For answers to a number of frequently asked questions on topics related to the formation and operation of hedge funds and other pooled investment vehicles, please refer to the links below. If you have further questions, please feel free to contact us to schedule a complimentary consultation.

Hedge fund managers typically charge an asset management fee based on the fund’s net assets, along with a performance-based fee structured as a share of the fund’s capital appreciation. The asset management fee is generally between 1% and 2% of the fund’s net assets, and is typically charged on a monthly or quarterly basis. The performance fee, structured as an allocation of partnership profits for tax purposes, has historically been 20% of each investor’s net profits for each calendar year. Hedge fund performance fees are almost always subject to a “high water mark” mechanism that prevents a fund manager from earning a performance fee on the same gains twice. That is, the “high water mark” ensures that the manager has recouped all prior losses for an investor before the manager earns a performance fee with respect to that investor. Some hedge funds also utilize a “hurdle rate”, which requires that the fund achieve a stated return before the manager can earn its performance fee.
Interests in a hedge fund are securities and, as such, the manager of a hedge fund is undertaking a securities offering when offering and selling interests in the fund to outside investors. Undertaking a securities offering without a competent attorney invites significant regulatory and litigation risk for the fund’s manager and principals. You should expect an investment law firm that assists with the formation of a hedge fund to:
  • advise you as to the applicable regulatory requirements and assist with important filings
  • counsel you on key structural considerations in light of current market imperatives
  • provide robust disclosure and governance documents (including an offering memorandum, limited partnership or operating agreement, and subscription documentation)
  • assist in developing marketing strategies and collateral materials
  • provide other documentation and advice as may be necessary to launch the fund in a compliant manner
Offshore funds are typically created by hedge fund managers that have an expectation of receiving significant capital contributions from investors located outside of the United States. Offshore funds are also attractive to U.S. tax-exempt investors as a way to avoid unrelated business taxable income (UBTI). Offshore funds are generally established in Caribbean jurisdictions, although a European offshore entity may be more appropriate if a substantial number of European investors are expected. We can help you determine whether an offshore fund is necessary based on your fund’s needs. Additionally, we can help you determine the proper structure (parallel or master-feeder fund) and the most desirable offshore jurisdiction (Cayman, BVI, Ireland, Luxembourg, etc.) based on your fund’s unique characteristics.
Hedge funds raise money from individual and institutional investors who contribute capital in exchange for interests in the fund entity. Because hedge funds are generally prohibited from using any public advertising to attract potential investors, hedge funds are typically marketed through close networks. These networks may include friends and friends of friends, business associates, or relationships introduced through third-party placement agents, who can certify that prospective investors are “accredited investors.” Hedge fund managers may also negotiate “seed” investment deals with anchor investors who will often expect reduced fees or an ownership stake in the fund’s management company in exchange for a significant early contribution. To introduce the fund to prospective investors, hedge fund managers often develop collateral marketing material, which generally includes a “pitch book” and a “tear sheet,” to provide an overview of the fund’s strategy, manager, performance history, and investment terms. A hedge fund manager may maintain a web presence but may not use a website to advertise any specific fund (although hedge funds may begin to advertise publicly as a result of new flexibility created by the 2010 JOBS Act). For this reason, a hedge fund manager’s website will generally have a public portion and a password-protected portion. The public portion of the site will often contain basic information about the fund’s advisor and investment strategy, and may include a questionnaire to gain information about a prospective investor. The information gained from such a questionnaire should be used to begin a dialogue to determine whether the investor is qualified to invest into a particular hedge fund. pdf buttonClick here to download our JOBS Act Client Alert
Most hedge funds raise money through a private offering exemption under Regulation D of the Securities Act of 1933. Although Reg. D prohibits general advertising, fund managers do distribute certain documents to prospective investors. These documents are designed to give an investor a complete picture of the fund’s investment strategy as well as the risks of investing in the fund. Having improper or incomplete documentation can subject a fund manager to the risk of regulatory intervention and civil liability, both of which may carry significant costs. Generally, a start up hedge fund requires a private placement memorandum, a limited partnership agreement or operating agreement, and subscription documents. If the hedge fund has multiple managing principals, these principals should generally have a management agreement or other operating agreement between themselves to define rights and responsibilities. Hedge funds that utilize third-party placement agents to solicit investors will also need additional documentation. Finally, hedge funds often develop collateral marketing material, including a “pitch book” and a “tear sheet” to provide an overview of the fund for prospective investors. All of the legal documents necessary to start a hedge fund should be drafted or reviewed by a licensed attorney with experience in the investment management industry.
