Tag Archives: hedge fund manager

Hedge Fund Capital – How to Raise Assets for a Hedge Fund

The biggest issue for start up hedge funds (and also established hedge fund managers) is how to grow assets under management. Growing a hedge fund’s capital base is very important because increased AUM mean both increased management fees and performance fees (assuming the fund has positive performance returns). This article focuses on traditional avenues of raising capital for a hedge fund.

Raising Hedge Fund Capital – Friends and Family

Most hedge funds raise capital to start up through their friends and families. Often this can be a significant sum, other times it can be relatively small. I have seen some hedge funds start with as little as $500,000 and sometimes less. Often, after a hedge fund has a few months of performance (assuming again positive performance) these friends and family members will invest more money. Other friends and family members, who did not originally invest, may also decided to invest. Family members of investors may also be persuaded to invest in the hedge fund.

Generally investments from friends and family are completed fairly quickly and through less formal conversations than from other types of investors. However, the hedge fund manager must always make sure that the friends and family have the fund’s offering documents and have made the appropriate representations in the subscription documents.

After an initial investment from friends and family, it is important for a start up manager to focus on the trading as it is most important to have a good 6-12 month track record that you will be able to market to other potential investors.

Raising Hedge Fund Capital – High Net Worth Individual Investors

High net worth investors (generally qualified purchasers as well as some qualified clients and accredited investors) often invest in hedge funds. High net worth investors will usually have legal and investing teams which will vet the managers and the strategy. Usually there will at least be a minimum amount of due diligence requests on the manager and the fund. Managers can be introduced to high net worth investors through their own networks or through other channels such as hedge fund conferences, hedge fund databases or through other means.

Raising Hedge Fund Capital – Institutional Investors

Institutional investors will occasionally invest in hedge funds with a track record shorter than one year. Generally in these cases the hedge fund sticks out to them for various reasons. Such reasons might be that the hedge fund performance was just spectacular, or the institutional investor likes the way the particular investment strategy fits within the institution’s allocation design, or the hedge fund manager may have a strong pedigree which appeals to the institutional investor.

Whatever the reason, getting an investment from an institutional investors is usually a longer and more in depth process than receiving money from friends and family or from a high net worth investor. The hedge fund manager will need to first establish a meeting with the institutional investor. Generally the meeting will be at the office of the institution and the manager will have a certain amount of time to give his pitch, usually through a pitchbook presentation. Some managers of the institution will look carefully at these presentations; others will not even open the cover. However, the hedge fund manager should be ready to answer any number of different questions from the institution regarding the program. Such questions will likely cover the following topics: risk management procedures, expected performance in down markets, performance analytics, etc. The hedge fund manager should act composed and answer each question directly and completely – this is the time for the manager to show his knowledge of the investment strategy and sell the strategy to others.

Either before or after the meeting with the institution, the hedge fund manager will likely be asked to complete some basic due diligence. I’ve outlined a sample request in this article: Institutional Hedge Fund Due Diligence. After the institution has interviewed and vetted a manager it may take some time before the institution actually invests in the fund. This happens for a variety of reasons and the hedge fund manager is urged to stay patient during the process.

Non-tradtional forms of raising hedge fund capital

I will be discussing other ways to raise capital in subsequent articles. Such non-traditional ways include: utilizing the services of a third party marketer, capital introduction services, hedge fund conferences, and hedge fund databases.

Legal Implications of Raising Capital for a Hedge Fund

As most hedge fund managers know, under the Regulation D offering rules managers cannot raise capital through any type of general advertising or solicitation. This means that they cannot: buy advertising in any financial publications, advertise generally on the internet (but please see article on Hedge Fund Websites), cold call potential investors and or engage in other similar activities. Additionally, hedge fund managers, and others raising money for hedge funds, must be aware of and abide by all broker-dealer regulations. This is a very important issue, so please discuss it with your hedge fund attorney (please see Guide to Broker-Dealer Registration).

Please contact us if you have a story on raising capital for you hedge fund – we would like to hear your story and potentially profile your fund on our blog. Other articles which are related to items in this article include:

Hedge Fund Manager – Information on Hedge Fund Managers

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I have seen many hedge fund managers and, like the investment strategies they pursue, each one is different. This article will attempt to discuss hedge fund managers in general, if you have any specific questions, please feel free to contact us.

