Inspired by Vanity Fair's recent piece on how to be a hedge fund honcho, thought I would republish my interview with hedge fund lawyer, Hannah Terhune
Traders and money managers often dream about one day running their own hedge fund, managing large sums of money, and competing head to head with the world’s top traders. For many, this dream remains an unfulfilled desire since they really don’t know where to begin. My guest this week will answer your questions, simplify this often complex subject, and point you in the right direction.
Hannah Terhune is chief attorney and member manager of Capital Management Services Group.com, Inc. Get ready for a tours de force education!
Dave: Greetings Hannah, Thank you for joining me today. Let’s start right at the beginning. Exactly what is a hedge fund?
Hannah: Although there is no universally accepted definition of the term hedge fund,” the term generally is used to refer to an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which are not registered as an investment company under the Investment Company Act. Alfred Winslow Jones is credited with establishing one of the first hedge funds as a private partnership in 1949. That hedge fund invested in equities and used leverage and short selling to “hedge” the portfolio’s exposure to movements of the corporate equity markets. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments and engage in a wider variety of investment strategies. Today, in addition to trading equities, hedge funds may trade fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options and other non-securities investments. Furthermore, hedge funds today may or may not utilize the hedging and arbitrage strategies that hedge funds historically employed, and many engage in relatively traditional, long-only equity strategies. In short, the term generally identifies an entity that holds a pool of securities and perhaps other assets that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act. Hedge funds are also characterized by their fee structure, which compensates the adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation. Hedge fund advisory personnel often invest significant amounts of their own money into the hedge funds that they manage. As discussed in the Report, although similar to hedge funds, there are other unregistered pools of investments, including venture capital funds, private equity funds and commodity pools that generally are not categorized as hedge funds. Hedge funds are often compared to registered investment companies. In addition, unregistered investment pools, such as venture capital funds, private equity funds and commodity pools, are sometimes referred to as hedge funds. Although all of these investment vehicles are similar in that they accept investors’ money and generally invest it on a collective basis, they also have characteristics that distinguish them from hedge funds.
Dave: When did this concept originate? Briefly, what’s the history?
Hannah: Hedge funds, while representing a relatively small portion of the U.S. financial markets, have grown significantly in size and influence in recent years. The SEC recognized over 30 years ago that hedge fund trading raises special concerns with respect to their impact on the securities markets. The growth in hedge funds has been fueled primarily by the increased interest of institutional investors such as pension plans, endowments and foundations seeking to diversify their portfolios with investments in vehicles that feature absolute return strategies – flexible investment strategies which hedge fund advisers use to pursue positive returns in both declining and rising securities markets, while generally attempting to protect investment principal. In addition, funds of hedge funds (“FOHF”), which invest substantially all of their assets in other hedge funds, have also fueled this growth.
Dave: What are the parts of a hedge fund?
Hannah: The parts of a hedge fund include the private placement memorandum, the subscription agreement, and the operating agreement for the fund. Hedge fund advisers typically provide information to investors during an investor’s initial due diligence review of the fund, although some, more proprietary, information may not be provided until after the investor has made a capital commitment to the fund, if at all. Most hedge funds provide written information to their investors in the form of a private offering memorandum or private placement memorandum (“PPM”). This reflects market practice and the expectations of the sophisticated investors who typically invest in hedge funds. It also reflects the realization of the sponsors and their attorneys that the exemptions from the registration and prospectus delivery provisions of Section 5 of the Securities Act available under Section 4(2) of the Securities Act and Rule 506 there under do not extend to the antifraud provisions of the federal securities laws. The disclosures furnished to investors serve as protection to the principals against liability under the antifraud provisions. Some of the information may be disclosed less formally in one-on-one conversations between investors and the hedge fund adviser. Hedge fund advisers may also provide information to hedge fund investors in the form of letters, conference calls and financial statements. In addition, some hedge fund advisers may provide prospective investors with access to their prime brokers and other service providers, such as administrators, both during the investor’s initial due diligence of the hedge fund and subsequently.
