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What expenses does a hedge fund pay for?

Question: What costs does a hedge fund pay for and what costs does the hedge fund management company pay for?

Answer: This is another very common question. Most hedge fund offering documents provide a boilerplate approach for splitting costs between the hedge fund and the management company. The general rule of thumb is that any cost which is directly associated with the fund’s investment activities (e.g. brokerage costs) will be paid for by the hedge fund. Any cost which is directly associated with the management company’s operations or overhead (e.g. salaries) will be paid for by the management company.

There are some costs which, arguably, could go either way – one such item is a Bloomberg terminal. A Bloomberg terminal could arguably be an expense of the management company (a Bloomberg is an informational tool similar to magazines and other information that a manager must use to shape its decision-making process) or of the hedge fund (information from the Bloomberg is directly attributable to investment decisions which are made). I do not have a bias as to which entity should pay these fees; however, a hedge fund manager with a smaller asset base that pays for the Bloomberg out of the fund must beware of the effect of Bloomberg’s costs on the fund’s performance.

Hedge Fund Expenses

hedge fund management fee
hedge fund performance allocation
offering and other start-up related expenses (often the management company will pay these expenses)
the administrator’s fees and expenses
accounting and tax preparation expenses
auditing
all investment expenses (such as brokerage commissions, expenses related to short sales, clearing and settlement charges, bank service fees, spreads, interest expenses, borrowing charges, short dividends, custodial expenses and other investment expenses)
costs and expenses of entering into and utilizing credit facilities and structured notes, swaps, or derivative instruments
quotation and news services (Bloomberg, NASDAQ) (or can be a management company expense)
ongoing sales and administrative expenses (e.g. printing)
legal and fees and expenses related to the fund (include Blue Sky filing fees)
optional: professional fees (including, without limitation, expenses of consultants and experts) relating to investments
optional: the management company’s legal expenses in relation to the Partnership
optional: advisory board fees and expenses
optional: reasonable out-of-pocket expenses of the management company (such as travel expenses related to due diligence investigations of existing and prospective investments)
other expenses associated with the operation of the hedge fund, including any extraordinary expenses (such as litigation and indemnification)

Hedge Fund Management Company Expenses

offering and other start-up related expenses (often the fund will pay these expenses)
salaries, benefits and other related compensation of the management company’s employees
rent
maintenance of its books and records
fixed expenses
telephones
computers
general purpose office equipment

While the above list of expenses is fairly standard, please remember that these expenses can be switched around to a certain extent. If you are a hedge fund manager, you should discuss with your attorney how the expenses are split between the hedge fund and the management company.

Should a start-up hedge fund have an audit?

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Question: Should a start-up hedge fund have an audit?

Answer: This is a question which we will get very often for funds that aim to launch on July 1 or later. While there is generally no legal requirement for a hedge fund to have their performance results audited, a vast majority of hedge funds have their returns audited because it will aid in the marketing efforts by lending credibility to performance results.

With regard to this question, and as with most business-issue oriented hedge fund questions, the answer is going to depend on the manager’s program and what the manager plans to accomplish during the first 6, 12 and 18 months of operations.

Generally, first year hedge fund manager’s are going to need to focus on costs. Not only from a cash flow perspective, but also from a return perspective. Any costs (which the fund bears) affect performance. Accordingly, many start-up hedge fund managers may forgo an audit of the fund’s track record during the first year. The manager then may have the fund audited after the end of the fund’s second year. A manager might consider doing this in a couple of situations. The first situation is when the fund starts trading during mid-year or later. In this instance it will probably not make a lot of sense to have an audit for fund operations of less than one year. An exception to this generality is if you have a decent amount of AUM and you are looking to begin courting institutional investors. If this is the case, then it will generally be a good idea to have an audit.

The second situation when a start-up hedge fund manager might not choose to have an audit after the first year is if the manager has a longer term hedge fund incubation program. This might be the case if the hedge fund manager has a longer term trading strategy (buy and hold) or when the manager does not plan to seek institutional money during the second year. Many managers will go with this slow and steady approach to asset raising in order to understand the back end operations of their fund. As noted in numerous places, one of the main reasons why hedge funds fail is inadequate back office operations.

If a start-up hedge fund manager plans to start with a larger asset base, say $10 million or more, and plans to aggressively court the institutional market during the first half of the coming year, then it might be wise to think about an audit. While the decision to forgo a first year audit is strictly a business decision, it is recommended that you discuss this decision with both your legal team and your potential auditor. Additionally, if you will be using the services of a third party marketer, you will want to discuss this decision with the third party marketer.

