Despite a challenging environment for the hedge fund industry, many institutional investors continue to allocate to hedge funds in a market environment otherwise devoid of promising investment opportunities. While the hedge fund industry saw net outflows in the first quarter of 2016, the $3.13 trillion in global hedge fund assets under management continues to attract new and innovative portfolio managers. Interestingly, a newly available source of seed capital for fund launches may come from managers themselves due to the required recognition in 2017 of years of deferred compensation.
So, whether a manager is establishing its first or its fifth hedge fund, what are the key considerations it should take into account in starting a hedge fund in 2016?
THE FUND’S TARGET INVESTOR BASE
One of the most important factors in structuring a fund is determining the type of investor to which the fund will be offered. Is there a target investor base?
One can take this a step further. The most important investors are often the early ones while critical mass is established. Should special or different considerations be given either to those investors or the fund as a whole as a result?
INVESTOR DOMICILE AND TAX REGIME
Investors will seek to invest in a fund vehicle that minimizes any taxation to which they may be subject. The domicile and structure of a hedge fund turns in part on the classes of investors the fund will be offered to – namely, US taxable, US tax-exempt and non-US investors.
If all the investors in the fund will be US taxable investors, then the fund is generally structured as a stand-alone limited partnership or a limited liability company that is treated as a partnership for US federal income tax purposes.
If the fund is targeting US tax-exempt investors and/or non-US investors, in addition to US taxable investors, it is possible to satisfy the tax requirements of all three types of investors by using a “master-feeder” structure. Here, investors will invest in different types of fund entities to suit their requirements, but all proceeds are ultimately invested through a single master vehicle. This is administratively easier and less expensive for the investment manager and, typically, investors than where two funds are operated side-by-side.
In a typical master-feeder structure, a master fund is formed in a no-tax or low-tax jurisdiction as a partnership for US federal income tax purposes. The master fund – typically a Cayman Islands limited partnership – is the manager’s primary investing entity and holds the fund’s investment portfolio.
US taxable investors may invest in a feeder fund typically organized in Delaware as a limited liability company or limited partnership and treated as a partnership for US federal income tax purposes. It is also often possible for US taxpayers to invest directly into the master fund.
Another feeder fund may be organized as a limited partner in a no-tax jurisdiction and treated as a corporation for US federal income tax purposes. Non-US and tax-exempt organizations invest in this type of tax-opaque entity since it allows US tax-exempt organizations to avoid incurring unrelated business taxable income (UBTI) as a result of the fund’s borrowing. The opaqueness of this entity also limits the risk that non-US investors will be treated as engaged in a US trade or business where this is relevant due to the master fund’s investment activities.
The trend over the past decade has been for institutional investors to replace high-net-worth individuals as the major part of the investor base for hedge funds. This is due partly to increased regulation that has made it more difficult to market to individuals, and partly to the increased willingness of some institutional investors to allocate to alternative investments. Perhaps more importantly, this shift also recognizes that many hedge funds are themselves more institutional, as well as the increasing need for pension, endowment and insurance funds to achieve an “absolute return.”
Institutional investors often have particular characteristics that a manager may need to take into account in establishing a fund:
Managers sometimes look to institutional investors to provide seed capital. While this helps alleviate concerns that the fund launch will not raise enough capital to be viable, seed investors typically seek an equity position in the fund’s investment manager and/or preferential treatment for their investment in the fund (in terms of, for example, liquidity, fees and transparency). They may also have strong views on the fund’s jurisdiction, structure and/or terms. Generally, care needs to be taken that any preferential arrangements do not include terms that prejudice the interests of other investors or the long-term viability of the project. Additional liquidity and/or transparency for only some of the investors is particularly sensitive.
