A Primer on Hedge Funds – Mark Radom

The name “hedge fund” suggests that a hedge fund is a fund that by some strategy seeks to protect the value of the assets of the fund against market downswings and other forms of loss.  Early on in the history of hedge funds, this may have been true.  Today, however, the term “hedge fund” is used more loosely and is held to encompass just about any form of investment vehicle for any type of investment.  The critical factor distinguishing a hedge fund from, e.g., a mutual fund or a private equity fund, is that a hedge fund is both unregulated and unlimited in what strategies it can use and investments it can make.

2. What can you do with a hedge fund?

So long as you make adequate disclosure to investors on what you are going to do, there is virtually no limit on what you can do with a hedge fund.  Some managers operate hedge funds just like mutual funds where they take positions in stocks or bonds and either trade or hold them for investment.  Other managers invest in a combination of stocks, bonds, futures, options and other derivatives.  Some managers invest in commodities, while others in property.  Some managers develop or acquire sophisticated algorithms and other programs which manage and trade the fund in an automated manner.  Other managers take a hands-on approach.  No other type of investment vehicle allows as much flexibility as a hedge fund.

3. How do you form and what documents are required for a hedge fund?

A typical hedge fund formation includes creating a limited partnership, which is otherwise referred to as the “fund”.  Investors subscribe for limited partnership interests and, if accepted, become limited partners. The fund’s managing partner is typically a limited liability company that was created specifically for participating in the fund and that is owned and controlled by the fund’s sponsor.  The managing partner will either manage the fund itself or contract the management to an outside company usually referred to as an investment manager.  The fund will open a bank account to accept subscription monies and cash positions and a brokerage, commodity or other type of account to effect transactions (the nature of which depends on the fund’s strategy).

To document the foregoing, a lawyer would form and open the limited partnership, the managing partner limited liability company and, if required, the investment manager entity.  The lawyer would also draft, among other things, a private placement memorandum, a limited liability partnership agreement and a subscription agreement.  If the manager elects to vary the terms and conditions of subscription to one or more investors, then various side letter agreements will also have to be prepared.  Depending on the sophistication of the fund’s trading, a prime brokerage agreement may also be required.

4.Fund Formation Issues

Typical principal issues confronting a fund manager who is embarking or about to embark on opening a new fund include:

• Minimum investment
• Capital contribution period
• Lock-up period/withdrawal restrictions
• Fees – management, performance, hurdle, high watermark, etc.
• Asset valuation practice
• Expenses
• Onshore vs. offshore/jurisdiction

5. What makes a hedge fund exempt from registration?

Sections 3(c)(1) and 3(c)(7) under the Investment Company Act of 1940 provide a safe harbor exemption for funds that limit the number of and have minimum net worth requirements for investors.  Should a hedge fund for any reason become subject to registration requirements, the resulting financial and reporting burden would not only cost the fund millions of dollars on an annual basis, but would necessitate the devotion of substantial management time and resource to compliance.  Accordingly, virtually all funds structure themselves in a way designed to avoid registration.

6. What makes a hedge fund manager exempt from registration?

Not only are funds themselves subject to registration requirements under US securities laws, but managers are also subject to registration, the rules and requirements of which are embodied in the Investment Advisers Act of 1940.  Section 203(b)(3) of such act, however, rescues managers from the onerous and expensive compliance burden of registration by exempting from registration any manager with less than 15 clients over a 12 month period.  The U.S. Securities and Exchange Commission agrees that, for purposes of complying with Section 203(b)(3), a manager counts the fund, not the number of investors, as its client so that, e.g., one fund with 250 investors still counts as only one client.

7. How does a hedge fund operate?

Once a fund is open and in operation, the manager will have as much latitude to operate as the fund’s strategy provides.  The fund’s strategy will have been agreed and disclosed to investors in the private placement memorandum.  So long as the manager makes the required reports and (hopefully) distributions to investors in a timely manner, the manager will be able to focus on and implement its business plan.  The amount of interaction a fund manager will have with its auditors, prime broker, administrator, lawyers, consultants and other third-parties depends on the strategy of the fund.