How To Set Up A Hedge Fund
How To Set Up A Hedge Fund
How To Set Up A Hedge Fund
Traders and money managers often dream about one day running their own
hedge fund, managing large sums of money, and competing head to head with
the world’s top traders. For many, though, this dream remains unfulfilled,
because they do not know where to begin and do not want to squander their
resources “reinventing the wheel.”
The first step toward setting up a hedge fund is getting a better grasp of what
exactly a hedge fund is. Hedge funds often are compared to registered
investment companies, unregistered investment pools, venture capital funds,
private equity funds, and commodity pools. Although all of these investment
vehicles are similar in that they accept investors’ money and generally invest it
on a collective basis, they also have characteristics that distinguish them from
hedge funds and they generally are not categorized as hedge funds.
As the name indicates, hedge funds initially specialized in hedging and arbitrage
strategies. When Alfred Winslow Jones established the first hedge fund as a
private partnership in 1949, that fund invested in equities and used leverage and
short selling to “hedge” the portfolio’s exposure to movements of the corporate
equity markets. Although hedge funds today often employ far more elaborate
hedging strategies, it is also true that some hedge funds simply use traditional,
long-only equity strategies.
Hedge funds are also well known for their fee structure, which compensates the
adviser based upon a percentage of the fund’s capital gains and capital
appreciation. Advisors at hedge funds often invest significant amounts of their
own money into the funds that they manage.
Although they still represent a relatively small portion of the U.S. financial
markets, hedge funds are a rapidly growing investment vehicle. The growth is
fueled primarily by the increased interest of institutional investors such as
pension plans, endowments, and foundations seeking to diversify their portfolios
with investments in vehicles that feature absolute return strategies – flexible
investment strategies that hedge fund advisers use to pursue positive returns in
both declining and rising securities markets, while generally attempting to protect
investment principal. In addition, funds of hedge funds, which invest substantially
all of their assets in other hedge funds, have also fueled this growth. This growth
has not escaped the notice of the SEC, which has expressed concerns about the
potential impact of hedge funds on the securities markets.
To start a hedge fund, documents are prepared to establish the fund and the
management company as legal entities. The subscription agreement and the
operating agreements for the fund and the management company also must be
drawn up. One document that is of particular importance is the private placement
memorandum (PPM), since potential investors generally rely heavily on the
information that the PPM provides.
The PPM is an extensive document individually created for each hedge fund.
Although there are no specific disclosure requirements for the PPM (provided the
offering is made solely to accredited investors), basic information about the
hedge fund’s adviser and the hedge fund itself typically, in fact is disclosed. The
information provided is general in nature, varying from adviser to adviser, and it
normally discusses in broad terms the fund’s investment strategies and practices.
For example, disclosures generally include the fact that the hedge fund’s adviser
may invest fund assets in illiquid, difficult-to-value securities, and that the adviser
reserves the discretion to value such securities as it believes appropriate under
the circumstances. Also often included is a disclosure about the adviser having
discretion to invest fund assets outside the stated strategies.
The PPM usually provides information about the qualifications and procedures
for a prospective investor to become a limited partner. It also provides
information on fund operations, such as fund expenses, allocations of gains and
losses, and tax aspects of investing in the fund. Disclosure of lock-up periods,
redemption rights and procedures, fund service providers, potential conflicts of
interests to investors, conflicts of interest due to fund valuation procedures, “side-
by-side management” of multiple accounts, and allocation of certain investment
opportunities among clients may be discussed briefly or in greater detail,
depending on the fund. The PPM also may include disclosures concerning soft
dollar arrangements, redirection of business to brokerages that introduce
investors to the fund, and further disclosure of how soft dollars are used. Copies
of financial statements may be provided with the PPM.
The PPM reflects market practice and the expectations of sophisticated investors
who typically invest in hedge funds. It also reflects the realization of the sponsors
and their attorneys that the exemptions from the registration and prospectus
delivery provisions of Section 5 of the Securities Act, available under Section 4(2)
of the Securities Act and Rule 506 thereunder, do not extend to the antifraud
provisions of the federal securities laws. The disclosures furnished to investors
therefore serve as protection to the principals against liability under the antifraud
provisions.
