Category Archives: Hedge Fund Structure

Overview of Regulation D for Hedge Funds

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Interests in hedge funds are securities which mean that hedge fund managers must follow the federal (and state) laws regarding the sale of securities to investors.  Typically, securities will need to be registered under the Securities Act of 1933 unless there is an exemption from the registration provisions.

There are two main exemptions from the registration provisions – Section 4(2) of the Securities Act and the Regulation D (also known as “Reg D”) safe harbor rules promulgated by the SEC under Section 4(2).  Typically hedge funds will offer their securities pursuant to the Regulation D safe harbor and specifically under Rule 506 which allows a hedge fund to offer an unlimited amount of interests to investors.

Below is a quick synopsis of the Regulation D rules (I have left out Rule 507 and Rule 508).  I have also posted all of the rules here: Regulation D Rules.  Most important to hedge fund managers will be Rule 502 which requires that the manager not engage in any public solicitation and Rule 506.

Rule 501 – Definitions and Terms Used in Regulation D

In general this rule defines certain terms used in the rest of the rules.  The most important definition is probably the accredited investor definition.

Rule 502 – General Conditions to Be Met

In general, this rule discusses certain aspects of the offering which should be met.  A fund’s attorney will be familiar with these issues.

Specifically, this rule addresses certain integration issues, the information which must be provided to investors who are not accredited investors and the limits of resale of interests in a Regulation D offering.  Most importantly, the rule does not allow fund managers to engage in any sort of general solicitation.  Because this is really the most important aspect of the rule for hedge fund managers, I will include this section explicitly below:

c.  Limitation on manner of offering. Except as provided in Rule 504(b)(1), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

1.    Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

2.    Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising;

Provided, however, that publication by an issuer of a notice in accordance with Rule 135c shall not be deemed to constitute general solicitation or general advertising for purposes of this section; Provided further, that, if the requirements of Rule 135e are satisfied, providing any journalist with access to press conferences held outside of the United States, to meeting with issuer or selling security holder representatives conducted outside of the United States, or to written press-related materials released outside the United States, at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising for purposes of this section.

Because of the broadness of this rule, hedge fund managers should consult with their attorney if they have any question regarding the prohibition on general advertising.

Rule 503 – Filings of Notice of Sales

In general this rule outlines of the requirement for hedge fund managers to file Form D with the SEC within 15 days of the first sale of securities.  See link below on blue sky filings for more information.

Rule 504 – Exemption for Limited Offerings and Sales of Securities Not Exceeding $1,000,000

This rule is known as the intrastate offering exemption, and generally this provides an exemption from registration if the offering  of hedge fund interests is made wholly intrastate and if the amount to be raised is less than $1million.  Few if any hedge funds will utilize this exemption.

Rule 505 –  Exemption for Limited Offers and Sales of Securities Not Exceeding $5,000,000

In general, this rule provides that an offering is exempt from registration if the issuer raises $5 million or less over any 12-month time period.  This rule also provides that there can be no more than 35 non-accredited investors.

Rule 506 – Exemption for Limited Offers and Sales without Regard to Dollar Amount of Offering

In general, this rule provides that an offering is exempt from registration if the fund raises money from no more than 35 non-accredited investors, provided that all non-accredited investors, either alone or with his purchaser representative(s), has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.  This rule does allow a hedge fund to sell an unlimited dollar amount of interests.

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The discussion below from the SEC on regulation D offerings is aimed more at hedge fund investors and the hedge fund due diligence which such investors should engage in; the discussion can be found here.  Managers are urged to discuss the Regulation D offerings with their hedge fund attorneys.

Regulation D Offerings

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. Regulation D (or Reg D) contains three rules providing exemptions from the registration requirements, allowing some smaller companies to offer and sell their securities without having to register the securities with the SEC. For more information about these exemptions, read our publications on Rules 504, 505, and 506 of Regulation D.

While companies using a Reg D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company.

If you are thinking about investing in a Reg D company, you should access EDGAR Company Search to determine whether the company has filed Form D. If the company has filed a Form D, you can request a copy. If the company has not filed a Form D, this should alert you that the company might not be in compliance with the federal securities laws.

You should always check with your state securities regulator to see if they have more information about the company and the people behind it. Be sure to ask whether your state regulator has cleared the offering for sale in your state. You can get the address and telephone number for your state securities regulator by calling the North American Securities Administrators Association at (202) 737-0900 or by visiting its website. You’ll also find this information in the state government section of your local phone book.
For more information about the SEC’s registration requirements and common exemptions, read our brochure, Q&A: Small Business & the SEC.

