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.
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:
- US taxable investors, those that pay income tax in the US such as high
net worth individuals, families, business companies and the like;
- 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
- 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.
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. 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. 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.
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. The PFIC regime is generally not favorable so investing in one is not
something for which a US taxable investor would have much appetite.
So to summarize to this point:
- US taxable investors favor US based limited partnerships, benefiting from
the pass through; and
- 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.”
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.
As for documentation:
- 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.
- The governing document in the US fund is the limited partnership agreement
(LPA) and in most non-US jurisdictions, the memorandum and articles of
- A subscription questionnaire is used to obtain information about the investors’
suitability to invest.
- 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
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:
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. As far as non-US investment managers are concerned, there are two exemptions
to be aware which are dealt with in a separate note. 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.
- 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).
- 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.
- 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.)
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.)
- 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.
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). 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.
- 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.)
ERISA 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%.
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
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.
For more information on the topic discussed, contact
Michael G. Tannenbaum at
firstname.lastname@example.org or at
212-508-6701 or the partner with whom you deal at the law firm.
The author, Michael G. Tannenbaum, is a founding partner of Tannenbaum
Helpern Syracuse & Hirschtritt LLP in New York and is co-head of its
Financial Services, Private Funds and Capital Markets Practice.
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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.
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.
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.
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.
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.
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.
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
See Tannenbaum Helpern’s “Regulatory Provisions in the US Affecting
Non-US Investment Advisers” GlobalNote, March 2016.
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.
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.
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.