2
Accredited Investors
• Individuals who have a net worth, or joint net worth with their spouse, above
$1,000,000, or who have income above $200,000 in the last two years (or joint
income with their spouse above $300,000) and a reasonable expectation of
reaching the same income level in the year of investment, or who are directors,
officers, or general partners of the hedge fund or its general partner; and
• Many, if not most, employee benefit plans and trusts with more than $5,000,000
in assets.
Of course, the hedge fund may wish to allow non-accredited investors into the
fund, in which case it will not be exempt from disclosure requirements. Moreover,
even if the fund will only open to “accredited investors,” those investors will want
information about the fund before buying into it. Indeed, prospective investors will
often subject the fund and its managers to an extensive process of due diligence.
Investors often spend significant resources, frequently hiring a consultant or a
private investigation firm, to discover or verify information about the background
and reputation of a hedge fund adviser. Prospective investors may gain access
to brokers, administrators, and other service providers during the initial due
diligence process, verifying most information contained in the PPM (including the
adviser’s history). Since the PPM usually is the starting point for those
conducting due diligence, it remains a crucial document, even for offerings
exclusively for “accredited investors.”
Do I need to register?
When the situation is complicated with investors from multiple states, usually a
notice filing is required. It is impossible to make a blanket statement pertaining to
3
registration requirements and exemption options, except to say that they vary by
state and fund structure.
Incubator Funds
One of the caveats of the Incubator option is that the fund manager cannot be
compensated for his trading activity. Thus, the acceptance of outside funds,
although permitted, exposes the fund manager to fiduciary obligations for which
he cannot receive any compensation. If outside funds are to be accepted, careful
planning is required to avoid potential legal issues.
Offshore Funds
4
Though often assumed, offshore funds are not established for the purpose of
avoiding U.S. taxation. This is the wrong reason to consider an offshore fund. In
short, setting up an offshore fund is not a tax minimization strategy, as U.S.
citizens and resident aliens (e.g., green card holders) are taxable on their
worldwide income. The U.S. tax results depend on the nationality and domicile of
the fund manager and his or her management company.
The word “offshore” has a certain mystique to many. Offshore hedge funds are
investment vehicles organized in offshore financial centers (“OFC”). OFCs are
countries that cater to the establishment and administration of mutual and hedge
funds (“funds”). Offshore funds offer securities primarily to non-U.S. investors
and to U.S. tax-exempt investors (e.g. retirement plans, pension plans,
universities, hospitals, etc.). U.S. money managers who have significant potential
investors outside the United States and tax-exempt investors typically create
offshore funds. In many OFCs, the low costs of setting up a company, along with
a kind tax environment, makes them attractive to establishing funds. Offshore
funds generally attract the investment of U.S. tax-exempt entities, such as
pension funds, charitable trusts, foundations, and endowments, as well as non-
U.S. residents. U.S. tax-exempt investors favor investments in offshore hedge
funds because they may be subject to taxation if they invest in domestic limited
partnership hedge funds. Offshore hedge funds may be organized by foreign
financial institutions or by U.S. financial institutions or their affiliates. Sales of
interests in the United States in offshore hedge funds are subject to the
registration and antifraud provisions of the federal securities laws.
Offshore hedge funds typically contract with an investment adviser, which may
employ a U.S. entity to serve as sub-adviser. An offshore hedge fund often has
an independent fund administrator, also located offshore, that may assist the
hedge fund’s adviser to value securities and calculate the fund’s net asset value,
maintain fund records, process investor transactions, handle fund accounting,
and perform other services. An offshore hedge fund sponsor typically appoints a
board of directors to provide oversight activities for the fund. These funds,
especially those formed more recently, may have directors who are independent
of the investment adviser.