Benefit plan investors
A large investor base for US managers consists of entities characterized as “benefit plan investors” under the Employee Retirement Income Security Act of 1974 (ERISA). Many funds will want to ensure that investments by benefit plan investors remain below 25% (calculated on a per-class basis and ignoring the investment of the investment manager and its affiliates); otherwise the fund and its service providers will be subject to certain burdensome requirements. These include: the imposition of additional responsibilities and duties on the fund’s investment manager; limitations on compensation, and prohibitions that could affect the investment manager’s ability to engage in certain transactions (for example, cross trading and trading through an affiliated broker); and certain restrictions on the custody of fund assets outside of the United States. As a practical matter, this would require the investment manager to be a “qualified professional asset manager.” For those managers that qualify, managing plan asset funds is becoming more common given the availability of asset flows from pensions.
Fund of funds investors
Funds of funds have their own investor base, performance and liquidity profile to consider. Accordingly, funds of funds will need to invest in hedge funds that do not jeopardize their own structure, will have a preference for funds that have a similar (or better) liquidity profile, and will seek to limit their exposure to funds that are able to limit redemptions. Funds of funds often have a short-term investment time horizon with a particularly low tolerance for poor investment returns (even on a very short-term basis).
THE FUND’S STRUCTURE
Once the jurisdiction of the fund and the target investor base have been identified, there are a number of considerations that will drive the fund’s structure – does it need to be open-ended or closed-ended, does its proposed investor base mean that it needs to be established as a stand-alone fund or as a master-feeder fund or should it be a single-cell or an umbrella fund?
OPEN-ENDED OR CLOSED-ENDED
Most hedge funds are “open-ended” (i.e., investors may subscribe for and redeem their investment from the fund on a regular basis). However, hedge funds with less-liquid strategies may be closed-ended, with investment limited to one or more initial subscription dates and investors being unable to redeem their interests at will. Investors generally prefer to invest in open-end structures for liquidity reasons. Closed-end structures, however, are commonly used for specialist fund strategies (e.g., real estate, infrastructure investment or debt). Closed-end funds are typically associated with lower fees and better performance, but marketing tends to be more difficult and focuses on a different investor base.
STAND-ALONE OR MASTER-FEEDER FUND
As discussed above, the type of investors targeted drives whether the fund is structured as a stand-alone fund or as a master-feeder fund. The different needs of investors for tax-opaque and tax-transparent vehicles can be achieved by running parallel funds. And, if only a tax-opaque or tax-transparent vehicle is required in light of the intended investor base, then a stand-alone vehicle with the appropriate tax characteristics should be sufficient and simpler. However, a master-feeder fund enhances the critical mass of investable assets and avoids the need for the investment manager to split tickets or engage in re-balancing trades between the parallel structures or for the fund to enter into duplicate arrangements with service providers and counterparties. Further, a master-feeder structure creates greater economies of scale for the day-to-day management and administration of the fund, which generally leads to lower operational and transaction costs.
STAND-ALONE OR SERIES FUND
If the fund will have one investment strategy and one portfolio of assets, a “single-cell”/portfolio vehicle may be appropriate. If more than one strategy will be run with multiple portfolios of assets, a series or “umbrella” structure may be more appropriate. The advantage of an umbrella structure is that it generally reduces costs and the level of fund documentation.
However, managers need to check that, as a matter of law or practice, each portfolio (or sub-fund) will be protected upon the default of another portfolio, so that creditors of the defaulting portfolio should not have recourse to the assets of a non-defaulting portfolio. Even then, there can be multiple problems of an administrative nature if one portfolio goes into default. The presence of other cells may also distract from the intended presentation.
In addition, the investment manager can run multiple portfolios through one structure, with one set of service providers without the need to establish separate fund structures.
FUND TERMS, ADVISER REGISTRATION AND SERVICE PROVIDERS
Once a manager has determined the appropriate fund structure, it can start to consider the terms of the offering itself. Among other things, the manager should think about the following:
SELECTING KEY SERVICE PROVIDERS
Prime brokers and custodians
Consideration should be given to a prime broker’s (or, if needed for a particular strategy, the custodian’s) familiarity and expertise in servicing the asset types and markets in which the fund proposes to invest. In addition, the prime broker can help raise assets. Which prime broker will be more effective at doing this?
