CAPITAL FUND LAW BLOG
John S. Lore, Esq. | Capital Fund Law Group, PC
As part of the hedge fund formation process, the attorney works closely with the fund sponsor to craft the terms to which the fund and its investors will be bound. When properly structured, hedge fund offering documents contain terms that adequately protect the fund sponsor and are attractive to investors. Hedge fund terms are driven by a combination of the market trends within the fund’s specific asset class and the particular needs and objectives of the fund.
The following is a brief survey of categories of some of the most common hedge fund terms.
Minimum Initial Contributions
Hedge fund offering documents typically contain minimum investment thresholds as a condition to investment. Each additional investor adds an administrative burden and a degree of liability to the fund. Additionally, the number of investors allowed in any given fund is finite. In a 3(c)(1) fund the number of investors is currently limited to 99 investors.
Generally, the investment minimum amounts are set in the discretion of the fund manager. Note however, that funds organized under the laws of the Cayman Islands require a statutory minimum initial investor contribution of $100,000.
Management Fee and Inventive Compensation
Fund managers are typically compensated by a monthly or quarterly management fee, usually 1-2% of the assets under management. Managers also receive a quarterly or yearly incentive allocation, typically in the range of 20% of the capital appreciation of the fund. For a detailed discussion of the fund compensation structure, see our post: Hedge Fund Manager Compensation.
High Water Marks
To prevent a manager from receiving duplicate performance compensation following periods of volatility, most funds require investors to recoup past losses before the fund manager is entitled to receive additional performance compensation.
To accomplish this, a high water mark is established immediately following the allocation of incentive compensation. Under the “loss carry forward” terms, fund management is only be entitled to be compensated for performance that exceeds the prior “high water mark.”
Some funds require the investment manager to achieve a certain level of return, either as a fixed percentage or a benchmark rate (such as LIBOR or the S&P 500) before managers are entitled to receive performance compensation. Hurdle rates can be either a “hard hurdle” or “soft hurdle.”
A hard hurdle means that the manager only receives performance compensation that exceeds the hurdle rate. A soft hurdle means that no performance compensation is received if performance falls short of the soft hurdle rate, but once the soft hurdle rate is exceeded, the manager is entitled to the entire performance
During the formation process the fund sponsor designates which of the expenses of the fund will borne by the manager and which will be borne by the fund.
Typically, the fund bears expenses directly related to forming and operating the fund, including: legal formation costs, accounting and administrative services, regulatory filings, brokerage costs, clearing costs, etc. Note that most funds amortize startup costs over a sixty-month period, even though it is not in alignment with GAAP, to prevent early investors from being unfairly impacted.
Most offering documents allow the management team to negotiate special terms (known as side letters) that are not applicable to other investors. Often the special arrangement involves better economic terms, such as reduced management or performance fee, or more convenient withdrawal terms. Care must be taken, however, not to allow side letters to prejudice other investors. For example, side letters that provide additional information rights or preferential liquidity treatment can present significant liability.
It is typical for a hedge fund to require an initial lock-up period of one year or more, before investors can withdraw invested funds, with quarterly or semi-annual redemption allowed thereafter. The lock-up period be shortened or lengthened depending on the fund’s investment strategy.
If a fund strategy involves fairly illiquid investments, such that a one- to two-year lock-up period is insufficient, the sponsor should consider a closed-ended private equity fund. (Learn more about our private equity fund services).
To prevent funds from being forced to untimely liquidate investment positions to satisfy large redemption requests, most hedge funds limit the percentage of the portfolio that can be withdrawn in any given redemption period. This is known as a gate. In 2008 and 2009 a large number of funds invoked gate provisions to prevent untimely liquidations.
Capital Fund Law Group has authored numerous investment fund publications, including instructive eBooks, white papers, blog posts and sample offering document excerpts with illustrative footnotes. These complementary downloads are dedicated to helping fund managers understand the legal fundamentals of launching and operating an investment fund.
Forming and Operating a Hedge Fund | an eBook
Written by the managing partner of Capital Fund Law Group, Forming and Operating a Hedge Fund provides an in-depth guide to assist emerging hedge fund managers through the process of successfully structuring, launching, and raising capital for a domestic or offshore hedge fund. Throughout the eBook, it highlights pitfalls that fund sponsors should watch for and suggests best practices to safely and effectively navigate the process of forming and operating a hedge fund.
ABOUT CAPITAL FUND LAW GROUP
Capital Fund Law Group is a boutique investment law firm focused on advising emerging and established investment funds on all aspects of formation and operation. We provide predictable flat-fee services for most of our engagements. Our legal team has extensive experience advising hedge funds, real estate funds and private equity funds throughout the United States in various structures and strategies. We also prepare debt and equity private placement offerings for companies in all major industry sectors.
FORMING A FUND
Call 801-456-3620 or email us to schedule a consultation with one of our attorneys to discuss the costs, timeline and regulatory considerations involved in forming a fund. We will be happy to answer any questions you may have.