Launching the First Fund

Some thoughts for new hedge fund managers

Originally published in the April 2011 issue

As a lawyer specialising in investment fund formation, I spend a lot of time with new clients looking to set up their first fund. Many are bankers or traders with extensive experience in running money. Some are academics, some are marketing specialists, others are involved in other aspects of the financial services industry. Many are teams combining some or all of the above. What unites them all is that they have great ideas, but are often starting from the beginning in terms of setting up their own fund management business.

It is my job to help these highly motivated, talented people do what they want to do. This process commonly begins with a meeting to set out a road map to fund launch.

The following is a distillation of those meetings, covering some of the points which come up time and again.

The importance of planning
Preparation is key. All new managers have a clear idea of the strategy for their new fund. Many have given thought to where the money they will run is going to come from. Fewer have thought in detail about the specifics of their new business. For example, precisely how will the team be structured and operate? Where will the fund be based, and how will it be structured? What terms will investors be offered?

The more thinking that is done in advance, the more efficient (and cheaper) the formation process will be. All specialist legal advisers should be able to provide a checklist to help organise thoughts, but there are set out below some of the key areas which new managers should consider. A new management business will, hopefully, be the promoter of numerous new funds in future, so it makes sense to devote serious time to creating a robust management structure from the start.

The senior team
The senior members of the team need to be clear about their business relationship from the outset. There are numerous issues here:

• How will the business be capitalised? How will profits be shared?

• Who is to have management control? Is it a democracy or a (hopefully benign) dictatorship?

• How are disputes to be resolved?

• How are new members to be admitted to the team?

• In what circumstances can team members be removed?

• In what circumstances can they retire?

• What are the financial consequences of exit (whether voluntary or otherwise)?

The junior team
Whilst hedge fund managers generally run lean operations, there will be some more junior employees. These may be junior analysts actively engaged in fund management, or those in more general support functions – IT and compliance, for example.

• New managers should consider what can be outsourced and what needs to remain in-house. In-house capability offers control, but can be expensive and may not be necessary.

• Outsourcing of IT and compliance functions is common, but both of these areas are critical to the firm. Careful due diligence is vital, and care should be taken over the terms of appointment of such providers.

• Where the manager retains functions in-house, robust employment contracts should be created for the relevant staff to avoid problems later on. For those coming out of institutions with HR teams who handled staffing issues, it may be worthwhile taking advice on employer responsibilities, which can be complex.

The hedge fund community is famously international – senior executives are as comfortable in London as in New York or Zug. There is, however, generally a need for a fixed management base, and the choice for this will affect a number of other factors, including the tax and regulatory regimes applicable to the management vehicle. Whilst it may be attractive to choose a base in a low-tax jurisdiction, managers should consider whether it is better for both personal and practical reasons to be based in a major financial centre. One UK-specific point is that it will be important to ensure that, if the manager is based in the UK, the conditions of the HMRC Investment Manager Exemption are met.

Funding and capital
A new hedge fund management business will need capital. Aside from general working capital, regulatory capital may be required as well. Also, whilst many service providers will defer billing fees related to the formation of a first fund until that fund has launched (and can bear its own expenses), some funding should be in place to cover costs which cannot be deferred, or which relate to the establishment of the management business itself. Where authorisation of the Financial Services Authority is sought, it will be necessary to demonstrate the availability of adequate capital (regulatory and working) as part of the application process.

The founders may contribute capital themselves, though some more junior members may have ‘sweat equity’ rather than a direct monetary contribution. Alternatively, capital may be provided by a seed investor. In the current capital-raising climate, seed investors are in a position of some dominance, and may require a piece of the management business as a condition of their investment in the new fund.

Profit sharing and tax
It is possible through the use of different classes of debt or equity or, perhaps more commonly, different classes of LLP membership, to cut profits between different members in whatever way suits the team. Many managers are likely to have, at least, a split between base and variable compensation, but it is quite possible to establish multiple tiers. Where a seed contribution has been made, it is likely that there will be a waterfall allowing repayment of that seed equity, and a preferential profit.

Tax structuring is another aspect to be considered. Where the managers are UK-domiciled and resident, and fees are received from the fund as straight contractual management and performance fees, the opportunities for planning may be limited.

However, if managers are not UK-domiciled, or ‘fee income’ from the fund can be structured in an innovative manner, then this may be of more interest. Forming as an LLP instead of a limited company can carry substantial savings in terms of National Insurance Contributions provided certain conditions are met.

Regulatory issues
Regulatory obligations should be at the forefront of every new fund manager’s mind. The consequences of getting it wrong are material, carrying both criminal liability and harsh civil consequences. It is also a reputational catastrophe.

In the UK, it is almost certain that the management vehicle will need to be authorised by the FSA. This raises several issues:

• Who will prepare the application? Law firms will gladly handle such matters, as will compliance consultants.

• Are the management team all “fit and proper” persons, within the specific FSAmeaning? In particular, are any formal qualifications required?

