Category Archives: Hedge Fund Structure

Hedge Fund Attorney

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What does a hedge fund attorney do for a start-up hedge fund?

A hedge fund attorney is the first service provider a start-up hedge fund manager will likely contact.  The hedge fund attorney will listen to the manager and discuss the investment program.  From here the hedge fund attorney will begin drafting the hedge fund’s offering documents and may also suggest the other service providers the manager should talk to (including the administrator, auditor, and brokers or prime brokers).  After the offering documents have been finalized, the hedge fund attorney will help the manager with many of the logistical items which need to be addressed before the fund begins doing business.

Once the fund has started trading, the hedge fund manager may need the hedge fund attorney to do the following items:

–    Blue sky filings
–    Provide updates on relevant hedge fund laws
–    Revise the offering documents if necessary
–    Draft side letter agreements for certain investors
–    Make 13F filings on behalf of the manager
–    Make Form SH filings on behalf of the manager
–    Consult with the manager if investors have certain needs
–    Consult with the manager to start a new fund
–    Review marketing and other promotional materials
–    Answer hedge fund related questions
–    Help prepare manager for investment advisor or commodity pool operator audits (if necessary)
–    Hedge fund due diligence, potentially

In addition to the above, the hedge fund attorney is going to be a resource for the manager and the fund on an ongoing basis.  Hedge fund lawyers that have been around for a while and who have launched all sorts of funds will have generally experienced most issues that will arise in the hedge fund context.

What else does a hedge fund attorney do?

Besides drafting offering documents for the client, a hedge fund lawyer needs to understand what is going on in the industry.  As such the hedge fund attorney will spend a good portion of his day researching issues for clients, talking with service providers to see what are the developing trends within the industry, talking with regulators to see what are some of the things they are focusing on, in addition to other items.  Your hedge fund attorney should have an ear to the ground and understand the issues that affect you from both a business and regulatory perspective.

Hedge fund attorney – boutique or big firm?

Hedge fund attorneys usually work for either (i) boutique law firms that focus on securities law or the investment management industry or (ii) very large regional or national law firms.  Generally both types of attorneys are competent, produce good documents, and have the requisite knowledge of the industry.  In general, you will be looking at a cost issue.  Hedge fund formation costs can be high and if you use a very large law firm the legal costs could be double or more.

If you are a very large fund which will have over a billion dollars in assets during the first year of operation, you are probably going to go with the very large law firms that have very good reputations for hedge fund work.  Funds smaller than this may decide to go with the boutique firm for cost savings purposes, but they may also decide to go with the large law firms if they feel that there is need to show “name brand” service providers in their offering documents.  This might be the case if these funds are going to be shopping around for very large institutional investors during the first six months of operations.

Another issue to consider is who will be your contact person at the law firm.  Many start-up hedge funds choose to go with the boutique law firm because of the direct access to partners.  At the large law firms, most client matters are handled at the associate level and the partner may only talk to the manager once or twice.

Above all, the most important item when choosing a hedge fund attorney is to make sure you are comfortable with the attorney and his knowledge of the industry.  When starting out, the hedge fund start-up process can take up to two or more months depending on the complexity of the project, so you will want to make sure you have a good working relationship with your attorney.

Hedge Fund Formation Legal Fees

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Question: How much does it cost to establish a hedge fund?

Answer: The costs of starting a hedge fund can vary considerably depending on the manager and the manager’s circumstances.  A start up hedge fund manager will need to consider the hedge fund start up costs which will include legal costs, administration costs and set up fees, bank fees, prime brokerage fees, rent, etc.  This article will detail hedge fund legal fees.

Hedge Fund Formation Legal Fees

The central legal fees for a start up hedge fund manager are the costs associated with preparing the offering documents for the hedge fund.  Most law firms who provide these services will charge on a flat fee basis, depending on the novelty and scope of the project.  The cost breakdown is, generally, as follows:

Large brand name New York based law firm: $35,000 – $75,000

Midsize law firm with known hedge fund practice: $25,000-$45,000

Small or boutique hedge fund law firm: $15,000-$30,000

The above are very large fee ranges, but for managers with very basic hedge fund strategies (say a long-short large cap investment strategy) you are looking at the lower end of the fee range.  If the strategy is more esoteric or if there are many structural issues (especially liquidity and valuation issues), then the costs will be more.  Additionally, if the strategy has certain ERISA or tax issues then the cost is going to be more.