Who are hedge fund managers?

In general hedge fund managers are people who have a strong conviction about their certain investment program and who are willing to put their money where their mouth is so to speak. At any given time there are any number of different ways to make money and because of this we have a chance to see all types of hedge fund managers, even those who go against conventional wisdom.

What types of backgrounds do hedge fund managers have?

I have seen all types of hedge fund managers. Many were traders at other investment advisory firms or were brokers at a broker or investment bank. Many managers were previously employed outside of the financial industry and traded for themselves on the side – managers like this have often found a program that works and want to allow their friends, family and other investors participate in the investment program and potential gains. Some hedge fund managers were involved in real estate and choose to run a real estate hedge fund or some sort of hybrid hedge fund. Some managers have relatively less experience in managing money and will act as a kind of sponsor of the hedge fund – participating in the business aspects of the hedge fund like raising assets.

Most all hedge fund managers will have at least a college degree. Many hedge fund managers, and analysts, will also have a Masters in Business Administration (MBA). Some hedge fund managers will be former professionals such as doctors or lawyers. It is also common to see a manager with a third party designation like a Chartered Financial Analyst (CFA) which is bestowed by the CFA Institute.

Are there any exam or qualification requirements to be a hedge fund manager?

There are no specific requirements to be a hedge fund manager, but depending on the domicile of the manager he may need to be registered as an investment advisor with the state securities commission or the SEC. If a manager was required to be registered as an investment advisor, he would likely need to have the Series 65 exam license or the Series 7 and Series 66. Depending on the nature of the hedge fund and the extent of the hedge fund’s activities, the manager may need to have the Series 7 and the fund, or a related company, would need to be registered as a broker-dealer.

Is there anything hedge fund managers cannot do?

Generally a hedge fund manager can mold his investment program as he sees fit. However there are two specific items to note. First, the manager should be careful when trading that he stays within the description of the trading program. Especially in these very volatile times, investors are very aware of style drift and managers should be very cognizant of this.

Second, the hedge fund manager cannot violate any laws while trading. The federal securities laws apply to hedge fund managers who are not registered as investment advisers in certain instances. In addition to out and out fraud, the manager should not engage in any activities which he is not sure is legal. If there are any questions, the hedge fund manager should consult a hedge fund attorney.

What are the common qualities of hedge fund managers?

The number one commonality between hedge fund managers is a desire to see their program and ideas come to fruition. Another trait which is common to hedge fund managers is a very strong work ethic.

What about pedigree?

You will often hear advisors and consultants talk about pedigree, especially hedge fund marketers. To these groups the term “pedigree” essentially means the strength of the manager’s bio. A manager who went to Harvard undergrad, Harvard MBA and then worked for Goldman Sachs will have a strong pedigree. It is generally going to be easier for a manager with a strong pedigree to get his foot in the door with regard to institutions and high net worth investors.

However, having a strong pedigree does not guarantee a hedge fund manager will be able to sell his hedge fund to investors. Indeed, I have seen firsthand instances where a manager with a strong pedigree did very poorly in front of institutional investors. Likewise, I have seen where a manager with a less strong pedigree shot the lights out during an institutional investor presentation. All this is to say that while pedigree is important in the eyes of some, it will not necessarily help a hedge fund manager to raise assets and of course, once a manager has assets, the manager must perform.

Start up hedge fund managers

If you are a start up hedge fund manager, you will first need to discuss the hedge fund formation process with a hedge fund attorney. Some other articles which provide background on many of the subjects covered in this article include:

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.

Hedge Fund IRA Investments

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Individual retirement account (IRA) investments into hedge funds are increasing rapidly. Below are some common questions hedge fund managers have about potential investments by IRAs.

Can an IRA invest in a hedge fund?

Generally yes, however the IRA and the hedge fund must make sure to follow certain regulations which a manager should discuss with a hedge fund attorney. A manager should not accept IRA investments into the hedge fund without first discussing this with his lawyer.

How does an IRA actually make the investment into the hedge fund?

Each IRA investment into the hedge fund needs to be made by the custodian of the IRA. That is, the beneficial owner of the IRA cannot simply take the money out of his IRA account and then place the money in the hedge fund – this would be deemed to be a withdrawal from the IRA and would be subject to very negative tax consequences.