HFLB note: other articles you may be interested in are:

Please contact us if you have any questions.

Hedge Fund Investors Overview

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The lifeblood of the hedge fund industry are hedge fund investors, those persons and institutions which put their money at risk with the hope of generating positive investment returns.  While there have been recent predictions of large amounts of investor money leaving the hedge fund space due to poor performance, there are many potential hedge fund investors who are just beginning to warm to the idea of investing in a hedge fund.

Who can invest in a hedge fund?

In general there are two types of hedge funds which are open to different types of investors.

Section 3(c)(1) hedge funds are open to investors who are both accredited investors and qualified clients. An accredited investor is generally an individual with a $1 million dollar net worth (can include the equity in the investor’s primary residence) or an individual who has made $200,000 in each of the two most recent years (or joint income with that person’s spouse in excess of $300,000 in each of those years) and has a reasonable expectation of reaching the same income level in the current year.  A qualified client is generally an individual with a $1.5 million dollar net worth.  Because investors will need to be both an accredited investor and a qualified client, many hedge fund managers will just say that the investor needs to be a qualified client as it has the higher net worth threshold.

Section 3(c)(7) hedge funds are open to qualified purchasers, which is a higher net worth threshold than for the accredited investor or qualified client standard.  A qualified purchaser is generally an individual investor with a $5 million dollar liquid net worth (cannot include the equity of the investor’s primary residence).

Occasionally you will see some Section 3(c)(1) hedge funds which allow non-accredited investors to invest in the fund.  In such instances, the fund will typically charge the non-accredited investor a higher management fee because the non-accredited investor cannot be charged a performance fee.  In general, hedge fund managers will not allow non-accredited investors into the hedge fund except for very close family and friends.

Why would someone invest in a hedge fund?

Hedge funds have historically been viewed as nimble investment vehicles run by savvy managers who are able to produce steady and absolute returns.  Hedge funds come in a variety of different sizes (from the one-man shops to the multi-billion dollar operations) and strategies.  The great diversity of funds and their investment objectives is what makes them exciting, but which also makes it difficult to describe them as a whole.  Suffice it to say that whatever investment strategy an investor is looking for, there is a hedge fund which would be able to meet the needs of that investor.

Who can recommend hedge fund investments?

Hedge fund investments are made through private placements according to the Regulation D offering rules.  This means that only the hedge fund manager and certain hedge fund brokers can offer an investor interests in a hedge fund, and that is only if the manager or the broker has a pre-existing relationship with the investor.  There are some ways which investors can gain access to hedge funds, most notably through hedge fund databases.

What should an investor do before investing in a hedge fund?

At a minimum an investor should carefully read the hedge fund’s offering documents.  An investor should also discuss any questions or concerns with the hedge fund manager.  Additionally, I always recommend that investors conduct some sort of due diligence on the hedge fund and the manager.

HFLB note: we are not recommending that readers invest in hedge funds and we are not recommending any specific hedge funds.  If an investor makes an investment into a hedge fund, any such investments should be made only after consultation with such investor’s legal and accounting advisors.

Other articles you may be interested in:

Overview of New Form D for Hedge Funds

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As we noted in a previous post about filing Form D online, Form D has been changed and I believe that the new Form D is a great improvement and is more appropriate for hedge fund offerings.  As we’ve noted before, many of the securities laws were drafted in the 1930s and 1940s and have not been overhauled to accommodate the current practices within the securities industry.  With the new Form D, we see a giant step forward and commend the SEC on producing a form which asks questions which are appropriate for both operating businesses and hedge funds.

The new Form D is cleaner and easier to read.  There is plenty of space for explanations if a hedge fund’s structure does not exactly fit the parameters of a specific question.  The new Form D also has great instructions on how to complete the various items.

Please note that hedge fund managers should have a hedge fund lawyer or compliance person complete and submit Form D on their behalf.  The SEC expects that each Form D will take approximately 4 hours to complete.  Please click to view a copy of the new Form D .

Items by Item run through of the new Form D is below:

Item 1. Issuer’s Identity – background information on the issuer including name, entity type, year of organization.

Item 2. Principal Place of Business and Contact Information

Item 3. Related Persons – should include the hedge fund manager;  additionally there is a continuation page where the manager will include key members of the management entity.

