Starting a hedge fund in 2015

By Peter Astleford, Partner, Mikhaelle Schiappacasse, Senior Associate, and Gemma Burke, Associate, Dechert LLP

Published: 30 June 2015

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Whether a promoter is establishing its first or its fifth hedge fund, what are the key considerations it should take into account in starting a hedge fund in 2015?
 

TARGET INVESTOR BASE
One of the most important factors in structuring a fund is determining the type of investor to which that fund will be offered.

Investor domicile and tax regime
Investors will seek to invest in a vehicle that minimises any taxation to which they may be subject. To address this, funds are typically structured in one of two ways: as an opaque entity (e.g. a corporate) or as a tax transparent entity (e.g. a partnership).

Continental taxed European investors generally prefer to invest through an opaque entity that allows profits to be realised later, or as capital gains rather than income (thus attracting a lower tax rate). Opaque entities are also generally essential for U.S. tax exempt investors (e.g. pension plans). U.S. taxpayers (e.g. U.S. individuals), on the other hand, are likely to prefer an investment in a tax transparent vehicle. Opaque entities tend to be undesirable to U.S. taxpayers due to stringent U.S. anti-tax avoidance provisions.

If the fund is targeting both types of U.S. investors as well as non-U.S. investors, it is possible to satisfy the tax requirements of each type of investor by using a “master-feeder” fund structure. Here, investors will invest in different types of entities to suit their requirements, but all proceeds are ultimately invested through a single “master” vehicle (which will be an entity treated as a partnership for U.S. tax purposes). A master-feeder fund enhances the critical mass of investable assets, and avoids the need for the investment manager to split tickets or engage in re-balancing trades between the parallel structures or for the fund to enter into duplicate arrangements with service providers and counterparties. Additionally, it creates greater economies of scale for the day-to-day management and administration of the fund, which generally leads to lower operational and transaction costs.

Investor types
The trend over the past decade has been for institutional investors to replace high net worth individuals as the investor base for hedge funds. Institutional investors may have particular characteristics that a promoter may need to take into account in establishing a fund:

  1. Seed investors – promoters sometimes look to institutional investors to provide seed capital in order to alleviate concerns that the fund launch will not raise enough capital to be viable. Seed investors may seek preferential treatment for their investment in the fund, and may also have strong views on the fund’s jurisdiction, structure and/or terms. Generally, care needs to be taken that any preferential arrangements do not include terms that prejudice the interests of other investors or the long term viability of the project.
     
  2. Benefit plan investors – a large investor base for promoters marketing their funds into the United States are entities characterised as ‘benefit plan investors’ under the U.S. Employee Retirement Income Security Act of 1974 (“ERISA”). Funds will generally want to ensure that investments by benefit plan investors remain below 25 per cent (calculated on a per class basis and ignoring the investment of the investment manager and its associates), otherwise the fund and its service providers will be subject to additional burdensome requirements.
     
  3. Fund of fund investors – funds of funds have their own investor base, performance and liquidity profile to consider. Accordingly, they will need to invest in hedge funds that do not jeopardise their own structure and will have a preference for funds that have a similar or better liquidity profile and will seek to limit their exposure to funds which are able to limit redemptions.

The fund’s jurisdiction of establishment

Jurisdictional Considerations
Popular fund establishment jurisdictions include the Cayman Islands, Ireland, Luxembourg and the U.S. (commonly Delaware when targeting U.S. investors). Malta is also an emerging European alternative. In choosing a fund domicile, promoters should consider the following issues:

  • Whether the jurisdiction is familiar with hedge funds (and therefore has the appropriate infrastructure).
  • The perception of the jurisdiction amongst investors (for example, U.S. investors will generally be more familiar with Cayman or Delaware structures, whereas continental European investors may prefer Luxembourg (or Irish) funds).
  • The laws and regulatory requirements of each jurisdiction (which will affect the timeframe for establishment, flexibility and continuing obligations in operating the fund).
  • The tax efficiency of establishing the fund in a particular jurisdiction.
  • Establishment and ongoing maintenance costs of the fund.

Implications of marketing a fund under the European Alternative Investment Fund Managers Directive (“AIFMD”)

While the Cayman Islands has become the jurisdiction of choice for global promoters, the implementation of AIFMD in the EEA and the limitations on marketing funds established outside of the EEA into the EEA should lead promoters to consider whether to establish funds within the EEA if they are targeting investors in the European market. Under AIFMD, funds established outside of the EEA may only be marketed into EEA countries pursuant to each relevant country’s private placement regime. Certain EEA jurisdictions do not permit private placement (e.g. France) or impose requirements that make it costly or complex to undertake marketing on a private placement basis (e.g. Germany). However, funds established in the EEA and managed by an EEA based alternative investment fund manager for the purposes of AIFMD may be marketed, as of right and following a simple registration process, into other EEA jurisdictions pursuant to a passport. Once an EEA established fund is qualified to market into one EEA country, it should be relatively straight forward to register it for marketing in all other EEA countries.
 

The fund’s structure

There are a number of considerations that will drive the fund’s structure.

Open-ended or closed-ended
Funds can be open-ended, allowing investors to subscribe for and redeem their investment from the fund on a regular basis. Alternatively they may be closed-ended, with investment limited to one or more initial subscription dates and investors being unable to redeem their interests at will with distributions being made at set intervals or at the end of the life of the fund. Investors generally prefer to invest in open-ended structures for liquidity reasons. Closed-ended structures, however, are commonly used for specialist fund structures, particularly those engaged in real estate, infrastructure investment or debt issues. Closed-ended funds are typically associated with lower fees and better performance but marketing tends to be harder and to a different investor base.
 

