Tag Archives: offering documents

Thoughts on Hedge Fund Offering Documents

FAQs on Offering Documents

I recently read an article by a hedge fund administration firm which discussed hedge fund offering documents and start up hedge fund expenses. I thought this was an interesting topic and one which is popular with many of my start up clients. Below I discuss some of the common questions regarding the offering documents and also provide reasons why a start up manager should use my law firm for starting a hedge fund.

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Offering documents are just boilerplate – why are they so expensive?

This is a common misperception. Offering documents (if done correctly) are not merely boilerplate where the attorney pops in the fund name and the address – offering documents are a tailored to the specific needs of the client based on the client’s investment program and fund structure.

For instance, there are at least 12 different questions related to the management fee and performance fee/ performance allocation. There are at least 22 different questions related to the fund’s contribution periods and withdrawal periods. This level of customization does not come from a boilerplate form. Furthermore, many of these questions or options may have specific implications for the manager’s business either from a legal standpoint or a business standpoint. Many times the lawyer will need to have an in-depth discussion with the manager to help the manager determine which option is right for the fund.

Why are offering documents so long?

Offering documents are long – there is no getting around it. The structure of the offering documents are determined by the federal and state securities laws and thus there is not really any wiggle room. While it is often said that the hedge fund industry is “not regulated” or “lightly regulated” there are many hedge fund laws and regulations which managers must follow. These laws dictate many aspects of the documents and are why offering documents are so long (and also why offering documents from different firms are structured so similarly).

In this prior post, discussing “Prospectus Creep” we discussed the length of offering documents:

4. Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers. Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program. The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents. However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.

Can I draft offering documents myself? I have a friend who has some documents I think I can modify.

No. You should never draft offering documents yourself. I have seen countless examples of people who have tried to draft their own offering documents based on another fund. Many times these people will ask me to “check the documents.” Ninety-five percent of the time a brief skim of the documents will reveal major errors that cannot simply be fixed with a 2 hour review. In most all occasions the documents will need to be completely scrapped.

Are all law firm offering documents the same?

No, but law firm documents are all very similar.

It is an interesting phenomenon in the hedge fund legal world that attorneys are always interested in (or obsessed with) reading the other law firms offering documents. As one of those lawyers that is very interested in the differences between the offering documents, I have studied the documents from most all of the major hedge fund law firms including the firms listed below which are considered to be the best in the industry.

Sidley Austin
Shartsis Friese
Seward & Kissel
Kleinberg, Kaplan, Wolff & Cohen
Katten Muchin Rosenman
Schulte Roth & Zabel
Akin Gump Strauss Hauer & Feld
K&L Gates

I have probably read through 500 different offering documents (many from the same large law firms) and have found most documents to be quite similar. For the most part with a name brand firm you are going to get a quality product that is probably pretty equal to another large or name brand law firm. These documents will very likely protect you in all of the necessary ways.

However, that is not to say that all large law firm offering documents are perfect. I have seen offering documents which cost over $70,000 with typos and errors. Many times expensive offering documents are sloppy in certain respects – I expect this is because many large law firms use inexperienced associate attorneys to draft the offering documents.

Does price equal quality?

Not necessarily. While you are less likely to receive white glove service from a document shop, BigLaw does not necessarily equate to fine quality – especially for small and start up managers. In a large law firm you are going to probably initially talk with a partner about your program who will then relay the information to an associate who will be in charge of your project. This means that your offering documents are likely drafted by an overworked associate who has relatively little experience.

I always recommend a start up manager ask the law firm who will be drafting the offering documents and how much experience the person has. Many large law firms will say that an associate will draft the documents but the partner will review prior to finalization. I find it hard to believe that a partner will review offering documents – many times this is not true.

Low cost offering documents – are you getting less quality?

In some cases yes, but in the case of my law firm documents the answer is a resounding NO. While my firm will charge around $13,000 to $18,000 for offering documents (considered to be on the lower end), this does not mean that the quality of my work is less than any other firm.

As I have mentioned before on this site, I have worked with a substantial number of start up hedge funds and have drafted the offering documents or worked on around 150 funds. Also, I have spent a great deal of time dissecting offering documents from a large number of firms. My dedication to completely understanding the offering documents, along with my passion for the industry and helping managers with their business issues makes my services a compelling alternative to other firms which may cost more.

Additionally, I value the client relationship and always strive to return emails and phone calls promptly.