In order to avoid these negative tax consequences the custodian needs to directly transfer the IRA assets to the hedge fund. Typically this is done through a self directed IRA account at a brokerage firm. Many brokerage firms do not have these self directed programs in place. If the brokerage firm does not have such a program in place the beneficial owner of the IRA would need to transfer the IRA to another custodian which does. Our law firm has worked with many custodians who have these programs and we can make recommendations.

Each custodian has different requirements for an investment into a hedge fund from an IRA. Typically the hedge fund manager is going to need to fill out a few pages of paperwork with the custodian and provide custodian with the fund’s offering documents. After the custodian’s compliance department has reviewed the paperwork, the custodian will be able to make the investment into the fund on behalf of the IRA. During this process the hedge fund manager is going to be spending time talking with the custodian and the compliance department. Additionally the law firm may need to be involved with the process as well; however, this is usually to a much lesser extent.

Are there any other issues with IRA investments into hedge funds?

Yes. There are many issues which a hedge fund manager should be aware of which include the following:

1. The manager should be sure that the hedge fund and the management company do not engage in any prohibited transactions with respect to the fund and the IRA. [More on this in a later article.]

2. The manager should make sure that if it uses any sort of leverage that such activities are clearly discussed in the fund’s offering documents. In certain circumstances where there is leverage, an IRA could be subject to tax on its unrelated business taxable income or UBTI.

3. The manager should make sure that the fund does not stray from its investment program. IRA are not allowed to make certain investments like investments in life insurance policies (life settlements).
As noted in an earlier article on hedge funds and ERISA, while IRAs are not specifically ERISA assets, they do count towards the 25% threshold and thus the manager needs to be aware of the amount of IRA and other ERISA assets in the hedge fund.

HFLB Note

Because of the gravity of the tax consequences to potential IRA investors, please contact your hedge fund attorney or accountant if you have specific questions about IRA investments into your fund. Additionally, savvy hedge fund investors will usually want to make sure that their own tax advisors have reviewed the hedge fund offering documents before investing in the fund.

Please contact us if you have any questions on the above. Also, please read our disclaimer with regard to discussions about tax items.

Hedge Fund Due Diligence 2.0

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We hear about the “web 2.0” and today’s San Francisco Chronicle used the term “Wall Street 2.0” which made me wonder what the hedge fund industry will look like after this mess clears itself over the next couple of months. First, it is obvious that there is going to be government regulation of some sort over the hedge fund industry which I will be detailing over the coming weeks and months. Additionally, investors are going to need to take proactive steps to protect their investments and hedge fund due diligence will become a greater part of the hedge fund industry – I’m dubbing this “Hedge Fund Due Diligence 2.0”.

Hedge Fund Due Diligence 2.0 is likely to include more questions on the hedge fund manager’s business acumen and operations. The current crisis has showed us, in numerous circumstances, that hedge fund managers were simply not prepared to handle a complete market crisis. Hedge fund managers already have to answer in depth questions relating to risk management policies and procedures, but these questions will likely become more in depth. Specifically, Hedge Fund Due Diligence 2.0 will likely inquire into a manager’s specific cash management policies. While this might be viewed as digging into the manager’s operational business (as opposed to just the managers performance results), it is necessary to protect an investor’s investment in the event that a high watermark provision is implicated.

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 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.

What is a qualified client? Qualified client definition

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UPDATE: the below article is based on the old “qualified client” definition. The new “qualified client” definition can be found in full here, and the SEC order increase the asset thresholds can be found here. As a gross summary, the new definition of a qualified client is:

entity or natural person with at least $1,000,000 under management of the advisor, OR
entity or natural person who has a net worth of more than $2,100,000

For the second test above, natural persons exclude the value of (and debt with respect to) their primary residence (assuming the primary residence is not under water).

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Certain hedge fund managers need to be registered as investment advisors with the SEC or with the state securities commission of the state which they reside in. For SEC-registered investment advisors, and most state registered advisors, the investors in their hedge fund will need to be “qualified clients” in addition to the requirement that such investors are also accredited investors. While many accredited investors will also be qualified clients, this might not always be the case because the qualified client defintion requires a higher net worth than the accredited investor definition. Hedge fund managers who are required to have investors who are both accredited investors and qualified clients cannot charge performance fees to those investors who do not meet the qualified client definition. Individual investors will generally need to have a $1.5 million net worth in order to be considered a “qualified client.”

