New York is the world’s most popular jurisdiction for starting a hedge fund, as well as one of the top states for startup private equity funds, real estate funds and other alternative investment funds. Fund managers starting a hedge fund in New York avail themselves of a well-paved regulatory structure that is benefited by regulatory bodies with decades of experience with hedge funds and other investment funds.
Structuring a Hedge Fund in New York
The structure of a New York hedge fund is dependent on a number of tax, financial and regulatory considerations. Structure is driven in large part by the fund’s investment strategy, such as portfolio investment liquidity, trading frequency, and asset class.
A fund’s structure is also dictated by the location and type of investor. Funds that anticipate offshore investors or tax-exempt investors (including retirement plans, pension plans, endowments, etc.) would generally incorporate an offshore fund structure to shield otherwise tax exempt investors from U.S. Taxation. The most common offshore fund structures are the master-feeder structure and the side-by-side structure. Funds that rely solely on U.S. based investors need only create a domestic fund structure.
Domestic Hedge Fund Structure
A domestic (U.S. investor-only) New York hedge fund structure typically consists of a limited partnership (the fund entity) and two limited liability companies (the general partner and the investment manager). As of the writing of this blog post, limited partnership-based funds are still the most common fund vehicle for domestic funds, but LLC-based funds are increasing in popularity.
The first LLC (formed in the state of New York) acts as the investment manager of the fund and is wholly owned by the fund sponsors. A second New York LLC is formed to act as the general partner (managing member in the case of an LLC) of the fund. In many other states, the investment management entity and general partner entity can sometimes be combined as a single entity. For funds where the managers are located in New York City, two separate entities should be created to minimize tax under the New York City Unincorporated Business Tax (UBT). The management fees generated by the fund is paid to the investment management entity, while the performance allocation (known as carried interest in a real estate or private equity fund) is allocated to the general partner.
New York UBT and Hedge Funds
The New York UBT imposes a tax (currently 4%) on trades, professions, partnerships and certain other occupations, including fund managers. Businesses engaged primarily with investment activities are partially exempt from UBT. The UBT tax is imposed only on the management fee and not the performance allocation. The performance allocation is statutorily excluded. Accordingly, hedge funds formed in New York City employ a separate management company (which receives the UBT taxable management fee) and general partner (which receives the UBT-exempt performance allocation).
New York Private Fund Advisor Exemption
Any hedge fund investing in securities with over $150 million in assets under management (which includes portfolio leverage) must register as an investment advisor (also spelled adviser) with the SEC. For hedge funds managing less than $150 million, state registration is required in some states and is exempt in others. New York is among the states that offers an exemption for advisors that solely advise private funds and do not hold themselves out as investment advisors. Note that a fund with $25 million under management, whether exempt from state registration or not, must file a short-form ADV as an exempt reporting advisor.
Benefits of the New York Private Fund Advisor Exemption
By starting a hedge fund in New York, the manager is generally exempt from investment advisor registration until the fund reaches $150 million under management. A number of states that have a private fund advisor exemption, such as California and Texas, require investors that are charged a performance allocation to be qualified clients (currently $2.1 million in net investments). New York currently has no such requirement. Rather, investors need only be accredited investors.
Form D is a federal notice of an exempt securities offering that is filed with the SEC when relying on Regulation D for an exempt offering. In addition to the federal Form D requirements, a hedge fund must file a notice filing (also known as a “Blue Sky Filing”) with every state in which it has an investor.
New York Form D Requirements
Most states require the notice filing to be made within fifteen days after a resident of the state makes an investment. New York requires that the notice filing be made prior to any offer of securities within the state. New York’s Form D notice filing, known as Form 99, is more involved than Form D filing requirements of other states. Unlike most states, New York requires that all of the offering documents, including the private placement memorandum, limited partnership agreement and subscription agreement be submitted in advance to the state. New York also requires a much deeper level of disclosure of fund sponsors, including providing social security numbers. In other states, the trigger for the Form D filing is the date of purchase of the securities, whereas when New York investors are involved, the trigger is the “offering” the investment, which can be interpreted broadly. Hedge fund sponsors should refrain from presenting the fund opportunity or disseminating any marketing material prior to filing the notice filing in the state.
If a fund manager anticipates starting a fund targeting any New York investors, more time should be built into the pre-launch timeline to allow the hedge fund attorney to complete and submit the fund offering documents prior to having discussions with investors.
New York Form D and Rule 506(c)
Following the SEC’s adoption of the provisions of the JOBS Act allowing for advertising and general solicitation of certain Regulation D offerings (now set forth in Rule 506(c)), many have used advertising when starting a hedge fund. Most of the advertising targets a national audience, which includes New York residents, especially where internet and social media is used. Before a fund sponsor uses any electronic advertising in a 506(c) offering, a New York Form D notice filing (Form 99) should be filed. This is the case even if New York residents are not specifically targeted, since they could view the material. Another option (which is yet to be tested judicially) would be to include specific disclaimers noting that the offering is not available to New York residents.
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 and internationally in various structures and strategies. We also prepare debt and equity private placement offerings for companies in all major industry sectors.