Hedge fund referral regulations

Discussion in 'Professional Trading' started by Hedger, Sep 20, 2003.

  1. Hedger


    If I have an investor who is willing to refer some of his friends for a percentage of my performance fee, does investor need to be registered with some regulatory agency?

    Assume the business is based in New York. Also assume the investor is not actively soliciting or negotiating the deal. THey are just giving me their friends contact info. They are even disclosing to their friends that they are making a percentage of the performance fee.

    THanks for any help you can provide. If you need more details about the circumstances to make a more appropriate reccomendation, don't hesitate to ask.
  2. Foz


    If your friend is just selling you the contact information, then I don't think your investor could get into any regulatory trouble for selling or recommending securities. (Your hedge fund is a security.) Your investor is selling leads to you, not securities to his friends.

    But... If you then solicit these people whom you don't know to invest in your fund, then you may be running afoul of the Reg. D prohibition against general solicitation. I don't think the SEC will care if you bought your leads from an investor or a stranger.

    Also, keep in mind the Blue Sky laws and the states the people live in that you discuss your fund with.

    The Reg. D prohibition against general solicitation is a real bear when trying to get the word out about your fund. You're supposed to only sell your fund to people you have a prior existing relationship with?! And they have to be sophisticated, if not accredited, investors willing to pony up $10's of thousands of dollars?! Great... It'll take all of an hour to send off those seven emails. Then what?? I guess that's where prime brokers and hedge fund databases come in.

    Hey, look at the bright side... you won't have to budget much money for marketing.
  3. Hedger


    Thanks for the response.

    It's an interesting angle to say that the investor is selling me the contact information. Especially if the contact is his friend that he has a previous relationship with. I'm not expecting the investor to solicit investments in my fund from people he doesn't know. My investor just wants to make a percentage of my performance fee for the friends he refers.

    Take care!
  4. ktm


    I am of the opinion that the referral fee you are paying must be disclosed to your clients from your end as well, since it is ongoing and a percentage. If you were buying a list with a one time payment, that might be different - aside from any solicitation regs that Foz mentioned.

    This is just my opinion based on material I've read over the years and securities exams I've taken. I am in no way qualified to actually give you real advice.
  5. chessman

    chessman Guest

    I have thought about this as well. Like others I am not a lawyer and I am not sure if your investor or you would get in trouble since its just word of mouth, this is somewhat of a grey area. I do believe you would have to disclose the fee arrangement in your disclosure document.

    One way someone said to circumvent the full disclosure was, rather then passing on a portion of fee to your investor. You would reduce the fee that you would charge him. For example if your fee is 2/20 and he brings in 3 accounts, you would charge the investor 1/14 etc

    And then in your disclosure document you would say that your fee structure is 1-2% management fee and 10-20% performance fee. The fee is negotiable anyway in most of the cases, based on size of the account etc.
  6. Hedger


    If I find out anything, i'll post it here. It seems to be a grey area. I just asked an investment advisor friend of mine, and he was not sure since it's in the hedgefund arena.
  7. Talk to a lawyer, not a message board. Just my 2c. The advice here sounds good, but you don't want to be in sing sing.
  8. Once again, I agree with Foz. In the example you provided, the issue is not that you have the leads (or whether you paid for them), but what you do with them. Foz is also right on target in his advice to pay attention to the blue sky requirements.

    Check out Section 203(b)(3) of the Investment Advisers Act of 1940. This is a an exemption section of the Act. It is what most hedge fund managers rely on to be exempted from having to register as an Investment Adviser at the federal level (state rules can be very different). See the code section here: http://www.law.uc.edu/CCL/InvAdvAct/sec203.html. The part that relates to what you are talking about is the Holding Out section.

    Here is some interpretation:

    (1) A person is holding himself out as an adviser for purposes of Section 203(b)(3) if: (1) he uses the term investment adviser or similar term on a business card or stationary; (2) is listed as an investment adviser in a telephone, business or building directory; or (3) lets it be known generally by word of mouth or otherwise that he is available to provide investment advice or will accept new clients.

    (2) Using a publicly available electronic medium, such as a World Wide Web site, to provide information about an adviser's services would also be considered holding out. An investment adviser that posted only information about private funds (structured as domestic or foreign partnerships, limited liability companies, trusts or other entities) on a restricted access web site would not be holding itself out generally to the public.

    (3) Any investment adviser relying on the private investment adviser exception is not deemed to be holding itself out generally to the public as an adviser solely because the investment adviser participates in a non-public offering of interests in a limited partnership under the Securities Act of 1933. Thus, the mere act of identifying a partnership's adviser in a private placement memorandum is not considered holding out for purposes of Section 203(b)(3).

    Assuming you use the leads to send out a bulk e-mail, I suspect that you would be deemed to be holding yourself out as an Investment Adviser, and that you would have "blown" your exemption. That is not something that you want to do.

    If your friend introduces you to his acquaintances (not for the purpose of "selling" your fund to the acquaintances), and you end up developing a relationship with them, it becomes a different situation. If you have a relationship with them, they are fair game. But that tends to be a long-term strategy that may not turn into an investor for you for several years.

    Good luck with your fund. You are up against what many hedge fund managers face. If you understand the rules going into the process, it is fine. But it can be a problem if you find out after the fact.

    It is my opinion that a lot of funds do not pay nearly close enough attention to these rules. I hope their actions do not come back to bite them.