Tag Archives: hedge fund offering documents

Hedge Fund Lock-Up Period

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What is a hedge fund lock-up?

Recently there have been many discussions about hedge fund structures and terms, including the ability (or inability) of investors to withdraw from hedge funds.  Generally the manager will have a number of structures in place to make sure that capital stays in the hedge fund.  These provisons include the hedge fund gate, the ability to limit all withdrawals in certain circumstances, and the hedge fund lock-up provision.

The hedge fund lock-up provision is a provision which provides that during a certain initial period, an investor may not make a withdrawal from the fund.  The period when the investor cannot withdraw the funds is known as the actual lock-up period.  Continue reading →

FINRA New Issue Rule 5130 (Text of the Rule)

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As we announced earlier today, the NASD New Issue Rule 2790 has changed and is now FINRA Rule 5130.  The text of the New Issue rule is below and can also be found on the FINRA website here.  With regard to hedge funds, this rule is most important with regard to who will be deemed a “restricted person” and thus generally ineligible to recieve a full allocation of any gains attributable to new issues (commonly known as initial public offerings or IPOs).  The full text of the rule follows.  Continue reading →

Hedge Fund “New Issue” Rule Changes

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Minor Modifications to “New Issues” Rule Approved; New FINRA Rule 5130

FINRA (formerly the NASD) has been reworking a new rulebook which means that many rules have been modified and renumbered.  At least one important hedge fund rule has been renumbered.  The “new issue” rule, which affects hedge funds and other members of the securities community, has been slightly modified and is now known as FINRA Rule 5130 (formerly Rule 2790). Hedge fund managers should discuss with their attorneys whether their hedge fund offering documents need to be updated to reflect this change.  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 Managers Look to Cut Costs – No Hedge Fund Audit?

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As hedge fund performance results are weak or negative, managers are becoming more interested in decreasing the costs that the management company bears directly as well as those costs which are borne by the fund. Continue reading →

Long-Short Equity Hedge Funds

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Hedge Fund Investment Strategies

Long-short equity is a popular hedge fund strategy where in which the manager initiates both long and short positions in the portfolio.  The exact strategy or substratgey the manager uses will be proprietary and the percentage of longs and shorts will differ with each manager.  Continue reading →

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.

What is a “gate” provision?

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A “gate” provision is a hedge fund manager’s right to limit the amount of withdrawals on any withdrawal date to not more than a stated percentage of a fund’s net assets — often 10% to 25%, depending on how frequently investors have a right to withdraw capital. Gates are a very common feature in hedge funds of almost all strategies. Imposing a gate slows a potential “run on the fund” by forcing investors to wait until the next regular withdrawal date to receive the unfulfilled balance of their withdrawal requests. Gates are especially important for hedge fund strategies which are more illiquid like MBS strategies.