The costs above generally do not include filing fees for entity incorporation, fees for investment advisor registration, or any blue sky filing fees.

Please note that you may find groups out there which provide hedge fund offering documents for lower prices.  As when selecting any attorney, price should not be the only determining factor.  There are also offering document software sources out there which purport to create offering documents for your fund for under $5,000 – do not use such services.  The legal documents provided by hedge fund lawyers are designed to protect you as the manager and any off the shelf solution is not going to be able to provide the customized legal advice you will need to be properly protected.  I have personally seen some of these documents and they are woefully inadequate.

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

Overview of hedge fund short sale rules and likely fallout from recent events

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I received a request today to talk about hedge fund short sales and the likely fallout from the recent market disruptions and the failed bailout bill.

Short Sale Ban

The SEC has banned short sales on 800 individual securities.  These securities are generally within the financial services industry.  The ban on shorting these securities ends at 11:59 p.m. ET on Oct. 2, 2008. The SEC may extend the ban beyond this date if it deems an extension necessary in the public interest and for the protection of investors, but the SEC will not extend the ban for more than 30 calendar days in total duration.  (The SEC press release can be found here.)

Short Sale Disclosure Requirements

For hedge fund managers who are subject to 13F filings (i.e. those managers who manage $100mm or more), such managers will need to disclose their short positions by filing Form SH with the SEC.  More information on this can be found at 13F questions and answers or at the SEC’s website here. Please click here to view form-sh

Likely Fallout

There is so much uncertainty in the air right now.  Congress is having trouble trying to find some way to unfreeze the credit markets and money managers are just trying to find a way to stay afloat.  Additionally, as I mentioned this morning, investors are getting worried and are pulling cash out of hedge funds.  They way I see it, there are many scenarios which are likely to play out in the next couple of weeks and months:

1. Hedge fund redemptions – many investors are scared and are looking for safety right now.  While some managers are doing phenomenal in this wildly votile market, most are not and have not been doing well for much of the year.  I think that we’ll see in the coming days stories of large amounts of redemptions.

2. Hedge fund closures – as I discussed previously, because of the problems with the hedge fund high watermark, you are going to see money managers face the difficult decision of whether or not to keep their fund running.  Undoubtedly many managers will choose to close down their funds because of lack of capital (from redemptions and/or losses) or because they are too far under to make any money in the coming year.

3. Hedge fund regulation – while hedge funds have not faced the front page criticisms that the large investment banks and other financial institutions have seen over the past few weeks, the lawmakers have already began calling for investigations into the cause of this mess.  These investigations are likely to focus on systemic risks and how hedge funds may have contributed to the current market crisis.  As these reports begin spilling out over the next few weeks and months, I believe hedge funds will be a prime target and you are likely hear lawmakers facing re-election calling for more regulation.  [Please also note, Congress has indicated that it is more than willing to require more regulation of the financial markets as evidenced by its willingness to allow the CFTC to begin regulating the retail spot forex market.  For more information, please see this note from the CFTC. ]

4. Hedge fund start ups – over the next couple of months as funds begin to close down, successful traders will decide to go and start up their own hedge funds.  For these traders the transition to hedge fund manager will be difficult, but they will be able to be successful if they can find investors willing to invest in a start up hedge fund manager.  These traders will need to talk with a hedge fund attorney in order to get started with the hedge fund formation process.

5. Hedge fund due diligence will increase – hedge fund due diligence is one of the areas that is set to grow quickly.  I expect that investors, especially smaller institutional investors, will require greater risk management disclosure from hedge funds.  A simple manager back ground check is no longer going to be sufficient.

6. Hedge fund consolidations – while every now and again I will hear something about hedge fund consolidation, it never really seems to happen in any sort of large scale way.  This year may be different as smaller firms with decent track record decide to merge with more established funds with greater risk management procedures.

