We ask hedge fund managers five main questions to determine who can invest in their fund. Many prospective fund managers mistakenly believe that the “accredited investor” standard is the only required investor accreditation standard for their investors. Accredited investors (for individuals) must have a $1 million individual or joint net worth (excluding the primary residence), or $200k annual income ($300k with a spouse), for the previous two years, with the expectation to meet or exceed this standard for the current year.

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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.

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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 private placement issuer or an investment fund (collectively, the “Issuer”). From an investor’s point of view, the purpose of the PPM is to obtain needed information about the Issuer and its securities, both good and bad, to make an informed decision about whether to purchase the security. The investor wants to know the parameters of investing in the Issuer and the potential rights, risks, and rewards of its investment. For the Issuer, the purpose of the PPM is to provide the necessary disclosures about the risks, strategies, management team, investment criteria and other information about its securities to protect itself and its managers against claims of misstatements or omissions.

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Your hedge fund attorney will prepare six core documents, which are necessary to launch the fund: (i) a private placement memorandum, (ii) a limited partnership agreement, (iii) a subscription agreement, (iv) an investment management agreement, and (v) a general partner operating agreement, and (vi) a management company operating agreement. 

Other services and documents that are also generally completed include the formation services of the limited partnership, the management company and the general partner; drafting the management company operating agreement; preparing and filing the Edgar registration; drafting and filing state and federal Form D notice filings; and as necessary, preparing and filing any state or federal registrations or exemptions (or other necessary fund formation documentation).

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Hedge fund strategies encompass a broad range of risk tolerance and investment philosophies within a wide array of investments, including debt and equity securities, commodities, currencies, derivatives, real estate, and other investment vehicles. The horizon of hedge fund investment strategies has seen unprecedented expansion in recent years. Hedge fund investment terms are driven in large part by the fund’s strategy and its level of liquidity. To learn more about forming and operating a hedge fund, we encourage you to read our eBook, Forming and Operating a Hedge Fund. 

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One of the initial considerations when structuring a hedge fund is whether to form the fund domestically, offshore or both. If a fund sponsor expects to have only U.S. investors, a domestic entity is sufficient. However, if a sponsor anticipates offshore investors or U.S. tax-exempt investors (IRAs, pension plans, endowments, etc.) an appropriate offshore fund will be needed to shield such investors from U.S. tax liability. Read More

This article provides an overview of CFTC and SEC regulation of cryptocurrency hedge funds for hedge fund managers investing in various strategies involving Bitcoin and alternative cryptocurrencies.

Our law firm focuses on advising hedge fund managers throughout the world in starting and operating US and offshore hedge funds. During the past several months, we have received more inquiries for starting cryptocurrency hedge funds (including Bitcoin Funds and coin alternative funds) than for all other hedge fund strategies combined.

 

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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 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.

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