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The procedure to establish a hedge fund in the United States follows a well-defined path because these alternative investment products have been in place for many decades and have regulatory recognition and marketplace acceptance. The start-up process is well-defined thereby providing comfort to the parties involved. This article focuses on how to set up a hedge fund in the United States. ^[1]

Some Definitions to Keep in Mind

When we refer to a “hedge fund” in the United States we refer to commingled assets, usually stocks, bonds and other securities, placed into an entity by a group of investors to be traded by an investment manager or investment adviser (the terms are generally interchangeable in the US). Often the fee structure is in two parts: (i) an incentive or performance based arrangement, such as 20% of the profits to the investment adviser, and (ii) ordinarily an asset value fee or the management fee – say 2% of the fund’s net asset value (NAV) each year.

Hedge funds are private funds, they can be domiciled in the United States or they can be in non-US jurisdictions such as Caymans, or BVI, Ireland, Lux etc. The choice of domicile is outside the scope of this article but in short it depends on the needs of the investors, the types of treaties that might be needed to make the investments more efficient in some way, government and banking stability, reputation, labor force, types of legal structures that are available, regulatory issues like the AIFM Directive in the European Union, tax considerations, and so on. Even time zone differences are taken into account.

The parties include the sponsor of the fund, the investors, and the investment adviser. The nature of the sponsor might range from a large global institution to a start-up investment adviser itself, an emerging manager – the processes described below are generally the same.

Meeting the Needs of the Investors

From a US perspective, in order to market a hedge fund, it is axiomatic that the sponsor needs to meet the investors’ needs. Investors come in (at least) three varieties:

1. US taxable investors, those that pay income tax in the US such as high net worth individuals, families, business companies and the like;
2. US non-taxable – i.e. tax exempt – investors such as foundations, charities, endowments and a special type of tax exempt investor: pension schemes (qualified ERISA funds or IRAs); and
3. Non-US investors. This group contains investors that have little or no connection with the US and prefer to keep it that way.

Each of the foregoing investor types requires (or at least makes desirable for tax or marketing purposes) a vehicle to suit their particular need. Generally, a one size fits all approach in the US is not suitable for all types of investors. The alternative investment world being as complex and creative as it is, one can never say “never” but generally speaking two different structures are needed to meet the needs of the foregoing classes of investors.

Hedge Fund Structures

US taxable investors prefer entities that are pass though entities for US income tax purposes. These include limited partnerships (LP) or limited liability companies (LLC). Investors in the LP are limited partners; in the LLC they are called “members.” LPs are managed by a general partner (GP); LLCs are managed by a “managing member.” LPs have a limited partnership agreement (LPA) that sets out the rights and obligations of the GP and the limited partners; LLCs have an operating agreement that serves the same purpose.

While for tax purposes LPs and LLCs are generally interchangeable, the LP seems to have a bit more market acceptance among high net worth and family office investors (perhaps because their own advisors are more familiar with this type of entity.) In this note, we’ll stick with the limited partnership. Usually the state of choice is either Delaware or New York because each is a highly commercial state, each has a well-defined enabling statute, a body of interpretive laws and judicial decisions that balance the needs of the issuer and the investor and from a purely marketing viewpoint are universally accepted.^[2]

What makes the LP advantageous for US taxable investors is that such entities are “pass though” vehicles, meaning that all of the items of income, gain loss, deduction, credit, etc. – all of the data that are taken into account in computing taxable income - flow through to the partners pro-rata to their interest in the LP or otherwise in accordance with the governing documents.^[3] The LP itself is not a tax paying entity – all flows through to the partners and tax is paid at that partner level, not at the partnership level.

As for non-Us investors it is safe to say that they prefer non-US entities often for little reason other than their desire to stay away from what they perceive to be a tax and regulatory regime that can be harmful to their financial health. Those of us that practice in the US would disagree certainly when the US regime is held up against those of other jurisdictions but surely the perception exists. And those do give up a level of protection by being “offshore” (access to our courts in some cases) but that is a decision each makes for itself.