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

Hedge Fund Redemptions and the Gate Provision

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It is no secret that many funds are hurting this year and that many investors are getting ready to, or have, pulled money from many hedge funds.  According to a New York Times article this morning, these redemptions are likely to cause managers to sell securities which may in turn further depress prices.  While the time period for hedge fund-of-funds redemptions has likely passed (FOFs usually require 95 days prior notice for redemption), redemption notices for normal hedge funds are due by tomorrow (assuming a 90-day notice period and end of year or quarter redemptions).

If your fund is feeling the pressure of quite a few redemptions, there are a couple of standard safeguards which are usually built into the hedge fund offering documents.  These provisions include the hedge fund gate provision and a general catch-all provision.  In general, the gate allows redemption requests to be reduced to a certain percentage of the fund’s total assets during any redemption period.  For example, if the fund has a gate of 15% and investors request redemptions which equal 20% of a fund’s NAV, then all redemption requests will be reduced pro rata until only 15% of the redemption requests are met.  The catch all provision allows a hedge fund manager to halt redemptions if certain catastrophic market events take place.  Depending on how the hedge fund offering documents are drafted, the current market situation may or may not apply and you should discuss this with your lawyer.

How to handle invoking a gate provision

In the next few days, managers will be getting a good idea of how much of the fund will be redeemed.  If a decision is made to invoke the gate provision, the manager should discuss this option with his attorney.   The attorney will help the manager decide the best course of action with regard to reducing the redemption amount, which will probably include writing a letter of explanation to the investors.  While each fund’s situation is different, that letter should probably include the expected amount of the reduction as well as a description of the authority (in the offering documents) for the reduction.  Additionally, you should also invite questions directly – it is during times like these when investors get scared and then start talking to their own attorneys.  It is much better to be candid and upfront than to receive a nasty letter from an attorney in the future.

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

Hedge Fund 13F Filings

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Many people talk about watching hedge funds through their 13F filings. A 13F filing is a quarterly report filed with the SEC by “institutional investment managers.” The reports include the name and number of the securities owned by the hedge fund. The term “institutional investment manager” means those managers who exercise discretion over $100 million or more in Section 13(f) securities. Typically a hedge fund attorney will help the manager file Form 13F.

A summary of Form 13F requirements from the SEC is below and can be found on the SEC’s website here.

Form 13F—Reports Filed by Institutional Investment Managers

Institutional investment managers who exercise investment discretion over $100 million or more in Section 13(f) securities must report their holdings on Form 13F with the SEC.

In general, an institutional investment manager is: (1) an entity that invests in, or buys and sells, securities for its own account; or (2) a person or an entity that exercises investment discretion over the account of any other person or entity. Institutional investment managers can include investment advisers, banks, insurance companies, broker-dealers, pension funds, and corporations. Section 13(f) securities generally include equity securities that trade on an exchange or are quoted on the Nasdaq National Market, some equity options and warrants, shares of closed-end investment companies, and some convertible debt securities. The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.

Form 13F requires disclosure of the names of institutional investment managers, the names of the securities they manage and the class of securities, the CUSIP number, the number of shares owned, and the total market value of each security.

You can search for and retrieve Form 13F filings using the SEC’s EDGAR database. To find the filings of a particular money manager, use the “Companies & Other Filers” search under “General Purpose Searches” and enter the money manager’s name. To see all recently filed 13Fs, use the “Latest Filings” search function and enter “13F” in the “Form Type” box.

The securities that institutional investment managers must report on Form 13F are found on what is known as the Official List of Section 13(f) Securities. The Official List is published quarterly and is available for free on the SEC’s website. It is not available in paper copy format or on computer disk.

You can learn more about Form 13F filings, as well as obtain a copy of the Form and instructions, and the applicable statutory and regulatory provisions, by reading Frequently Asked Questions About Form 13F prepared by the SEC’s Division of Investment Management.

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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:

Hedge fund performance fees – is it time to rethink the high watermark?