As with prime brokers, the administrator should be familiar with the types of assets in which the fund will be investing, since it is the administrator who will (in practice) be calculating the value of the fund’s assets. In addition, the administrator’s operations should ideally be based in a time zone that is convenient for liaison with the investment manager and investors.
The auditor should be a reputable accounting firm of international standing. For SEC-registered advisers, the auditor generally needs to be PCAOB-registered or examined, as well as independent under both AICPA and SEC standards.
Other considerations in appointing any service provider include: the responsiveness of the service provider; its experience and reputation; and cost. If an investor is to invest with a new manager or strategy, it is nice if they are familiar with
INVESTMENT ADVISER REGISTRATION
Consideration should also be given to whether the manager will be required to register as an investment adviser with the Securities and Exchange Commission (SEC). Depending on its size, an investment adviser will need to register with either the SEC or the state securities agency where it has its principal place of business. As a general matter, an investment adviser that manages $150 million or more in exclusively private fund assets must register with the SEC, while an investment adviser that manages between $100 million ($20 million in New York) and $150 million in private fund assets must file as an exempt reporting adviser with the SEC and may have to register with the applicable state securities agency.
Investment advisers file Form ADV to register with both the SEC and state securities agencies. The form consists of two parts. Part 1 requires information about the investment adviser’s business, ownership, clients, employees, business practices, affiliations and any disciplinary events of the adviser or its employees. Part 1 is organized in a check-the-box, fill-in-the-blank format. The SEC reviews the information from this part of the form to process registrations and manage its regulatory and examination programs. Part 2 requires investment advisers to prepare narrative brochures that contain information such as the types of advisory services offered, the adviser’s fee schedule, disciplinary information, conflicts of interest and the educational and business background of management and key advisory personnel of the adviser. The brochure is the primary disclosure document that investment advisers provide to their clients.
In addition to Form ADV, Form PF is required to be filed on a quarterly or annual basis by SEC-registered investment advisers, and those required to be SEC-registered, who manage private funds with at least $150 million in private fund assets under management as of the adviser’s most recent fiscal year-end. Form PF is intended to provide the Financial Stability Oversight Council with information necessary to monitor the systemic risk created by private funds and determine whether particular entities should be designated as “systemically important financial institutions.”
Managers must also consider whether registration with the Commodity Futures Trading Commission (CFTC) is necessary. Generally a manager that trades futures and/or commodities is subject to CFTC registration as a commodity pool operator and commodity trading advisor. There are several carve-outs and exemptions. Certain derivatives (e.g., certain security-based swaps) commonly used by US hedge funds are not subject to CFTC jurisdiction and therefore do not trigger CFTC registration. Exemptions from registration may also be available if a manager anticipates trading only a de minimis amount of derivatives (e.g., the aggregate notional amount of a fund's derivatives is less than 100% of the fund’s liquidation value each time a new position is established).
It may be appropriate for a hedge fund to issue different classes of interests for a variety of reasons:
The fund may wish to offer lower fees to investors who commit early, accept less liquidity, or subscribe for a larger amount in the fund.
Different investors might wish to invest in different currencies (for example, US investors might prefer to invest in a US dollar class, whereas European investors might prefer a Euro class).
These are any initial public offerings of securities made pursuant to a registration statement or offering circular. Restricted persons (which include broker-dealers and portfolio managers) have limited rights under the rules of the Financial Industry Regulatory Authority (FINRA) to invest in new issues. When investing in a new issue, the fund must confirm to its counterparty that the fund’s investors are not restricted from participating in such an investment, and the fund may therefore want to have separate classes available for investment by restricted and unrestricted persons.
The investment manager, its personnel and their connected persons may wish to invest in the fund. A management class would allow such persons to benefit from lower (or the absence of) management or performance fees or (where appropriate) to hold the voting rights in the fund.
The needs of seed investors and/or key institutional investors may drive the creation of other share classes as well.