Distressed debt hedge fund closes doors

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I previously wrote an article about distressed debt hedge funds and the popularity of such funds as they try to get in for a deal. However, the considerable amount of media attention which has been focused on this sector of the market has spooked investors enough to get them moving on redemption day. FINaltenatives is reporting that a fairly large hedge fund managed by Turnberry Capital Management is completely closing its doors. It is at least somewhat surprising that a group this large (the fund reportedly ran up to $800 million at one point) would close its doors immediately instead of trying to wind the fund down over the course of a couple redemption dates.

A few reasons why they might want to wind down the fund over a period of time may include: (1) the fund offering documents did not include a hedge fund gate provision, (2) the manager no longer thought the fund’s strategy was viable with such a severely reduced asset base or (3) the manager thought that he could get the best prices on the assets if he sold them in a large bundle instead of piece meal over time. The article also stated the manager is planning to start a corporate bond fund, which is another reason the manager decided to wind the fund down immediately.

What is most interesting about this event is the disconnect between the strategies managers wish to pursue and the strategies that the investing masses are willing to (remain) invest(ed) in.

The article is at http://www.finalternatives.com/node/5251.

How to register as a CPO or a CTA

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Many hedge fund managers choose to utilize futures and/or commodities in their trading purposes. Generally such managers will need to register as commodity pool operators (“CPO”) and as commodity trading advisors (“CTA”). The hedge fund itself will be deemed to be a commodity pool. For purposes of the Commodities Exchange Act (“CEA”), a future and commodity are functionally equal as it relates to hedge fund manager registration. Registration as a CPO or a CTA is an often overlooked part of the hedge fund formation process. Your attorney should discuss the requirements for registration and whether any exemptions from registration are available.

In addition to hedge fund managers, retail foreign exchange (“Forex”) managers may very soon be required to register because of the recently passed “Farm Bill.” The retail Forex markets have been very loosely regulated and the CFTC and NFA have been clamoring for authority to regulate this are of the markets. Accordingly, this article will give you the basics on how to register as a CPO and/or a CTA.

A very general outline of the CPO registration process is as follows:

Prerequisite – the Series 3 exam

Each CPO or CTA firm will need to have at least one Associated Person (AP). Generally an AP will be anyone in the firm who has contact with clients in something more than a purely administrative or clerical role. All managers and non-clerical employees will be APs. All APs must have passed the Series 3 exam. Information on the Series 3 exam:

Series 3 (National Commodity Futures Examination)
Cost: $95
Number of Questions: 120 True/False and Multiple Choice
Subject Matter: (part 1) Market knowledge and (part 2) U.S. regulations
Time: 2 hours 30 minutes
Passing Score: 70% for each part

Like the Series 65 exam, I highly recommend you spend plenty of time studying for the exam. If you would like some suggestions on various study guides, please let me know.

Filing the application forms with the NFA

During this process your compliance professional will: gain access to the NFA’s registration system on your behalf, input certain basic information on the Form 7-R (for your CPO/CTA firm) and Form 8-R (for the initial AP) – generally you will provide this information to your compliance professional prior to completing these forms, and submit the 7-R and 8-R on your firms behalf.

After the Form 7-R and 8-R have been submitted you will need to pay for registration ($200 registration fee for the CPO or CTA; $85 for each associated person or principal; $750 for NFA membership (this is an annual fee)). After payment has been submitted, the NFA will review your application. Typically registration should be complete within about 3-5 weeks. The next step will be to have your disclosure document approved by the NFA – your compliance professional can help you with this process.

You will be able to check on your registration through the NFA’s BASIC system.

Definitions

According to the CFTC website, the definition of CPO and CTA are as follows:

Commodity Pool Operator (CPO): A person engaged in a business similar to an investment trust or a syndicate and who solicits or accepts funds, securities, or property for the purpose of trading commodity futures contracts or commodity options. The commodity pool operator either itself makes trading decisions on behalf of the pool or engages a commodity trading advisor to do so.

Commodity Trading Advisor (CTA): A person who, for pay, regularly engages in the business of advising others as to the value of commodity futures or options or the advisability of trading in commodity futures or options, or issues analyses or reports concerning commodity futures or options.