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There are many news stories out covering what may be a worst case scenario for many hedge funds – the distinct possibility of no performance fees this year.  This seems to be a major topic of conversation for many people within the industry and just yesterday I received the following comment with a link to a Wall Street Journal article discussing this issue.

The comment:

Regarding performance fees: the underlying hedge funds naturally also have high performance fees. But in the current climate, they aren’t making them. “Just one in 10 hedge funds is currently receiving performance fees from their funds.” See: http://blogs.wsj.com/deals/2008/09/22/fee-slump-hits-hedge-funds/

Unfortunately, with the current market conditions, many funds are going to be feeling the pressure of little to no performance fees at the end of the year.  For many hedge fund managers, the problem is compounded by the fact that their asset management fee is simply not enough to keep the business going.  Many managers cannot keep operations going with only the management fee.  Without performance fees, hedge fund managers may have their operations disrupted for a number of reasons, including the fact that for some, the traders will be expecting bonuses no matter the performance of the fund as a whole.  If these traders don’t receive bonuses, then some hedge funds could see talent drain, to the extent that such traders thought they could receive greater compensation at other firms or by starting their own fund.

Still worse, managers who have negative performance numbers at the end of the year will have another issue to deal with – the high watermark.  The high watermark is a concept designed as an investor-friendly provision that essentially prevents a manager from taking a performance fee on the same gains more than once.  The high watermark is a similar concept to the clawback provision in a private equity fund.

When a fund suffers a significant drawdown during a performance fee period, the high watermark will actually create a perverse incentive for the investment manager – either take extra risk to generate higher returns so that there will be a performance fee in the next performance fee period or close down the fund and start again.  Both of these potential actions would be taken to the detriment of the investor, and the investor may only have the choice of making a redemption or letting the investment ride. 

If the manager does shut his doors, the investor is going to have his assets at risk as the hedge fund wind-down takes place.  Depending on the hedge fund’s strategy, the wind-down could subject the fund to a fire sale of its assets which will reduce the value of the investment even further.  If such investor was to move into another hedge fund, he would step into the new fund with a high watermark equal to his investment and would be subject to performance fees on those assets anyway. Because such a turn of events is detrimental to such an investor, it might make sense for such investors to allow for some sort of modification of the high watermark.

Some potential alternatives to the standard hedge fund highwatermark might include the following:

No high watermark – this is probably not a viable solution as it would afford investors absolutely no protection from paying two sets of performance fees on the “same” gains.  Additionally, without the threat of the high watermark, there would be little deterrent for a manager to improperly manage risk.  Additionally, because the highwatermark provision is one of the most uniform provisions in the hedge fund industry, it is unlikely to simply disappear.  (Although I have seen a couple of funds which actually did not have the provision.)

Modified high watermark – I have seen all types of variations within the performance fee structure and the withdrawal structure, but the high watermark is one provision which is generally resistant to modification. The high watermark could potentially be modified in many ways including the following:

Reset to zero – under certain circumstances, that if stated in the offering documents prior to investment, the investment manager can be given the ability to reset the high-watermark to zero.

Amortization – one potential way could be to “amortize” the losses over a 2- or 3-year period so that some performance fees can be earned on a going forward basis.  Additionally, if the investor chose to withdraw before the end of the high watermark amortization period, there could be some sort of clawback.

Rolling – the high watermark can be taken under certain circumstances over a rolling period.  The concept is that the high watermark will be determined for a certain window so a drawdown would in essence be erased after a certain amount of time has elapsed.  This might work better for those funds that have a monthly or quarterly performance fee period.

Resetting to zero and an amortization reduction method could be both potentially valuable to investors as it will keep a manager in the game and it will reduce the incentive for a manager to abandon risk management procedures. Also, management companies may be willing to decrease fees if investors agree to keep their investment in the fund for a certain amount of time after the reset or amortization.

[HFLB note: any new investors coming into a fund during a performance fee period will have an initial high watermark that is equal to the initial investment value; depending on the time of the contribution and when the fund made its losses, there may be some performance fees paid even during a down year for such incoming investors.]

Further Resources

Another good article and some good comments on the article can be found here.

