HEDGE FUNDS
Starting A Hedge Fund

"How to Set Up Your Own Hedge Fund."
An article by Hannah Terhune, Chief Attorney of GreenTraderLaw PLLC.
This article has been widely published on the Internet and recommended by TheStreet.com and other respected media. After reading this article, click here to learn more about our hedge fund development services and getting started.

An older version of this same content is published below.

Note the below article preceeded SEC rule changes discussed at our Must I Register? and Operations and Compliance pages.

November 2003 Active Trader magazine: So you want to be a HEDGE FUND MANAGER...Traders are increasingly interested in hedge funds - not as investments, but as business opportunities. Before you decide you're ready to manage money, there are some things to consider: How is a fund established? How much regulatory hassle will there be? Read on to find the answers to these and other questions.

Are you ready to "run" other people's money in a hedge fund? If you are, there are many questions that must be answered. How do you set it up? Is there any money in it for you? How much regulatory hassle will there be?

Hedge funds are hot. The profits have been exceeding those of mutual funds and the broad averages. And, there's more good news: You can set up your own hedge fund for less than $10,000.

Hedge Fund = Security (but not a security blanket!)

At its most basic level, a hedge fund is the pooling of investments from multiple individuals into a single brokerage account. The hedge fund manager attempts to achieve investment results that match the objective of the hedge fund, rather than the objective of any of the individual investors.

The SEC treats a hedge fund as a security. Securities are regulated under Regulation D of the Securities Act of 1933. However, there is an exemption that allows you to make a private placement of your hedge fund without having to register the security with the SEC and each state (an expensive and time-consuming process). The attorneys that create your offering documents will ensure that the disclosures in the documents will allow you to achieve this exemption. The exemption is great news, and all the states honor this exemption from registration.

If you desire the exemption, you probably want to form what is known as a Section 3(c)(1) fund (from the Investment Company Act of 1940). That kind of a fund allows you to have fewer than 100 investors, up to 35 of whom can be non-accredited investors.

A typical hedge fund manager has only one client - the hedge fund. The individuals that buy into the hedge fund are the investors.

You will want to make certain that an attorney is actively involved in the set-up of your hedge fund. The laws are convoluted, but it is critical that you follow them to keep yourself out of trouble! Through GreenTraderTax, your attorney will be Hannah Terhune. This allows our clients to get the best of all worlds, since our Ms. Terhune is actively involved in the review of all legal issues.

Pool or Fund?

If you trade commodities or futures in your hedge fund, you will probably need to set up a Commodities Pool that is registered with the National Futures Association (NFA). The Commodity Futures Trading Commission (CFTC) has delegated most of its day-to-day regulatory duties to the NFA. There are a number of additional regulations associated with Commodity Pools, but they can be handled with no problem.

There are two exemptions that allow you to make futures and commodities trades in your hedge fund without requiring that you register with the NFA, or at least reduce your regulatory oversight.

If you have a very small commodities pool (where the total amount of the investments into the pool never exceeds $400,000), you can also be exempt from registration with the NFA. The pool can grow to more than $400,000 without having to register; the initial investments cannot exceed that level. There are other requirements to be able to meet the exemption, so use caution.

The second exemption requires that you register with the NFA (and take the Series 3 Commodities exam), but it significantly reduces your regulatory oversight from the NFA/CFTC. This exemption requires that all of the investors in the pool meet a standard of wealth called Qualified Eligible Person - basically, they need to have $1 million of net assets and own securities with an aggregate market value of at least $2 million. If your investors meet that standard, you can cut down on the regulatory burden.

Offshore hedge funds, Master/Feeder structures, and funds of funds are all other types of hedge funds.

What does the hedge fund manager get out of the deal?

Over the past several years (with the exception of the last couple), the economy has created an increased number of individuals that meet the criteria for investment in a hedge fund. A hedge fund investor needs to be a sophisticated investor that understands the risks associated with the fund. Since more people are eligible, the media has identified to the general population that hedge funds are both performing well and are available to individuals. Your prospective investors may just be waiting to have someone ask them to invest in a hedge fund.

