How Can I Start a Hedge Fund?

Hedge funds have been extremely successful investment funds in the past two decades. These funds handle alternative assets not generally held by traditional funds, such as mutual or pension funds. Managing a fund requires a strong knowledge of asset valuation and the ability to recognize potential for appreciation. Perhaps just as difficult as managing a fund, however, is starting and raising the capital for the fund. This can be particularly difficult for someone without a track record in the industry who is trying to convince investors to invest money in the fund.

This article discusses the various considerations and steps necessary in setting up a hedge fund.

Hedge Fund Structure 

Anyone staring a hedge fund will need to work with a transactional lawyer to help you in setting up the structure of the funds to meet regulatory requirements. It generally requires the formation of multiple business entities that are interconnected to allow separation between fund managers, advisors, and investors. The most common structure is known as a master-feeder, fund structure. This Investors (limited partiers) in the fund, place their money into feeder funds. The general partner, the fund owner, contracts with a management company that manages the investments. There are normally two feeder funds. One is used for US investors, and the second is used for Non-US investors. There may be two separate management companies serving each feeder fund. The feeder funds then invests money into a single master fund. The master fund, which may be organized as a Limited Partners, which another General Partner and contracted management company. The master fund actually makes investments into the investment vehicles, alternative assets, and portfolio companies. The funds are generally organized in Delaware or in an offshore location, such as the Cayman Islands of British Virgin Islands. The purpose of this is to establish a foreign tax base. There are numerous transactional fees that will also apply. Your attorney will draft the governance documents (operating agreements or partnership agreements), disclosure documents for investors (private placement memoranda), and investment agreements (subscription agreements).

Regulatory Compliance

Hedge funds are subject to extensive regulations in the United States. Traditionally, the funds have been subject to far less regulation than traditional funds, such as mutual funds. They are largely exempt from the provisions of the Investment Company Act, if the fund maintains certain standards in dealing with the portfolio assets. The fund is still highly regulated and has become more so since the passage of the Dodd-Frank Act. The most notable regulations applicable to the hedge fund and hedge fund advisor include:

• The Securities Act of 1933 - This Act generally places requirements on investor disclosure and the raising of capital through private placements. This includes dollar limits, disclosure requirements, investors knowledge or worth status.

• The Investment Advisor Act of 1940 - This Act requires certain fiduciary standards for fund advisors. It also places certain qualified purchaser standards on fund investors.

• Commodity Future Trading Commission - This body regulates the sale of commodities, a common asset class for hedge funds. Advisors may individually be registered as commodity pool operators or commodity trading advisors.

• Dodd-Frank Act - This Act placed additional requirements on fund managers to meet additional reporting standards to the SEC and CFTC.

⁃ Registration - If the fund manager has $100m or more under management, she must register with the SEC.

⁃ Counterparts - Banks and insurance companies dealing in derivative instruments (such as default swaps) are required to register with the CFTC.

⁃ Central Clearing - Many asset purchases qualifying as swaps were previously over-the-counter transactions. Many of these assets must now be purchased through a central clearing exchange.

Fund Administrator

The general partner, who raises the capital for the fund and identifies investment opportunities, will need to hire a fund administrator. The administrator handles the accounting and reporting requirements for the various entities, known as “back-office work”. The fund administrator is a company that specializes in administrative functions and provides extensive advice and guidance on running fund operations.

Audit and Tax Compliance

Fund regulations require extensive disclosure. The disclosure of information must be accurate. Regulatory requirements often require hedge funds to undergo private audit. The results of audit are disclosed during investor solicitations and, in some cases, to regulatory bodies. You will need to work with an auditor (CPA firm) who is separate from your operational accountant and who is familiar with hedge fund operations.

Raising the Fund

Remember, one of the most difficult aspects of raising a hedge fund is attracting investors. This requires the ability to convince individuals, businesses, endowments, trusts, or money funds to invest money in your hedge fund. This can be difficult if you do not have a track record demonstrating success in the field. Also, it requires extensive connections with potential investors. If you do not have top-of-mind awareness with potential investors, it may require the company to undertaking significant marketing efforts.