Single cell or umbrella structure
If the fund will have one investment strategy and one portfolio of assets, a single cell/portfolio vehicle may be appropriate. If more than one strategy will be run with multiple portfolios of assets, an umbrella structure may be more appropriate. The advantage of an umbrella structure is that it reduces costs and the level of fund documentation. However, promoters need to be wary of the possibility of cross class liability, i.e. that in some jurisdictions and with some structures, as a matter of law, creditors of a defaulting portfolio may have recourse to the assets of a non-defaulting portfolio.
 

Third-party fund platforms
If a promoter does not have the time or means to establish its own fund structure, an alternative is to use a third-party fund platform. Third-party fund platforms are generally umbrella structures that allow promoters to “plug and play” by joining the platform with their own separately managed sub-funds. Platforms may benefit from shared costs, speed to market and potential distribution through capital introduction capabilities. Platforms may, however, in certain circumstances be more costly and provide limited control to the promoter of the fund.
 

Fund terms and service providers
Once a promoter has determined the appropriate fund structure, it can start to consider service providers and the terms of the offering itself.
 

Selecting key service providers
Consideration should be given to a service provider’s familiarity and expertise in servicing the asset types and markets in which the fund proposes to invest. Other considerations in appointing a service provider include: the jurisdiction and time zone of the service provider, the service provider’s reputation, and the service provider’s cost.
 

Classes
It may be appropriate for a hedge fund to issue different classes of interests for a variety of reasons:
 

  1. Accumulation and distribution policy – some investors may wish to receive dividends, while others will prefer income to be rolled-up.
     
  2. Reporting classes  – if the fund is targeting, for example, UK individual investors or UK investment trusts, it should consider seeking approval of one or more classes as a reporting fund so that any gains realised by such investor on the redemption or disposal of an interest in the fund will be subject to capital gains tax rather than income tax.
     
  3. Liquidity/fee terms – the fund may wish to offer lower fees to investors who commit early, to a less liquid investment or subscribe for a larger amount into the fund.
     
  4. Currency – different investors might wish to invest in different currencies (for example, U.S. investors might prefer to invest in a U.S. dollar class, whereas European investors might prefer a Euro class).
     
  5. New issues –restricted persons (which include broker-dealers and portfolio managers) have limited rights under the rules of the U.S. Financial Industry Regulatory Authority to invest in initial public offerings of securities made pursuant to a registration statement or offering circular. When investing in a new issue, the fund will have to confirm to its counterparty that its investors are not restricted from participating in such an investment, and may therefore want to have separate classes available for investment by restricted and unrestricted persons.
     
  6. Management shares – the promoter, the investment manager and their respective personnel and connected persons may wish to invest in the fund. A management class would allow such persons to benefit from lower, or no, management or performance fees or (where appropriate) to hold the voting rights in the fund.

Listing the fund
The principal reason to list a fund is to enhance its marketability as certain investors (such as pension funds and insurance companies) may be required to invest mainly or wholly in listed securities. The publicity provided about a fund by, for example, the Irish Stock Exchange may prove useful in facilitating subscriptions under reverse solicitation under the AIFMD.
 

Investment management fees
Investment management fees usually comprise two elements: a management fee (say 1 to 2 per cent. per annum of the fund’s NAV) and a performance related fee (usually 20 per cent. of profits over a specified period). Underperformance is usually carried forward so that a performance fee is not paid twice on the same performance. Performance fees can be made more investor friendly by introducing a hurdle rate of return to be reached before the performance fee is payable, such as the risk free rate of return or a percentage above a relevant market index but this is not common.
 

Dealing terms
Circumstances may arise where it is no longer possible or appropriate to make redemptions in the usual manner. In these circumstances, the fund needs to have tools to be able to effectively and fairly manage the situation. Such tools can include:

  1. Gate - redemptions are limited on a particular dealing day to a stated maximum, usually in circumstances where the directors believe that, owing to the liquidity of the underlying investments, such an action would be in the overall interests of investors. Gates can be imposed on a fund level, a class level or on an investor-by-investor basis. Gates may also be imposed on a priority basis (where the first to request redemption are the first redeemed) or on a pro rata basis (where pending redemption requests as of each dealing day are honoured pro rata).
     
  2. In specie or in kind –illiquid assets are transferred to a vehicle and investors are given a share in that vehicle (which the investment manager tries to wind down over time) (an “in kind” redemption) or there is an outright transfer of the fund’s underlying assets to investors (an “in specie” redemption).
     
  3. Side pockets –assets or positions that are illiquid and/or hard to value are separated from the rest of the fund’s portfolio. They are often established as a separate pool of assets referenced by a particular class of interests in the fund in which new investors will not participate. Redemptions are not processed from the side pocket until the relevant asset or position is sold or unwound.
     
  4. Reduce dealing day frequency – the fund could provide for the ability to reduce the frequency of dealing days or even cancel certain dealing days in order to provide additional time to realise assets or impose longer notice periods in respect of redemptions which need to be met.
     
  5. Suspend trading – suspension is traditionally considered an option of last resort. It may sometimes be used to provide sufficient time to implement certain of the liquidity management tools discussed above and is likely to be an appropriate tool where a significant portion of the fund’s assets cannot be valued where, for example, the asset in question has been suspended from trading on a stock exchange.


The above description of factors is a very brief overview only. The establishment of a hedge fund requires promoters to make, in addition to decisions regarding strategy and the nature of the fund’s offering, key decisions regarding target investor markets, jurisdiction, corporate structure and dealing terms. These decisions govern, in the long term, the ease with which the fund may be operated, the fund’s access to available pools of capital and (along with performance) the long-term success of the fund.

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