For an interesting academic paper on this subject, please click here. The paper is by William N. Goetzmann, Yale School of Management.  The abstract for the paper states:

Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company.

We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggest that successful managers, and large fund managers are less willing to take new money than small fund managers.

Real Estate Hedge Fund Structure

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Real estate hedge funds have always been popular and considering the current stock market turmoil and volatility many real estate hedge fund sponsors believe that the time is ripe to offer a real estate product to market weary investors.

Potential Investments

Real estate hedge funds are not limited in their investment strategy and many such funds have different strategies. Many funds purchase real property and hold onto the real property for appreciation. Other funds will purchase raw land and then develop the land or hire other companies (including companies related to the sponsor of the fund) to develop the land. Still other funds will buy properties to manage for current income. Our law firm has handled all of these types of funds, as well as funds which seek to profit from turning around distressed real estate. The real estate may or may not be located in the United States. Other popular strategies include investing in commercial, multi family, general investment quality properties, and properties which have not yet been developed.

Structure and offering documents

Investors

The real estate hedge fund structure is similar to a hedge fund focused on trading securities; however there are some important differences. Most importantly, as long as the real estate fund is not investing in any securities (or money market accounts which may, in certain circumstances, be deemed to be securities), the fund will not be subject to the Investment Company Act of 1940 and therefore will not need to fall within either the 3(c)(1) or the 3(c)(7) exemption. This allows the real estate hedge fund a little more flexibility than securities hedge funds. Notably, the fund will need to adhere to the Regulation D requirements of the Securities Act of 1933 only and not the Investment Company Act. This means that the fund will be able to have an unlimited amount of accredited investors and up to 35 non-accredited investors. There is no requirement that investors in a real estate fund be either a qualified client or a qualified purchaser.

Structure

Because real estate hedge funds invest in assets which are not easily valued the real estate hedge fund will oftentimes take on a private equity like fund structure. The major characteristics of the private equity fund structure is the (i) closing/drawdown process for capital contributions and (ii) the limit on withdrawals until there is a disposition event. In this way the private equity fund does not have to deal with valuation issues until a value is determined. This helps to prevent the problem of the general partner taking a performance fee on an unknown rise in the asset value. In addition many general partners will also agree to a clawback provision.

An alternative to the strictly private equity structure is for the fund to implement side pocket investments. In their most simplest form a side pocket investment is an investment which is carried on the books to the side. Generally only those investors who were in the fund at the time of the investment (or in some programs, those who opt into the investment) are “owners” of that investment. Generally there will be no performance allocation on any investments in a side pocket account until there has been a disposition of the investment. Then, profits can be distributed to the investors in the side pocket account. Like the private equity structure this allows the fund to invest in hard to value assets without having to actually value the assets until distribution.

The side pocket account also allows a real estate hedge fund to offer a “hybrid” hedge fund product. Managers are finding that hybrid hedge funds are becoming more popular with investors and allow them to sell a product which may potentially resonate with a larger group of potential investors.

There are numerous iterations of a side pocket account and what is allocated to the account and when so we will not go into these in detail here. Once the manager has decided on a general structure the lawyer will work with the manager to identify any questions or issues with the structure. The general rule is that any structural design of the fund can be accommodated within the hedge fund structure – the question is how long it will take the manager and the lawyer to talk through and identify all of the issues of any particular structure.

The real estate hedge fund offering documents will follow the same standard format for hedge fund offering documents which includes a private placement memorandum, a limited partnership (or limited liability company) agreement, and subscription documents.

Real estate hedge fund fees and expenses

Because no two real estate hedge funds are going to have the same investment program and structure of the investment program, there are not any standard fees for these funds. Generally there will be some sort of asset management fee which might range from 1% to 3%. Often a fund will feature a preferred return and then some sort of carry over the preferred return. In this way the performance fees of a real estate hedge fund resemble the structure of the private equity funds. Because of the great variety of fee structures, though, for real estate hedge funds, there is no expected fee structure like for a securities hedge fund.

