set up a hedge fund

Establishing a Hedge Fund: An Overview

After all the effort you have committed throughout the years, you are now ready to start and manage a hedge fund. It is important to evaluate the options available to you in order to establish your fund, manage the regulatory processes and select the right allies to guarantee that your fund and management company have the right conditions for progression. Building a hedge fund is a serious challenge that necessitates a methodical way of approaching it and experienced allies from various industries and knowledge backgrounds. Brokerage, legal, tax and technological factors are all imperative for a successful fund. Constructing a legal and structural framework that complies with the investment goals and investors of the fund is the base for success. This is an outline of the legal, structural and practical elements to consider when forming your hedge fund.



I. Type of Funding:

Two factors are mainly responsible for the form and place of residence of a hedge fund: (i) the tax status and home country of its potential investors; and (ii) the investment plan employed by the manager.



Domestic Hedge Funds:

In the case of U.S. citizens or U.S. taxable investors, a hedge fund can often be structured as a single U.S. domestic hedge fund. Generally, this is established as a General Partnership, with a limited liability company (LLC) serving as the General Partner. This setup has the benefit of offering limited liability for both the investors and the managers (by way of the LLC) and the advantage of “pass-through taxation” (which means all income is passed through to the partners and members) that is inherent in the partnership structure, eliminating the double-taxation problem that can arise with the corporate structure.



In general, the investment manager’s domicile typically organizes the general partner or LLC, while the LP or Fund is often established as a Delaware company due to its advantageous and business-friendly regulations. Both an operating agreement and a limited partnership contract are prepared, the latter of which grants considerable power in determining the control, operation and fee structures of the fund.



Investments in offshore funds are becoming increasingly popular as more people recognize the potential benefits they can offer. These funds involve placing money into an account in a different country, which provides investors with access to a different set of financial opportunities. Offshore funds can provide an additional degree of diversification, enabling investors to capitalize on the growth of international markets with higher yields than domestic investments. Furthermore, certain countries may offer tax advantages that can add to the overall return on investment.


If a fund manager in the US wants to let non-US citizens or US tax-exempt investors invest in their fund, then an offshore vehicle must be set up. Since the majority of these offshore funds are placed in countries with low to no taxes, there is little or no corporate-level taxation for the fund, however, investors will still have to pay taxes in their home country for any profits or earnings generated by the fund. The Cayman Islands and the British Virgin Islands are the two most popular jurisdictions for offshore funds, while Bermuda, Ireland and the Netherlands Antilles are less commonly used. Both of the Cayman Islands and BVI have strong regulatory structures in place to give assurance to investors that the funds they are investing in are legitimate. There are three main structures used for establishing offshore funds.



The Single Fund Structure is primarily created with non-US investors in mind, and may be suitable for US investors who are not subject to tax (such as pension and endowment funds). The sponsor and management company involved with this type of fund structure can either be US based or offshore based. Generally, offshore solo funds are overseen by an offshore entity.



Side by Side Structure : This kind of setup involves a US-based manager handling two distinct funds, a domestic and a foreign one, in precisely the same way. This type of structure is beneficial for certain tactics, like a fund of funds approach, yet less attractive for trading intensive strategies due to the need to split trade tickets between the two funds.



A Master-Feeder Structure is a well-known set up in which both US and offshore investors can invest in the same “master” offshore fund by means of two distinct “feeder” entities based domestically and overseas.



II. Management Pay and Expenditures:

A management fee is typically charged by most funds, usually ranging from 1-2% of the net asset value, to cover expenses incurred by the General Partner in running the fund, such as rent, salaries and computer hardware.


The most remarkable feature of the hedge fund structure is the performance-based element of a manager’s compensation. This is meant to incentivize the manager to bring in positive returns. Typically, the industry standard for said compensation is 20% of the fund’s profits over losses, allocated to the General Partner on a per-investor basis. This incentive is usually calculated on either a quarterly, semi-annual, or annual basis.


Performance-based allocations generally involve a high water mark, which means the manager must make up for any prior losses before they can get a return for the current period. These allocations occur monthly, quarterly, or yearly. There can be additional hurdles to receive a performance payment, which require the fund’s performance to surpass a certain rate of return. Hurdles are usually calculated either on an annual basis or cumulatively.




The Fund documents can be structured in such a way that the manager is able to recoup their legal and other costs associated with setting up the Fund over a period of one to five years. This is an action that most managers choose to take. The costs associated with the ongoing running of a fund, such as legal, administrative, audit and trading commission fees, are generally covered by the fund itself.



Third Party Capital Raising : Typically, the management firm shoulders the expense of rewarding third party promoters, solicitors or finders for their capital raising initiatives, which is normally done by allotting 20% of the administrative and performance fee associated with the investors they bring to the fund.

Managers may choose to exempt provisions of the LPA when deemed necessary.



Separate Agreements : In certain cases, a manager might need to authorize themselves to accept investors on terms that are more advantageous than those specified in the offering documents. Side letters are regularly used when a fund is in its initial stages in order to appeal to seed investors with more favorable conditions. Common side letter arrangements can comprise of decreased management or performance fees and/or heightened access to fund data. These letters are predominantly kept confidential.



III. Donations, Removals and Termination:

Investors in hedge funds have less liquidity than those in regulated investment vehicles. The liquidity of the fund is dependent upon the assets it invests in; funds that invest in highly liquid assets like large cap stocks usually allow investors to withdraw on a monthly or quarterly basis, while those in less liquid assets may only allow withdrawals semi-annually or annually. The Jones fund had the same level of liquidity as many funds today, with investors needing to give written notice 30-90 days in advance in order to exercise their redemption rights. To help the manager manage liquidity, liquidity management tools are utilized.



The Lock-Up feature requires investors to keep their original and/or additional investments in place for a predetermined period of time. An example of this might be a hedge fund that has an initial two-year lock-up and then allows semiannual withdrawals with a 45-day notification period.



A gate offers a manager a way to restrict the total amount of redemption on any given day, which is generally linked to a certain percentage of the fund’s net asset value, in order to reduce the possible harm caused by a large number of simultaneous withdrawals. As an example, if a fund allows for semi-annual redemption with a 15% gate, the manager could cap the sum of redemption of all investors on any redemption date at 15% of the fund’s net asset value, adjusting each investor’s withdrawal on a proportionate basis.



Investors may worry that their investments could be stuck should any key personnel at a hedge fund depart or become unable to work. In order to deal with this, certain funds include a key man clause that allows investors to pull out their money if a key manager suddenly leaves, or is unable to continue working for any reason.



IV. Supervision of the Offering, the Manager and the Fund According to Federal and State Securities Rules:

Hedge funds and their investment advisers are subject to a variety of securities regulations and oversight by a variety of regulators. The marketing of hedge fund interests is generally classified as an offering under the Securities Act of 1933. As an investment adviser, the fund manager is subject to the Investment Advisers Act of 1940, and the fund itself is covered by the Investment Company Act of 1940. However, these laws provide exemptions that can allow the offering and fund to avoid the costs and burdens of registration with the SEC, as well as the disclosure requirements. Furthermore, the fund manager may be exempt from SEC registration if they advise private funds with less than $150 million under management. Each state also has its own laws relating to hedge fund offerings and the registration of fund managers, which must also be addressed.



Controlling the Availability of the Offering:

Under the 1933 Act’s Regulation D, a safe harbor has been created to exempt private placements of securities from registration requirements. Rule 506 of Regulation D is usually tapped by the majority of hedge funds to offer interests. This Rule does not impose any monetary limits on the size of the offering and allows sales to an unlimited number of “accredited investors” and a maximum of thirty-five non-accredited investors.



Before September 2013, it was not possible to market or sell a fund through general solicitation or advertising. This meant that information regarding the offering could only be shared with individuals already known to the manager, such as friends, family, or other personal connections. On September 23 2013, the SEC amended Rule 506 of Regulation D (Rule 506(c)) to allow general solicitation or general advertising of private funds, provided that the manager reasonably believes and takes “reasonable steps” to verify that all investors in the offering are accredited. The SEC has adopted a “principles based approach” to determine if appropriate steps were taken to validate an investor’s accreditation, including obtaining copies of IRS income tax returns or statements of the net worth of investors verified by third parties. Thus, a manager now has the option of operating their fund under the pre-2013 solicitation regime or taking on the further compliance requirements necessitated by funds that generally solicit under Rule 506(c).



Quantities and Qualifications of Investors : The fund can be offered to an unrestricted amount of “accredited investors” and up to 35 other buyers. If non-accredited investors are allowed to buy fund shares, which is usually not the case due to various reasons, they must, either individually or with a purchaser representative, be considered as sophisticated investors , showing that they have sufficient understanding and experience in financial and corporate matters to be able to assess the advantages and risks of the proposed investment. The phrase ” Accredited Investor ” is currently defined to include:


Individuals with either a net worth, or combined net worth with their spouse, in excess of $1 million (not including primary residence) or an income surpassing $200,000 in the past two years (or a combined income with their spouse of greater than $300,000) and reasonable expectations of achieving the same level of income in the year of investment qualify.



Institutional investors, such as banks, savings and loan associations, registered brokers, dealers, investment companies, and ERISA plans, can be categorized under the term, provided that they possess more than $5 million in assets.


The interests that investors gain in the fund are termed as “restricted”, implying that they are unable to be marketed for twelve months without registering them under the regulations of the securities industry.



The Securities and Exchange Commission (SEC) must be informed about each offering conducted under Rule 506, but it does not require registration. To do this, Form D is filled in and submitted, which contains basic information about the Fund and its manager.



The 33 Act does not require accredited investors to be presented with specific information regarding a private placement of securities. On the other hand, non-accredited investors must be provided disclosure that is similar to what is required for a registered offering, so long as it is material to understanding the issuer, its business, and the securities being offered. Even though there are several federal and state antifraud regulations, a fund should still put together a comprehensive offering memorandum (known as a PPM) for both accredited and non-accredited investors.



The PPM will vary depending on the fund, but it normally covers the fund’s investment strategies, the manager’s background and key owners, the fund’s structure and practices, and any risks that come with investing in the fund. Additionally, the PPM will detail the limited partnership agreement, including withdrawal and transfer restrictions, valuation procedures, profit and loss allocations, as well as information regarding investor qualification and suitability. It may also provide information on lock-up periods, redemption rights and procedures, the fund’s service providers, any potential conflicts of interest, and how certain investment opportunities are allocated among clients. Other items that may be included in the PPM are soft dollar arrangements, redirection of business to brokerages, proxy voting standards, and guidelines for record keeping. Financial statements may also be included.


The Manager is to be regulated:

The Advisers Act regulates the registration of investment advisers. Prior to July 2010, when the Dodd Frank regulatory reform act was passed, all hedge funds could bypass being registered with the SEC due to the private adviser exemption, which provided a safe harbor for an adviser to private funds with no more than 15 “clients” in the prior twelve months who did not advertise themselves as an investment adviser. Each fund was viewed as a single customer for the exemption. However, Dodd Frank revoked the private adviser exemption but put a more limited exemption into effect in Rule 230(m) of the Advisers Act.

Rule 230(m) provides a safe harbor from SEC registration for any adviser managing private funds with a value of less than $150 million. Private funds are those which are included in Sections 3(c)(1) or 3(c)(7) of the Company Act. Those with assets under management of between $25 million and $150 million are called exempt reporting advisers. The calculation of assets under management is done on a gross basis, which requires advisers utilizing leverage to include assets bought on margin. Despite being exempt from registration, exempt reporting advisers must still comply with certain reporting requirements under a subset of Form ADV and may be required to register in the states where they conduct business.


The new 230(m) exemption has no cap on the number of private funds a private manager can advise, unlike the Repealed Private Adviser Exemption. When determining whether or not an investment adviser qualifies for the exemption, the types of clients advised are crucial. If a single client that is not a “qualifying private fund” is accepted, the adviser will not be eligible. Taking on a managed account would render the adviser ineligible. It is important to bear in mind that the exemption will be lost immediately if a non-qualifying private fund is taken on as a client. Thus, it is imperative to gain SEC registration before accepting such a client.


The regulations governing the Fund are based on the Company Act, which necessitates the registering of any “investment company.” Hedge funds, on the other hand, are exempt from registration thanks to Sections 3(c)(1) and 3(c)(7) of the Act, due to them being considered private funds.

Under Section 3(c)(1), an exemption is given to a fund that has no more than 100 shareholders and does not publically offer its securities (i.e. makes a Regulation D offering). Each individual investor is considered a beneficial owner, with spouses owning jointly registered as one. Any entity investing in the fund (e.g. corporations, trusts, or partnerships) is seen as a single beneficial owner unless it is another 3(c)(1) fund and holds more than a 10% stake. If more than 10% is held, the SEC will “look through” the fund and count each of its investors as a beneficial owner to prevent the pyramiding of 3(c)(1) funds in order to avoid mutual fund registration rules.


Under Section 3(c)(7) of the Company Act, a fund with no more than 499 investors can be exempt, provided that all of them qualify as “qualified purchasers” when they make their investment. For an individual to be considered a qualified purchaser, they must have at least $5 million invested. Alternatively, an institutional investor must have a minimum of $25 million in investments to be eligible.


The federal and state governments regulate the implementation of hedge fund performance fees. Generally, investment advisers registered with the SEC or a state that has adopted the Advisers Act are barred from gathering performance based remuneration or imposing performance based fees or allocations. Rule 205-3 of the Advisers Act provides a safe harbor for registered investment advisers when dealing with private investment funds solely for investors that meet the “qualified client” standards. Currently, a qualified client under Rule 205-3 is either (i) a natural person or a company with a net worth (with their spouse’s assets) of more than $2 million (not including the value of the primary residence), or (ii) a natural person or a company with at least $1 million under the management with the investment adviser after signing the advisory contract, or (iii) an officer, general partner, or employee that take part in the investment activities of the investment adviser.


V. Companies Offering Services

The fifth point to consider is the presence of businesses that offer services. It is essential to understand that these companies exist in order to provide help to those who need it. Therefore, it is important to research and make sure that the company is legitimate and can offer the help that is needed.

The success of a manager in terms of obtaining capital will be based on their performance, but to gain the trust of investors, they should enlist the services of the following service providers.


The long-term success and attractiveness of the fund and its manager can only be guaranteed if the fund is structured correctly and the necessary documents are drafted correctly from the start. Moreover, all regulatory requirements have to be met. For this reason, it is essential to select an attorney with expertise in securities law.


It is advised that an individual manager should set up an account with a Prime Brokerage Firm. The services these firms offer are quite extensive and include asset custody, trade execution, trade settling, portfolio financing and management, risk analysis and reporting.


The role of a Fund Administrator is to offer accounting services on a monthly and yearly basis to hedge funds. These services may include portfolio and reporting records, subscription and redemption accounting, performance fees and soft dollar accounting, invoicing and bookkeeping.


An audit of the fund’s finances is not legally necessary unless the manager is a registered investment adviser, however it is highly regarded by investors and is seen as a part of due diligence. Start-up fund managers may wait until the end of the fund’s first year of operation to get an audit done.


VI. An Alternative to Entire Hedge Fund Development: Incubator Funds.

Hedge fund managers who are looking to establish themselves often use an “incubator fund” as a method of proving their strategy to potential investors. This way, they can demonstrate their capabilities without having attained the necessary track record to gain investor confidence.


The incubator fund set-up can be broken down into two distinct stages. Initially, the fund and all related management entities are formed, including any applicable agreements covering performance, liquidity, and other important details. This allows the fund to begin trading, with the manager’s own capital, so that a track record separate from their personal account can be established. After approximately six to twelve months, the PPM is circulated and investors can be brought into the fund. This method provides an avenue for experienced traders to manage and complete the hedge fund development process.


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