Starting a Hedge Fund

Compliance and regulatory

So far, everything sounds too good to be true. Depending on the manager’s performance in the fund he or she can earn a very nice living by doing something that they love to do. There is a catch, though; there are a few barriers to entry. The barriers are not too high, and do not cause too much pain. But you have to make certain that you understand them and what they mean.

We talked earlier about how the hedge fund is a security. Since the hedge fund manager is making investment decisions and is being compensated for those decisions, the other area of law that affects the hedge fund relates to investment advisers. In this area, the two major laws that have an impact on you—the Investment Advisers Act of 1940 and the Investment Company Act of 1940. But your state’s laws may also have a significant impact on you regarding registration as an investment adviser.

We won’t get too deep into the regulatory environment, but this is information that you need to know about if you are going to form a hedge fund.

Accredited is Good!
To keep an offering of securities exempted under Regulation D of the Securities Act of 1933, there can be no solicitation of investors and there can be no more than 35 investors that are not "accredited investors" as defined in the Securities Act. There are a number of examples of accredited investors under the 1933 Act, but the two most common for hedge fund investors are:

1. A natural person whose individual net worth—defined as the excess of the fair market value of total assets (including home, home furnishings, and automobiles) over total liabilities (including mortgages)—or joint net worth with his or her spouse, at the time of purchase exceeds $1 million.

2. A natural person who had an individual income exceeding $200,000 in each of the two most recent years, or joint income with his or her spouse in excess of $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year.

Investment Advisers are the Gold Standard
You may qualify for an exemption from registration as an Investment Advisor under the Investment Advisor Act of 1940. Section 203(b) of the Investment Advisers Act exempts certain persons who meet the definition of investment adviser from the registration provisions of the Act. Section 203(b) of the Advisers Act provides five limited exemptions from registration. The exemption that would most likely apply to you is the 15-client limit.

15-Client Limit: Section 203(b)(3) exempts any adviser that: (1) during the previous twelve months has had fewer than fifteen clients; (2) does not hold itself out generally to the public as an investment adviser; and (3) does not act as an investment adviser to a registered investment company or business development company. (See Marketing and Advertising, below.)

Rule 203(b)(3)-1 provides that a corporation, general partnership, limited partnership, limited liability company, trust or other ''legal organization'' that receives investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners or other owners, may be counted as a single client of its investment adviser.

Each state (with the exception of Wyoming) has created rules relating to Investment Adviser activities. Some of those state rules will take precedence over the federal rules. For example, in Texas and California (and many other states), if you have a business presence in the state and have a single client that is compensating you for investment adviser activities, you must register as an Investment Adviser.

Other states have different rules that will allow you to operate your hedge fund without being a Registered Investment Adviser (RIA). Determining whether you need to become an RIA should be one of the first steps you take in the process of forming your hedge fund.

Usually, becoming an RIA means that you will only be able to charge your performance allocation to your accredited investors. The RIA rules exist to protect the prospective investors. But some people look at the regulations as a negative to being an RIA. There is no question that being an RIA increases your regulatory structure. But being an RIA tells your prospective investors that you are serious about protecting their assets and that you are taking the extra step to register.

You can use the restriction on the kind of fees you can charge to non-accredited investors to make a decision to not accept them into the fund. If you do not accept non-accredited investors into your fund, that will allow you to spend more of your time trading the fund, doing research, and searching for new prospective investors (the small investors often require the largest amount of hand-holding). Plus, being an RIA puts you ahead of the game if the law changes and all hedge fund managers are required to become RIAs (we haven’t seen any proposals to that effect yet, but we would not be surprised if it happened!).

 

The Regulators are Getting Restless
Over the years, there have been a number of hedge funds that have failed. Some were spectacular failures, such as Long Term Capital Management. The failure of some of these hedge funds and the resulting losses for investors caused the SEC to start to rethink its regulatory structure in the hedge fund world. As this article is being written, the SEC has already completed public hearings regarding the regulation of hedge fund industry.

No preliminary indications of the SEC's direction have been published. One wire service news story indicates that the SEC is considering requiring that hedge funds meet certain to-be-defined standards of disclosure. (Disclosure is easy!) Even after the hearings, some of the commissioners are still searching for additional information, such as the degree to which hedge funds have become part of the retail investment environment.

