23 Dec 2010, Vanessa Molloy, partner, M Partners, Hedge Funds Review
The legal process of setting up a hedge fund usually starts with a planning consultation with a lawyer. This meeting can take place over the phone or face to face. During the meeting the lawyer will ask a number of questions with the aim of identifying the appropriate fund structure. A good lawyer will also identify any commercial issues that may hinder the success of the fund launch and provide an opinion on how this can be resolved or point you in the right direction for resolution of the issue.
Where possible a lawyer should be jurisdiction-agnostic and have a broad knowledge of the fund industry as a whole so that a cost effective and suitable fund and management structure can be identified. The typical issues dealt with at the initial consultation are: Has an investor already agreed to invest and what is the size of the fund at launch? The hardest part of launching a fund successfully is finding outside investors prepared to invest. If the manager is lucky enough to have investors lined up then it is a good idea at the planning stage to take into account the initial investor’s tax status, jurisdictional location and fund jurisdiction preferences.
If the investor has strong preferences (for example, a Ucits structure), then it may be appropriate from a timing, cost and regulatory perspective to consider housing such an investor on a platform provided by a third party. The initial size of the fund and the expected assets under management (AUM) after one year will open possible discussions on incubator fund structures and platforms established to assist emerging fund managers. It is possible to set up a structure offshore and, once AUM has grown sufficiently, to move the fund onshore with the track record still in place.
Typically, the legal form that a fund may assume are entities that are transparent such as limited partnerships, unit trusts and the Luxembourg fonds commun de placement (FCPs) that require a general partner/trustee/manager, or corporate entities that have legal personality in their own right. It is possible to have umbrella funds with different sub-funds and to cater for different currencies, with different currency classes. Often the choice of legal form will be determined by the tax status of the potential investors (for instance, US taxable investors who tend to prefer a partnership form and non-taxable US investors who may prefer a corporate vehicle).
An additional issue that should be raised is control of the vehicle. It is common in offshore hedge fund structures for the promoter of the fund to control the vehicle with investors having the right to remove the general partner in limited circumstances or holding shares that do not elect the board of the fund. It will be necessary to consider the control issue in light of what investors may prefer, the liquidity policy of the proposed fund, independence of the board and whether particular jurisdiction regulations allow structures where control is vested in the hands of the promoter.
Most jurisdictions allow corporate entities to be established as segregated portfolios, protected cells or compartment funds. The segregated portfolios are essentially a ring-fenced group of assets and liabilities which are given statutory segregation. Creditors of one segregated portfolio only have access to the assets of that segregated portfolio and not the fund’s other segregated portfolios. This allows the manager to set up a number of different sub-funds under one corporate structure.
It is important that agreements entered into in relation to one sub-fund are executed in a certain manner, which include the provision that creditors’ right of recourse is limited to only the assets allocated to that one particular sub-fund, excluding the fund’s other assets, particularly where the governing law of the agreement does not recognise the concept of segregation.
High net worth individuals (HNWIs), family offices and institutional investors have in the past been comfortable investing in lightly regulated fund structures found both onshore (such as in Luxembourg, Malta and Ireland) and offshore.
The jurisdiction of the targeted investors will highlight regulator considerations such as the US Investment Company Act and the Investment Advisers Act and if there are any possible safe harbour provisions.
It is important that the individuals launching the fund have a structure to collect the fees and fulfil the investment portfolio management obligations. The structure is primarily determined by where the key persons will be situated and the regulatory framework in that jurisdiction. Considerations such insurance, capital requirements, transfer pricing, VAT, outsourcing to third parties and time to obtain regulatory approval need to be considered.
It is important to state clearly to the lawyer what the strategy is and how it will be achieved so it can be made clear in the private placement memorandum (PPM) and checking if it can be accommodated within the regulatory framework of certain jurisdictions. The British Virgin Islands (BVI) and Cayman Islands non-retail fund structures have no diversification, investment, leverage and borrowing restrictions but many other jurisdictions do have such rules. These are generally quite flexible for non-retail fund structures. The envisaged liquidity policy should also be covered at the initial consultations to make sure it matches with the underlying investments, is in line with market practice and can be accommodated by the laws and practices of the shortlist of jurisdictions identified as possible fund set-up jurisdictions.
The discussions should also focus on redemption notice periods, gates, investor-agreed gates, side pockets, valuation of investments and suspension of net asset value (NAV)/redemptions and other related matters. To attract investors, managers often agree more favourable terms for one large investor over others.
The use of side letters should be disclosed in the PPM and the jurisdiction of the fund should permit their use.
It is possible to list funds (including offshore funds) on various European Union (EU) exchanges. Whether or not a listing is required is often driven by the potential investors’ own investment restrictions (for example if they can only hold listed securities). The requirements for listing will also be discussed in more detail in the consultation.
Board composition and service providers are another area to consider. It is fairly standard practice that as part of the fund approval process the relevant regulator will review the directors to determine if they are ‘fit and proper’ and the service providers to ascertain whether they are regulated.
Often the laws of a particular jurisdiction will require that certain activities be carried out in the jurisdiction of the fund. Independence on the board is something that will be emphasised and discussed at the planning meeting.
Once these issues have been discussed, the lawyer should have a shortlist of suitable jurisdictions. Advice from local counsel in the relevant jurisdiction will be necessary but at this stage the pros and cons of the jurisdictions can broadly be discussed, emphasising promoter, manager requirements, tax, reputation, costs and timing issues.
An outline will be given of the fund documents and their content (PPM, subscription agreement, constitutional documents and material agreements). The laws of some jurisdictions dictate what needs to be included in the PPM, which forms the contract between the investor and the fund, while other jurisdictions just require that sufficient information be disclosed so that investors can make an informed decision.
It is important that a letter of engagement be signed setting out the legal fees, third party costs (such as regulatory fees) and deposit required, who will be invoiced, what fees will be charged if the fund set-up does not proceed and a timeline to completion.
Some managers will pay the set-up costs themselves instead of the fund in order to avoid the initial NAV being affected. It is also important to discuss the accounting standards that the fund will use to determine if amortisation of the set-up costs is possible.
Once the letter of engagement is signed, the lawyer can start to draft the fund documentation and initiate the regulatory approval process as appropriate.
It is well worth the time to do a survey of potential lawyers and develop a shortlist before deciding who to use. Often the best way to ensure the lawyer is the right one and knows the fund industry is to go with a lawyer recommended by someone who has used them in the past.