Conclusion

While the offering documents are the tangible item which you receive from your hedge fund lawyer, it is not the only part of the representation. The offering documents are not valuable as objects, but really as a representation of the prior experience of the attorney who prepared those documents for your fund, based on your needs.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about becoming registered as a CPO or CTA, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Formation Legal Fees

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Question: How much does it cost to establish a hedge fund?

Answer: The costs of starting a hedge fund can vary considerably depending on the manager and the manager’s circumstances. A start up hedge fund manager will need to consider the hedge fund start up costs which will include legal costs, administration costs and set up fees, bank fees, prime brokerage fees, rent, etc. This article will detail hedge fund legal fees.

Hedge Fund Formation Legal Fees

The central legal fees for a start up hedge fund manager are the costs associated with preparing the offering documents for the hedge fund. Most law firms who provide these services will charge on a flat fee basis, depending on the novelty and scope of the project. The cost breakdown is, generally, as follows:

Large brand name New York based law firm: $35,000 – $75,000

Midsize law firm with known hedge fund practice: $25,000-$45,000

Small or boutique hedge fund law firm: $15,000-$30,000

The above are very large fee ranges, but for managers with very basic hedge fund strategies (say a long-short large cap investment strategy) you are looking at the lower end of the fee range. If the strategy is more esoteric or if there are many structural issues (especially liquidity and valuation issues), then the costs will be more. Additionally, if the strategy has certain ERISA or tax issues then the cost is going to be more.

The costs above generally do not include filing fees for entity incorporation, fees for investment advisor registration, or any blue sky filing fees.

Please note that you may find groups out there which provide hedge fund offering documents for lower prices. As when selecting any attorney, price should not be the only determining factor. There are also offering document software sources out there which purport to create offering documents for your fund for under $5,000 – do not use such services. The legal documents provided by hedge fund lawyers are designed to protect you as the manager and any off the shelf solution is not going to be able to provide the customized legal advice you will need to be properly protected. I have personally seen some of these documents and they are woefully inadequate.

Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

SEC Wins another Hedge Fund Fraud Case – Provides Insight to Hedge Fund Managers

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Hedge fund fraud cases are important because they give some definition and life to the various investment advisor and hedge fund laws. Much of the advice that hedge fund lawyers give to their clients is based on reasonableness and best guesses on how the securities laws will be implemented in the hedge fund context. For many hedge fund issues there are not clear cut cases which give color to the securities laws. One of my colleagues refers to this as the “square peg – round hole” dilemma by which he means it is hard to apply the archaic securities laws with the current state of the hedge fund and investment management industry.

When the SEC does bring cases, as practitioners we get to see how the SEC views the securities rules and how we should be advising clients. While many of the fraud cases represent completely unbelievable actions by unscrupulous people, there are still lessons which well-intentioned managers can learn from.

Specifically this case gives us an opportunity to examine five separate areas which invesment managers should be aware of:

1. Make sure all statements in the hedge fund offering documents and collateral marketing materials is are accurate.

In this case the hedge fund offering documents contained many material misstatements including materially false and misleading statements in offering materials and newsletters about, among other things, the Funds’ holdings, performances, values and management backgrounds. For example the complaint alledges:

Specifically, both PPMs represented that most investments made by Partners and Offshore would trade on “listed exchanges.” In truth, a majority of those funds’ investments were and are on unlisted exchanges such as the OTCBB or pink sheets. Furthermore, the Partners’ PPM stated that investors would receive yearly audited financials upon request. Partners has not obtained audited financials since the year ended 2000 and repeatedly refused at least one investor’s requests for audited financials for the year ended 2001.

2. Make sure all appropriate disclosure relating to personnel are made.

Hedge fund attorneys will usually spend time with the manager discussing the employees of the management company and their backgrounds. During this time the attorney will ask the manager, among other questions, whether any person who is part of the management company has been involved in any securities related offense. In this case there were two specific items which the manager should have disclosed in the offering documents and other collateral material:

Failed to disclose that a “consultant” to the management company was enjoined, fined and also barred from serving as an officer or director of a public company for five years for his fraudulent conduct involving, among other things, misallocating to himself securities while serving as CFO and later president of a publicly traded company.

Failed to discloase a member of the fund’s board of directors was barred from associating with any broker or dealer for 9 years.

