Category Archives: Business Issues

Hedge Fund Auditors | Thought Piece From Castle Hall Alternatives

The following article is by Christopher Addy, President and CEO of Castle Hall Alternatives, a hedge fund due diligence firm.  We have published a number of pieces by Mr. Addy in the past (please see Hedge Fund Fees, Hedge Fund Due Diligence Issues, Issues for Hedge Fund Administrators to Consider and ERISA vs. the Hedge Fund Industry).  The following post can be found here.

****

And the auditors work for….

Audit opinions of a hedge fund’s financial statements are unlikely to make the New York Times bestseller list.  As a result, we can certainly understand if the auditor’s fine print is not exactly top of the list for investor attention.  However, not all audit opinions are the same and, over time, it seems that different audit firms are quietly introducing different standards of care and attention – and, of course, liability, which is always the 800 pound gorilla.

The issue is the addressee of the audit report – or, put more simply, who the auditor works for.  In a public company, the auditors report to both the shareholders and the Board of Directors.  A quick web search gives us a couple of examples – GE and Goldman Sachs (don’t laugh at the Level III assets, by the way).

In a hedge fund, however, sometimes the audit report mentions the shareholders, but sometimes it does not.  What seems to be a fine difference is actually very profound – exactly why would a hedge fund auditor report only to the Board of Directors and deliberately fail to address their report to the shareholders?  Adding insult to injury, of course, is the reality that the average Board of Caymanian rent-a-directors hardly acts with the same vigor and intervention as the non execs on the boards of GE and Goldman.

In our experience, certain audit firms appear to have taken a deliberate decision to direct their audit opinions, wherever possible, only to the directors.  This is a difference which applies across both US GAAP reports as well as audits completed under International Financial Reporting Standards.  Check 10 audit reports from different firms, and see what we mean.

The underlying issue – of course – is the lack of investor control.  Investors, if asked, would very likely have an opinion on this issue: but, needless to say, they are not asked.  Audit engagement letters are signed under cloak and dagger secrecy (usually because they include ever more expansive terms seeking to limit auditor liability under Caymanian law).  Thereafter, as investors and due diligence practitioners know to their ongoing annoyance, it proves incredibly difficult and pointlessly time consuming to get some auditors even to confirm that they are the auditor of record for the hedge fund in question.

In the short term, one answer would be for offshore jurisdictions such as the Cayman Islands to mandate that all audit reports filed for Caymanian hedge funds be addressed to the shareholders rather than just the Board.  If it’s good enough for GE, it should be good enough for any hedge fund.

In the bigger picture, however, this is just one question within the broad construct of Hedge Funds 2.0 post Madoff.  Unfortunately, it is only investor pressure which can enforce any change so that service providers – auditors, administrators, lawyers et al – take responsibility and recognize that their primary duty of care is to the investors that pay them.  Without that pressure, hedge funds will continue to be the asset class where everyone wants to get paid, but no-one wants to take responsibility.

www.castlehallalternatives.com
Hedge Fund Operational Due Diligence

****

Other related hedge fund law and start up articles include:

Thoughts on Hedge Fund Offering Documents

FAQs on Offering Documents

I recently read an article by a hedge fund administration firm which discussed hedge fund offering documents and start up hedge fund expenses.  I thought this was an interesting topic and one which is popular with many of my start up clients.  Below I discuss some of the common questions regarding the offering documents and also provide reasons why a start up manager should use my law firm for starting a hedge fund.

****

Offering documents are just boilerplate – why are they so expensive?

This is a common misperception.  Offering documents (if done correctly) are not merely boilerplate where the attorney pops in the fund name and the address – offering documents are a tailored to the specific needs of the client based on the client’s investment program and fund structure.

For instance, there are at least 12 different questions related to the management fee and performance fee/ performance allocation.  There are at least 22 different questions related to the fund’s contribution periods and withdrawal periods.  This level of customization does not come from a boilerplate form.  Furthermore, many of these questions or options may have specific implications for the manager’s business either from a legal standpoint or a business standpoint.  Many times the lawyer will need to have an in-depth discussion with the manager to help the manager determine which option is right for the fund.

