Author Archives: Hedge Fund Lawyer

Monthly Feature: Hedge fund offering documents

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”

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Reuters is reporting that a 2.3 billion dollar Texas fund will be satisfying redemption requests in installments not to exceed 9 months from the redemption date. The Highland Crusader Fund, managed by SEC registered investment adviser Highland Capital Management, reportedly used the highly unusual move in order to avoid a fire sale of the firm’s illiquid assets. The fund invested in distressed assets.

There are many legal ways that funds can find ways to halt or slow redemptions. Generally funds’ legal documents are drafted to allow the management company the ultimate flexibility to slow or halt redemptions in certain instances. One clear cut way is through a hedge fund gate. Another way is through a general catch all provision which allows the manager to halt redemptions in certain “emergency” circumstances.

Last year this issue came to the forefront as many investors in certain funds rushed for the exit doors. The hedge funds halted redemptions because of the market turmoil and investors were not happy. It remains to be seen whether investors moving into the hedge fund space will pushback on these manager-friendly provisions.

SEC Release 2008-167: New SEC Commissioner Sworn In

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Troy Paredes Sworn In as SEC Commissioner

FOR IMMEDIATE RELEASE

2008-167

Washington, D.C., Aug. 1, 2008 — Troy A. Paredes was sworn in this afternoon as a Commissioner of the Securities and Exchange Commission by SEC Chairman Christopher Cox during a ceremony at the SEC’s Washington D.C. headquarters.

The ceremony was attended by his wife Laura Paredes, his parents Smiley and Hollie Paredes, his brother Randy Paredes, as well as other family members and friends. Other SEC commissioners and senior officials also attended.

Commissioner Paredes was appointed to the SEC by President George W. Bush on June 30, 2008. Prior to his appointment, Commissioner Paredes was teaching and researching in the areas of securities regulation and corporate governance as a professor at Washington University School of Law in St. Louis, Mo.

“Commissioner Paredes brings extensive knowledge of securities regulation and corporate governance that will be of enormous help to the Commission’s work to safeguard investors, maintain orderly markets, and encourage capital formation,” said SEC Chairman Christopher Cox. “I look forward to working with him and welcome his expertise as we move forward with a busy agenda at the SEC to help the American investor.”

Commissioner Paredes said, “I am deeply honored and humbled by the opportunity to join the Commission and to do my part in helping to advance the Commission’s vital mission of protecting investors, promoting capital formation, and ensuring that our country’s securities markets function effectively. I look forward to working with Chairman Cox, my fellow commissioners, and the SEC’s dedicated staff as we work together to serve the public interest at this very important time.”

Commissioner Paredes has pursued numerous research interests during his time in academia, including such pertinent topics as executive compensation, hedge funds, the allocation of control within firms, the impact of psychology on corporate decision making and investor behavior, and the development of corporate governance and securities law systems in emerging markets. Commissioner Paredes has authored articles on these topics and is a co-author of a leading multi-volume securities regulation treatise.

Before joining Washington University’s faculty in 2001, Commissioner Paredes practiced law, working on a variety of transactions and matters involving financings, mergers and acquisitions, and corporate governance.

Commissioner Paredes graduated from the University of California at Berkeley with a degree in economics in 1992, and graduated from Yale Law School in 1996.

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”

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For offshore hedge funds one of the central questions during the formation process is which jurisdiction will you choose? While there are many possibilities, there are two jurisidictions which a vast majority of the hedge funds will choose – either the BVI or Cayman Islands. Because both offer the same liability protections and tax favored status, the question comes down to cost and regulation.

Generally Cayman is considered to be the “premier” jurisdiction with many of the blue chip hedge funds domiciled here. Cayman also had a bit of a first-mover status and has just announced that it had it’s 10,000th fund. Cayman is also the more expensive jurisdiction.

Because of these facts many funds, including many start-up hedge funds, will choose to go with the BVI. One issue with the BVI is that the fund “recogition” process is much more capricious. Where Cayman offers funds a very dependable timeline to fund start ups, the BVI’s “recognition” process can be delayed by the BVI’s Financial Services Commission (“FSC”), which has the authority to request certain information for BVI professional funds. In fact, the FSC is free to request any additional information as they please. (Note: this is also true during the entity formation stage, which is distinct from the fund formation stage.) In the past they have asked for more detailed information on the past job duties of Directors. They have also requested future confirmations on certain items in the offering documents related to a manager’s past performance. They have also requested information related to the service providers.

As a result of the requests they have made, the final “recognition” of certain funds has been delayed. However, this will not happen on a routine basis (it has happened, with my previous clients, maybe once every 10 funds) and normally the information request and subsequent recognition is handled relatively quickly so that there has really been no delay of a manager’s launch date.

When deciding on a jurisdiction, this is something to be aware of, but it should not be dispositive on your decision one way or another.

Hedge fund early redemption fees

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It was very common a couple of years ago, after the hedge fund registration rule, for funds to institute lock-ups of two years or more. After the hedge fund registration rule was effectively vacated by the courts, the lock-ups came down. Many hedge funds now have shorter lock-ups and many choose to go with a 1 year lock-up.

Whatever the time horizon, the issue often arises as to what to do when an investor needs to get out of the hedge fund because of an extreme personal emergency. Almost all hedge fund documents will give the manager the flexibility to allow a redemption in such an instance. However, by doing so, the manager may be disadvantaging the other investors in the hedge fund (including the manager himself).

