Tag Archives: hedge fund investors

Hedge Fund Registration Quick Facts

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Hedge Fund Transparency Act of 2009 Overview

This article provides an overview of the major provisions of the Hedge Fund Transparency Act of 2009.  There are two major things that the HFTA does: (1) increases regulation of hedge funds under the Investment Company Act and (2) requires hedge funds to adopt anti-money laundering programs.

Changes under the Investment Company Act

The HFTA replaces Section 3(c)(1) of the Investment Company Act  with a new Section 6(a)(6).  Section 3(c)(7) is replaced by new Section 6(a)(6).  These new sections, which are functionally equivalent to Section 3(c)(1) and Section 3(c)(7) respectively, will exempt hedge funds from the mutual fund regulations that are found in the Investment Company Act, provided that the hedge funds comply with the provisions of Section 6(g).

Section 6(g) applies to hedge funds with assets under management (AUM) of $50 million or more.  Those hedge funds which have less than $50 million of AUM will not be subject to Section 6(g).  Section 6(g) requires:

1.  The hedge fund manager to register with the SEC.  (HFLB note: I believe the statute is not clearly written.  It seems that the hedge fund itself would be required to register with the SEC which does not make sense.)

2.  Maintain certain books and records as required by the SEC.  This requirements is likely to look like the current books and records rule of the Investment Advisors Act (Rule 204-2), for more background please see article on Investment Advisor Compliance Information.

3.  Cooperate with the SEC with regard to any request for information or examination.

4.  File the following information with the SEC on a no less than annual basis:

a.  The name and current address of each investor in the fund.

b.  The name and current address of the primary accountant and broker of the fund.

c.  An overview of the fund’s ownership structure.

d.  An overview of the fund’s affiliations, if any, with financial institutions.

e.  A statement of the fund’s terms (i.e. minimum investment).

f.  Other information including the total number of investors and the current value of the fund’s assets.

The SEC is charged with issuing forms and guidance on the implementation of the above.  Such forms and guidance must be issued within 180 days from the enactment of the HFTA.

New AML Requirements

The HFTA requires the Secretary of the Treasury (in consultations with the Chairman of the SEC and the Chairman of the CFTC) to establish AML requirements for hedge funds.  The bill sets aggressive timelines for drafting and implementation of the rules.

Hedge Fund Transparency Act Analysis

In the current politically charged environment it is not surprising that a hedge fund regulation law is being contemplated.  What is interesting, however, is the way that Grassley and Levin have chosen to regulate hedge funds.  The prior hedge fund registration rule, promulgated by the SEC, was enacted under the Investment Advisors Act – in essence requiring hedge fund managers (and not the hedge fund itself) to register as Investment Advisors with the SEC.  The Hedge Fund Transparency Act does not follow this path – instead, it regulates hedge funds under the Investment Company Act by modifying the current exemptions which hedge funds enjoy under the act.  In essence the changes subject hedge funds to a kind of light version of the mutual fund regulations.  In this way Congress is going past previous registration by regulating the hedge fund vehicle, as well as the hedge fund management company through the registration requirement.

While it is no surprise that regulation and registration has reached the hedge fund industry, one aspect of the bill is surprising.  The act would require hedge funds to disclose the names and addresses of each investor in the fund.  These names and addresses would be made available to the general public through an electronic searchable format to be developed by the SEC.  Hedge fund investors are notoriously protective of their privacy and I cannot imagine that there will not be pushback by the hedge fund industry on this point.

Another consequence of investment advisor registration is that hedge fund managers (if not currently regulated by the state in which their business resides) may be subject to certain state investment advisory rules including a “notice” filing requirement.  Depending on the nature of the management company’s business, some employees may need to register as investment advisor representatives at the state level which generally requires an employee to have passed the Series 65 exam.  We will keep you updated on this possibility as we learn more about the HFTA over time.