3. Take care when going outside stated valuation policies.

Many hedge fund documents have stated valuation policies but then allow the manager to modify the valuation, in the manager’s discretion, to better reflect the true value of the securities. However, when a manager uses this discretion, the manager should have a basis for the valuation. Such valuation should not be based on an artificially inflated value of the asset. To be safe managers should probably have some internal valuation policies which should be in line with generally accepted valuation standards for such assets. I found the following paragraph from the SEC’s complaint particularly interesting (emphasis added):

II. Bogus Valuations

34. In order to obtain at least year end 2001 audited financials for Offshore, Lancer Management provided Offshore’s auditor with appraisals valuing certain of that fund’s holdings. These appraisals mirrored or closely approximated the values assigned to Offshore’s holdings by Defendants based on the manipulated closing prices at month end. These valuation reports were, however, fatally flawed and did not reflect the true values of Offshore’s holdings under the generally accepted Uniform Standards of Professional Appraisal Practice or American Society of Appraisers Business Valuation Standards. For example, the valuations were improperly based on unreliable market prices of thinly traded securities; unjustified prices of private transactions in thinly traded securities; unfounded, baseless and unrealistic projections; hypotheticals; and/or an averaging of various factors. Indeed, under accepted standards of valuing businesses, certain of the Funds’ holdings were and/or are essentially worthless.

4. Do not engage in market manipulation.

Many of the securities in which this hedge fund invested were traded on the OTCBB. The fund engaged in trading in these securities near valuation periods in order to artificially inflate the price of these very thinly traded securities. Additionally, the complaint alleges many incidents of “marking the close.” This goes without saying but a hedge fund manager should not engage in market manipulation.

5. Always produce accurate portfolio statements. Do not overstate earnings. Always make sure that statements to investors are accurate.

Enough said.

While many of the examples above are so egregious they probably do not need to be listed on a “do not” list, you should make sure you do not engage in any of these activities. Additionally, if you do make some error or mistake (for example, if a valuation turns out to be incorrect or inaccurate), immediately contact your attorney to create a plan to inform investors about the incorrect or inaccurate statements. A mistake can generally be cured, all out fraud cannot.

I have posted a full text version of the SEC’s case, SEC v. Lauer. I have included the statement by the SEC below which can be found here.

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SEC Wins Major Hedge Fund Fraud Case Against Michael Lauer, Head of Lancer Management Group

FOR IMMEDIATE RELEASE
2008-225

Washington, D.C., Sept. 24, 2008—The Securities and Exchange Commission announced that a district court judge today granted its motion for summary judgment against the architect of a massive billion-dollar hedge fund fraud.

Michael Lauer of Greenwich, Conn., was found liable for violating the anti-fraud provisions of the federal securities laws. In a 67-page order, The Honorable Kenneth A. Marra, U.S. District Judge for the Southern District of Florida, found that Lauer’s fraud as head of two Connecticut-based companies – Lancer Management Group and Lancer Management Group II – that managed investors’ money and acted as hedge fund advisers was “egregious, pervasive, premeditated and resulted in the loss of hundreds of millions of dollars in investors’ funds.”

Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “This case highlights the SEC’s ongoing efforts to combat hedge fund fraud and our dedicated work on behalf of investors to ensure that hedge fund managers are held accountable for any unlawful conduct.”
David Nelson, Director of the SEC’s Miami Regional Office, added, “We are particularly gratified at this decision, which resulted from several years of hard work to protect investors, starting when we successfully halted the fraud while it was still ongoing.”

Lauer raised more than $1.1 billion from investors and his fraudulent actions caused investor losses of approximately $500 million. The SEC initially won emergency temporary restraining orders and asset freezes against Lauer and his companies, which were placed under the control of a Court-appointed receiver after the SEC filed its enforcement action in 2003.

During the protracted litigation, the SEC successfully stopped Lauer from diverting or hiding millions of dollars of assets from the Court’s asset freeze.

The summary judgment order found that Lauer:

Materially overstated the hedge funds’ valuations for the years 1999 to 2002.
Manipulated the prices of seven securities that were a material portion of the funds’ portfolios from November 1999 through at least April 2003.
Failed to provide any basis to substantiate or explain the exorbitant valuations of the shell corporations that saturated the funds’ portfolios.
Hid or lied to investors about the Funds’ actual holdings by providing them with fake portfolio statements.
Falsely represented the funds’ holdings in newsletters.