Item 4. Industry Group – there is a specific box for hedge or other investment funds.  This is a significant improvement over the old Form D which did not include anything like this.

Item 5. Issuer Size – hedge funds will now provide an aggregate net asset value range, which is a more appropriate inquiry.

Item 6. Federal Exemptions and Exclusions Claimed – here most hedge funds will check at least a couple of boxes, your attorney or compliance professional will be able to help you with this.

Item 7. Type of Filing – you will provide information on whether this is a new filing or an amendment to a previous filing.  The instructions to the Form D provide a list of times when it is necessary to file an amendment.

Item 8. Duration of Offering – generally hedge fund interests are offered on a continual bases and the hedge fund will accordingly indicate that the offering will last greater than one year.

Item 9. Type(s) of Securities Offered – the hedge fund will typically check two boxes here.

Item 10. Business Combination Transaction

Item 11. Minimum Investment – old Form D also required this information

Item 12. Sales Compensation – if a hedge fund uses a broker or a third party marketer to raise money then the hedge fund will need to provide certain information on the broker or third party marketer.

Item 13. Offering and Sales Amounts – here hedge funds will typically check “Indefinite” where appropriate.

Item 14. Investors – the SEC requests information on whether there have been sales to persons who are not accredited investors (typically referred to as non-accredited investors)

Item 15.  Sales Commissions and Finders’ Fees Expenses – here the hedge fund will provide more information on the transactions discussed in Item 12.

Item 16. Use of Proceeds

Other related articles of interest:

Hedge Fund Administration – New Issues for Managers to Consider

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I came across another very good article which examines the new landscape of the hedge fund industry and brings up some pertinent points which both hedge fund managers and investors should be aware of.  The issue is that many of the prime brokerage firms and very large global banks have established administration businesses to cater to the ever growing hedge fund industry.  While this expansion gives managers more choices for administration (and arguably better service as admin and other back office functions, like banking, can be handled by one organization), it does create new risks that both managers and investors should investigate.  This article details some of the issues which should be considered; these issues should probably be talking points between the manager and the administrator during the process of choosing an administrator.   The original article can be found here: www.castlehallalternatives.com.

How will the credit crisis impact the administration industry?

In the past two weeks, Fortis has been rescued not once, but twice.  While hardly at the top of the priority list in times of global economic meltdown, it’s still an interesting question to ask what would have happened to Fortis’ administration business if the bank had ceased operations.

Thinking of a different point, it’s also ironic – and fortuitous – that Lehman was one of the few of the prime brokers which had not decided to create a fund admin sideline to help attract managers to the firm’s PB services.

In this environment, however, both hedge fund managers and investors need to evaluate the stability and viability of fund administration entities.  There is both a possibility of direct bankruptcy and also a risk that a parent entity in financial distress could decide to close a peripheral admin business in short order.
We can immediately think of several issues:

1) If the administrator goes bankrupt, do funds have a contingency plan in place to enable them to continue operations?  Do hedge funds have copies (ideally electronic) of the administrator’s accounting which could be given to a new provider?

While audit firms in the US may not agree with us (they tend to audit the manager’s accounting and largely ignore the admin), the offshore administrator’s accounting forms the official books and records of a hedge fund.  If the administrator is no longer in business, does the fund have a contingency plan to recover those records so that the next NAV can be struck on a timely basis?

2) Administrators usually control cash movements for subscriptions, redemptions and fund expense payments.

Do these cash movements pass through a cash account within the administrator?  This would, of course, expose a fund to loss if cash is sitting in an account at the time of bankruptcy.

More discreetly, does the administrator use some form of commingled Escrow account to receive incoming subscriptions and perhaps hold cash until anti money laundering procedures have been completed?  Are hedge funds sure that these assets are properly segregated and controlled?

Separately, if the administrator is the only one with signing authority over the offshore bank account, can the manager withdraw any residual cash and process new redemption and expense payments if the signatories are no longer available?

3) If administrators complete anti money laundering and know your customer checks, does the hedge fund have access to these records to prove that AML has been performed in the event that the admin is bankrupt?

4) Does the hedge fund have access to the full shareholder’s register / list of partners capital accounts to identify all investor balances in the event that the administrator is bankrupt?

More generally, it’s worth noting that many administration companies are small, independent firms which may not be well capitalized.  In an environment which sees a sharp fall in hedge fund assets through both negative performance and net redemptions, administrators’ fees will also fall. Administrator financial viability is, therefore, a real issue for both managers and investors as we navigate the coming year.

