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.
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).
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.