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Please contact us if you have any questions releted to this post or registering your management company as an investment advisor with the SEC.  Other related posts include:

Hedge Fund Best Practices

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Private Group Promulgates Hedge Fund Best Practices

Under direction from the President’s Working Group on Financial Markets, a private sector group comprised of financial industry professionals and regulators released a finalized set of best practices for hedge funds and hedge fund investors.  Continue reading →

Incubator Hedge Funds

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How to Create an Auditable and Marketable Trackrecord

One of the biggest hurdles that start up hedge fund managers face is the issue of having a marketable track record. Many managers do not have an audited marketable trackrecord for any number of reasons. While it is not strictly necessary to have an audited marketable trackrecord, it will help with the marketing efforts when soliciting investors, especially institutional investors. To solve this problem many start up managers establish incubator hedge funds. Continue reading →

Hedge Fund Predictions for the New Year

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Typically we do not comment non-law related hedge fund news stories.  However, we’d like to point attention to a very good article which opines on the likely trends for the hedge fund industry in 2009.  This article will be good reading for those managers who are starting a hedge fund in 2009.  The following are the takeaways from the article:

– Market neutral strategies to see increased demand
– Trend toward less leverage
– Investors are expected to ask for increased transparency and liquidity
– Short biased funds will be popular
– Commodity programs will become more popular
– Shrinking assets until end of Q2
– Institutional investors expected to dominate investor landscape Continue reading →

How to Invest in a Hedge Fund

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Hedge Fund Investors Guide

Many potential hedge fund investors come to this website for information on how to invest in a hedge fund.  While there are many headlines and resources for hedge fund managers, there are fewer resources out there for hedge fund investors.  This article will provide an overview of how to go about investing in a hedge fund. Continue reading →

Non-Accredited Investors in Hedge Funds

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Many start-up hedge fund managers want to know if their friends and family can invest in the start-up hedge fund.  Most of the time, such friends and family do not fall within the definition of accredited investor under the Regulation D rules. The regulation D rules allow a maximum of 35 non-accredited investors to invest in any single offering.  Because a hedge fund offering is continuous, the limit of 35 non-accredited investors is cumulative.  That means that over the life of the fund there can be no more than 35 non-accredited investors (as opposed to 35 non-accredited investors in the fund at any single point in time). Continue reading →

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:

Hedge Fund UBTI (unrelated business taxable income)

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Hedge fund investors are always cognizant of the potential tax consequences of an investment into a hedge fund.  One of the issues which a hedge fund manager should be aware of is the concept of unrelated business taxable income or UBTI.

What is UBTI and why is it important?

As it relates to a tax-exempt investor in a hedge fund, UBTI is debt financed income derived by the hedge fund which does not relate to the activities of the tax-exempt investor.  As hedge funds are “flow through” vehicles, the designation of income as UBTI flows through the tax-exempt investor.  This is important because the tax-exempt investor must pay tax (called the unrelated business income tax or UBIT) on that portion of the income received by the fund which is UBTI.  UBTI is generally going to be taxed at a 35% rate.
Is there a way to get around UBTI?

There are two ways to make sure that tax-exempt investors do not receive any UBTI.  The first and most obvious is to make sure that the fund will use no leverage.  Because this might not be an option for some hedge funds, and because these funds would like to receive assets from tax-exempt entities, another option is for the fund to create an offshore hedge fund (either through a side by side structure or a master feeder structure).  In these structures that income does not “flow-through” to the investors like with the domestic hedge fund, but rather the income is paid to the investors through a dividend which is generally not taxable to a tax-exempt organization.  Using an offshore structure in this manner is often described as using a “blocker” because the UBTI is blocked out.

Do short sales give rise to UBTI?

Short sales alone do not give rise to UBTI.  The IRS has specifically provided guidance to the hedge fund community on this issue.  Please see Revenue Rule 95-8.  However, if a hedge fund borrowed money to engage in the short sale, this would probably give rise to UBTI.  If the fund utilizes short sales and engages in no leverage activities, then the there will likely be no UBTI with regard to the short sales.

What are the tax code provisions dealing with UBTI?

