All about Hedge Funds

Hedge funds and other alternative investment funds developed on the basis of exceptions from the securities legislation enacted in the U.S. in the 1940s to regulate collective investment undertakings. The purpose of the exceptions was to exclude “private investment companies” and personal and family holding companies from the scope of legislation, but the SEC “knowingly permitted any group of up to 100 people to create a private investment pool.” The first hedge fund (A.W. Jones & Co.) and Venture Capitalist funds appeared, but it took almost two decades until they were named. Private equity funds appeared in 1970s on the basis of the same statutory safe harbor.

It is a simple process to enter the hedge fund industry; practically anyone with $15k to $20k can start a hedge fund and forming a hedge fund gets easier every year. It has become common for brokerages, attorneys, accountants and other financial professionals to team up in order to provide a one-stop-shop approach to developing and launching a hedge fund. Much of the consultation work is conducted over the phone, email and the internet. Key items needed to start a hedge fund are: money, a hedge fund consultant, an attorney, a prime broker, office space (or a home office), and eventually, an accountant and auditor.

A hedge fund is usually structured as a limited partnership or limited liability company to give the general partner (the fund manager) a share of the profits earned on the limited partners or members (the investors) money. The profit sharing (referred to as a “performance fee” or an “incentive allocation” if referring to an onshore fund) is typically 20 to 30 percent of the fund’s profits. Management fees are typically 1 to 2 percent of assets under management and are paid to support the cost of day-to-day fund operations. The best hedge funds are those that actually engage in arbitrage and employ hedging strategies and duck or minimize management fees. As noted, a genuine hedge fund has a manager that engages in arbitrage and employs hedging strategies.

So-called “hedge fund managers” that use traditional, long-only equity strategies and do not hedge in fact operate a type of mutual fund, and an expensive one at that. A hedge fund manager that uses large amounts of leverage to take long positions but fails to use short positions to protect against market bottoms will most likely fail.

Start a Hedge Fund

It is very easy for people to join the hedge fund industry. Setting up a hedge fund gets easier every year. By networking, some of the best legal and financial services talent in the business is either a click or a phone call away. Brokerages, lawyers, accountants and other financial professionals team up in order to provide a one-stop-shop approach to developing and launching a hedge fund. Much of the consultation work (if not all) is conducted over the phone or Internet. Key items needed to start a hedge fund are the following: money, a lawyer, a prime (or introducing) broker, office space (or a home office), and eventually, an accountant.

Money

The first people hedge fund managers tap for seed capital money are friends and family. It is difficult to attract institutional investors to a new fund. The first investors in a new fund are usually the fund manager’s close associates and family members who know and trust the fund manager. As noted, all hedge funds have some if not most of their manager’s wealth invested in them.

Legal Services

The legal development process normally begins with a planning consultation. This is when important issues, such as investment adviser registration, location of the hedge fund and its management, reliance on safe harbours and exemptions, etc. are addressed and resolved. A good legal consultation will expose areas (outside the legal process) that need further planning. Once the course is charted, 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 preparing for the administrative needs of the hedge 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 (private placement memorandum), first in draft stage and then finalized for distribution to prospective investors.

Prime Broker Services

Once the lawyer is engaged, the hedge fund is organized, and the offering documents are drafted, the next thing needed is a relationship with a prime (or introducing) broker. An introducing broker is a registered broker/dealer that has an agreement with a prime broker to use that firm’s custody and clearing services. A good prime broker or introducing broker will provide marketing and capital introduction services. Conventional advertising and marketing of hedge funds is prohibited but alternatives have been developed by brokers so that good fund managers get the right kind of investor attention. When setting up a hedge fund, it is best to stay away from the retail brokerage firms since they are not geared toward hedge funds and the needs of hedge fund managers.

Office Space

Advances in technology and the Internet have made investment research and trading convenient and efficient. One can work from any location where there is high-speed Internet service. As everyone knows someone starting a hedge fund these days, the industry cannot not keep track of all the hedge fund managers and their business operations, whether based at home or at a hedge fund hotel. There is no stigma to running a hedge fund from home. Hedge fund managers, even the best one’s in the business, can and do work from home.

