Basics of Hedge Fund Startup Law For New York Businesses and Others–PT 3 of 4
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.
Hedge Funds raise their capital by offering interests in their funds to prospective investors. As limited partnerships, the interests of a domestically organized fund are generally considered securities under federal and state securities law. The Securities Act of 1933 (the “Securities Act”) generally requires offering of securities to be registered with the SEC unless an exemption from registration is available.
Private Placement: Hedge funds raising capital in the U.S. typically do so pursuant to a procate placement exemption from registration under Section 4(2) of the Securities Act and Rule 506 of Regulation D. Rule 506 imposes no dollar limit on the size of the offering and permits sales to a unlimited number of “accredited investors” but limits the sales of interests to not more than thirty-five non-accredited investors. The term “accredited investors” is defined to include:
• Individuals who have a net worth, or joint net worth with their spouse, above $1,000,000, or who 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 who 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.
Disclosure Requirements: Given their perceived sophistication, funds are not required to furnish speficied information to accredited investors. Non-accredited investors must, however, receive a level of disclosure regarding the fund akin to that required in a registered offering “to the extent material to an understanding of the issuer, its business and securities being offered.” Nonetheless, given the various federal and state anti-fraud provisions, a fund is well advised to prepare a comprehensive offering memorandum to both accredited and non-accredited investors known as a private placement memoranda (“PPM”). The information provided in a PPM is general in nature, varying from adviser to adviser, and it normally discusses in broad terms the fund’s investment strategies and practices. The PPM usually provides information about the qualifications and procedures for a prospective investor to become a limited partner. It also provides information on fund operations, such as fund expenses, allocations of gains and losses, and tax aspects of investing in the fund. Disclosure of lock-up periods, redemption rights and procedures, fund service providers, potential conflicts of interests to investors, conflicts of interest due to fund valuation procedures, “side-by-side management” of multiple accounts, and allocation of certain investment opportunities among clients may be discussed briefly or in greater detail, depending on the fund. The PPM also may include disclosures concerning soft dollar arrangements, redirection of business to brokerages that introduce investors to the fund, and further disclosure of how soft dollars are used. Copies of financial statements may be provided with the PPM.
Manner of Offering: In offering a fund, one must not only ensure that adequate disclosure is provided but also ensure that such disclosure is made in a manner permitted under Regulation D. Rule 502(c) prohibits an offering from utilizing any form of general solicitation or advertising, including any newspaper, radio, or television communication.
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