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Brief Survey of Common Hedge Fund Terms

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 and investor appetite 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, which means that managers will need flexibility to manage investor numbers. 

Generally, the investment minimum amounts are set at the discretion of the fund manager. Note however, that funds organized under the laws of the Cayman Islands and registered with the Cayman Islands Monetary Authority as mutual funds (with which generally most open-end Cayman Islands hedge funds are registered)require a statutory minimum initial investor contribution of $100,000.

Management Fee and InCentive Compensation

Hedge funds typically compensate their managers with a management fee, usually 1% to 2% per year of the assets under management. Hedge funds also pay their general partners a quarterly or yearly incentive or performance compensation, typically in the range of 15% to 20% of the capital appreciation of the fund. For a detailed discussion of the fund compensation structure, see our post: Hedge Fund Manager Compensation.

After the global financial crisis in 2008, the SEC increased its scrutiny of fees and expenses charged to investment funds and their investors. Some of their concerns lie with the conflicts of interest arising from a sponsor charging transaction and other fees. Hedge fund sponsors should work with their attorney to ensure that all fees and expenses charged to the fund are fair, reasonable, and clearly and fully explained in the offering materials.

High WaterMarks

To prevent a general partner from receiving excessive incentive or performance compensation fees following periods of volatility, most funds require investors to recoup past losses before the general partner is entitled to receive any additional performance compensation.

A high watermark is a tool used to establish a rising, minimum threshold of performance the fund must achieve immediately following the allocation of a paid performance compensation before any additional performance compensation can be paid. A hedge fund will typically include a high watermark to ensure fairness to the investors and incentivize the general partner to increase the value of the assets under management. Commonly, a loss-carryforward account is used to achieve the goal of the high watermark.  In return, the general partner will be compensated for performance that exceeds the prior high watermark.

Hurdle Rates

Some hedge funds are required to achieve a certain minimum level of return, either as a fixed percentage or a benchmark rate (such as LIBOR or the S&P 500) before the general partner is entitled to receive any performance compensation. Hurdle rates can either be hard or soft. No performance compensation is paid if the fund fails to increase the value of its assets by the hurdle rate.

A hard hurdle rate means that the general partner receives performance compensation on only that portion of the increase that goes beyond the established hurdle rate. A soft hurdle means that after the hurdle rate is exceeded, the general partner is entitled to receive its performance compensation on the entire increase of the fund’s assets under management.

Fund Expenses

The costs associated with setting up and administering a fund can be high. During the formation process the fund sponsor designates which of the expenses of the fund will be borne by the sponsors, generally paid by the general partner or investment manager from management fees and performance compensation received,  and which will be borne by the fund.

Typically, the fund bears expenses directly related to operating the fund, including ongoing legal costs, third-party accounting and administrative services, regulatory filings, brokerage costs, clearing costs, etc. Organizational costs, those costs associated with the formation of the fund and the offering can either be expensed to the fund or covered by the sponsors.  Most funds that cover the organization costs amortize such organizational costs over a sixty-month period, even though it is not in alignment with GAAP, to prevent early investors from being unfairly impacted. 

Generally, the general partner and management company  pays for its own administrative costs, which may include salaries and benefits of employees, office space, utilities, and related matters. The 1% to 2% management fee is usually sufficient to cover these expenses.

Side Letters

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 fee or performance compensation. 

Some of the more common terms that may be found in a side letter include:

  •  reduced minimum contribution amounts;
  • more lenient terms for transfers to an affiliate of an investor; and
  • membership on, or the ability to nominate a member to, the fund’s advisory board or committee.

Care must be taken, however, not to allow side letters to create conflicts of interest. For example, side letters that provide additional information rights or preferential liquidity treatment can potentially present significant liability.

The SEC has expressed concern with the conflicts of interest arising from preferential terms granted to some investors in side letters, such as those dealing with expenses, fees, and preferential access to co-investments. A fund sponsor must work closely with its attorney in creating any side letter agreement and should only do so if proper disclosures were made in the original organizational and offering documents.

Lock-up Period

It is typical for a hedge fund to require an initial lock-up period of between six months and one year, before investors can withdraw invested funds, with quarterly or semi-annual redemption allowed thereafter. The lock-up period may be shortened or lengthened depending on the fund’s investment strategy. Typically, the more liquid the strategy, the shorter the lock-up period.

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-end private equity fund. (Learn more about our private equity fund services).

Gates

To prevent funds from being forced to untimely liquidate investment positions to satisfy large redemption requests, hedge funds can limit the percentage of the portfolio that can be withdrawn, or the amount an individual investor can withdraw, in any given redemption period through provisions known as a gate.  With a gate provision in place, withdraws in excess of the gate are typically deferred to the next withdrawal period.

Hedge funds often have strategies and positions that require significant amounts of capital to be invested, and larger or frequent redemption requests can harm such strategy. The gate provision is usually designed as a withdrawal  limitation to grant the manager time to manage the fund’s positions without significant interruptions by investors. 


 

INSTRUCTIVE RESOURCES

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 complimentary downloads are dedicated to helping fund managers understand the legal fundamentals of launching and operating an investment fund.

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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.

 

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