The judge’s order entered a permanent injunction against Lauer against future violations of Sections 17(a)(1)-(3) of the Securities Act of 1933 (Securities Act), Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (Exchange Act), and Sections 206(1) and (2) of the Investment Advisers Act of 1940 (Advisers Act). The order reserved ruling on the SEC’s claim for disgorgement with prejudgment interest against Lauer, and on the amount of a financial penalty Lauer must pay. The SEC is seeking a financial penalty and disgorgement of the more than $50 million Lauer received in ill-gotten gains from his fraudulent scheme.

What happens if a hedge fund doesn’t do proper diligence to ascertain that a client meets the qualified purchaser standards?

Monthly Feature: Hedge fund offering documents

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The central reason that beginning hedge fund managers need a lawyer is that the lawyer will prepare the offering documents for the fund. The offering documents are designed to comply with the requirements of the federal securities laws as interests in the fund (whether the fund is a limited partnership or a limited liability company). Specifically the offering documents will most likely be drafted to conform to the requirements of Rule 506 of Regulation D under the Securities Act of 1933.

The offering documents are the necessary paperwork that the manager must give to prospective investors. The offering documents will look very similar to a mutual fund prospectus. The three parts of the offering documents are:

The private placement memorandum (also sometimes called the offering memorandum). The private placement memorandum (also known as the “PPM”), is the main offering document. It provides the prospective investor with information on the structural and business aspects of the fund.
The limited partnership agreement (or, if the fund is an LLC, the operating agreement). The limited partnership agreement (also known as the “LPA”), is the actual governing legal document. It provides a description of the rights of the investors and the manager. When an investor becomes a “partner” in the fund, the investor is executing the limited partnership agreement.
The subscription documents. The subscription documents are the documents which provide the manager with background information on the investor. These documents include assurance and warranties by the potential investor that the potential investor is qualified to invest in the offering. These documements usually include the signature page to the LPA.

A more in depth description of the potential parts of the offering documents follows:

Private Placement Memorandum

While each law firm’s general PPM template is different, they all share many of the same items of information which are included. Below is a non-exhaustive list of some of the major sections of the PPM which you are likely to find in all offering documents.

Coverage
Legends and securities laws notices
Table of contents
Summary
Use of proceeds
Investment Program
Risk factors
Description of the management company and managers
Discussion of fees (Management fees, Performance fees)
Manner of valuing the investments
Discussion of conflicts of interest
Discussion of brokerage
Discussion of litigation of the investment manager
Discussion of financial statements of the fund
A summary of the LPA or Operating Agreement
Discussion of service providers
Tax disclosures
ERISA disclosures
Other notices (privacy notice, definition of investors qualified to invest, disclosure on the lack of transferability, etc.)

Limited Partnership Agreement

Like the PPM, each law firm has a different way to draft the LPA. For instance, some law firms will craft a lengthy definition section at the very beginning, other law firms will have definitions attached as an appendix, other firms will define specific terms throughout the document. A very rough guideline of the items which are in the LPA include:

Coverpage
Table of contents
Preamble
Defintions
Information on formation (business office, registered agent, length of fund, etc.)
Capitalization structure (initially and on a going-forward basis)
Manner of allocation of profits and losses (including the various tax allocation provisions)
Manner of distributions and withdrawals
Rights and duties of the management company
Rights and duties of the investors
Information on accounting, books and records
Transfer rights
Dissolution of the partnership; winding up
Manner of final distributions
Grant of power of attorney
Miscellaneous provisions (headings, amendments, applicable law, jurisdiction)

Subscription Documents

The subscription documents from one firm to another may differ fairly substantially. Some firms have separate subscription documents for individual investors and for institutional investors. Some firms include the necessary representations with the actual subscription agreement. The basic information included in the subscription documents includes:

Coverpage with certain legal disclaimers
Directions on how to complete the subscription documents
Subscription agreement (including certain acknowledgements, representations and warranties)
Investor suitability questions (may be embedded in the subscription agreement) – generally accredited investor, qualified client, or qualified purchaser status
LPA investor signature page

If a fund accepts non-accredited investors, the manager will need to make sure that the non-accredited investor meets certain that the non-accredited investor, together if applicable with their purchaser representative, is sufficiently sophisticated to understand the risks of making an investment in the fund. These supplemental representations can be made either in the subscription documents or in a supplement to the subscription documents.

