Questions and discussions from Hedge Fund Law Blog readers

I get quite a few questions from readers and usually I am able to answer these questions via email within a couple of days.  If you have any questions, comments or simply want more information on starting a hedge fund, please feel free to contact us.  We also will take requests for blog posts on certain issues and we also will publish articles (with all appropriate recognition and links) by guest authors.  [Note: any grammatical errors in the original messages have not been corrected.]

Message 1

Im in the early stages of fund start up and was wondering if I can have my “non accredited” friends and family set up their own corporation that would invest directly into my fund. Would it be counted as a single entity or would it be counted individually? Could I charge a performance fee if its over $1.5MM?

Response 1

This is a common issue which comes up for many start up hedge funds and unfortunately, it is not a very good structure.  First, by forming another entity, which would itself be deemed to be a 3(c)(1) funds, you would implicate both the Investment Company Act as well as the Securities Act.  This means that all of the offering documents you have prepared for the hedge fund would also need to be prepared for the new entity.  Additionally, there would likely be look through issues [HFLB: a topic we will discuss in greater detail soon] so that your fund would need to count the owners of the corporation as investors as well.  Finally, this may or may not get around the qualified client issues – however, the performance fee rules are oftentimes state specific and there are some states which have more lenient rules.

To go into further detail, I would need to know the specific facts of your situation…

Message 2

How about discussing gates as a way of locking up capitol? I’ve been hearing a lot about using a gate to add to a lockup to protect the manager during the execution of his strategy.

Im getting into the small cap arena, and while taking out start ups, we usually need a minimum of 6-18 months. I did find people dont like to hear 18 month lock up in this environment.

Response 2

The hedge fund gate provision is an effective way of locking up capital.  Like any hedge fund provision, the gate is a customizable and is traditionally based on the liquidity structure of the hedge fund’s investment program.  The hedge fund gate is decided upon by the hedge fund manager and incorporated into the hedge fund offering documents.

Prior to this year many hedge fund investors did not know what a gate provision was, those investors that did know usually did not pay very much attention to the provision.  However, many investors who had requested withdrawals are seeing the gate provision imposed and these investors are generally not too happy to understand that they may not see their money for quite a long time.

The big issue for managers going forward is going to be what provisions will be palatable to potential investors.  This is obviously a business issue which will need to be worked out on the manager’s side – the hedge fund attorney can provide advice, but the manager is the one who will be selling the program to investors.  It is my personal feeling that long lock-up periods and low gate thresholds are likely to be used in rare circumstances.  One of those circumstances could very well be a small cap investment program in which the securities are more illiquid.

Message 3

I would like to know what the registration requirements are for a 3PM who is affiliated with a BD in a different state, and marketing only to Foundations, Endowments, Pensions, and other institutional entities.

Thank you.

Response 3

The answer to your question will depend generally on the state laws where the broker-dealer (BD) representative (the 3PM) resides.  In general the representative will probably be deemed to be doing business in the state in which he resides if he regularly (or even occasionally) meets with clients at a place within the state (a home office would count).  In most instances the BD would thus need to be registered in the state where the representative resides and the representative would generally need to be registered with the state as well.  Like you mentioned below, there may be some state specific exemptions available if the only clients being solicited are institutional investors – this is an issue we would need to research based on the facts of your situation.    …

Message 4

My name is [redacted] and currently I work in a Private Equity firm in the accouting and tax department.  My brother is currently enrolled at college and is getting International Finance and Accounting with minor in Economics and will graduate in 2012.

The reason that I wanted to email you is, we have been talking about starting a hedge fund once he finishes school.  We have been trading together for about a year now with decent returns for the turmoil in the markets.

In the next year I plan on sitting and hopefully obtaining my CPA and level one of the CFA license.  Also if I have time to study I want to get my Series 65 exam.

Over the next three years what should we do both he and I to get ready to start the hedge fund.  i know this is a ways away and things are going to be different but what should we do to get ready?

Thanks for all your help
[redacted]

Response 4

First, I think it is commendable that you are planning well in advance of your anticipated launch date.  During these next few years you are undoubtedly going to learn much about the hedge fund industry and the financial markets.  At this point you should be trying to absorb all potential pieces of wisdom that you can – understanding how markets work in bear markets and volatile markets will serve you well and give you the background knowledge to answer the pointed questions about your investment program from potential investors you are likely to get in pitch meetings.

I think that obtaining your CPA, as well as the CFA license are good goals; these designations are looked at with high regard.  I would not worry about the series 65 at this point in time.  If you need to take it in a couple of years for regulatory reasons then you should worry about it then.  Focus now on the CPA and the CFA which are much more important designations.

With regard to your brother, he may want to intern at a hedge fund during one of his summers.  Even if he works for no pay, the experience and resume building aspects of the position will be invaluable moving forward.  You should also continue to build a track record with your combined account, but if you start managing outside money, you will need to seek the advice of a hedge fund attorney.

I would also keep up to date with current events in the hedge fund industry and I can think of no better place for that then the Hedge Fund Law Blog (shameless self promotion).

I hope this helps.  Good luck and keep in touch.