New York Business Lawyers

Basics of Hedge Fund Startup Law For New York Businesses and Others–PT 2 of 4

by / Friday, 29 October 2010 / Published in Venture Capital

Our own Simon Riveles has for some time been heralding a second coming of small cap hedge funds, even given the current economic climate.  However, while many are eyeing the possibility of starting a hedge fund, they should tread lightly and seek to get a handle on the legal basics.  This Four Part Series provides an entry level discussion for anyone interested in starting a hedge fund.

Part I | Part II | Part III | Part IV

Hedge Fund Legal Structure:

In its most basic form, a domestically organized hedge fund consists of the fund itself and the investment advisory firm that manages the fund (the “management company”). The fund itself is generally organized as a limited partnership under state law. This allows the fund to provide flow-through tax treatment and limited liability to its investors. The management company to the fund serves as its general partner and the investors receive limited partnership interests at the time of subscription to the fund. Since the general partner remains liable for all debts and obligations of the partnership it is generally organized as a limited liability company under state law.

The limited partnership agreement governing the fund and the limited liability company operating agreement organizing the management company can be tailored to suit the different needs of investors and managers. The following provisions, in some form, are typical of all fund:

Management Fee: Most domestic hedge funds compensate managers with both a asset based management fee and a performance based profits allocation. Typically, the management fee is set as a percentage of the fund’s net asset value and ranges from 1 to 2%. Some funds have implemented expense pass-through arrangement entitling the manager to pass through to the fund some of the expenses of the LLC,  either in lieu or in addition to a management fee.

Performance-based allocation: The performance based element of a managers compensation is one of the key distinguishing factors of the hedge fund and is intended to reward the manager for generating positive returns on the funds investment portfolio. Today, the industry standard for performance based compensation is 20% of any realized profits over realized losses. Performance based allocations are generally subject to a high water mark which requires the manager to make up for previous years losses before being entitled to a current year performance allocation. Some funds include an additional requirement before the manager may receive a performance allocation. These are known as “hurdles” which require the fund’s performance to exceed a certain minimum rate of return before a performance payment is allowed to be made. Some hurdles are calculated on an annual basis with each years return measured against the hurdle applicable to that particular year. Others are calculated on a cumulative basis.

Liquidity: Hedge funds typically provide less liquidity to their investors than mutual funds, whose interests generally can be sold on a daily basis. The original Jones fund permitted investors the ability to exit on an annual basis. This level of liquidity is followed by many funds today. Other funds allow investors to redeem on a monthly, quarterly or semi-annual basis. A fund’s liquidity provisions often are directly related to liquidity of the instrument in which the fund invests. Funds invested in less liquid securities generally prefer to limit the frequency of redemptions available to investors since such investment take more time to close. In all cases, exercise of redemption rights requires the investor to provide advance notice of intent to withdraw in order to allow the manager to liquidate positions and free up cash.  In order to provide the manager with some control over redemptions certain liquidity management tools have been incorporated into funds. One such tool is the “lock-up” which is a term that subjects an an investor’s initial and/or future investment in the fund to a minimum holding period. For example, a hedge fund may have an initial two year lock up and them provide semi-annual redemption on  forty-five day notice. A second liquidity management tool is a “gate”. A gate provides a manager with a means of limiting aggregate with drawls on a given date, typically tied to some specified percentage of the fund’s net asset value. Thus, for example, if a fund provides for semi-annual redemption, subject to a fifteen percent gate, the manager may limit the aggregate redemption of all investors on any redemption date to fifteen percent of the funds net asset value, reducing each investor’s redemption on a pro-rata basis accordingly.

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