Start-up hedge fund timeline | How to Start a Hedge Fund

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Starting a Hedge Fund Timeline

Many prospective hedge fund managers know that they would like to start a hedge fund but have not gone through the process necessary to understand what the process is like or how long it will take. For some managers the process is painless, for others the process is more time consuming and frustrating than they would like. Unfortunately, the timing of an actual fund launch cannot usually be determined with absolute certainty and will depend upon, in large part, your program and your service providers.

A good rule of thumb (for managers who do not need to register as investment advisers with their states) is that the fund formation process should take about 2 months. Often a fund can be up in running in a month or less, but to be on the safe side, I recommend 2 months.* If you need to register with a state, you are going to want to add anywhere from 3 – 6 weeks to the process.**

* It is not unheard of to have funds up and running in a couple of weeks. I’ve had a fund up and running in 4 days. If I need to work with a manager on an extremely tight deadline, this can probably be done in 2 to 3 days, depending on the availability of outside service providers.

** States like California will be closer to 3 weeks (UPDATE: CA is now taking two months to register investment advisers 08-18-09); states like Texas are going to be closer to 6 weeks.

In general the timeline might look like this:

Day 1 – Discussion with legal counsel regarding the structure of your fund (fees, contribution provisions, withdrawal provisions, other items to be included in the legal documents). During this time you will also discuss your investment program and your background.

Day 7-10 – Delivery of offering documents. During this time your legal team should respond to you with your legal documents. Your hedge fund’s legal documents will include the following:

Private placement memorandum
Limited partnership agreement (or limited liability company operating agreement)
Subscription documents

Don’t be scared when you first review these offering documents – they will usually be around 100 pages. Some very large fund offering documents might be up to 200 page or more in length.

Day 10-14 – Review of your offering documents. During this time you should be reviewing the offering documents and familiarizing yourself with their provisions. You will need to understand what all of the legal provisions in your documents mean. If you don’t understand a concept or phrase – mark it down and be sure to ask your attorney. Remember, these are your legal documents and you paid very good money for them – you should know what they say.

Day 17 – Discussion with legal counsel regarding offering documents. You should take about an hour (sometimes it is more or less) to discuss the key points of your offering documents with your legal counsel. You should bring up items which you have questions on and your lawyer should run down the key points of the offering documents with you.

Day 24 – Delivery of revised offering documents. Your legal team should be able to deliver you revised offering documents within about a week. At this time the offering documents are very close to being complete. You should review the documents to make sure that all your questions have been addressed and your changes incorporated. If the revised wording does not make sense, let your attorney know as soon as possible.

At this point these offering documents are in good enough shape to send to your administrator and your auditor (if you decide to name an auditor in the offering documents). In addition, you should begin the account application process with your broker or prime broker.

Day 24-30 – Begin finalizing service provider contracts and make sure all service providers are on the same page. The brokerage account application can potentially be a stumbling block in the process. Certain brokers have certain due diligence requirements which must be met before the account will be ready for live trading. You might not know of these requirements beforehand or the broker’s compliance department may come back with extra requirements – you never know what might be required. For example: one fund was not allowed to have the word “Fund” in their name if they started with less than $2 million in AUM. Another fund was not allowed to clear through a certain prime broker because the managing member of the management company did not have enough experience in the eyes of the clearing broker. While stories like this are the exception rather than the rule, the brokerage account opening process is the most uncertain in terms of time.

Day 30-45 – Last minute prep work with lawyers and service providers. The auditors or administrators may have some minor comments for the lawyers on the offering documents. Some of these service providers may require certain disclaiming language regarding the services which will be provided. It is not uncommon for these requested modifications to be passed on directly to the attorney, sometimes these requests will go through you. Your lawyer will send you finalized offering documents during this time.

Day 46-60 – Begin getting ready for trading. You should make sure that everything is in place for a smooth first day – make sure you know when and how you will be doing your trading. Make sure you will have assets in the brokerage account on Day 1. Make sure your computers will be working.

Keys to remember during the process

Start early. Give yourself too much time.
Be responsive to all emails and phone calls.
Keep the lines of communication open with your service providers. This is your fund and you are paying your service providers good money. They should be responsive to you and should answer all of your questions. If you do not get the response you would like it is your responsibility to discuss this with your service providers.
Be patient.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. has written most all of the articles which appear on the Hedge Fund Law Blog. Mr. Mallon’s legal practice, Cole-Frieman & Mallon LLP, is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.