HFLB note – other related articles include:

Section 3(c)(1) Hedge Funds

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Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940.  All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.

There are two separate exemptions from the registration provisions of the Investment Company Act.  This post deals with the more common Section 3(c)(1) exemption which generally requires that the hedge fund have 100 or fewer investors.

Not Owned by More Than 100 Investors

A 3(c)(1) hedge fund is exempt under the Investment Company Act provided that the fund is beneficially owned by not more than 100 investors and is not making a public offering of its securities.  The actual text of Section 3(c)(1) provides:

None of the following persons is an investment company within the meaning of this title: Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:

(A) Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company’s outstanding securities (other than short-term paper).

(B) Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.

Certain Look Through Rules

Part A above provides “look through” provisions for certain entity investors.  This rule provides that if another 3(c)(1) hedge fund (the “Investor Fund”) owns more than 10% of another 3(c)(1) hedge fund (the “Investee Fund”) then the Investee Fund would count all of the investors of the Investor Fund as investors as well.  This rule is designed to prevent the pyramiding of 3(c)(1) funds to avoid the application of the mutual fund registration rules.  Through various no-action letters the SEC has provided further guidance in this area which we will be writing about shortly.

Types of 3(c)(1) Investors

Generally speaking investors in Section 3(c)(1) hedge funds will be both accredited investors and qualified clients.  A 3(c)(1) fund must limit its investors to qualified clients if it wants to charge a performance fee.

Other related articles include:

For more information on mutual funds in general, mutual fund investment programs and investing in mutual funds, please see investing in no load mutual funds.  No load mutual funds are funds which do not have a front or back end load because the distribution fees are usually paid through section 12b-1 fees.

Please contact us if you have any questions.

Section 3(c)(7) Hedge Funds

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Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940.  All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.

In addition to the Section 3(c)(1) exemption discussed in a previous post, this article describes the section 3(c)(7) exemption.

A 3(c)(7) hedge fund is exempt under the Investment Company Act and must comply with two basic requirements: (1) the fund can have only qualified purchasers as investors and (2) the fund can have no more than 499 investors.  These requirements are detailed below.

Qualified Purchaser Requirement

There are two exemptions from the Investment Company Act registration provisions for hedge funds.  Under the first regulation, each investor must be a qualified purchaser.  Section 3(c)(7) states:

None of the following persons is an investment company within the meaning of this title: any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Generally, a qualified purchaser is an individual with a liquid net worth of $5 million or an institution with a net worth of $25 million. You will notice that in additional to the qualified purchaser requirement, the fund cannot make a public offering of its securities.  Because almost all hedge funds are offered pursuant to the Regulation D offering rules, this requirement will always be met.

500 or Fewer Investors

Unlike the Section 3(c)(1) exemption which limits the amount of investors in this type of fund, the Section 3(c)(7) exemption does not contain any such limit on the amount of qualified purchasers who can invest in the fund. However, hedge funds are subject to all of the federal securities laws which include the Securities Exchange Act of 1934.  Under the Exchange Act, Section 12(g)(1) provides that a Section 3(c)(7) hedge fund would be required to register under the Exchange Act as a reporting company if the hedge fund had more than $10,000,000 in assets and 500 or more investors.  As 3(c)(7) hedge funds are available only to qualified purchasers, the $10 million in assets would be an easy threshold to meet and this is why 3(c)(7) funds are limited to 499 investors.

While registration under Exchange Act is not as onerous as under the Securities Act of 1933, it is still undesirable for hedge fund managers.  If a hedge fund manager did register under the Exchange Act (which some have chosen to do, although mostly in the non-securities context), the fund would become a “reporting company” and would need to submit certain periodic reports to the SEC.  Because these reports are time consuming and expensive to produce, most 3(c)(7) hedge funds will specifically state that no more than 499 investors may participate in the offering.

Other related articles include:

Please contact us if you have any questions.

Overview of Hedge Fund Investment Advisors

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It is often said that hedge funds are unregistered or lightly regulated investment pools.  While this is correct, there are certain regulations which an investment manager must follow, including certain regulations under the Investment Advisers Act of 1940 (and the securities laws of the hedge fund manager’s state of residence).  These regulations may require a hedge fund manager to be registered as an investment advisor.

Definition

In general terms, an investment advisor is any person (or company) which receives remuneration for providing investment advice to a client.  This will include all hedge fund managers.