To discourage early requests for withdrawal (and to compensate the manager or other investors for the potential disadvantage of having to reposition the fund), the manager can institute an early redemption fee. The early redemption fee is simply a fee which is deducted from the withdrawal proceeds. The early redemption fee can be paid to the hedge fund manager, the hedge fund investors, or a combination of the two. The early redemption fee can range anywhere from 1% to 10% with a majority in the range of 2% to 5% of the withdrawal proceeds. Obviously, the exact amount a manager charges will depend on his investment strategy and the extent to which an early withdrawal would disadvantage the other investors and manager.

Discussion: Options on futures

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What Are Options?

There are two basic types of options on futures contracts: “calls” and “puts.” A call option on futures contracts conveys the right (but not the obligation) to the buyer to purchase a specific futures contract (for example, a corn contract for a December 1997 delivery month) at a particular price during a specified period of time. A put option conveys the right (but not the obligation) to the buyer to sell a specific futures contract at a given price during a specified period of time. The price for which the futures contract can be bought (in the case of a call option) or sold (in the case of a put option) under the terms of the option contract is referred to as the option’s strike price or exercise price. The date on which an option expires–the date after which it can no longer be exercised–is the option’s expiration date. The price of a specific option, that is, the amount of money paid by the buyer of an option and received by the seller of any option, is the option premium.

Where Are Options Traded?

Options are traded on the same exchanges as those of the underlying futures contracts. There are 11 different commodity exchanges in the U.S. as well as abroad. The major domestic agricultural crops are traded on the Chicago Board of Trade, the Kansas City Board of Trade, the Minneapolis Grain Exchange, the New York Cotton Exchange, and the Coffee, Sugar and Cocoa Exchange.

How Are Options Traded?

Options contracts are traded in much the same manner as their underlying futures contracts. There are several important factors to remember when trading options. The most important one is that trading a call option is completely separate and distinct from trading a put option. If producers buy or sell a call option, it does not in any way involve a put option. Trading a put does not involve a call option. Calls and puts are separate contracts, not opposite sides of the same transaction.

At any given time, there is simultaneous trading in a number of different call and put options–different in terms of delivery months and strike prices. Option delivery months are typically the same as those of the underlying futures contract.

Strike prices are listed in predetermined multiples for each commodity. The listed strike prices will include an at- or near-the-money option, at least five strikes below, and at least nine strikes above the at-the-money option. At-the-money is defined as an option whose strike price is equal–or approximately equal–to the current market price of the underlying futures contract. The five lower strikes would follow normal intervals. The nine higher strikes would include five normal intervals above the at-the-money option(s), plus an additional four strikes listed in even strikes that are double the normal interval. As prices increase or decrease, additional strike prices are listed as needed so that there are always five strike prices listed in normal intervals and four strike prices in double intervals above the current futures price, and at lease five strike prices below the current futures prices.

An important difference between futures and options is that trading in futures contracts is based on prices, while trading in options is based on premiums. The premium depends on market conditions such as volatility, time until expiration, and other economic variables affecting the value of the underlying futures contract. How various factors influence premiums and how and to what extent market price declines are offset by option profits are among the topics to discuss in detail with a broker.

The premium is the only part of the option contract negotiated in the trading pit; all other contract terms are predetermined. For an option buyer, the premium represents the maximum amount that he or she can lose, since the buyer is limited only to his initial investment. For an option seller, however, the premium represents the maximum amount he or she can gain, since the option seller faces the possibility of the option being exercised against him or her. When an option is exercised, the futures position assigned to an option seller will almost always be a losing one, since only an in-the-money option will normally be exercised by the option buyer.

Why Should Producers Consider Options?

Amid the perceived complexity of options, there is one feature that is especially important to hedgers: options offer price protection without limiting profit potential. This follows from the fact that the buyer of an option has the opportunity, but not the obligation, to buy or sell a particular commodity at a certain price for a limited period of time. The buyer’s risks are known up front and are limited. For producers, that means obtaining protection against declining crop prices without giving up the opportunity to profit if crop prices increase.

What is a “gate” provision?

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A “gate” provision is a hedge fund manager’s right to limit the amount of withdrawals on any withdrawal date to not more than a stated percentage of a fund’s net assets — often 10% to 25%, depending on how frequently investors have a right to withdraw capital. Gates are a very common feature in hedge funds of almost all strategies. Imposing a gate slows a potential “run on the fund” by forcing investors to wait until the next regular withdrawal date to receive the unfulfilled balance of their withdrawal requests. Gates are especially important for hedge fund strategies which are more illiquid like MBS strategies.

Deciding on a strategy for your hedge fund

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One of the most critical questions that a soon-to-be hedge fund manager must ask themselves is this: what exactly is my strategy going to be and (most importantly) is this a strategy I can sell to potential investors. Of course the strategy must be sound and must be something that the manager knows – this is not the time to begin experimenting.

It is most common for a manager to continue on with a strategy which he has been running for a long time, either on the side or with a previous employer. For many different reasons (fear, greed, uncertainty) the manager may decide to implement a dual strategy hedge fund . Often the dual strategy hedge fund will have a more conservative strategy and a more aggressive strategy. The dual strategy approach is different from a principal protection hedge fund and is more than simply hedge fund risk management procedures.

Whether a manager decides to utilize a dual strategy approach is business consideration. If you are running two strategies – a major and minor strategy – then you are going to be, at least somewhat, internally conflicted when it comes to time management, especially if the minor strategy is a time intensive strategy. It might be that the higher returns from the minor strategy (instead of, say, a money market) may not be high enough to justify the time necessary to achieve those higher returns. If that time cuts into the time for the major strategy, then you are probably going to be better off focusing in on your major strategy.

Like anything, when you focus on one trading program, especially for smaller, non-institutionalized fund managers, you are generally going to be better able to perform.