In addition the asset management fee and performance fees, real estate funds are unique in the fact that they have other expenses which are different from a securities only hedge fund. Specifically there are property acquisition fees as well as fees related to: property managers, leasing and sales agents, construction managers or other services as necessary. It is very common for the general partner to control entities which will provide such services to the fund. Generally the offering documents will note this conflict of interest and/or include a statement that such affiliated entities will be compensated at current market rates.

Valuation

As with any asset for which there is not a liquid exchange market, valuation of real estate is subjective. Accordingly valuation becomes a major issue for many real estate hedge funds if there is going to be withdrawals from the fund or if the general partner will receive a performance fee for any “paper” gains attributable to increase in the value of the real estate. Valuation becomes less of an issue if there the real estate will be placed in a side pocket account or if there are no withdrawals or performance fees until a disposition event. In the event that a fund needs to implement a valuation policy, the real estate hedge fund manager will basically choose from between three methods of valation (or some combination thereof).

The basic methods of valuation include: (1) book value; (2) outside valuation agent; or (3) by formula. There are advantages and disadvantages to each one of these methods and if you need to have a valuation methodology your lawyer will be able to help you to decide on one of theses methods.

Risks

There are always a number of risks involved in any type of hedge fund structure.  One potential risk when dealing with real property is eminent domain.  Depending on the real estate holdings and other investments a fund will make, there are considerations about the ability of the government to reposes the hedge fund holding through the eminent domain process (for more information, please see Washington state eminent domain). This is a risk which should be disclosed in the offering document if it is applicable to the fund’s investments.

Conclusion

Real estate hedge funds are a great structure for the current market and allow non-traditional hedge fund managers an entry point into the alternative investments industry. If you are a real estate professional who is thinking of establishing a real estate hedge fund, please feel free to contact us.

Hedge Fund of Funds

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One hedge fund strategy is a hedge fund of funds or fund of funds for short. Fund of funds managers invest in other hedge funds rather than trade directly in the financial markets, and thus offer investors broader exposure to different hedge fund managers and strategies. Like hedge funds, funds of funds may be exempt from various aspects of federal securities and investment law and regulation.

Structure and Offering documents

As noted above the FOF structure is generally the same as a regular hedge fund. The FOF manager will need to consider whether he will need to be registered as an investment advisr with the SEC or state securities commission. The FOF also may be a 3(c)(1) fund or a 3(c)(7) fund and of course, the FOF may also be an offshore fund. The fund of funds offering documents are going to look exactly the same as the hedge fund.

Fund of Funds Fees

FOFs regularly face a lot of criticism for the fee structure. FOFs will generally charge annual management fees of 0.5% to 1.5% and annual performance fees of 5% to 15%. These fees are on top of the management and performance fees which are paid out at the fund level. Because of the two layers of fees FOFs can be very expensive.

Reason for FOFs – Diversification

Although FOFs face criticism because of their high fees, they do offer investors a greater degree of diversification than individual hedge funds. Because FOFs invest in many hedge funds the performance of any single hedge fund will not, in theory, affect the whole portfolio. In extremely volatile times like we are currently experiencing, the FOF is trying to dampen volatility by being diversified. Many FOFs can weather these volatile times, but many FOFs are suffering along with their underlying funds.

Reason for FOFs – Access to managers

One of the main selling points to accredited and high net worth investors is access to hedge funds and managers which the individual investor may not have access to. Many of the very large premier hedge funds are no longer open to any investors. These premier hedge funds may, every so often, open their funds for new investments by existing investors. FOFs which have an investment with these managers will be able to get investor money into these funds.

Many individual hedge funds have very high minimum investment requirements which certain individual investors would not be able to meet. An accredited investor with $250,000 to invest will not be able to invest in a fund with a $1 million minimum, but that same investor will be able to get exposure to that fund through a FOFs. By pooling money from many investors the FOF is able to meet the minimums to these hedge funds with high minimum investments.

Reasons for FOFs – Due Diligence

Fund of fund managers are expected to perform in depth due diligence on the underlying hedge fund investments. This includes both operational due diligence as well hedge fund manager background checks. Many times a FOF manager will actually make in-person visits to the hedge fund’s offices to make sure that the hedge fund is not acting fraudulently.

