Category Archives: Hedge Fund Questions and Answers

Question: can my firm have a “silent owner”

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Question: I am a manager registered as an investment adviser in [State]. Can I have a “silent owner” who solicits clients for the management company or the fund? Also, since the owner is only a “silent owner” who does not do any of the trading, will the “silent owner” need to be registered as an investment adviser representative and have to take the Series 65?

Answer: Maybe surprisingly, this is a question which comes up on a very regular basis. In many situations, the manager will have some friends with a great network of high net worth individuals and these friends think they will be able to help the manager raise assets. As noted in my previous article on the broker-dealer issues, there is a potential broker-dealer issue if the person will be compensated for helping to sell interests in a hedge fund. Additionally, there is a potential state investment adviser representative registration issue.

As mentioned in a previous aritcle, almost all of the state securities laws are based off of the Uniform Securities Act, which has a general definition of what constitutes an “investment adviser representative.” Generally, each “investment adviser representative” will need to be registered as such at the state level.

The definition form Uniform Securities Act (Last revised or Amended in 2005), Section 102(16) (emphasis added) provides:

“Investment adviser representative” means an individual employed by or associated with an investment adviser or federal covered investment adviser and who makes any recommendations or otherwise gives investment advice regarding securities, manages accounts or portfolios of clients, determines which recommendation or advice regarding securities should be given, provides investment advice or holds herself or himself out as providing investment advice, receives compensation to solicit, offer, or negotiate for the sale of or for selling investment advice, or supervises employees who perform any of the foregoing. The term does not include an individual who: (A) performs only clerical or ministerial acts; (B) is an agent whose performance of investment advice is solely incidental to the individual acting as an agent and who does not receive special compensation for investment advisory services; (C) is employed by or associated with a federal covered investment adviser, unless the individual has a “place of business” in this State as that term is defined by rule adopted under Section 203A of the Investment Advisers Act of 1940 (15 U.S.C. Section 80b-3a) and is (i) an “investment adviser representative” as that term is defined by rule adopted under Section 203A of the Investment Advisers Act of 1940 (15 U.S.C. Section 80b-3a); or (ii) not a “supervised person” as that term is defined in Section 202(a)(25) of the Investment Advisers Act of 1940 (15 U.S.C. Section 80b-2(a)(25)); or (D) is excluded by rule adopted or order issued under this [Act].

http://www.uniformsecuritiesact.org/usa/DesktopDefault.aspx?tabindex=2&tabid=48

From the plain language of the statute (if adopted in substantially the same manner as above), a “silent owner” will generally fall within the definition of investment adviser representative. This means that the investment adviser representative will need to be registered as such with the state unless the state has an exemption from the registration provisions. While maybe contrary to what one would expect, it seems that some states may be willing to go along with an investment manager. I have heard of some states informally (over the phone) taking the position that when a “silent owner” merely tells people about the IA firm and does not involve himself further in the negotiation process, then such a “silent owner” would not be deemed to be an investment adviser representative. However, managers should consult with legal counsel if they would like to take this aggressive position. It is also highly recommended that before proceeding without registration, the IA firm should seek a no-action letter from the state on this topic. The no-action letter can be drafted by your attorney. There will probably be a filing fee at the state (around $100) in addition to any legal fees you may incur; generally answers can be received within 30 days.

A manager should also be aware that the firm can be fined if an employee acts in the capacity of an investment adviser representative without being registered. On February 4, 2008, the Kentucky Office of Financial Services levied a $54,668.53 fine against an investment advisor for failing to properly supervise the activities of an employee who was acting in the capacity of an investment adviser representative. Office of Financial Institutions v. Questar Capital Corp., Case No. 2008-AH-008, 2008 Ky. Sec. LEXIS 3 (Feb. 4, 2008). In this case, an unregistered employee of an investment fund was soliciting clients to a hedge fund. As a result of these referrals, the management company received compensation totaling $54,668.53. The Kentucky Office of Financial Institutions ruled that the investment advisor who oversaw the employee to be violation of KRS 292.330(1), and fined the fund $54,668.53 to disgorge its illicit profit. The investment adviser representative was to be put on heightened supervisory status and was also barred from receiving any compensation relating to advisory accounts until he was registered as an investment adviser representative.

Question: hedge fund investor and qualification requirements

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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.

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.

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.

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.