Why are offering documents so long?

Offering documents are long – there is no getting around it.  The structure of the offering documents are determined by the federal and state securities laws and thus there is not really any wiggle room.  While it is often said that the hedge fund industry is “not regulated” or “lightly regulated” there are many hedge fund laws and regulations which managers must follow.   These laws dictate many aspects of the documents and are why offering documents are so long (and also why offering documents from different firms are structured so similarly).

In this prior post, discussing “Prospectus Creep” we discussed the length of offering documents:

4.  Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers.  Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program.  The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents.  However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.


Can I draft offering documents myself?  I have a friend who has some documents I think I can modify.

No.  You should never draft offering documents yourself.  I have seen countless examples of people who have tried to draft their own offering documents based on another fund.  Many times these people will ask me to “check the documents.”  Ninety-five percent of the time a brief skim of the documents will reveal major errors that cannot simply be fixed with a 2 hour review.   In most all occasions the documents will need to be completely scrapped.

Are all law firm offering documents the same?

No, but law firm documents are all very similar.

It is an interesting phenomenon in the hedge fund legal world that attorneys are always interested in (or obsessed with) reading the other law firms offering documents. As one of those lawyers that is very interested in the differences between the offering documents, I have studied the documents from most all of the major hedge fund law firms including the firms listed below which are considered to be the best in the industry.

  • Sidley Austin
  • Shartsis Friese
  • Seward & Kissel
  • Kleinberg, Kaplan, Wolff & Cohen
  • Katten Muchin Rosenman
  • Schulte Roth & Zabel
  • Akin Gump Strauss Hauer & Feld
  • K&L Gates

I have probably read through 500 different offering documents (many from the same large law firms) and have found most documents to be quite similar. For the most part with a name brand firm you are going to get a quality product that is probably pretty equal to another large or name brand law firm.  These documents will very likely protect you in all of the necessary ways.

However, that is not to say that all large law firm offering documents are perfect.  I have seen offering documents which cost over $70,000 with typos and errors.  Many times expensive offering documents are sloppy in certain respects – I expect this is because many large law firms use inexperienced associate attorneys to draft the offering documents.

Does price equal quality?

Not necessarily.  While you are less likely to receive white glove service from a document shop, BigLaw does not necessarily equate to fine quality – especially for small and start up managers.  In a large law firm you are going to probably initially talk with a partner about your program who will then relay the information to an associate who will be in charge of your project.  This means that your offering documents are likely drafted by an overworked associate who has relatively little experience.

I always recommend a start up manager ask the law firm who will be drafting the offering documents and how much experience the person has.  Many large law firms will say that an associate will draft the documents but the partner will review prior to finalization.  I find it hard to believe that a partner will review offering documents – many times this is not true.

Low cost offering documents – are you getting less quality?

In some cases yes, but in the case of my law firm documents the answer is a resounding NO.  While my firm will charge around $13,000 to $18,000 for offering documents (considered to be on the lower end), this does not mean that the quality of my work is less than any other firm.

As I have mentioned before on this site, I have worked with a substantial number of start up hedge funds and have drafted the offering documents or worked on around 150 funds.   Also, I have spent a great deal of time dissecting offering documents from a large number of firms.  My dedication to completely understanding the offering documents, along with my passion for the industry and helping managers with their business issues makes my services a compelling alternative to other firms which may cost more.

Additionally, I value the client relationship and always strive to return emails and phone calls promptly.

Conclusion

While the offering documents are the tangible item which you receive from your hedge fund lawyer, it is not the only part of the representation.  The offering documents are not valuable as objects, but really as a representation of the prior experience of the attorney who prepared those documents for your fund, based on your needs.

****

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. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice 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 becoming registered as a CPO or CTA, please call Mr. Mallon directly at 415-296-8510.

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

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

  1. Start early. Give yourself too much time.
  2. Be responsive to all emails and phone calls.
  3. 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.
  4. Be patient.

****

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.