The third category of investor – the US tax exempt investor - requires some special care. While exempt from US income taxation, such investors are in fact required to pay income tax with regard to profits derived from investment strategies that use leverage – borrowings and debt. Such profits are referred to as “unrelated business taxable income” – UBTI.^[4] Had the tax exempt investor invested in a limited partnership with its pass through attributes, the UBTI character would pass through to the tax exempt investor (pro-rata share but nonetheless its share of income from the leveraged activity would be UBTI.)

To avoid the UBTI issue, a corporate vehicle (a “blocker”) is used. The question is where to domicile the blocker? If the blocker is a US corporation, the tax exempt investor would avoid UBTI but the US domestic corporation itself would be subject to income tax. Accordingly, a non-US corporation established as the blocker. Assuming as we do that the activity of the non-US entity is trading in stocks and bonds, there would be no corporate income tax in the US imposed on the entity and no UBTI imposed on the investor.^[5]

By the way, a non-US corporate vehicle would not be favorable for US taxable investors because such vehicles, trading as they do in stocks and securities, are “passive foreign investment companies” or PFICs for US tax purpose.^[6] The PFIC regime is generally not favorable so investing in one is not something for which a US taxable investor would have much appetite.^[7]

So to summarize to this point:

1. US taxable investors favor US based limited partnerships, benefiting from the pass through; and
2. non-US investors and US tax exempts favor non-US corporate vehicles.

One final point before moving on: there is nothing improper or illegal about a US taxable investing in a PFIC or about a tax exempt suffering UBTI. It’s a tax issue - the taxes would be what they are and payable as such. The IRS is happy to accommodate! The point is that that cost would be one item among others to be considered by the investor and may not make sense given its “big picture.”

Various Arrangements

Often investment advisers maintain both entities in order to satisfy the needs of the three investor types. Such a “side by side” arrangement is not uncommon. More often than not, however, the two funds become feeders into yet a third entity that serves as the “master fund” which holds the assets and at which level the trading actually occurs. Such is a master feeder arrangement. And a third variation is the “mini-master” in which the US LP fund serves as the master fund into which all investors invest, including the non-US fund which serves as the blocker for the tax exempts and the non-US investors, and feeds into the master fund. Each of the aforesaid has its place.

Documentation

As for documentation:

1. Each fund requires a disclosure document by whatever name called - private placement memorandum, offering circular, information memorandum, listing particulars, et. al. (Collectively, the (“PPM”). The PPM describes the strategy, the biographical information of the manager and its decision makers, an appropriate set of risk factors about the deal, a tax analysis, explains the fees and expenses and other material information so as to enable a prospect to make an informed decision about whether or not to make the investment.
2. The governing document in the US fund is the limited partnership agreement (LPA) and in most non-US jurisdictions, the memorandum and articles of association.
3. A subscription questionnaire is used to obtain information about the investors’ suitability to invest.
4. And to complete the picture, there is a set of ancillary agreements. One for the administrator if one is retained, directors’ agreements if there are directors (usually the case in an offshore fund), the investment management agreement between the fund and the investment adviser, the prime brokerage agreement, engagement letters for counsel and accountants, and other agreements that might relate to the particular investment strategy.

These documents vary from deal to deal and need to be carefully drafted. US counsel and non-US counsel combine their efforts to generate the appropriate materials.

Certain Key US Regulatory Matters

There is a myriad of US rules and regulations that impact the formation, operation and sales of hedge funds in the US. This is a short list of the key items to consider:

1. Investment Advisers Act of 1940 (Advisers Act). Persons that provide investment advice about securities for compensation are “investment advisers” and as such, they are subject to the Advisers Act. Absent an exemption, investment advisers are required to register as such with the SEC.^[8] As far as non-US investment managers are concerned, there are two exemptions to be aware which are dealt with in a separate note.^[9] If registration with the SEC is required, Form ADV is to be filed with the SEC; the rules are outlined at www.sec.gov and readily available elsewhere. The Advisers Act regulates the manager, not the fund.
2. Securities Act of 1933 (33 Act) governs private placement of the hedge fund interests to avoid the need for the issuer (the fund) to register the issue with the SEC. Fortunately, the 33 Act provides a private placement exemption described in Regulation D (Rule 506) which enables a hedge fund to proceed without SEC registration. To meet Rule 506, the hedge fund must make a full and fair disclosure of all material elements of the deal – risk factors, fees arrangements, subscription and withdrawal features, lock ups gates, biographical data of the decision makers, and a description of the strategy and investment program descriptions and the like. (That’s the PPM described above). There are now two paths to achieve the exemption: one in Rule 506(b) and a second in Rule 506(c).
   1. 506(b) provides a registration exemption for interests placed with persons with whom the issuer (or its agent) has a preexisting relationship, to not more than 35 non-accredited investors who have sufficient knowledge and experience to be considered sophisticated investors and only where there has not been a “general solicitation” – i.e. truly privately placed situations to persons expected to be eligible.
   2. 506(c) provides a much more expansive registration exemption. Here the interests can be placed via a general solicitation but only if all of the investors are in fact accredited investors and the issuer has taken steps to “verify” that status. (Unlike 506b, a self-certification as to accredited investor status is not permitted under 506c – there needs to be objective financial analysis.)
3. Investment Company Act of 1940 (Company Act.) This is the statute that governs the operation of mutual funds and other investment companies in the US. Hedge funds seek to avoid the Company Act because its rules restrict the use of leverage, limit the imposition of performance based compensation, and impose all sorts of governance and diversification principles that are inconsistent with the usual operation of a hedge fund. The Company Act is avoided by meeting one of two exceptions to the definition of “investment company” described in the Company Act ─ section 3(c)1 exception or the section 3(c)7 exception. In the case of either exception, it is essential that the fund is not currently nor proposing to make a public offering (i.e. it must meet the Reg D private placement exemption, the 506 rules, described above.)
   1. Sec. 3(c)1. The Sec. 3(c)1 exception saves from registration funds that limit the number of its beneficial owners to 100 or less. There are critical ‘look through’ rules in counting to 100: First, if the fund (“our fund”) is a US based fund, the counting of investors test is worldwide. For a non-US based fund, the test is for US investors only. Secondly, with regard to entities that invest in our fund, if the entity investor was formed primarily to make the investment into our fund, then each of the entity’s beneficial owners is to be considered in making our 100 count. (If the investing entity has invested 40% or more of its assets in our fund, then there is a presumption that it was formed for the purpose of making the investment). Lastly, if an investing entity is one that itself relies on either Sec. 3(c)1 or Sec. 3(c)7 (for example another fund, or a fund-of-funds) and if that investor fund owns 10% or more of our fund, then its beneficial owners are added to those of our fund in making the 100 count.
   2. The second exception is the Sec. 3(c)7 exception. The focus here is on the financial quality of the investor not just the count. For US domestic offerings, Sec. 3(c)7 permits the fund to have up to 2,000 investors (better than 100, of course), but each and every investor needs to be a Qualified Purchaser (QP).^[10] The threshold for a foreign private issuer differs from that of domestic private placements. If a foreign private issuer has (i) more than 300 US investors, (ii) more than 2,000 investors (or more than 500 who are non-accredited investors), and (iii) has more than $10 million in assets, it must register under the Company Act.
4. Securities Act of 1934 (34 Act.) The 34 Act governs and regulates the persons who facilitate the sale of securities in the US; these are the broker dealer rules. The issue here is whether or not such activities require the person to register with the SEC and comply with the rules and regulation of FINRA (the regulatory agency that has oversight.)
5. ERISA^[11] imposes obligations on the investment advisers and others (called fiduciaries) if the percentage of investment by employee benefit plan investors equals or exceeds 25% of the fund or any class of the fund. These rules, called “plan asset rules” or the “25% rule” are observed carefully to avoid their imposition. For this reason a start-up hedge fund will often restrict ERISA investment to below 25%.^[12]

Internal Revenue Code. The tax aspects are briefly described in the text above on pass through treatment, PFIC issues and UBTI.

The various states in the US have their own securities laws that relate to the sales of securities to residents of the state. These “blue sky” laws are usually monitored as the distribution of the fund moves along.