Hedge funds accept investors based on many considerations, including: wealth, sophistication, ability to absorb losses, tax status, citizenship, and more. Hedge funds must choose investors carefully because the exemption from registration that hedge funds utilize require that the fund only accept subscriptions from wealthy and sophisticated investors who can either withstand the loss of their investment or who invest with substantial knowledge of the attendant risks. A domestic hedge fund, structured as a 3(c)(1) fund, can generally accept up to 35 investors that are not “accredited investors,” as defined by the Securities Act of 1933. The rest of the fund’s investors must be accredited investors. Individual investors with a net worth greater than $1 million (excluding the value of such investor’s primary residence) are considered to be “accredited investors.” An individual who makes more than $200,000 per year (or $300,000 jointly with a spouse) will also generally be considered an “accredited investor.” Investors that are not accredited must certify that they are sophisticated enough to understand the risks of the an investment in the fund, and that they, or their financial advisor have carefully reviewed the fund’s offering documents. Institutional or entity investors must meet different criteria to be considered accredited. There are also limits on the amount of money a hedge fund may accept from retirement plans (ERISA plans). The investor eligibility criteria can become very complicated depending on where the fund’s manager is located, exemption or registration status, the fund’s investment strategy, and other factors. It is critical to consult a qualified hedge fund attorney prior to launching a hedge fund to gain a clear understanding of investor eligibility issues.
Hedge fund managers typically charge an asset management fee based on the fund’s net assets, along with a performance-based fee structured as a share of the fund’s capital appreciation. The asset management fee is generally between 1% and 2% of the fund’s net assets, and is typically charged on a monthly or quarterly basis. The performance fee, structured as an allocation of partnership profits for tax purposes, has historically been 20% of each investor’s net profits for each calendar year. Hedge fund performance fees are almost always subject to a “high water mark” mechanism that prevents a fund manager from earning a performance fee on the same gains twice. That is, the “high water mark” ensures that the manager has recouped all prior losses for an investor before the manager earns a performance fee with respect to that investor. Some hedge funds also utilize a “hurdle rate”, which requires that the fund achieve a stated return before the manager can earn its performance fee.
The CFTC regulates all the futures, foreign currency (“forex”), and swap markets, including options and other derivatives related to the foregoing. If you plan to trade futures, forex, swaps, or related instruments in a hedge fund, you may have to register the fund’s management company with the CFTC as a commodity pool operator (CPO) and, if you plan to give advice to individual accounts outside of the fund, then you may also have to register as a commodity trading advisor (CTA). There are, however, several exemptions that hedge fund managers use to avoid CFTC registration. The most common exemption from CPO registration, known as the “de minimis” exemption, requires that you not market your hedge fund as a vehicle to access the futures/forex/swap markets, you limit participation to “accredited investors” and “qualified eligible persons,” as those terms are defined in the applicable regulations, and, either: i) the aggregate initial margin and premiums used to establish positions in futures/forex/swaps does not exceed 5% of the liquidation value of the fund’s portfolio; or ii) the aggregate net notional value of such positions does not exceed 100% of the liquidation value of the fund’s portfolio. There are certain other exemptions that may also be applicable depending on your circumstances. You should consult with a licensed attorney with experience in fund formation matters to determine whether you will be able to operate under an exemption.
