7 Keys for Starting a Hedge Fund – Structural Considerations
7 Keys for Starting a Hedge Fund – Structural Considerations
There are a number of structural considerations to think about prior to launching a hedge fund or other investment fund, such as a private equity fund or a real estate fund. Some of these considerations include the type of entity to structure, the domicile, whether to structure an open end fund or closed end fund, the amounts and frequency of management and performance fees, along with reporting requirements and regulatory filings.
1. Fund Domicile
The decision of the fund domicile is one that involves numerous considerations, such as the geographical location of the investment manager and the location of investors, preference of the target investors, tax concerns, investment manager budget, and other various considerations. There are numerous offshore jurisdictions including BVI, Cayman, Bermuda, and other popular venues for offshore investment funds. Most US (domestic) funds are established in Delaware.
A US domestic fund is typically used when the investors are US-based, taxable investors. An offshore fund structure is utilized for foreign, global investors and US tax-exempt investors. Again, there are other factors involved in the decision of where to establish the investment vehicle.
2. Open End and Closed End Funds
The strategy of an investment fund can play a large role in determining the type of fund vehicle used, and thus determines various restrictions a management company might implement for investors who are looking to participate as limited partners.
Investment funds that trade liquid instruments such as stocks, options, bonds, and other listed, marketable securities, are typically managed in an open-end fund structure and are considered to be “hedge funds”. Hedge funds typically have quarterly or even monthly liquidity for its investors.
Illiquid investment funds that invest in instruments that are not easily marked to market require investors to have a long-term horizon when looking for returns. Investments in private companies, real estate, commercial lending, commodity finance, and other similarly illiquid strategies require capital to remain within the investment vehicle for an extended period of time. A closed end fund structure is typically utilized for these types of investments, and the fund vehicle is considered to be a private equity fund, a real estate fund, or an ABL fund, depending on the underlying instruments. Investors in closed end funds also don’t have access to their capital for a specified period of time. Closed end funds usually only accept a specific amount of capital with redemption upon liquidation.
3. Management and Performance Fees
The management company usually receives compensation for managing the investment fund (which is generally referred to as a management fee), as well as, a portion of the profits, which is called a performance fee or performance allocation. For tax considerations it is typically preferable to segregate fees for services and profit participation. In some cases funds should be separated where management fees and incentive fees flow into separate entities. Additionally, determining the appropriate entity through which to pay expenses, including organization and marketing fees, are other considerations for startup hedge funds.
Most hedge funds have a combination of fees that are used to compensate the management company for their efforts in increasing the net asset value of the fund. Management fees are charged to each investor and are usually calculated as a percentage of the capital that is managed. These fees can run from 0% to 5%, but are typically set at 2%. The fees can be calculated in advance or in arrears and each approach has benefits to the management company. While performance fees can typically range from 10% to 80%, they are most often between 20% and 30%. The level of performance allocation is also affected by the amount of the management fee charged, with a higher performance allocation when a low management fee is assessed.
4. Tax and Liability Considerations
When starting an investment fund, there are a few tax implications and liability considerations at the management company level. Most managers wish to avoid double taxation and also protect the capital gains treatment of the founder’s capital. This decision affects the allocation of funds that are earned by the management company. Additionally, the liability of the owners should be limited to their investment in the management company.
Incentive fees are defined as a share in the profits that are earned by the management company. The structure of this fee has important tax implications when they are transferred to a general partner or a managing member. The allocation of an incentive fee is based on realized and unrealized gains (and losses). If profits are unrealized and allocated to the management company as increasing the percentage ownership within the fund, the gains occur without tax implications to the management company. If these funds are paid as fees, the management company pays taxes on the gains.
The portion of the allocation to the management fee that represents realized gains has the same tax treatment for the management company as it has for the Fund. If the allocated amount is considered to be a fee, the management company would pay ordinary income tax on the specified amount of revenue. Allocations to the management company reduce profits allocated to the fund. If this amount were considered a fee, the deductibility of the fee might be subject to tax implications to some investors.
5. High water mark
Profits received by a management company in the form of incentive compensation for a specific period usually only occur to the extent that the profits exceed any losses that occurred in the current period or prior periods. If a hedge fund generates losses, the management company will not receive incentive compensation until the losses are recovered and profits are made in excess of losses. Generally, management fees are charged to investors without recognition of profits or losses. Some funds have provisions that will reset losses after a specific period of time.
6. Regulations and Registration
Hedge funds are subject to different regulations typically based on the state in which the management company operates and other factors such as the number of investors and the total assets under management. Certain states, and in some situations the SEC, consider a manager of a fund to be an investment adviser. In some situations, there are various exemptions and de minimis exemptions available to investment managers of investment funds.
7. Summary of Fund Structural Considerations
The decision to utilize a particular fund structure is primarily based on the underlying investment instruments, and it is prudent to plan ahead and think about specific structural considerations prior to establishing a company that will manage investor capital. Fund domicile, management and performance fees, tax implications, risk/liability, and potential regulatory and reporting requirements are all additional considerations for a fund manager prior to opening an investment fund to investors.
An investment manager should speak with a knowledgeable hedge fund attorney regarding risk and liability issues. Fund managers should also work with an experienced hedge fund administrator regarding structural issues, and should discuss specific tax implications and questions with their hedge fund audit and tax counsel.
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