INVESTMENT MANAGEMENT FEES
The investment manager’s fees usually comprise two elements: a management fee (typically at an annual rate of 1%-2% of the net asset value of the fund) and a performance-related fee or allocation (typically 20% of the increase in the net asset value over a specified period). The traditional 2/20 model has been under stress due to recent lower hedge fund performance. Management fees, for example, have come down closer to 1.5%. Management fees typically are paid monthly or quarterly. Performance fees are typically paid annually.
Underperformance through the use of a high-water mark is usually carried forward so that a performance fee is not paid twice on the same performance. Performance fees can be made more investor-friendly by introducing a hurdle rate of return to be reached before the performance fee is payable (such as the risk-free rate of return or a percentage above a relevant market index). While commonplace among private equity funds, this is less frequent in the hedge fund industry.
The financial crises highlighted the importance of liquidity management. Usually, requests for redemption from a fund are given effect as of the relevant redemption date, and redemption proceeds are calculated with reference to net asset value as of that redemption date and paid in cash within a relatively short pre-agreed timeframe. However, in circumstances where it is no longer possible or appropriate to make redemptions, the fund needs to have tools to be able to effectively and fairly manage the situation. Such tools can include:
A gate limits redemptions on a particular redemption date to a stated maximum, usually in circumstances where the directors believe that, due to the liquidity of the underlying investments, such limit would be in the overall interest of investors. Gates can be imposed on a fund level, a class level and/or on an investor-by-investor basis. Gates may also be imposed on a priority basis, such that investors requesting a redemption first are redeemed in full before redemption payments are made to investors submitting redemption requests at a later date. This approach, while very fair, may lead to a “race to the exit.” An alternative is to apply the gate on a pro rata basis to all redemption requests outstanding on each redemption date. Imposing a gate is a reasonable approach if the deferral of redemptions is likely to enable the fund to achieve enough liquidity to meet redemptions in an orderly fashion without disadvantaging continuing investors.
In-kind redemptions allow time for the disposal of very illiquid assets. This can be done by an outright transfer of underlying assets. Alternatively, the investment manager can facilitate an eventual cash redemption by transferring the illiquid assets to a vehicle in which the investors have shares proportional to their interests in the fund, while the investment manager continues to try to realize the value of the underlying illiquid assets.
Side pockets separate assets or positions that are illiquid and/or hard-to-value from the rest of the fund’s portfolio. They are often established as a separate pool of assets referenced by a particular class of interest in the fund. An investor’s holding in the side pocket is apportioned pro rata to its holding in the fund as a whole at the time of the side pocket’s creation; redemptions are not processed from the side pocket until the relevant asset or position is sold or unwound. New investors in the fund would not participate in the side-pocketed asset.
Reduced redemption frequency
The fund could provide for the ability to reduce the frequency of redemption dates, or even cancel certain redemption dates, in order to provide additional time to realize assets or impose longer notice periods in respect of redemptions that need to be met.
Suspension of redemptions
This is traditionally considered an option of last resort where no others are available. It is hard to make the case for suspension when the fund can continue to provide full or partial liquidity to redeeming investors using the other liquidity management tools set out above. A suspension may sometimes be used to provide sufficient time to implement certain of the other liquidity management tools, and is likely to be an appropriate tool where a significant portion of the fund’s assets cannot be valued (for example, where the asset in question has been suspended from trading on a stock exchange).
The above description is a very brief overview. The establishment of a hedge fund requires managers to make key decisions regarding target investor markets, jurisdiction, corporate structure and business terms, as well as decisions about the strategy and nature of the fund’s offering. These decisions govern, in the long term, the ease with which the fund may be operated, the fund’s access to available pools of capital, and (along with performance) the long-term success of the fund. As such, these factors should be given measured consideration prior to and throughout the fund launch process.
An added benefit is that thinking through these issues in advance will allow the investment manager to give much more polished and thoughtful responses to difficult investor questions in those early criticalinvestor presentations.
Astleford is a partner in Dechert’s London office. Egbert, Kerfoot, Perkins and Vaughan are partners in Dechert’s New York office. Spangler is a partner in Dechert’s Orange County office.