securities exams I have taken – I have passed the Series 3, Series 7, Series 24, Series 65 and Series 66 exams. The major frustration with the Kaplan guide is that it contained many errors. However, I think that Kaplan does the best job of preparing practice questions which will be very similar (if not exactly the same) to what you are likely to see on the exam. There are some other study guides out there like the “Pass the 65,” however, I have not found a guide which presents the information in a simple, matter-of-fact way like the Kaplan materials.

Other study options include various multi-media and internet applications. Kaplan also has a full-day class you can take from an instructor.

Take two to three practice exams. I took two Kaplan practice exams. After taking each exam, I examined the answer to every question, including the ones I correctly answered. This review process really helped me to solidify my understanding of the material. [Note: you may need to take more than two practice exams to feel comfortable with your knowledge base. If this is the case, I highly recommend taking more practice exams.]

Get a good night of rest the night before the exam. I always scheduled my exams in the morning. This way I can get the exam out of the way early and I do not need to be anxious during the day. I try to get a good night’s sleep the night before. At this point, it is not going to help your exam performance to stay up into the morning trying to cram.

Day of exam

Make sure you wake up early enough to be awake and alert. You should eat a proper breakfast. Allow extra time to get to the testing site. Pearson and Prometric have different rules about when you are supposed to show up at the testing site. A good rule of thumb is 45 minutes prior to your testing time. When you get to the testing site, you will sign in and the proctor will give you the rules of the testing site. Be ready to take everything out of your pockets and to take your jacket off (it is advisable to dress in layers as the testing rooms are often kept at very cool temperatures). You will likely be nervous before the test – I took the opportunity after signing in and before the test time to review a few of the more important note cards before I put them in my provided locker. This kept my mind busy, calmed my nerves, and gave me a little extra bit of confidence that I could answer the questions on the exam.

The exam

The exam is a computer-based exam so the first five minutes or so you’ll be given an on-line demonstration of the manner in which to answer questions and mark them for review. After this demonstration, the exam will start. The first ten to fifteen questions will generally be easier than the questions which come in the middle of the exam – don’t get too complacent. The middle of the exam will drag on and during this time there were many questions which I was not sure about and there were a lot of questions where I had to give a best guess. At about 2/3 of the way through the exam, I thought that I was going to fail for sure. Be aware of this, it happened to me in almost every single FINRA exam which I took.

Because the exam is so long – 180 minutes – you may need to use the restroom during the middle. If this is the case don’t hesitate to take some time for a break. During these breaks I would take some time to grab a drink of water and take a few deep breaths. When you get back, complete the last half or third of the exam in a methodical manner. If you encounter a question which you do not have a clue about how to answer, either guess and move on or guess and mark the question for review. Do not spend an inordinate amount of time trying to come to the correct answer – there are enough questions which you will know the answers to and it is most important that you get to those questions without being flustered. Remember also that the final 15 to 20 questions are generally going to be easier.

When you have answered all of the questions you will have the option to go back over your answers and to change any of your previous answers. It is recommended that you do not make any changes unless you are positive that your new answer is correct. Once you have certified that you are satisfied with your present answers the computer will ask you to confirm that you wish to proceed. When you confirm, the computer will begin to process your answers. During this minute or so your heart will race as adrenaline pumps through you. The screen will then tell you if you have passed or not.

If you don’t pass

Some people will not pass this exam – I have spent plenty of time on the phone talking to managers who almost passed. If you don’t pass it is not the end of the world. The major drawback of not passing the exam is that you will have to wait 30 days to take the exam again. If time is of the essence, this drawback could be the difference between an on-time hedge fund launch and the dreaded delay. As such, I always stress to the client that it is much better to be overprepared than underprepared. You will thank yourself for those extra few hours when you have passed the exam. If you do not pass the exam on the second try, you will need to wait 60 days to take the exam again.

***UPDATE FOR MAY 2010***

As many of you know, the Series 65 exam changed in 2010 and it is now much more difficult to pass. I have heard more stories from people this year about not passing than I did last year. Also a concern is that the study guides are not spending enough time on the new emphasis in the exam. For instance, one person I just spoke with mentioned that there were many more questions on trusts and pensions than were covered in the study guides. As always I recommend you get an up to date study guide and take at least two practice exams before taking the actual exam.

Article: What happened with the Quants?

New York based Hedge Fund Group mulls self-regulatory regime

Five Challenges to Raising Institutional Assets

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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.

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