Hedge fund investors must often spend significant resources, frequently hiring a consultant or a private investigation firm, to discover or verify information about the background and reputation of a hedge fund adviser. In practice, even very large and sophisticated investors often have little leverage in setting terms of their investment and accessing information about hedge funds and their advisers. As a matter of practice, hedge funds generally provide investors with a PPM before an investment is made. As with any other offering solely to accredited investors, there are no specific disclosure requirements that pertain to the PPM under Section 4(2) or Rule 506. While we are not passing on the adequacy and content of PPM disclosure generally, we note that certain basic information about the hedge fund’s adviser and the hedge fund is typically disclosed. The information disclosed in PPMs varies from adviser to adviser, however, and often is general in scope. PPMs generally discuss in broad terms the fund’s investment strategies and practices. They also typically disclose that the hedge fund’s investment adviser may invest fund assets in illiquid, difficult-to-value securities and that the adviser reserves the discretion to value such securities as it believes appropriate under the circumstances. The PPM also may disclose that the adviser may exercise its discretion to invest fund assets outside the stated strategy or strategies. PPMs also generally discuss qualifications and procedures for a prospective investor to become a limited partner, as well as provide information about the hedge fund’s operations. For example, PPMs generally discuss fund expenses, allocations of gains and losses, tax aspects of investing in the fund and may incorporate the hedge fund’s financial statements. PPMs disclose any lock-up period that new investors must observe, as well as laying out the specifics for when investors will be able to redeem some or all of their investments out of the hedge fund. PPMs also may name frequently used service providers to the fund. PPMs may generally disclose potential conflicts of interest to investors, frequently under the heading of “risk factors.” A hedge fund’s PPM may note that the fund’s valuation practices give rise to an inherent conflict of interest because the level of fees that the investment adviser earns is based on the value of the fund’s portfolio holdings as determined by the fund’s adviser. PPMs also may discuss potential conflicts arising from the adviser’s “side-by-side management” of multiple accounts, including the hedge fund, private accounts, proprietary accounts and registered investment companies. A hedge fund’s PPM may also disclose the investment adviser’s conflicts in allocating its time and certain investment opportunities among its clients. Some PPMs spell out allocation policies with respect to limited investment opportunities in great detail, while others may list, and only briefly discuss, the factors on which such allocations will be decided. PPMs also often provide information concerning the use of affiliated services providers, including affiliated broker-dealers. Some PPMs also may note that the hedge fund may direct brokerage business to, and use other services of, firms that introduce investors to the fund. PPMs may disclose that the adviser may use soft dollars to pay for research and other services used by the adviser to benefit other accounts that it manages, and may further disclose that soft dollars.
Dave: Are these documents boiler plate or created individually for each fund?
Hannah: They are created individually for each client.
Dave: Does this paperwork need to be filed with the SEC or anyone?
Hannah: Form D is filed with the SEC and other forms may be required to be filed with each state where investors are located.
Dave: What is the definition of “accredited investor”?
Hannah: The safe harbor protection most often relied upon by hedge funds under Rule 506 exempts offerings that are made exclusively to “accredited investors.” Issuers are permitted under these provisions to sell securities to an unlimited number of “accredited investors.” In addition, if the offering is made only to accredited investors, no specific information is required to be provided to prospective investors. The term “accredited investors” is defined to include: Individuals who have a net worth, or joint worth with their spouse, above $1,000,000, or have income above $200,000 in the last two years (or joint income with their spouse above $300,000) and a reasonable expectation of reaching the same income level in the year of investment; or are directors, officers or general partners of the hedge fund or its general partner; and Certain institutional investors, including: banks; savings and loan associations; registered brokers, dealers and investment companies; licensed small business investment companies; corporations, partnerships, limited liability companies and business trusts with more than $5,000,000 in assets; and many, if not most, employee benefit plans and trusts with more than $5,000,000 in assets.
Dave: Does everyone who invests in a hedge fund need to be an “accredited investor” or high net worth individual?
Hannah: No.
Dave: I have several friends who would love to invest in a hedge fund, but don’t meet the above criteria. Is there anyway around the regulation?