The definition of “qualified client” comes from rules promulgated by the SEC under the Investment Advisors Act of 1940, specifically Rule 205-3. That rule provides:

The term qualified client means:

1. A natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser;

2. A natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:

a. Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into; or

b. Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the contract is entered into; or

3. A natural person who immediately prior to entering into the contract is:

a. An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or

b. An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months.

Hedge Fund Websites – How to Run a Hedge Fund Website

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A common question from start-up hedge fund managers is what kind of a website can I have and how do I go about getting investors through an internet solicitation? The unfortunate answer is that hedge fund managers must be very careful when they are designing their website. In general, websites for a hedge fund or a hedge fund manager need to be very low key and potentially password protected. This is especially important in the current regulatory enviornment because securities officials, at both the federal and state level, are becoming more and more vigilant about enforcing the website solicitation rules. This article will briefly detail the legal background and some website best practices.

Regulation D – no “public offering”

Most hedge funds are offered to investors through a Regulation D private placement offering. One of the requirements of the Reg. D offering is that the sale of securities (interests in the hedge fund) is not done through a “public offering.” While there is no exact definition of “public offering,” it will generally mean that the hedge fund is not allowed to offer or sell interests through general solicitation or general advertising. According to the SEC, the analysis can be broken down into two main questions: (i) is a communication a general solicitation or advertisement, and, if so, (ii) is it being used to offer or sell securities? If the answer to either of these questions is negative, the fund is not in violation of public offering rules.

Regulation D – the “pre-existing” relationship

If a private placement is offered to potential investors with whom the hedge fund manager has no pre-existing relationship, the SEC may conclude that there was a general solicitation in violation of the Reg D rules.

Frequently, an issuer can satisfy the pre-existing relationship requirement through prior investment or other business dealings with the potential purchaser. The pre-existing relationship generally involves at least some degree of contact between the issuer and the prospective purchaser prior to the offering – generally 30 days from a “first contact.”

[HFLB note: there are a couple of very important no-action letters on this subject. I will be posting these in the next couple of days.]

Website Best Practices

We will generally recommend that all web presence be minimized. The two most important principles with regard to web presence and web communications are (1) do not name the hedge fund and (2) do not personally, or by fiat, write that you manage a hedge fund. Besides those two overriding items, we recommend that the web presence is minimal at all times. However, we are aware that from a business standpoint, the manager would like to have a web presence.

There are five important parts to a hedge fund website:

The Splash Page

The hedge fund manager should have an initial “splash page” which might include the name of the management company (do not say you are an “investment advisor” unless registered as such in your state of residence or with the SEC). The splash page should include very minimal information.

Note: you should not include your phone number or contact information on this splash page.

Registration Page

This page should have questions to determine if a viewer is qualified to be viewing the fund’s information over the internet. Generally this will include the accredited investor qualifications; it may also mean that the qualified client qualifications are also included.

This page will be for viewers who are either currently invested in your fund or who have met the qualifications of registration.

Password protected content

All identifying information of the fund and management company should be password protected. You should never post the fund’s offering documents on the internet unless there are stringent controls in place to make sure that the offering documents can only be viewed by the one investor they are intended for – even if there are these stringent controls, we would normally recommend against this practice.

General disclaimer

The site should have a general disclaimer which should be prepared by an attorney. Additionally, all performance information within the password protected portion of your website should have all appropriate disclaimers.

Note: it is recommended that once you have an almost final draft of the website, you should have your lawyer review before it goes live.

Legal Developments and Conclusion

The regulators are very sensitve about website solicitations. For example,the State of Massachusetts is trying to fine activist hedge fund manager Phillip Goldstein, of Bulldog Investors, because of how he designed his fund’s website. The famed investment adviser is under prosecution by Massachusetts for allowing potential investors unrestricted access to Bulldog’s website. [HFLB to insert the complaint.]

Because of this and other activity it is extremely important that you have your hedge fund attorney discuss the website rules with you. Please contact us if you have further questions or if you would like help launching your hedge fund website.

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