Entry point for Institutional Investors

Fund of funds serve as a common entry point for institutional investors who want to get into the alternative investment arena. While there is a very large amount of assets in hedge funds through institutional investors, investments by these groups is growing at a great rate. Because these investors are typically conservative by nature, the more diverse FOFs serve as a great way for the investor to test the alternatives market. It is expected that institutional investors will become even bigger players in the alternatives area and therefore it is expected that FOFs will continue to serve as a good entry point to the industry.

For more information on this topic, please see our earlier post (GAO hedge fund report) which details what institutional investors look for when they invest in hedge fund of funds.

Non-active management – Sponsor

The FOF managers main job is to monitor investments in underlying hedge funds. While most fund of hedge funds managers were once active stock pickers, brokers or other industry professional, we are seeing the advent of the FOF manager who is really a sponsor of the fund of funds. A great example of this is Ron Insana, the CNBC analyst who became a FOF manager.

These types of FOF managers have great connections and are able to raise assets for investments in hedge funds but will not spend as much time determining the investments which will be made in the fund. In fact these managers may hire a sub advisor (paid out of the management fee) who will determine the investments the FOF will make. Other parts of the FOF back office can be outsourced – for instance there are firms which will do much of the initial hedge fund manager screening (through databases and other sources) and hedge fund due diligence. If you would like more information on these groups, please contact us.

Hedge funds and ERISA

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Hedge fund managers have to be especially aware of the ERISA rules with regard to their hedge fund and the investors in the fund. ERISA stands for the Employee Retirement Income Security Act of 1974 and it governs, among other things, pension investments into hedge funds.  The Department of Labor is the governmental agency which is in charge of promulgating regulations regarding ERISA.

There are many items to be aware of with regard to ERISA. The most important item for a hedge fund manager is the 25% ERISA threshold limitation for “benefit plans.” If investments into a hedge fund by “benefit plans” exceed the 25% threshold then the manager will become subject to certain ERISA rules. For these purposes the term “benefit plan” means both traditional pension plans and also Individual Retirement Accounts (IRAs).

Requirements for hedge fund managers subject to ERISA

The hedge fund manager who is subject to the ERISA rules will, most importantly, need to (i) be registered as an investment adviser with either the SEC or the state securities commission and (ii) maintain a fidelity bond (which usually costs a few thousand dollars a year).

Additionally, there are many other issues the hedge fund manager will need to be aware of and which he should discuss with his attorney including:

  • Performance Fees
  • Soft dollars and brokerage
  • Dealing with “Parties in interest”
  • Use of Affiliated Brokers
  • Cross Trades
  • Principal Transactions
  • Expenses
  • Information reporting and side-letters
  • Record retention

The 25% threshold

There are many intricacies to the 25% threshold and if you have any questions you should speak further with an attorney regarding the specific facts of you situation.  A couple of items to note about the 25% rule:

1. Investments by the manager and affiliates do not count toward determining the 25% threshold.

For example, if a hedge fund has shares outstanding with a total net asset value of $100M and the fund manager and its affiliates (e.g., portfolio managers, employees, etc.) hold a $20M investment in the fund, the 25% threshold would be 25% of $80M (i.e., $20M), rather than 25% of $100M (i.e., $25M).

2. You will need to test on a class basis.

For example if a hedge fund has two classes of interests, you will need to determine the 25% threshold for each class of interests. If Class A has $90M in assets and no “benefit plan” investments and Class B has $10M in assets and has a $5M investment by benefit plans, then the whole fund, not just the Class B, will be subject to ERISA because of the Class B investment.

Additionally, with the advent of new structures such as the Delaware Series LLC and the offshore Segregated Portfolio Company, the application of the test is likely to be at the series of segregated portfolio level, and not simply at the fund level. The last time we researched this question the issue was not definitively decided, but there may have been some definitive guidance since that time. If you are contemplating one of these structures you should discuss this issue with legal counsel. Also, the calculations may get a little get a little difficult with an offshore master-feeder structure.