Hannah: Yes, non accredited investors can invest in a hedge fund. It depends on the fund manager’s discretion.
Dave: Does the manager need to have a Series 7 or other licenses?
Hannah: No, a Series 7 is not relevant to this discussion.
Dave: How about registration? Does the manager need to register with the SEC?
Hannah: Yes, in certain cases, given recent law changes.
Dave: Does the manager need to register in the state the fund is domiciled in?
Hannah: Form D needs to filed with the SEC.
Dave: What about the funds trader (s). Do they need to register with anyone?
Hannah: Yes, in certain cases. This requires a state-by-state determination. A fund manager must sign up with their state as the investment adviser if they have less than $25 million under management. Between $25 million and under $30 million under management, the fund manager may choose the regulator—either the state or the SEC. If the fund manager has more than $30 million under management, the fund manager would need to register with the SEC as an investment adviser.
Dave: What if the investors are from different states? Does the manager need to register in every state an investor is from?
Hannah: Yes, usually a notice filing is required as long as they are registered in another state or with the SEC.
Dave: Is this in all cases? What about very small start up funds?
Hannah: It depends on the state and the structure the fund manager opts to use.
Dave: Is there anyway to legally avoid registration?
Hannah: You either have to register or you fall within an exemption.
Dave: If the manager is a CTA does he still need to register as a fund manager?
Hannah: The difference between a CPO and a CTA is that a CTA manages individual accounts, while a CPO manages only the hedge fund, or Pool. Few of our clients remain interested in the CTA option once they realize the administrative hassle associated with managing the separate accounts. No sponsor is needed to take the Series 3 exam. The Series 3 exam is given under the auspices of the NASD’s testing program. Two different testing services provide their services to the NASD.
Unlike a traditional hedge fund (where the SEC may end up being a regulator if enough money is under management), the government regulator that may associated with CPOs is the CFTC—the Commodity Futures Trading Commission.
The CFTC has allowed the National Futures Association (NFA) to become the primary regulator of futures and commodity products (as a Self-Regulatory Organization, similar to the NASD’s status with the SEC). It is my opinion that the NFA is a very effective and competent regulator.
Dave: How about if the manager has a series 7. Is registration still required?
Hannah: A Series 7 is of no particular value to either an RIA or a CPO. If someone has a current Series 7 (they’ve been registered within the past two years with a broker/dealer), they can choose to take the Series 66 instead of the Series 65. The Series 7 plus the Series 66 is always (in all states) equivalent to the Series 65. After two years of not being with a broker/dealer, all prior registrations (such as a Series 7) expire and are no longer valid. Similarly, if someone previously passed the Series 65 but has not had it registered with either a broker/dealer or an investment advisory firm, the exam has expired and will need to be taken again. Some states will not consider someone for investment advisory status unless they were previously registered as a Series 7 with a broker/dealer.
Dave: Ok, now that we have the basics out of the way. What’s the first step someone should take before launching a fund?
Dave: Is there a minimum capital amount that you feel is needed before launch?
Hannah: No.
Dave: What about someone who does not have any investors yet, who just wants to set up the fund structure for the future?
Set up an incubator fund? I know your firm runs some type of “hedge fund incubator” Can you explain what this is?
Hannah: It’s a start up process for a prospective fund manager to develop and document a track record that could be legally marketed to prospective investors when he or she is ready to open the fund to outside investors.
Dave: Do you actually do capital introductions?
Hannah: Yes, often, as a professional courtesy to our clients. We do not accept referral fees from non lawyers, as we are prohibited from accepting such fees by the rules governing the practice of law. We have an extensive network of contacts worldwide. We endeavor to set up our clients for success and look toward a long term relationship as well as build global relationships.
Dave: How about hooking a fledging manager up with a prime broker?
Hannah: Yes, as a professional courtesy to our clients. We do not accept referral fees from non lawyers, as we are prohibited from accepting such fees by the rules governing the practice of law. We have an extensive network of contacts worldwide. We endeavor to set up our clients for success and look toward a long term relationship.