The income that a hedge fund manager can earn can be substantial. Let's assume you have $2 million under management and your hedge fund has a 1-percent management fee and a 20-percent performance allocation. We will also assume the fund started the first day of the year and the gains at year-end were 30 percent.

Under these assumptions, the hedge fund manager would have gross income of $140,000. That is comprised of a $20,000 management fee ($2 million * 1%) and a $120,000 performance allocation ($2 million * 30% performance = $600,000 x 20%). A hedge fund with $5 million under management and all of the same assumptions would generate $350,000 of income for the hedge fund manager.

Plus, you probably have a significant portion of your own money invested in your hedge fund. Your prospective investors will like to see that you are putting your own money into the fund. You don't charge yourself fees (it would just increase your taxes), so you earned the 30 percent that you gained for the fund on your own investment in addition to your other income.

Is This Another 12-Step Program?

The formation of a hedge fund is actually very easy, if you have the right provider on your team.

1. Choose your provider wisely! We have quickly become a leader in this area. See what some of our clients have said about our services on this Testimonials page.
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. If you do not have the time to do this or need some help to make sure it gets done right the first time, GTT can help you with this process as well.
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 setup as to trader tax status, etc. We provide you with a form (we call it a terms sheet) that makes this easy for you. The terms sheet identifies most everything that needs to be defined to set up your hedge fund the way that you want it done. We give you real-life examples, and discuss other alternatives you can consider.
4. If you are forming a Commodity Hedge Fund, start the process of becoming a member of the NFA. See this page: www.nfa.futures.org/registration/nfa_membership.asp. You will need to register as a Commodity Pool Operator with the NFA. See www.nfa.futures.org/registration/cpo.asp. Most of our clients have wanted to do this part themselves to save some money, but we can help you with this part as well if you like.
5. Obtain a first draft of your offering documents (private placement memorandum, LLC operating agreement, and subscription materials) from your provider. Do a very thorough 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. Answering your questions is part of GTT's hedge fund formation process. We want to make certain that you understand your fund and what it all means.
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. GTT helps you with all of this as part of the hedge fund formation process. We use a business formation service that makes all of this complicated process turn into a simple process for you.
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, and GTT's attorney is top notch. Our Hannah Terhune has significant experience in this area, and her expertise is included as part of our hedge fund development process.
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. This is all part of our standard hedge fund development service. We give you your Form D and one state blue sky filing document as part of the standard service. Additional blue sky documents can be prepared fro a modest additional fee. GTT's instruction package provides answers to all of the who/what/when/where questions.
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. You can have no marketing materials other than your offering documents.
11. Mail your SEC Form D. You can check to see its status with the SEC at 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 (we give you a form to make this easy). Deposit your seed capital and start the initial trading of the 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 they love to do anyway. 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 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, there are two major laws that have an impact on you - the Investment Advisers Act of 1940 and the Investment Company Act of 1940. 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 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 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 12 months has had fewer than 15 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 many states (most notably Texas and California), 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 qualified investors. Qualified investors have a higher level of wealth than accredited investors. Although there are several ways to achieve qualified investor status, the one that most often applies is an individual (or an individual combined with a spouse) with a net worth of more than $1.5 million.

The RIA rules exist to protect the prospective investors. However, 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; however, it also 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, 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 of late summer 2003, the SEC has already completed public hearings regarding the regulation of the hedge fund industry.

No preliminary indications of the SEC's direction have been published. One wire service news story indicates the SEC is considering mandating 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. However, 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 you are going to be able to attract enough investors 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" - i.e., 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 is guaranteed to be achieved in the future.)

You can create a web site 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 web site, you are complying with the rules. You can also choose to use the web site 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 web site 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 this page 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. However, 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!

Other Web Resources:

Also see the links in the 12-Step Section, above (such as those for the NFA if you want to set up a commodities pool).
Securities Law: www.law.uc.edu/CCL/sldtoc.html
State Securities Administrators: http://nasaa.org/nasaa/abtnasaa/memberweb.asp
CFTC Law and Regulation links: www.cftc.gov/cftc/cftclawreg.htm
Investment Adviser application (for most states): www.iard.com

Ready for help?

If you have any questions or would like a custom quote for our tax preparation and compliance services, e-mail Robert A. Green CPA at info@greencompany.com or call him.