Hedge Fund Mechanics

To start a hedge fund, the aspiring hedge fund manager needs to set up the hedge fund entity and the management company. In the United States, the hedge fund is typically established as a limited partnership or a limited liability company. With hedge fund start-ups, the management company will also function as the hedge fund’s general partner and is set up as a limited liability company or, in some special cases, as a corporation.

The lawyer or hedge fund consultant is responsible for drafting the offering documents. Some fund organizers try to draft their own set of documents or use a family member who is a lawyer with experience in a specialty other than securities law. In most cases, it will be obvious to the potential investor that proper legal counsel was lacking. A poor set of offering documents is a mark against the hedge fund manager.

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) and a lot of boilerplate language is used, basic information about the hedge fund’s manager and the hedge fund itself is disclosed. The information provided is general in nature, and it normally presented in broad terms the fund’s investment strategies and practices. For example, disclosures generally include the fact that the hedge fund’s manager may invest fund assets in illiquid, difficult-to-value securities, and that the hedge fund manager reserves the discretion to value such securities, as he believes appropriate under the circumstances. Also often included is a disclosure about the hedge fund manager having discretion to invest fund assets outside the stated strategies. The PPM will tend to list every type of security, commodity, or futures contract in the financial market to provide the hedge fund manager with freedom and latitude to make money.

The PPM usually provides information about the qualifications and procedures for a prospective in vestor to become a limited partner or member. 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 also be provided with the PPM.

Audits

In theory, the investment policy and strategy sections of the PPM exist to help investors evaluate the hedge fund as an investment opportunity. So the PPM should be written with accountability in mind. Consider the PPM that states “the goal of the fund is capital preservation.” Unless capital preservation is clearly defined in terms of asset allocation, one might expect that all of the fund’s assets consist of principal protected investments with specific maturity dates as such investment would most likely preserve capital. Given this, PPMs should not state capital preservation as a goal unless the fund invests in items that return the principal investment. When used in a PPM, the terms “capital preservation,” “liquidity and marketability,” “risk aversion” need to be defined (and adhered to by the hedge fund manager) with a future audit in mind.

In the future, there may be a trend toward investment policy audits (at the top levels of the hedge fund industry). An investment policy audit evaluates whether the hedge fund manager is in compliance with the statements made in the investment policy and investment strategy section of the PPM. An asset allocation audit examines whether the fund’s portfolio is within the range of a PPMs stated asset allocations percentages.

Time Line

The legal process of setting up a hedge fund usually can be completed within 60-90 days, though registration as an investment adviser, specialized circumstances, or delays in providing information can lengthen the fund launch process.

Accredited Investors

Offerings made to “accredited investors” exclusively are exempt from disclosure requirements under Rule 506. Before you allow an investor into your hedge fund, you will need to determine if a prospective investor is accredited. There are two tests for accreditation: the Income Test and the Net Worth Test. Generally, accredited investors include individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth (excluding residence, furniture and automobiles) and most institutions with $5 million in assets.

Side Letters

Investments in a hedge fund are subject to the fund’s offering documents (PPM, limited partnership agreement, etc.). A hedge fund manager may enter into a separate agreement (called a side letter) with an investor in the hedge fund. Typically, seed capital investors and large institutional investors seek preferential terms from a hedge fund’s manager in a side letter. A side letter provides preferential treatment to the investor that obtains the side letter. Other investors in the fund do not benefit from the terms of the side letter. Side letters cover a range of topics. They may provide the investor with reduced fees or impose limits on the expenses that can be charged to the hedge fund. Side letters may grant the investor special redemption rights (such as a no “claw back,” a percentage of the amount redeemed that is held back from the investor for a specified period of time) and modify the lock-up period (a time period during which an investor cannot redeem money from the hedge fund) or notice period for withdrawals from the hedge fund. Some side letters provide the investor with daily or weekly net asset values for the fund and information on levels of leverage and risk. They may also grant to an investor “most favoured nation” status. This status automatically provides an investor the most favourable terms or conditions granted to other investors through side letters.

The problem with side letters is that they may create a new share class in the fund and/or cause a breach in the hedge fund manager’s fiduciary duty to the hedge fund. Fiduciaries of a hedge fund owe an identical obligation to each investor in the fund. Should a side letter favour one investor at the expense of another, legal complications could arise. In some cases, the terms of a side letter may be so unique that the investor is arguably, in legal and economic senses, a separate client of the fund manager rather than just another investor in the fund.

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