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.
In September 2103, the SEC adopted rules allowing private issuers of securities, including hedge funds, to engage in advertising and general solicitation under Regulation D. Until the recent CFTC announcement, hedge funds that include commodities or futures within their portfolios could not engage in general solicitation, since such instruments are regulated by the Commodities Futures Trading Commission (CFTC).
Filing the ADV and other registration documents is only the beginning of an RIA’s regulatory obligations. Following registration, RIAs and their representatives become subject to a network of complex compliance obligations. This article touches briefly on a few of the many components of RIA compliance, including: annual license renewals, detailed record keeping, investor disclosure, compliance/ethics manual issues, and preparing for audits. RIAs should work closely with an experienced investment management attorney to maintain compliance with its obligations.
A prime broker is a central broker through whom the fund executes most or all of its trades and who typically acts as custodian to the fund’s assets. When the hedge fund executes trades through other brokers, the prime broker works with the executing brokers to settle and transfer all assets through the prime broker.
The investor standard of investor suitability applied to an investment fund may depend on the state or federal investment adviser regulations the fund manager is bound by. The two most common investor standards for private fund advisers are the “accredited investor” standard or the significantly higher “qualified client” standard.
Hedge fund manager fees typically consist of (i) an annual management fee and (ii) a performance allocation, also referred to as incentive allocation, or carried interest. The latter is not technically a “fee,” but rather a capital allocation, as will be discussed below. This blog post describes the role of both compensation components.