Hedge funds are well into the transition from bastions of alternative investment to being accepted into the mainstream investment marketplace. It is now estimated that global hedge fund assets under management amount to in excess of $3 trillion1 spread across a multitude of funds, management houses and strategies. The introduction of the European Alternative Investment Fund Manager’s Directive (“AIFMD”) in July 2013 provides standardised European Economic Area (“EEA”) rules on the operation and marketing and management of hedge funds and, as such, is very likely to bring hedge funds further into the mainstream.
So, 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?
The Fund’s Target Investor Base
One of the most important factors in structuring a fund is determining the type of investor to which that the fund will be offered. Is there a target investor base?
One can take this a step further. The most critical investors are often the early ones while critical mass is established. Should special or different consideration be given to those investors?
Investor domicile and tax regime
Investors will seek to invest in a fund 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 into hedge funds 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). Corporate entities are also attractive to U.S. tax exempt investors, such as qualified pension and profit-sharing plans, individual retirement accounts and endowments of education institutions. U.S. taxpayers (such as U.S. resident individuals and the treasuries of U.S. companies), on the other hand, are likely to prefer an investment in a partnership or other tax transparent vehicle. Opaque corporate entities tend to be undesirable to U.S. taxpayers due to stringent U.S. anti-tax avoidance provisions.
If the fund is targeting both principal types of U.S. investors and 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 fund entities to suit their requirements, but all proceeds are ultimately invested through a single master vehicle (which will be an entity that is treated as a partnership for U.S. tax purposes) and investment activity will be undertaken at the level of this “master” vehicle. This is administratively easier and cheaper for the investment manager and, typically, investors than where two funds are operated side by side.
The trend over the past decade has been for institutional investors to replace high net worth individuals as the investor base for hedge funds. This is due in some degree to the encroachment of regulation which has made it more difficult to market to individuals and to the large pools of capital which institutional investors have increasingly made available to the alternative investment space. Perhaps more importantly, it also recognises the institutional nature that many hedge funds have now taken on and the increasing need for pension, endowment and insurance funds to achieve an “absolute return”.
Institutional investors may have particular characteristics that a promoter may need to take into account in establishing a fund:
Seed investors – promoters sometimes look to institutional investors to provide seed capital. While this helps alleviate concerns that the fund launch will not raise enough capital to be viable, seed investors may seek an equity position in the fund’s investment manager and/or preferential treatment for its investment in the fund in terms of, for example, liquidity, fees and transparency, 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.
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 certain burdensome requirements. These include the imposition of additional responsibilities and duties on the fund’s investment manager and prohibitions that could affect the investment manager’s ability to engage in certain transactions (for example, cross trading and trading through an affiliated broker), as well as certain restrictions on the custody of fund assets outside of the United States. Certain of these requirements can be alleviated somewhat if the investment manager can qualify as a “qualified professional asset manager”.
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 liquidity profile and will seek to limit their exposure to funds which are able to limit redemptions. Investment managers need to recognise that funds of funds often have a short term investment time horizon with a low tolerance for poor investment returns (even on a very short term basis).
The Fund’s Jurisdiction of Establishment
There is considerable competition between leading jurisdictions. Popular 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 have a bearing on the timeframe for establishment, flexibility and the burdens of continuing obligations in operating the fund).
- The tax efficiency of establishing the fund in a particular jurisdiction.
- Establishment costs, expenses and ongoing maintenance costs of the fund.
Implications of marketing a fund under the AIFMD
While the Cayman Islands has become the jurisdiction of choice for global promoters, the implementation of the 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 the 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 the AIFMD (“AIFM”) 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. Accordingly, if some or all of a fund’s target investor base is in continental Europe, it may be better to establish the fund (and its investment manager) in the EEA.
Where the Fund’s Investment Manager is Established
While a promoter can establish the investment management company with the principals of that entity resident anywhere, it is possible that for tax structuring, control or other purposes the investment manager may wish to include in its structure an off-shore or non-EEA based entity. From a regulatory perspective, promoters may want to give consideration as to whether they wish the investment manager to be fully within, partly within or outside the scope of the AIFMD regime. Where the intention is for the fund to be marketed into the US and elsewhere in the world, but not generally into Europe, the promoter may not want to incur the added expense and effort of complying with AIFMD and may therefore wish to establish the investment management company (or the entity within the structure fulfilling the obligations of the AIFM pursuant to AIFMD) outside of the EEA. On the other hand, a promoter establishing a fund which intends to target a material number or proportion of EEA domiciled investors may wish to establish both the investment management company (AIFM) and the fund in the EEA so that it can benefit from the marketing passport provided for under AIFMD.
The Fund’s Structure
Once the jurisdiction of the fund (and the investment manager) and the target investor base has been identified, there are a number of considerations that will drive the fund’s structure – does it need to be open ended or closed ended, does its proposed investor base mean that it needs to be established as a standalone fund or as a master-feeder fund, should it be a single cell or an umbrella fund, or should the promoter instead join a third party fund platform?
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.
Stand alone or master-feeder structure
As discussed under “Investor domicile and tax regime” above, the types of investors that the fund wants to target will heavily influence whether the fund is structured as a stand alone fund or as a master-feeder fund. While the different needs of investors for tax opaque and tax transparent vehicles can be achieved by running parallel funds, 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. If only a tax opaque or tax transparent vehicle is required in light of the intended investor base, then a stand-alone vehicle with the appropriate tax characteristics should be sufficient and simpler.
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 check that as a matter of law or practice each portfolio (or sub-fund) will be protected upon the default of another portfolio, meaning that creditors of the defaulting portfolio should not have recourse to the assets of a non-defaulting portfolio. In addition, the investment manager can run multiple portfolios through one structure, with one set of service providers etc. without the need to establish separate fund structures.