Associated Person (AP): An individual who solicits or accepts (other than in a clerical capacity) orders, discretionary accounts, or participation in a commodity pool, or supervises any individual so engaged, on behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a commodity pool operator, or an agricultural trade option merchant.

Hedge fund bank account questions

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Question: Do I need to open a bank account for the management company and/or the hedge fund? How do I open a brokerage account for my fund?

Answer: This is a question I will get at least once per week. First, you will need to establish a bank account for the management company. You will need a bank account at the management company level to pay for expenses related to the management company and, maybe more importantly, to receive the management fees (and later performance fees or performance allocations).

To open a bank account for the management company, you will need to complete an account opening application which will request certain identifying information for the entity. The application will also require supporting documentation. You should be prepared to bring the following items to the bank: (1) the management company’s formation documents from the state department of corporations and (2) your taxpayer identification number (“EIN” or “TIN”). Additionally, some banks may have additional requirements; such banks might require you to produce a resolution authorizing the opening of the bank account, or the governing legal documents (LLC operating agreement or corporate bylaws), or even a certificate to do business from the state or city. If you have any questions on what your bank might require, it would be a good idea to call your branch to find out what documentation you will need to bring.

Whether you will need to open a bank account for the hedge fund itself is not so straight-forward. My general advice would be yes – but other lawyers are of the opinion that the fewer bank accounts (and less paperwork) the better. I feel like it is always good to have a bank account in case it is ever required (by a prime broker or otherwise). Additionally, the fund will be able to start establishing a relationship with the bank as well – this might prove helpful later on if the fund wants to later utilize a credit facility.

Whether you need a bank account will also depend on your prime broker. Some prime brokers only allow wires to the fund’s brokerage account to come from a “same name” account. These brokers will also require that outgoing wires be deposited in a “same name” account. Effectively this means that the fund would need to have a separate bank account which investors would wire funds into – the manager would then wire the funds to the brokerage account. Of course, there may be wire fees associated with such transfers and this is an issue that the hedge fund manager should be aware of – many times the investor will pay the wire fees.

Establishing a bank account for the fund should be a similar process to establishing a bank account for the management company.

Question: Does it matter which bank that I use?

Answer: No. It is perfectly acceptable for you to establish the accounts at your local bank.

One item of consideration will be the fees that are charged. Generally you should be able to establish bank accounts that won’t charge monthly fees. However, some larger funds may need to access the services of a larger bank which, in many cases, charge a monthly fee. Also, be aware that if you are going to establish an offshore fund (usually in the Caymans or BVI), you are probably going to be hit with monthly fees. In addition to monthly fees, a manager should also be aware of wire fees and other transaction costs.

Hedge Fund IT Provider (press release)

CFTC Announces Formation of Retail Foreign Currency Fraud Enforcement Task Force

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Washington, DC— The Commodity Futures Trading Commission (CFTC) has formed a special task force charged with investigating and litigating fraud in the off-exchange retail foreign currency (forex) market.

The creation of the task force within the Division of Enforcement comes in the wake of Congress’ passage in June 2008 of “The Food, Conservation, and Energy Act of 2008” that clarified and strengthened the CFTC’s jurisdiction over this market. The task force will focus on fraud in the retail forex market and will work cooperatively with other federal and state regulatory and criminal authorities.

“The formation of the CFTC’s new Forex Enforcement Task Force reaffirms our agency’s commitment to stopping unscrupulous individuals working in this space. Not only do forex fraudsters prey upon unsuspecting citizens, but their illegal activities taint the reputations of those working honestly in the futures industry,” said CFTC Commissioner Michael Dunn, head of the agency’s Forex Education and Outreach Task Force. “This announcement sends a clear signal that the CFTC is on the beat, and that our continued and increased cooperation with law enforcement authorities will help put these forex dealers where they belong – in jail.”

“Forex fraud impacts investors of all stripes,” CFTC Acting Director of Enforcement Stephen J. Obie said. “With the creation of the retail forex task force, the CFTC has committed the resources necessary to expand its efforts to identify and prosecute those who commit fraud in the retail forex market.”

Since enactment of the Commodity Futures Modernization Act in 2000, the CFTC has filed nearly 100 enforcement actions against firms and individuals selling illegal forex futures and option contracts. To date, the CFTC has obtained judgments in these enforcement actions for civil monetary penalties of approximately $560 million and restitution of investor losses totaling $450 million.

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.

Hedge fund seeder invests in ABL hedge fund

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