3. Continuously monitor the 25% threshold.

Because hedge funds typically will allow additional capital contributions as well as withdrawals at regular intervals, the percentage of fund’s investments by benefit plans will change. If, because of a redemption of another investor, the 25% threshold is reached, the hedge fund manager will be subject to ERISA.

Only IRA investments – still subject to ERISA?

One items that always comes up is what happens if the fund exceeds the 25% threshold but only has IRA investments.  Although a fund which exceeds the 25% threshold will generally be subject to the ERISA rules, those rules only will apply to the pension plans and not the IRAs (although the manager will need to make sure to conform all actions to certain IRS requirements).  In this way a hedge fund manager which exceeds the 25% threshold and only has IRA money will not be subject to the registration and bonding requirements.  Many of our clients fall within this category.

Conclusion

ERISA is one of the more specialized parts of hedge fund law. If a manager is thinking of potentially being subject to ERISA the manager should thouroughly discuss the possibility with his hedge fund counsel. The manager should always make sure that the law firm he works with has an attorney which specializes in ERISA or works with an outside ERISA counsel on all ERISA issues.

While many managers will make sure that their fund is never subject to ERISA, I have seen many managers who have become subject to ERISA because of a significant investment by certain pension plans. Indeed in many situations it will make a lot of sense to become subject to ERISA and start up hedge fund managers should not automatically reject potential investments because they may become subject to ERISA. Our firm has worked with many managers who becomes subject to ERISA and it has worked out well – one suggestion I would make is to start the process early because investment advisor registration will be necessary.

What is a private equity fund?

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Question: What is a private equity fund?  What is the difference between a private equity fund and a hedge fund?

Answer: For many people who are not familiar with the alternative investment industry, hedge funds and private equity funds look like the same thing.  The distinction is not necessarily in the legal structure (which is similar), but in the investment style.  The GAO’s hedge fund and pension report, which I discussed recently, provided a great definition for private equity funds:

Like hedge funds, there is no legal or commonly accepted definition of private equity funds, but the term generally includes privately managed pools of capital that invest in companies, many of which are not listed on a stock exchange. Although there are some similarities in the structure of hedge funds and private equity funds, the investment strategies employed are different. Unlike many hedge funds, private equity funds typically make longer-term investments in private companies and seek to obtain financial returns not through particular trading strategies and techniques, but through long-term appreciation based on corporate stewardship, improved operating processes and financial restructuring of those companies, which may involve a merger or acquisition of companies. Private equity is generally considered to involve a substantially higher degree of risk than traditional investments, such as stocks and bonds, for a higher return.

While strategies of private equity funds vary, most funds target either venture capital or buy-out opportunities. Venture capital funds invest in young companies often developing a new product or technology. Private equity fund managers may provide expertise to a fledgling company to help it advance toward a position suitable for an initial public offering. Buyout funds generally invest in larger established companies in order to add value, in part, by increasing efficiencies and, in some cases, consolidating resources by merging complementary businesses or technologies. For both venture capital and buy-out strategies, investors hope to profit when the company is eventually sold, either when offered to the public or when sold to another investor or company. Each private equity fund generally focuses on only one type of investment opportunity, usually specializing in either venture capital or buyout and often
specializing further in terms of industry or geographical area. (Other less common types of private equity include mezzanine financing, in which investors provide a final round of financing to help carry the company through its initial public offering, and distressed debt investments, in which firms buy companies that have filed for bankruptcy or may do so and then typically liquidate the company.)

Investment in private equity has grown considerably over recent decades. According to a venture capital industry organization, the amount of capital raised by private equity funds grew from just over $2 billion in 1980 to about $207 billion in 2007; while the number of private equity funds grew from 56 to 432 funds over the same time period.

As with hedge funds, private equity funds operate as privately managed investment pools and have generally not been subject to Securities and Exchange Commission (SEC) examinations. Pension plans typically invest in private equity through limited partnerships in which the general partner develops an investment strategy and limited partners provide the large majority of the capital. After creating a new fund and raising capital from the limited partners, the general partner begins to invest in companies that will make up the fund portfolio. Limited partners have both limited control over the underlying investments and also limited liability for potential debts incurred by the general partners through the fund.