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 and potential distribution through capital introduction capabilities. Setting up on a platform can also be quicker than launching a bespoke fund. The downsides of launching on a platform include cost (with costs calculated on an AUM basis, platforms can be more expensive for larger funds), a lack of control (an investment manager is a service provider and so is unlikely to have any representation on the platform’s board), the investment manager may have limited choice in terms of service providers, and problems will arise if the investment manager wishes to move to its own platform or the platform itself goes out of business.
For a more in-depth discussion on platforms, see the Dechert OnPoint entitled “Key Considerations When Launching a Fund on a Third-Party UCITS or AIFMD Compliant Platform".
Fund Terms and Service Providers
Once a promoter has determined the appropriate fund structure, it can start to consider the terms of the offering itself. Among other things, the promoter should ask itself:
- Who will the fund’s service providers be?
- Will different classes be issued?
- Should the fund be listed?
- What are appropriate fees (for itself and others)?
- What are the fund’s dealing terms and how can it give itself appropriate flexibility if something goes wrong?
Selecting key service providers
Prime brokers and custodians – consideration should be given to a prime broker’s and/or custodian’s familiarity and expertise in servicing the asset types and markets in which the fund proposes to invest.
Administrator – as with prime brokers, it is important that the administrator be familiar with the types of assets in which the fund will be investing as it is the administrator who will (in practice) be calculating the value of the fund’s assets. In addition, the administrator’s operations should ideally be based in a time zone which is convenient for liaison with the investment manager and investors.
Auditor – the auditor should be a reputable accounting firm of international standing or one which is known for its specialisation in the hedge fund industry.
Other considerations in appointing any service provider include: the jurisdiction and time zone of the service provider, the service provider’s reputation, and the service provider’s cost. If an investor is to invest with a new manager or strategy, it is nice if they are familiar with everything else!
It may be appropriate for a hedge fund to issue different classes of interests for a variety of reasons:
Accumulation and distribution policy – some investors may wish to receive dividends, while others will prefer income to be rolled-up.
Reporting classes – under the UK’s offshore fund tax rules, any gains realised by an investor on the redemption or disposal of an interest in an offshore fund will be treated as “offshore income gains” and subject to income tax unless the relevant fund (or class) is approved by HM Revenue & Customs as a “reporting fund”. Therefore, 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.
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.
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).
New issues – these are any initial public offering of securities made pursuant to a registration statement or offering circular. Restricted persons (which include broker-dealers and portfolio managers) have limited rights under the rules of the U.S. Financial Industry Regulatory Authority (FINRA) to invest in new issues. 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.
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.
Promoters should consider the following factors in choosing an exchange: reputation, simplicity of the exchange’s procedures, the exchange’s fees and the fees of any listing agent, speed of the listing process, listing requirements and the burden of continuing obligations on the fund as well as the AIFMD benefits.
Investment management fees
Investment management fees usually comprise two elements: a management fee (usually at an annual rate of 1 to 2 per cent. of the net asset value of the fund) and a performance related fee (usually of 20 per cent. of the increase in the net asset value 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. While this is common place amongst private equity funds, it remains relatively rare in the hedge fund industry.
The financial crises highlighted the importance of liquidity management. Usually, requests for redemption from a fund are given effect to as of the relevant dealing day and redemption proceeds are calculated with reference to net asset value as at that dealing day and paid in cash within a relatively short pre-agreed timeframe. However, circumstances may arise where it is no longer possible or appropriate to make redemptions in this manner. In these circumstances, the fund needs to have tools to be able to effectively and fairly manage the situation. Such tools can include:
Gate - a gate is a mechanism whereby 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, such that investors redeeming first are redeemed in full before redemption payments are made to investors submitting redemption requests for a later date. This approach, while very fair, may lead to a “race to the exit”. An alternative is to apply the gate on a pro rata basis to all redemption requests outstanding as at each dealing day. Imposing a gate may be a reasonable approach if the deferral of redemptions is likely to enable the fund to achieve a liquid position to meet redemptions in an orderly fashion without disadvantaging continuing investors.
In specie or in kind – to allow time for the disposal of very illiquid assets. This can be done by an outright transfer or the investment manager can facilitate an eventual cash redemption by transferring such assets to a vehicle that gives an investor a share in that vehicle that has a value relative to their proportion of the underlying illiquid assets in question (an “in kind” redemption) which the investment manager continues to try to realise. Alternatively, some investors may feel that they could manage the assets as well themselves and would prefer to take a portion of the illiquid assets directly (an “in specie” redemption).
Side pockets – side pockets are a mechanism for a fund to separate assets or positions that are illiquid and/or hard to value 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. An investor’s holding in the side pocket is apportioned pro rata to its holding in the fund as a whole at the time of the side pocket’s creation and redemptions are not processed from the side pocket until the relevant asset or position is sold or unwound. New investors in the fund would not participate in the side pocketed asset.
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.
Suspend trading – this is traditionally considered an option of last resort where no others are available. It is hard to make the case for suspension when the fund can continue to provide full or partial liquidity to redeeming investors where the other liquidity management tools sets out above are available. It may sometimes be used to provide sufficient time to implement certain of the other liquidity management tools 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. As such, they should be given measured consideration prior to and throughout the fund launch process. A good adviser will be able to advise on institutional preferences and expectations globally, as well as the individual characteristics of local fund jurisdictions. The independence of your adviser by being jurisdiction neutral and free of conflicts of interest will make the job of the fund promoter much easier.
1) Prequin’s Press Release: 2014 Sees Alternative Assets Industry Near $7tn in Value (21 January 2015).