Yes, hedge funds are extremely flexible vehicles and are used by investment managers to pursue strategies across many different asset classes, from the highly liquid to the highly illiquid. Hedge funds that trade illiquid assets often utilize “side pockets,” an accounting mechanism that segregates illiquid investments from each other and from the fund’s liquid securities. Side pockets are designed to treat investors equitably, by allocating the side-pocketed investment to investors on a pro rata basis on the day the investment is made. This mechanism prevents later investors from receiving a stake in illiquid investments that are difficult to value. Likewise, because withdrawals from side pockets are restricted, side pockets prevent withdrawing investors from depleting a fund’s liquid assets to the detriment of the remaining investors. It should be noted that although side pockets serve a constructive purpose, side pockets create opportunities for improper use and have received some negative attention for this reason.
Hedge funds are typically structured as limited partnerships (LPs) or limited liability companies (LLCs). Both LPs and LLCs are taxed as partnerships by default, which means that they are pass-through vehicles for tax purposes. This means that there is typically no tax at the entity, or fund, level and investors will be distributed their proportionate share of the fund’s gains and losses for tax purposes. Investors will report these gains and losses on their individual tax returns and will pay tax on items of income and gain according to the character of the income or gain reported on a K-1 form provided by the fund. For example, if a hedge fund generates long-term capital gains, by holding an investment for more than one year, investors will pay taxes on such gains at the long-term capital gains rate. The fund’s manager will generally pay tax on its management fee at ordinary income rates and structure the performance fee as a profit allocation, rather than as compensation for services, in order to receive more favorable tax treatment with respect to assets that are eligible for long-term capital gains.
Hedge funds and mutual funds are both pooled investment vehicles that invest primarily in securities and commodities. However, mutual funds are subject to far more government regulation than hedge funds. Mutual funds are registered as investment companies under the Investment Company Act of 1940. As such, they are subject to certain limitations on their ability to short sell, use leverage, and charge management fees. Hedge funds, on the other hand, are known for their free use of leverage and short sale strategies as well as performance based management fees. Mutual funds also must provide investors with daily liquidity, meaning that investors can buy or sell shares at the end of each trading day. Conversely, hedge funds often have lock-up periods of several years where investors cannot leave the fund. Mutual funds generally have much lower minimum investments, as well, and therefore are available to many small investors. Hedge funds, of course, often have very high minimum investments and are only available to very wealthy individual investors and institutions.
Hedge fund managers are often regulated by the state in which the hedge fund manager conducts business or by the SEC, depending on the manager’s assets under management (known as “AUM”).  Hedge funds themselves do not register, although there are increased reporting requirements for funds themselves as a result of the 2010 Dodd-Frank Act.  A hedge fund manager may be required to register as an investment advisor with the manager’s home state, although registration requirements and available exemptions vary from state to state.  A hedge fund manager is not eligible for registration with the SEC until the manager has greater than $25 million in AUM.  Many states have recently adopted exemptions for investment advisors that only advise private funds (i.e., hedge funds and similar privately offered funds).  These “private fund advisor exemptions,” as they are known, often restrict the investors that the hedge fund may accept and may include other requirements, as well.  Navigating the state registration rules is complicated and will generally require the assistance of a hedge fund attorney with experience in state investment advisor regulations.
Lock-up provisions restrict an investor’s ability to withdraw capital from a hedge fund for some stated period of time. Traditionally, it was common for hedge funds to lock-up an investor’s contribution for one or two years. In the wake of the recent financial crisis, lock-up provisions received considerable negative publicity as investors attempted to withdraw funds to meet liquidity needs, and were unable to do so. As such, many hedge funds launched since have determined not to include a lock-up on investor capital. These funds will generally restrict liquidity in other ways, by decreasing the frequency of periodic withdrawal dates and increasing notice periods to effect a withdrawal, for example. Despite the negative association of lock-up provisions, lock-ups are still relatively common and are often important for funds that trade illiquid assets.
Investment advisors, including hedge fund managers, are subject to new registration and reporting requirements as a result of changes implemented by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank“). In general, if an investment advisor has less than $25 million in assets under management, the adviser is not eligible for SEC registration and must look to the laws of the advisor’s home state to determine registration and licensing requirements. Advisors registered in their home state can avoid SEC registration until they reach $100 million in assets under management. Advisors that only manage hedge funds and other private funds can avoid registration until they reach $150 million in assets under management. Dodd-Frank also increases reporting requirements for hedge fund managers with more advisors reporting on Form ADV and new Form PF.