Conclusion

The process of setting up a hedge fund can be accomplished with the proper legal advisors and related consultants. This need not be a mysterious process. While there are considerable rules in the United States, they are increasingly well-understood and can be explained by professional advisors who can help effectively navigate the process.

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^[1]This article deals with funds that trade in securities buy and sell stocks and bonds. Other products such as private equity funds or venture capital deals, commodity pools and the like all have attributes that require some special attention. In the case of private equity funds or distressed credit funds which over time start of look and feel like businesses instead of stock or bond traders, care needs to be taken by non US investors to deal with what is referred to in the US as “effectively connected income,” or ECI. Such cases may require blocker corporations or other arrangements. These special cases are outside the scope of this brief memo but are available on request by contacting the author.

^[2]Keep in mind that there are several non-US jurisdictions that have limited partnership statutes that are designed after the Delaware statutes so are “user friendly” for US lawyers. Those entities reach the same result for US taxable investors if certain elections are made to cause them to be treated as partnerships for US tax purposes. Often this election is referred to as the “check the box” election.

^[3]It’s favorable because without the flow through aspect, there would be double taxation, two taxes – one at the entity level and one at the investor level. Partnerships avoid the first layer of tax.

^[4]For more about UBTI, see https://www.irs.gov/. But for our purpose, generally debt financed activities by a tax exempt entity generates UBTI.

^[5]Note that entities that are set up offshore US as partnerships in certain jurisdictions are often treated as corporations for US tax purposes unless contrary election is made. For purposes of this note, non-US entities to which we refer are corporate vehicles but they might in fact be other types of entities that serve the same purpose – namely blocking the UBTI.

^[6]A PFIC is A foreign corporation is a PFIC if either 75% or more of its gross income is passive income (interest, dividend, rents, royalties, etc.) or if 50% or more of its assets produce, or could produce passive income.

^[7]While taxpayers usually seek to avoid PFIC taxation, the effect of the tax regime is to defer taxation on profits (a good thing) until a future date when the gains are recognized, but then spread back over the holding period and taxed at the highest rate for that year without benefit of being capital gains (not so good) and adding an interest charge as though the tax should have been paid in each of the earlier years (also, not so good.) But the spread between the US capital gains rate and the ordinary income rate is a quantifiable amount; the interest rate on the deferral is also known and fluctuates. In this economic environment, the rate is historically quite low – 4% as of this writing. Accordingly, the PFIC amount can be computed. This raises the possibility of earning more on the deferred amount than the PFIC costs. One more planning idea to keep in mind.

^[8]The statutory definition is: “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

^[9]See Tannenbaum Helpern’s “Regulatory Provisions in the US Affecting Non-US Investment Advisers” GlobalNote, March 2016.

^[10]The QP definition differs for individuals and for entities. In general terms, for individual investors, a QP is one with at least $5 million of investible assets – ‘investments’. The term ‘investments’ is a defined term, including marketable securities or real estate provided neither the owner nor a dependent resides in it or closely held stock provided the investor is not working for the company issuing the stock. The full definition is complex and should be consulted before relying on this exception. It is posted on the law firm’s website. For entities, the test is $25 million or more investments unless each equity owner of the entity is himself a QP. And lastly, there is a category of QP that is unrelated to the asset test, namely the knowledgeable employee. Knowledgeable employees include officers, directors or partners of the hedge fund or its adviser, and certain professional investment personnel. Lastly, no pass through test exists for Sec. 3(c)7.

^[11]The Employee Retirement Income Security Act of 1974. Oversight is by the US Department of Labor and many rules are imposed, some of which are quite complex and can be difficult or virtually impossible to comply with for start-ups or emerging managers.

^[12]The 25% computation is complex and non-intuitive. And there are times, albeit rarely, when measurement can take place at the master fund level where the denominator of the fraction is obviously higher. Contact the author for further information with regard to ERISA investment.

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For more information on the topic discussed, contact:

• Michael G. Tannenbaum  |  tannenbaum@thsh.com  |  212-508-6701