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.
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.
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.
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.
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).
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. Below is a description of some of the more common hedge fund strategies. Note that hedge fund investment terms are driven in large part by the fund’s strategy and its level of liquidity. See our article: Brief Survey of Common Hedge Fund Terms.