If you can avoid state registration through the use of exemptions then you may not have to take any exams to run your hedge fund. However, if you have to register your fund’s management company as an investment advisor, or if you have to register yourself as an investment advisor representative, then you will probably have to take a securities exam as a prerequisite to registration. Most states require that investment advisor representatives take either the Series 65 exam or both the Series 7 and Series 66 exams. Some states do have different exam requirements though, so it is important to research specific state requirements so that you aren’t surprised. Taking exams can delay the launch of your fund so it is best to get started studying early in the formation process. Many states do have exemptions for certain professional certifications including: CPA, ChFC, CFP, CFA, PFS, and CIC.
It is not uncommon for a hedge fund to have multiple managers who share the responsibilities of running the fund. Multiple managers may execute different strategies or may operate in different functions so that each can concentrate on their own specific skill set. Responsibilities should be divided carefully and a management agreement or the management company’s operating agreement should clearly outline what happens in situations of conflict. An operating agreement should be drafted by a licensed attorney who has experience in the investment management industry.
Hedge funds are private investment funds known for their lightly regulated nature, use of leverage and short-selling, structural flexibility, and varied investment mandates. Hedge funds are also characterized by the expectation of significant co-investment from the fund’s management team as well as the use of performance-based fee structures. Although not all hedge funds utilize hedging strategies, hedge funds are able to play both sides of the market (long and short) and therefore should typically exhibit lower correlation to the broader market than a mutual fund or other “long only” investment vehicle. While it is generally agreed that the first hedge fund was started in 1949 by A.W. Jones, the term hedge fund has been used to describe almost any private investment vehicle, exempt from registration as an investment company, that employs proprietary investment strategies to leverage the expertise of the fund’s manager. Unlike mutual funds, hedge funds must generally only accept “accredited investors,” as that term is defined by the Securities Act of 1933, a restriction that results from a hedge fund’s privately offered status. Common investment strategies utilized by hedge funds include long/short equity, risk arbitrage, event-driven arbitrage, market neutral, short-bias, emerging markets, and managed futures investing.
For a 3(c)(1) fund (or a 3(c)(7) fund) to invest in another 3(c)(1) fund and only be counted as 1 owner for the purposes of the 100 beneficial owner limitation, the “Investing Fund” must own less than 10% of the “Receiving Fund’s” outstanding voting securities. The SEC generally considers limited partnership interests to be voting securities but may not under circumstances where limited partners do not participate in the management of the Receiving Fund. Limited partnership interests will be considered voting securities if any limited partner in the Investing Fund is a 3(c)(1) fund, not registered under the Investment Company Act, or if the Investing Fund was formed for the purpose of investing in the Receiving Fund. The SEC has indicated that an Investing Fund will be considered to be formed for the purposes of investing in the Receiving Fund if 40% or more of the Investing Funds committed capital is invested in the Receiving Fund.
No. Rule 3c-5 under the Investment Company Act of 1940 provides that knowledgeable employees of a 3(c)(1) fund do not count toward the 100 beneficial owner limitation. The term “knowledgeable employee” includes executive officers of a fund as well as investment person. The term “executive officer” includes any executive officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity. The term “investment person” refers to an employee of a 3(c)(1) fund or an affiliated management person who actively participates in the investment activities of the fund in connection with his or her regular duties.
Historically, hedge funds have been prohibited from conducting any public offering by Rule 502(c) of Regulation D, which prohibited all forms of general solicitation and advertising. However, the JOBS Act is changing this long-standing regime to allow hedge funds to advertise via media which have traditionally been unavailable to hedge fund managers. Within the scope of the existing Regulation D rules, hedge fund managers can still maintain a web presence that has a public portion and a password-protected portion. Specific information about any hedge funds must be maintained behind password protection and access to the password-protected content must be limited to pre-screened investors whom the manager has determined to be “qualified.” A hedge fund manager’s website must not allow visitors to “self-certify” as “accredited investors” in order to gain access to the password-protected content. pdf buttonClick here to download our JOBS Act Client Alert