There is no indication the regulators are going to be taking radical action in this area. But keep watching this space for a summary of how any new regulations will affect the hedge fund industry.

Marketing and advertising
Once you start a hedge fund, you would like to be able to tell the world that you have a fund and that you can start accepting investors. If you do that, you eliminate your exemption from registration under the Investment Advisers act. Hedge funds should be sold to friends, business associates, and people that you meet in your everyday activities.

Under the rules, you cannot get up in a group setting and announce to everyone in the group that you have a hedge fund and can accept investments. You cannot place an ad in the phone book talking either about your hedge fund or your investment adviser services. You cannot have business cards that say investment adviser on them. You cannot let it generally be known that you are accepting new investors.

All of these rules make it difficult to find prospective investors. Again, they are intended to. The objective of the regulators is to restrict the investments in hedge funds to those individuals that are knowledgeable and understand the risks.

The only way to market your fund is via word-of-mouth to those individuals who you believe are already qualified to be investors. Understanding these restrictions needs to be an important part of your business plan. You want to make sure that you are going to be able to attract enough investors to be able to allow you to cover your expenses and earn a reasonable living for your trouble.

As far as advertising, there are more restrictions. You cannot do a one-page summary of your offering documents. You shouldn’t give out a chart of your performance results. Your offering documents must stand “on their own,” e.g. no embellishment. No other material can support your securities offering—no slick folder, no charts, no cover letter. Again, this makes the marketing process difficult, but that is part of the barrier to entry. (Plus, we don’t want your less-savvy investors to think that the chart represents some rate of return that should be able to be achieved in the future.)

You can create a website for your hedge fund, but prospective investors should only be allowed to see the front cover page. All other content should be password-protected. You can ask prospective investors to fill out a form and provide you with information that would help you determine whether they are valid prospective investors. If you gain an understanding of their financial situation and then allow them password access to your website, you are complying with the rules. You can also choose to use the website to provide your investors with updated information as to the fund performance. But you need to be careful to ensure that you are not using the website to advertise the existence of the fund.

Part of the value of setting up a hedge fund is that it serves to protect your personal assets. You want to make sure that you follow these Marketing and Advertising Rules to maximize your protection from malicious lawsuits. We see lots of situation where hedge funds are being more aggressive in marketing and advertising than we believe they should. Be very careful in this area.

Tax Implications

There are a number of the decisions you will make about taxes for your hedge fund. You need an expert to help you flesh out the various options, pitfalls, and opportunities. Make sure your hedge fund formation service provider has the proper expertise in this area. See the “Hedging Your Bets” article from the May 2003 edition of Active Trader Magazine for a thorough discussion of the tax implications of your hedge fund.

Ready to Form your Hedge Fund?

It is an area filled with rules and regulations. But it is not rocket science. You can form the fund without making a huge investment. But make sure you know what the ongoing costs are going to be as well. It’s a business, and you need to have a business plan to see how and when the hedge fund will start generating a reasonable income.

Find a trusted adviser that is focused on client service, and you can have your fund set up in about two months!

 

12 Steps to set up your hedge fund

1. Choose your provider wisely!
2. If you need to register as an Investment Adviser, start the process. This process should be done concurrently with the rest of this list. See www.iard.com to get started on this process.
3. Determine what will make your hedge fund unique to you. Finalize the fund’s Investment Objective and Investment Strategies, prepare biographical data on yourself to include in the offering documents, and make decisions that will affect how often you accept investors, how you will be compensated, what expenses the Fund will bear as opposed to the Management Company, how you will be set-up as to trader tax status, etc.
4. If you are forming a Commodity Hedge Fund, start the process of becoming a member of the NFA. See this page: http://www.nfa.futures.org/registration/nfa_membership.asp. You will need to register as a Commodity Pool Operator with the NFA. See http://www.nfa.futures.org/registration/cpo.asp.
5. Obtain a first draft of your offering documents from your provider (Private Placement Memorandum, LLC Agreement, and Subscription Materials). Do a very through review of the first draft of your offering documents. Ask questions to make sure you understand all of the aspects of your fund as defined in the offering documents.
6. Form your entities, get the tax ID numbers, make the appropriate IRS elections, and prepare resolutions so you can open bank and brokerage accounts.
7. Your provider’s attorney should be actively involved in the review of your documents. This is an important part of the preparation of your fund.
8. If you registered as an Investment Adviser or with the NFA for as a Commodity Pool Operator, ensure that the regulators have approved any such applications.
9. Your provider should give you the SEC Form D and the blue sky filings for the initial states where you expect to distribute your offering documents. Make sure your provider gives you instructions on how and where to file the various documents, and general instructions regarding the distribution of your offering documents. You should now have a final set of offering documents
10. Take your offering documents to a Kinko’s-type store and have it printed and bound. Consider the image you wish your fund to project when choosing the printing materials and binding method. Remember that you can have no marketing materials other than your offering documents.
11. Mail your SEC Form D. You can check to see that it was processed by the SEC here: http://www.sec.gov/edgar/searchedgar/companysearch.html. File your blue sky filings within the appropriate time—either before distribution or within 15 days of the first sale in that state, depending on the state’s rules.
12. Start distributing your offering documents and attracting investors. Keep a log of all individuals to whom you distribute your documents. Deposit your seed capital and start the initial trading of the fund.