Dave: I see, your firm is really a “one stop shop”. Do you do the back office stuff too?
Hannah: Yes, of course.
Dave: While we are on this topic, what is a “back office”?
Hannah: Many clients are accustomed to being one-person businesses, trading from their home office. They are interested in trading for others to leverage their knowledge and make more money, but they don't want to change how they work. They don't want to have to hire accountants and secretaries, or rent an office or gain tons of paperwork. They don't want to spend their days with attorneys, accountants, consultants and business operation hassles. We provide a full service, virtual Web-based and e-commerce solution takes all the hassle out of entering the hedge fund business. Clients can continue working from home, without any of the above mentioned hassles. We handle all of the charges to your investors for the management fees and the performance allocations as well as prepares the statements for investors. Most of clients use our hedge fund accounting services on a monthly basis; others on a weekly, quarterly, annually basis, or whenever they like. The work product includes NAV, performance records, brokerage statement reconciliation, advisory fee billing, performance allocation, investor changes, and other related reports generated from the software programs.
Dave: When the fund grows, are there capital levels or partner numbers that need to be watched? What I mean is, is there additional regulation, registration, et al on a 100 million dollar fund than there is on a 250k startup?
Hannah: No.
Dave: Recently, I have noticed a proliferation of off shore funds. What exactly is an off shore fund? What reasons would a manager want to set up an off shore fund?
Hannah: The word “offshore” has a certain mystique to many. Offshore hedge funds are investment vehicles organized in offshore financial centers (“OFC”). OFCs are countries that cater to the establishment and administration of mutual and hedge funds (“funds”). Offshore funds offer securities primarily to non-U.S. investors and to U.S. tax-exempt investors (e.g., retirement plans, pension plans, universities, hospitals, etc.). U.S. money managers who have significant potential investors outside the United States and tax-exempt investors typically create offshore funds. In many OFCs, the low costs setting up a company along with a kind tax environment make them attractive to establishing funds. Offshore hedge funds are typically organized as corporations in countries such as the Cayman Islands, British Virgin Islands, the Bahamas, Panama, the Netherlands Antilles or Bermuda. Offshore funds generally attract investment of U.S. tax-exempt entities, such as pension funds, charitable trusts, foundations and endowments, as well as non-U.S. residents. U.S. tax-exempt investors favor investments in offshore hedge funds because they may be subject to taxation if they invest in domestic limited partnership hedge funds. Offshore hedge funds may be organized by foreign financial institutions or by U.S. financial institutions or their affiliates. Sales of interests in the United States in offshore hedge funds are subject to the registration and antifraud provisions of the federal securities laws. Offshore hedge funds typically contract with an investment adviser, which may employ a U.S. entity to serve as sub adviser. An offshore hedge fund often has an independent fund administrator, also located offshore, that may assist the hedge fund’s adviser to value securities and calculate the fund’s net asset value, maintain fund records, process investor transactions, handle fund accounting and perform other services. An offshore hedge fund sponsor typically appoints a board of directors to provide oversight activities for the fund. These funds, especially those formed more recently, may have directors who are independent of the investment adviser.
Dave: Sounds like a good way to avoid taxes. Does the manager of a fund domiciled off shore still need to pay capital gain taxes, etc?
Hannah: The Do’s and Don’t of offshore funds are can be summed up as follows:
Do: Consider setting up an offshore fund is you manage money for either foreign and/or U.S. tax-exempt individuals and businesses. Under U.S. income tax laws, a tax-exempt organization (such as an ERISA plan, a foundation or an endowment) engaging in an investment strategy that involves borrowing money is liable for a tax on “unrelated business taxable income” (“UBTI”), notwithstanding its tax-exempt status. The UBTI tax can be avoided by the tax-exempt entity by investing in non-U.S. corporate structures (i.e., offshore hedge funds).
Don’t: Go offshore to avoid U.S. taxation. This is the wrong reason to consider an offshore fund. In short, setting up an offshore fund is not a tax minimization strategy as U.S. citizens, resident aliens (e.g., green card holders) are taxable on their worldwide income. The U.S. tax results depend on the nationality and domicile of the fund manager and his or her management company.
