The structure of crypto-asset investment funds are driven by investment strategy goals, regulatory requirements, and tax considerations. The fund’s entity structure and allocation provisions aim to create efficiencies for fund managers and investors alike. For digital asset funds anticipating only US taxpayers, the fund vehicle is generally structured as a pass-through vehicle taxed as a partnership, either as a limited partnership or a limited liability company. However, as noted below, some crypto asset funds elect to trade through an offshore master-feeder or mini-master structure, regardless of whether the fund anticipates offshore investors.
The CFTC treats certain digital assets as commodities, including virtual payment tokens, utility tokens, and others under Section 1a(9) of the Commodities Act of 1936. CFTC regulated assets interests include: futures contracts, options on futures contracts, and swaps, including foreign exchange transactions. The CFTC has taken the position that virtual payment tokens, such as Bitcoin, are not considered currency because it is not accepted as legal tender in any jurisdiction.
Compared with the SEC, the CFTC has proven less of an obstacle for digital asset fund managers. CFTC commissioners have publicly encouraged forbearance and regulatory expansion to encourage the further development of digital asset innovation, including adding support to discussions calling for the creation of a self-regulatory organization to govern virtual commodities.
There are important distinctions between the scope of CFTC regulation of investment fund managers versus the SEC’s regulation of investment advisers. Unlike the SEC, which imposes adviser registration based on the inclusion of securities assets with the manager’s portfolio, the CFTC requires registration only from advisers that invest in commodities and other qualifying instruments using certain derivative strategies and leverage use.
On December 14, 2018, in anticipation of the IRS hearing for the Qualified Opportunity Zone (the “QOZ”) legislation, our firm hosted the Opportunity Zone Real Estate Fund Workshop at Columbia University’s Faculty House.
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.
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.
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.
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.
One of the most important aspects of forming a real estate fund is to set the terms of the investment. When properly structured, real estate fund offering documents contain terms that adequately protect the fund sponsor and are attractive to investors. Real estate fund terms are driven by the fund’s strategy, the market trends within the fund’s specific asset class and the particular needs and objectives of the fund. It is crucial that the investment fund legal counsel have an in-depth understanding of current investment market trends and how those trends affect the strategy the fund will employ.
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.
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.
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.