Registration or Exemption

While all hedge fund managers will fall within the definition of investment advisor, not all hedge fund managers will need to be registered. An investment advisor will need to be registered with the U.S. Securities and Exchange Commission or with the state securities division if the advisor does not fall within an exemption from the registration provisions.  The exemption may be at the federal level, the state level, or both.  (Please see this article on the Section 203(b)(3) exemption.)

Other Requirements

All investment advisors are fiduciaries and must act in the best interest of their clients.  Investment advisors (whether or not such advisor is registered) will need to adhere to the anti-fraud provision of the Investment Adviser’s Act of 1940.

Other helpful articles on investment advisors include:

Please contact us if you have any questions.

Hedge Fund Performance Fees

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The hedge fund performance fee (also known as the “performance allocation,” the “incentive allocation,” the “incentive fee,” among other aliases), is a periodic fee which is calculated as a percentage of any gains of a hedge fund over a predetermined period of time.

The fee is normally taken on both realized and unrealized gains of the hedge fund.

How often do most managers take the performance fee?

The performance fee can be taken over any predetermined period of time.  For most hedge fund managers, the performance fee is taken on a yearly basis.  However, many managers will take the performance fee on a quarterly basis as well.  Some managers (mostly in the forex and futures arenas) will take a performance fee on a monthly basis.

The manager should consider the characteristics of the hedge fund strategy when determining the appropriate time period to measure performance.  If a manager is a long-term investor holding positions for 12 or more months, then it would not really be appropriate to take a performance fee on a quarterly or monthly basis.  However, for a day trader or a forex manager, who is in and out of multiple positions on a daily basis, it might make sense to have a performance fee period of shorter than one year.

What is the most common performance fee?

The most common performance fee is 20% of the gains of the fund during the performance fee period.  For managers who have shown exceptional returns over a long period of time the performance fees may be as high as 40% or 50%.

For hedge fund-of-funds the performance fee is typically 10%.  Sometimes hedge fund-of-funds will have performance fees as low as 5% and as high as 15%.

What are some of the variations of the performance fee structure?

Some managers will only take performance fees over a hurdle rate, or a minimum return required before the performance fee is taken.  Some managers will have a graduated performance fee structure where the performance fee will increase as the returns to the fund increase.

Also you should note that the hedge fund may not always have a performance fee when there are gains if the gains to not exceed the hedge fund high watermark.

Some other articles you may be interested in:

If you have any questions, please contact us.

Hedge Fund Management Fees

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The hedge fund management fee, or asset management fee, is a periodic fixed fee payable to the hedge fund manager based on the amount of the hedge fund’s assets.

How often do most managers take the asset management fee?

The management fee can be taken during any period of time but most managers will take the management fee either monthly or quarterly.  Some managers may take the fee annually, or semi-annually, but this is much less common.

What is the most common management fee?

Most management fees range from 1% to 2% of assets under management.

The amount of the management fee will differ from manager to manager based on a number of factors including the strategy of the fund.  In theory, the management fee is supposed to cover all of the manager’s expenses and costs such as the manager’s rent, salary for employees, computer equipment, etc.  For certain strategies, the above expenses will be relatively low and for other strategies the expenses will be high.  This should be one of the factors that a manager considers when deciding on the asset management fee.

Another consideration is the historical returns of the fund.  Many of the major blue chip hedge funds will charge a larger management fee (in addition to a larger performance fee), which may be anywhere from 2.5% to 5%.

Hedge fund-of-funds will usually charge a management fee of 0.5% to 1.5%, with a vast majority of managers charging 1%.  For hedge fund-of-funds, I most typically see a quarterly management fee that usually corresponds with the quarterly reports sent to investors.

HFLB note: if a manager is a state-registered investment advisor, the manager may not be able to have a management fee higher than 3%.  Specifically, California has said a California-registered investment advisor cannot have a management fee which exceeds 3%.   Additionally, the manager would probably need to include a disclaimer stating that a 3% management fee is in excess of the industry standard.

Management fees and leverage

Some hedge fund managers utilize leverage in their investment programs and they will want to receive the management fee based on the amount of assets being managed with the leverage as opposed to simply the capital account balances of the limited partners.  Depending on what is provided in the offering documents, this may or may not be the default and managers who wish to receive the higher management fee should discuss this with their hedge fund attorney.

Some other articles you may be interested in:

Please feel free to contact us if you have any questions.