Dave: Am I able to set up an off shore fund without ever even visiting the country?
Hannah: Yes, of course. Our firm liaisons with foreign legal counsel. Everything is handled on a turnkey basis. You don’t need to stop trading or take a break from the markets. Just call us as we will work around your trading schedule.
Dave: What countries are most hospitable to off shore funds?
Hannah: Investment fund managers typically create offshore funds in Caribbean OFCs, although a European offshore entity may be more appropriate if a significant number of European investors are involved. Funds legally domiciled in OFCs hold around half of the hedge fund assets reported by the TASS hedge fund data base, with the British Virgin Island and the Cayman Islands being the most popular location. It has been estimated that over half of the world’s funds are incorporated in the British Virgin Islands However, management of funds is often conducted in or near major international financial centers such as London and New York although the actual fund is registered in an OFC. Ask where a hedge fund is domiciled and you are likely to hear the name of a handful of places worldwide. In the United States, domestic hedge fund businesses tend to cluster in a few states, in particular California, Delaware, Connecticut, Illinois, New Jersey, New York and Texas. Each state has different tax and regulatory laws. Outside the United States, several centers in the Caribbean and Europe present different benefits and costs to fund managers. Regulatory burdens and expenses can be worth bearing, depending on the nature of the investment vehicle and its clients.
Dave: Is there anywhere you would avoid and why?
Hannah: Any country lacking monetary or political stability.
Dave: Moving onto the next structure. Master-Feeder funds. What are they?
Hannah: The corporate structure of a hedge fund depends primarily on whether the fund is organized under U.S. law (“domestic hedge fund”) or under foreign law and located outside of the United States (“offshore hedge fund”). The investment adviser of a domestic hedge fund often operates a related offshore hedge fund, either as a separate hedge fund or often by employing a “master-feeder” structure that allows for the unified management of multiple pools of assets for investors in different taxable categories. The master/feeder fund structure allows the investment manager to collectively manage money for varying types of investors in different investment vehicles without having to allocate trades and while producing similar performance returns for the same strategies. Feeder funds invest fund assets in a master fund that has the same investment strategy as the feeder fund. The master fund, structured as a partnership, engages in all trading activity. In today's trading environment, a master/feeder structure will includes a US limited partnership or limited liability company for US investors and a foreign corporation for foreign investors and US tax-exempt organizations. The typical investors in an offshore hedge fund structured as a corporation will be foreign investors, US tax-exempt entities, and offshore funds of funds. Although certain organizations, such as qualified retirement plans, generally are exempt from federal income tax, unrelated business taxable income (UBTI) passed through partnerships to tax-exempt partners is subject to that tax. UBTI is income from regularly carrying on a trade or business that is not substantially related to the organization's exempt purpose. UBTI excludes various types of income such as dividends, interest, royalties, rents from real property (and incidental rent from personal property), and gains from the disposition of capital assets, unless the income is from "debt-financed property," which is any property that is held to produce income with respect to which there is acquisition indebtedness (such as margin debt). As a fund's income attributable to debt-financed property allocable to tax-exempt partners may constitute UBTI to them, tax-exempt investors generally refrain from investing in offshore hedge funds classified as partnerships that expect to engage in leveraged trading strategies. As a result, fund sponsors organize separate offshore hedge funds for tax-exempt investors and have such corporate funds participate in the master-feeder fund structure. If US individual investors participate in an offshore hedge fund structured as a corporation, they may be exposed to onerous tax rules applicable to controlled foreign corporations, foreign personal holding companies, or a passive foreign investment companies (PFIC). To attract US individual investors, fund sponsors organize separate hedge funds that elect to be treated as partnerships for US tax purposes so that these investors receive favorable tax treatment. These funds participate in the master/feeder structure. Under the US entity classification (i.e., check-the-box) rules, an offshore hedge fund can elect to be treated as a partnership for US tax purposes by filing Form 8832, "Entity Classification Election," so long as the fund is not one of several enumerated entities that are required to be treated as corporations.
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