Other Web Resources:

Also see the links in the Sidebar (such as those for the NFA if you want to set up a commodities pool).
Securities Law: http://www.law.uc.edu/CCL/sldtoc.html
State Securities Administrators: http://nasaa.org/nasaa/abtnasaa/memberweb.asp
CFTC Law and Regulation links: http://www.cftc.gov/cftc/cftclawreg.htm - cea
Investment Adviser application (for most states): www.iard.com

 

wow thats a lot of paperwork and expense to do before you even know if anyone will give you any money. wouldnt most people be better of just setting up an ib friends and family account and start out that way since its most likely any money you do get will be from friends and family? it costs nothing and works great. you can set it up to allocate trades between accounts and to automaticly pay you a precentage of the profits so there is no hassle with collection. there is also no record keeping because ib will send out a statement everyday. since you never actually take posession of other peoples money but just have authorization to trade their account i dont think you are under government regulations either.

 

Yes, it is a lot of work. But the work accomplishes several things.

First and foremost, it protects your personal assets. By setting up the LLCs, you insulate yourself (unless you commit fraud or illegal acts).

Second, by accepting payment for your services, depending on the number of accounts you are managing, you may be running up against the Investment Adviser (IA) rules that your state has implemented. The hedge fund is a single client of the management company. You may still need to register as an IA, depending on your state's rules (even though you have only one client).

If you should be registered as an IA and are not, and the performance declines to the point that a former friend now sues you, if you do not have a hedge fund, you are in a potentially difficult situation. For example, and this varies by state, if you should have been registered as an IA, the state may be able to sue you as well, and hold you personally liable for the losses incurred by the investors.

Third, it sets you up as a business from which you can succeed.

If your plan is to have this account for only friends and family and not grow it into a business, you may not want a hedge fund and its associated expense (but you may still need to protect your personal assets, depending on your personal situation).

 

Very nice overview. I think that you effectively hit all the main operational issues involved with starting a hedge fund. I would add however, the most difficult and important aspect is raising the seed capital for the Fund. I believe that you should have a substantial amount (substantial defined on an individual basis) of initial investor capital lined up before going through the process. Chicken and egg is a phrase you will use and hear a lot. Anyway, Wes, you seem like a competent CPA and I wish you luck finding new clients. Sounds like you know what you are talking about.

Neal Berger
President
Aquila Capital Partners, L.P.

 

i agree. people dont consider how hard it will be to get money from anyone other than friends and family. thats why i think it best to at least start out with the ib f&f account option. if things go well you can always go the full hedge fund route later.
news like this just makes it harder to raise money. on average hedge funds are trailing badly a passive investment in the qqq this year.
http://www.thestreet.com/_tscs/markets/matthewgoldstein/10100487.html

 

How do they compare over 3, 5, and 10 years? Perhaps a diversified portfolio should have a little tech and a little in hedge funds.

 

dont know. i have a feeling that there are a few very good hedge funds that keep a low profile but that most are run by so called hotshots that think they are better than their records show and are a danger to your money. imho you would need to see substantially better performance after fees than the market to justify taking the risk that some of these guys take.

 

This may be off-topic:

I've had some success advising friends on investing their 401k money. If they refer people to me for similar advice and I charge to give it, am I required to register as an investment adviser?

DS