• What is the impact on timing? Completing the FSA application pack is likely to take perhaps a month, including preparing a regulatory business plan. The FSA can then take up to six months to consider applications, although four to five months, or less, is more likely. Timing of submission is also important – material changes once the forms have been submitted may cause delay.

Once authorisation has been received, there is then the ongoing burden of continuing compliance. As above, this can largely be outsourced, or can be retained in-house. In any event, it is important to make sure that all those involved are clear as to their reporting lines and obligations, and that there are prudent oversight policies in place.

And regulation changes, of course. The Alternative Investment Fund Managers Directive and recent short selling disclosure proposals are but two examples of recent hot topics which will impact hedge fund managers. For those with investors or operations in the US, the Dodd-Frank reforms will also be significant. The Alternative Investment Management Association offers regular updates, and the opportunity to join in lobbying efforts on key points, and managers may wish to consider membership.

Getting the right investors
It is something of a cliché that raising a fund is more of a challenge in 2011 than it was in 2007. If a start-up manager is to be successful, then it is crucial that the right investors are offered the right product. Investors come in a variety of shapes and sizes, from risk-averse pension funds and other large institutions, to more aggressive HNWIs, through family offices, sovereign wealth funds and a raft of others. The manager needs to have a clear target group of investors in mind from within this universe, the more focused, the better.

Aside from the type of investor, the manager needs to know where potential investors are located. This will drive both tax structuring and regulatory issues (for example in terms of securities offering rules, the breach of which may carry criminal penalties). The targeting of US investors raises particular issues. For example, is either a pass-through or a blocker entity required for tax reasons? Are there likely to be ERISA issues or issues relating to the Bank Holding Company Act? The Dodd-Frank reforms have also affected the private placement regime in the US, and care must be taken if (state and federal) registration obligations are to be avoided. Ultimately, it may well be desirable either to establish several share classes in the fund, or to establish a master/feeder structure, allowing different investment routes for different constituencies of investor.

The right product
There is often a preconceived preference for a standard Cayman-domiciled master/feeder fund structure. In many cases, that is the right way to go, but it can pay to keep an open mind. As true third party fund-raisings have become more difficult, we have found alternative (and lighter touch) structures to be increasingly popular. For example, if the manager is, effectively, building track record by managing money for a single investor, then it may be possible to avoid much initial cost by adopting a managed account structure.

Establishment jurisdiction is also worth considering. Cayman remains a favourite, but there are numerous alternatives. Depending on the target investors, an EU-domiciled vehicle (Luxembourg, Ireland or Malta) may be appropriate. Also, increasing use is being made of UCITS IV-compliant vehicles, which carry certain marketing and asset allocation benefits (at the cost of flexibility and greater expense).

Whichever jurisdiction is selected, managers should remember that they will need both local legal advice and, most likely, the services of local professional directors and auditors (and possibly others). There will also be local registration and similar fees to pay and, to some degree, local regulatory obligations to be satisfied.

Service providers
The selection of the right fund service providers is an important practical decision. A new hedge fund is likely to need at least an administrator and prime broker and may also have a custodian, registrar, transfer agent or valuer.

The selection of the right administrator is key. Managers should take soundings about the reputation of the administrator for customer service as well as their technical capabilities. Given the administrator’s role as an interface for investors, poor service can have a real impact on investor relations. The terms of appointment of each service provider will undoubtedly need negotiation from the provider’s standard form (and their attitude to this process can be a useful indicator of their approach more generally).

There is now increased investor scrutiny on the terms on which assets are held by the fund’s prime broker. Given the problems that erupted following the collapse of Lehman Brothers, there is now much greater focus on issues such as treatment of fund assets as client money and, in particular, rehypothecation.

Setting the terms
A key part of the product design stage is setting the fund terms. Whereas in the past managers could expect something of a sellers’ market, the environment now is different and those now seeking new capital would be wise to make their offerings as investor-friendly as possible. The following are some important areas, but there are many more:

• Management fees must not be excessive, and should reflect the real costs of running the manager’s business. A flat 2% of assets under management may be acceptable, but only if that number is defensible as a fair price for the running of the fund.

• Performance fees must be subject to a high-water mark. More radically, there has been increasing discussion of performance fee structures based on overall returns to investors rather than NAV growth. If it is possible to offer a fee structure based on realised investor profits, then that has obvious attractions, but it is far from the norm. What is increasingly usual is a requirement, driven by concerns as to the role of the manager in NAV determination, for NAV to be set by an independent valuer.

• The ability to re-charge management expenses to a fund must be limited. This must not be seen as a back-door method of extracting value.

• Sophisticated investors recognise the value of liquidity tools such as suspension powers and gates, and those features remain common. Side pockets (carefully crafted and limited in application) are also acceptable, and should be considered where future illiquidity is an issue. It is clear that investors expect all of these tools to be used in each case in the best interests of the fund.

David Williams is a partner at DLA Piper, the global law firm. He heads the investment funds practice and is based in London. He has worked extensively with investment funds, including private equity and hedge fund firms.