The following are links to the tax code dealing with UBTI:

Section 511 – provides for a tax on UBTI

Section 512 – defines UBTI and provides for the pass through treatment of UBTI to tax-exmpt investors in a fund (see 512(c))

Section 513 – provides a definition for “unrelated trade or business.”

Section 514 – provides additional definitional support for determining the amount of UBTI under section 512.

Question: hedge fund investor and qualification requirements

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Question: I wanted to inquire as to legalities for a new hedge fund formation. My question is can I get by the limit of 500 investors and qualification requirements. I mean is there another type of fund to start with same freedom and lack of regulation with breadth of trading types, but that can accept investors with net worth under $250,000…and more than 500 of them?

Answer: Let’s break down your question first:

“…can I get by the limit of 499 investors and qualification requirements”

A little preliminary background on hedge fund laws may be helpful. Hedge funds are investment vehicles which, by definition, would be subject to the registration requirements of the federal Investment Company Act of 1940. This means that, absent an exemption from registration, these funds would need to be regulated as mutual funds under the ICA. Many funds do not want to be registered as such because the regulations under the ICA are extremely onerous.

Luckily, the ICA contains two different exemptions for hedge funds – the Section 3(c)(1) exemption and the Section 3(c)(7) exemption. Under the 3(c)(1) exemption a hedge fund manager can accept investments from up to 99 outside investors. Generally these investors will need to be “accredited investors” and may also need to be “qualified clients” (these requirements come from other federal securies acts, and state laws, as appropriate). Under the 3(c)(7) exemption, a hedge fund manager can accept investments from an unlimited amount of “qualified purchasers.” A “qualified purchaser” is a very high net worth individual or institution (generally those persons who own $5 million in “investable” assets, which does not include a person residence). Because of other federal rules, a 3(c)(7) fund will often limit the amount of qualified purchaser investors to 500. Because many beginning hedge fund managers do not have a rolodex filled with “qualified purchaser” contacts, many of these start-up managers will initially begin a 3(c)(1) fund.

To your question, assuming you run a 3(c)(7) fund, you can “get by” the 499 investor limit but you would be subject to other federal laws. The 499 investor limit is in place because of the Securities Exchange Act of 1934 (“34 Act”). While most hedge funds do not need to register their securities because of the private offering exemption (Regulation D) under the Secutities Act of 1933, the hedge fund would still potentially be subject to registration under the 34 Act. The 34 Act requires an issuer (the hedge fund) to register its securities if (1) it has $10 million or more in total assets as of the end of a fiscal year and (2) has a class of equity interests which are owned by 500 or more persons. Generally a 3(c)(7) fund will have no problem meeting the first requirement and therefore the limit to 499 investors keeps such a fund from the registration provisions of the 34 Act.

So the answer to the first part of the question is yes – if you want to register your fund under the 1934 Act.

The second part of the question is no – unless you want to register under the ICA.

The next question you asked was:

I mean is there another type of fund to start with same freedom and lack of regulation with breadth of trading types, but that can accept investors with net worth under $250,000…and more than 500 of them?

Yes, you can start a registered fund – either (1) a mutual fund or (2) a fund registered under the 1933 Act. As noted above mutual funds are very highly regulated and a hedge fund manager probably does not want to start a mutual fund. The considerations involved in starting a mutual fund are considerable, and the legal costs to establish a mutual fund will be anywhere from about $50,000 to $150,000, whereas the legal costs to establish a hedge fund will be anywhere from $15,000 – $45,000 depending on the strategy. When establishing a mutual fund there are other considerations such as distribution and administration which can quickly escalate all costs.

If you only trade forex and certain types of futures, you may be able to do a registered fund (under the 1933 Act), but that is a longer and more expensive process than a traditional hedge fund. The legal costs to establish a fund registered under the 1933 act will be similar to the costs to establish the mutual fund. Additionally, the distribution and administration costs will need to be considered.

Please feel free to email any hedge fund questions you have through our contacts page. I will attempt to answer all questions and may post yours on this site.