Operating a hedge fund entails significant legal exposure, with substantial liability for improper disclosure. Even inadvertent mistakes can lead to substantial personal liability. The SEC, the CFTC, the NFA and state securities regulators have developed complex regulatory frameworks with which a fund sponsor must comply to avoid liability.
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.
The process for starting a hedge fund involves much more than a hedge fund attorney drafting the disclosure documents and preparing regulatory filings. Drafting the documents is only one component of a comprehensive fund formation process. A common mistake we see is hedge funds that are prepared using a form-driven approach, which results in investment fund terms and structure that are based on a generic structure, or often the wrong structure entirely. A template-based approach results in fund terms and structure that are not in line with the specific fund's needs, market position and regulatory structure.
Dodd-Frank exempts from registration two types of advisers: (i) advisers to qualifying venture capital funds; and (ii) advisers solely to private funds (including hedge funds and private equity funds) and having less than $150 million of assets under management. These two categories of investors are known as exempt reporting advisers. Certain exempt reporting advisers are required to file exempt reporting adviser registrations, as will be discussed below.
Since domestic hedge funds are typically formed in the state of Delaware, managers must qualify the fund to do business in the manager's state of operation. This is known as foreign qualifying. Foreign qualifying simply means registering to do business in a state other than the state of incorporation.
The state of Texas has become one of the nation's hubs for the alternative fund industry and has produced a number of internationally recognized funds. In recent years, Texas has made significant changes to its regulation of hedge fund managers, easing regulatory burdens on emerging hedge fund managers. This article discusses key aspects of starting a hedge fund in Texas.
Section 475 of the tax code permits certain active traders to treat all investment transactions as generating ordinary income or loss. Fund managers making a mark-to-market election recognize all gain or loss in open positions at year-end at the current fair market value as though they had been sold on December 31. By recognizing all transactions as ordinary income a fund manager forfeits the ability to treat any assets as long-term capital gains. Similarly, by marking portfolio assets to market at year-end, a manager loses the ability to defer income to later years.
After the initial seed raise, many issuers find it difficult to locate sufficient accredited investors to participate in the offering and turn to intermediaries. When using intermediaries, a company must (unless conducting a Rule 506(c) offering ensure that the intermediaries follow the rules requiring substantive pre-existing relationships with any prospective investors and avoid general advertising and solicitation. Intermediary violations of securities rules and regulations can subject the issuer to the same liabilities as if the issuer had committed the violations.
Successful investment funds rely heavily on the intellect and expertise of key individuals, the loss of which can prove ruinous to hedge funds of all sizes. In November 2014, one of Europe’s largest money managers, BlueBay, had to close a $1.4 billion fund because of the departure of a single key fund manager.
A company seeking to raise capital through a private placement generally looks to either debt or equity. Each has its respective advantages and disadvantages, both to the company and to the investor. An equity investment presents the investors with the possibility of a larger upside participation, but does not does not require the repayment of capital. A debt investments provides a periodic, fixed return to investors, but can put the company at risk if the company cannot timely meet its debt repayment obligations. If your company wants the benefits of debt without the risk of default, consider a hybrid approach: preferred equity.
Regulation D contains safe harbors that provide exemptions from federal registration. These include exemptions under Rules 504, Rule 505, and Rule 506. Rule 506 is the most commonly relied upon exemption in private offerings (accounting for more than 90% of offerings, according to SEC statistics).
Improper drafting of PPM disclosures often results in significant liability, even when the company did not overtly intend to deceive investors. The SEC and state securities commissions have developed a complex system of disclosure regulations, with which a company must comply for the securities to be deemed properly sold. In recent years, SEC regulations have undergone and continue to undergo major shifts, largely in response to the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd Frank) and the Jumpstart our Business Startups Act (JOBS Act). Failure to properly navigate the complex and continually changing regulations carries significant liability, including personal civil liability and criminal penalties in some cases.
A private placement offering’s basic structure involves either debt, equity, or some combination of debt and equity. Within the basic structure, an issuer has numerous options, from convertible securities (debts that convert to equity upon certain events), to priority distributions and resumptions. Not one structure fits every issuer. The offering structure is driven in large part by investor appetite for the particular investment.
A Private Placement Memorandum (“PPM”), also known as a private offering document and confidential offering memorandum, is a securities disclosure document used in a private offering of securities by a company or investment fund. From an investor’s point of view, the purpose of a PPM is to obtain needed information about the security and the company, both good and bad, to allow investors to make an informed decision about whether to purchase the security. From the company’s perspective, the purpose of a PPM is to provide the necessary disclosures about the company and its securities to protect the company against claims of misstatements or omissions.
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.