Consider setting up an offshore fund if you manage money for foreign and/or
U.S. tax-exempt individuals and businesses. Under U.S. income tax laws, a tax-
exempt organization (such as an ERISA plan, a foundation, or an endowment)
engaging in an investment strategy that involves borrowing money is liable for a
tax on “unrelated business taxable income” (“UBTI”), notwithstanding its tax-
exempt status. The UBTI tax can be avoided by the tax-exempt entity by
investing in non-U.S. corporate structures (i.e., offshore hedge funds).
A manager planning a new fund needs to answer a few key questions in order to
decide where to register, what kind of investor the vehicle is for, where those
investors are, and what they want in a domicile. Experienced alternatives
5
investors typically are less worried about domicile than are first-time investors.
Funds designed for mass distribution to the retail market need to have more
regulation than those meant for wealthy individuals who already are in hedge
funds. Some institutions may be bound by rules that limit investment to regulated
jurisdictions, while others face no such requirement.
6
Islands, fund incorporation can occur earlier in the process, but afterwards time
has to be spent preparing documentation.
British Virgin Islands: More than 2,000 mutual funds worth an estimated $55
billion currently are incorporated in the BVI. So too are many hedge funds. In all,
11 banks operate on the BVI, catering mainly to high net-worth wealth and trust
management. The government launched new laws to placate the international
community’s concerns over a lack of financial regulation.
Cayman Islands: The Cayman Islands is one of the world’s lowest tax domiciles
with no personal or corporate taxes. Registering in the Cayman Islands does not
involve much due diligence by the Cayman Islands Monetary Authority during the
incorporation process, but is not necessarily cheaper or faster overall. Cayman
does not require monthly reports or prior consent to change service providers,
but before a fund can commence trading, it has to be registered with CIMA under
the Mutual Funds Law (subject to some exceptions). This means identifying all
service providers to the fund and providing certain information about the fund and
the offering of its securities, and CIMA has to be notified of any subsequent
changes. However, currently the Cayman Islands does not require a fund to file
regular reports with CIMA.
The Bahamas: The Bahamas is a very low tax jurisdiction. Banking, wealth and
asset management are core industries, with around $200 billion under
management. The island also boasts some 700 mutual funds with around $100
billion.
Master-Feeder Funds
The corporate structure of a hedge fund depends primarily on whether the fund is
organized under U.S. law (“domestic hedge fund”) or under foreign law and
located outside of the United States (“offshore hedge fund”). The investment
adviser of a domestic hedge fund often operates a related offshore hedge fund,
either as a separate hedge fund or often by employing a “master-feeder”
structure that allows for the unified management of multiple pools of assets for
investors in different taxable categories.
7
entities, and offshore funds of funds.
The legal development process is one that requires careful planning. As seen
above, a variety of regulatory issues intersects concurrently when developing a
fund: tax, registration, entity type and classification, jurisdiction, security type,
and so on. The wisest course of action for those thinking about developing a fund
is to consult with qualified legal counsel before taking definitive steps. Due to the
many regulatory issues that must be complied with, it is best to define the
structure of your fund properly before commencing any form of fund development
or engaging the services of administrators or service providers.
The legal development process normally begins with a planning consultation with
an attorney experienced in forming hedge funds. This is where important
determinations such as registration, jurisdiction choice, and utilization of safe
harbors are made. The consultation may expose areas (outside the legal
8
process) that need further planning, thus requiring the manager to deal with
those issues before proceeding. After clearing up any such issues, a full
engagement is entered into and the legal development process begins. The fund
and management company entities are first formed in their appropriate
jurisdictions. This enables the fund manager to begin the process of opening
bank and brokerage accounts and setting up the administrative functions of the
fund. After the entities are formed, the legal team gathers the necessary
information to form the operating agreements for the entities and then the
offering documents, first in draft stage and then finalized for distribution to
prospective investors. The legal process of setting up a hedge fund usually can
be completed within 60-90 days, though registration as a Commodity Pool
Operator, specialized circumstances, or delays in providing information can
lengthen the process.
Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.
Alternative Proxies: