STARTING A HEDGE FUND
By Leslie E. Fourton, Esq.
Hedge funds often are compared to registered investment companies, unregistered investment pools, venture capital funds, private equity funds, and commodity pools. Although all of the these investment vehicles are similar in that they accept investors’ money and generally invest it on a collective basis, they also have characteristics that distinguish them from hedge funds and they generally are not categorized as hedge funds.
Unlike a mutual fund, a hedge fund is not registered as an investment company under the Investment Company Act and any interest in the fund is not sold in a registered public offering.
I. Legal Documents to Set Up a Hedge Fund
A. Starting a Hedge Fund
To start a hedge fund, documents are prepared to establish the fund (and the management company), as legal entities. The subscription agreement and the operating agreements for the fund and the management company must also be drawn up, as such. Indeed, 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, thereof.
a. Here, the PPM is an extensive document individually created for each hedge fund. In addition, there are no specific disclosure requirements for the PPM (provided the offering is made solely to accredited investors), basic information about the hedge fund’s adviser and the hedge fund itself typically. The information provided is general in nature, of course varying from adviser to adviser, and it normally discusses the given fund in broad terms the fund’s investment strategies and practices.
b. Specifically, the term “accredited investors” is defined as only including individuals who have a net worth, (or joint net worth with their spouse), above $1,000,000, or who have income above $200,000 in the last two years (or joint income with their spouse above $300,000) and a reasonable expectation of reaching the same income level in the year of investment; or people who are directors, officers, or general partners of the hedge fund or its general partners; and certain institutional investors, including banks, savings and loan.
c. The PPM usually provides information about the qualifications and procedures for a prospective investor to become a limited partner, and it also provides information on fund operations, such as fund expenses, allocations of gains and losses, and tax aspects of investing in the fund. In addition, 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, as such.
d. In addition, the PPM also may reflect the market practice and expectations of sophisticated investors who typically may invest in a given hedge fund. Further, it may also point out the managers exemptions from the registration and prospectus delivery provisions of Section 5 of the Securities Act, which is available under Section 4(2) of the Securities Act and Rule 506, there under.
e. It should be noted that offerings made to “accredited investors” exclusively are exempt from disclosure requirements under Rule 506. If the offering is made exclusively to accredited investors only, issuers are not required to provide any specific information to prospective investors.
f. On the other hand, a particular fund may wish to allow non-accredited investors into the fund, in which case it may not be exempt from disclosure requirements; but, it is in the best interests of all of the parties involved to disclose all of the information pertaining to the fund. Finally, because the PPM most typically is the starting point for those conducting due diligence, it remains a crucial document even for offerings exclusively for “accredited investors.”
g. In addition, a Non-Accredited Investor is defined as an individual investor who earns less than $200,000 and has assets worth less than $1,000,000 and certain entities; on the other hand, as previously stated, an Accredited Investor is an individual who earns $200,000 or more or has assets worth $1,000,000 or more and certain entities; and Super-Accredited Investor: an individual who owns $5,000,000 worth of investments and certain entities that own $25,000,000 of investments. Please note that even “non-accredited investors” must have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the investment in the hedge fund. Finally, to minimize potential liability, many hedge fund advisers choose to sell interests only to accredited investors; nevertheless, accepting non-accredited investors is a great (and acceptable) methodology to begin a hedge fund.
B. Investor Types
In summary, the three main types of investors are:
- Non-Accredited Investor: an individual investor who earns less than $200,000 and has assets worth less than $1,000,000 and certain entities;
- Accredited Investor: an individual who earns $200,000 or more or has assets worth $1,000,000 or more and certain entities; and
- Super-Accredited Investor: an individual who owns $5,000,000 worth of investments and certain entities that own $25,000,000 of investments.
Please note that even “non-accredited investors” must have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the investment in the hedge fund. To minimize potential liability, many hedge fund advisers choose to sell interests only to accredited investors; but, so long as such investors understand the potential risks it is possible to accept non-accredited investors into a hedge fund.
C. Number of Investors
Generally, a hedge fund may have either:
- Up to 100 investors, provided that no more than 35 investors are non-accredited investors with the rest being accredited investors (sometimes called a “3(c)(1)-type hedge fund);” or
- Up to 500 super-accredited investors (sometimes called a “3(c)(7)-type hedge fund”).
When counting non-accredited investors for purposes of the 35-investor limit, the following persons are not counted:
- Any relative, spouse or relative of the spouse of the purchaser, provided such person lives in the purchaser’s principal residence;
- Any trust, estate or corporation in which a purchaser or persons related to the purchaser has a 50% or greater interest in; and
- Any knowledgeable employees of the investment adviser.
When counting investors for purposes of the 100-investor and 500-investor limits, the investors in a fund that own 10% or more of the hedge fund will be counted.
II. Registration of a Fund Manager(s)
A. Under New York law, it merely requires a hedge fund (e.g. hedge fund manager) to be registered upon giving advice (and managing) to 5 or more clients, and upon doing so such manager must have the Series 65, and he must become a registered advisor. In addition, it does not matter where the clients are from and who is in the hedge fund. Here, a hedge fund (e.g. the actual fund) counts as one client. It should be noted that if a client is from Italy (or any other respective) country, then the laws of their respective country apply, hereof.
B. Under New York law, the amount of money that you manage is not relevant. To be clear, a hedge fund may have either have up to 100 investors, provided that no more than 35 investors are non-accredited investors with the rest being accredited investors (sometimes called a “3(c)(1)-type hedge fund);” or up to 500 super-accredited investors (sometimes called a “3(c)(7)-type hedge fund”). Here, when counting non-accredited investors for purposes of the 35-investor limit, the following persons are not counted: any relative, spouse or relative of the spouse of the purchaser, provided such person lives in the purchaser’s principal residence; any trust, estate or corporation in which a purchaser or persons related to the purchaser has a 50% or greater interest in; and any knowledgeable employees of the investment adviser. When counting investors for purposes of the 100-investor and 500-investor limits, the investors in a fund that owns 10% or more of the hedge fund will be counted.
C. Under SEC Regulation D, a hedge fund can have 35 investors (e.g. they would be defined as one client) that are non-accredited investors; but, they can be problematic in the sense that if they had significant losses perhaps they could get litigious, and put forth a lawsuit whereby the rule of law would be in their favor with a low burden of proof, as such. Clearly, they must be people that the Hedge Fund manager(s) would certainly believe to be non-litigious in any manner. That is, even though the managers know that they would not lose their investment; the investors should have the attitude that they MAY lose their entire investment even though the aforementioned manager(s) know that they would not lose their capital, as such. Here, in the instant case, for the record any attorney dealing with Hedge Funds would typically advise in not having any non-accredited investors unless the given manager wholeheartedly believed that they knew enough about the particular individuals so as to believe (and be convinced) that they would not be litigious, per se. To be clear, it is possible both technically and legally to have non-accredited investors, and they technically would be considered to be “one” client; but, again they must be trustworthy in a sense that they fully commit to being in the fund, and fully understand the possibility that they could have a significant degree of losses, thereof.
III. Alternatives to immediate full Hedge Fund Development — An Incubator
A. An “Incubator” can be created by breaking down the hedge fund development process into two stages and isolating the first, if you will. Here, the first stage sets up the fund and management company entities, as well as other significant operating agreements and resolutions, which is enough to allow the hedge fund to begin trading, usually with the manger’s own funds or with funds from friends and relatives.
B. The question arises as to why a aspiring hedge fund manager would use an “Incubator” methodology? To be clear, by doing so such manager(s) may develop a track record, which can be marketed legally to potential investors in the offering documents. Further, at this stage the PPM is then developed with the performance information included, as such. Finally, the incubator method creates the opportunity for those with a skill for trading to break down the hedge fund development process into a manageable undertaking, which is highly advisable, thereof.
IV. Other related issues — Financial Market Materials and The Dodd-Frank Act
A. What if the hedge fund manager has other items such as technical analysis books (or products) selling Items separately on their web-site? Here, this practice does not have any bearing whatsoever on beginning a hedge fund or the management of it, thereof; in addition, nor would having a trading course practice as a business, as well. Upon doing so a mere statement legally bifurcating their respective hedge fund (and their financial market materials), and trading course(s) should be stated on the actual web-site so as to solidify the respective bifurcation, thereof.
B. What effect will the Dodd Frank Act have on launching a hedge fund? Here, the Dodd Frank proposed rules will not be put into effect until 2012, so there will be enough time to prepare for any new regulation, which is reasonable due to the fact they will have to enforce the requirement, and that will take time to go into effect, thereof. In conclusion, the Dodd Frank Bill will have no immediate legal effect on launching a hedge fund.
