Successfully launching a private investment fund
Reprinted by kind permission of Hedgeweek. Successfully launching a private investment fund, involving hedging strategies, private equity, venture capital or real estate, is dependent upon selecting the proper corporate structure and complying with regulations promulgated by regulatory agencies that govern funds and their managers in the United States (US), including the US Commodity Futures Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC).
Under certain circumstances, as discussed below, funds and their managers that are based in the US may also be subject to oversight by non-US based regulators. Structuring a fund involves both the creation of one or more entities through which investments will be made (domestic and offshore funds), as well as the management entities through which the advisory services will be provided to the funds (the general partner and/or the investment manager). The structure and domicile of the fund is primarily dependent upon two variables: (i) the nature and demographics of the prospective investors, and (ii) the investment strategy employed by the manager. The structure and domicile of the manager is primarily determined by the citizenship and tax considerations of its principals, as well as the regulatory regime of the domicile.
Structuring the Fund. Investors can be divided into three classes: (i) US taxable investors, (ii) US tax exempt investors, and (iii) non-US persons. In the majority of circumstances, if the investors are US taxable investors, the fund will be formed as a US limited partnership or a limited liability company. The US fund is often referred to as a “domestic fund.” Most domestic funds are organized in Delaware. If the investors are US tax-exempt investors or non-US persons, the fund generally will be formed in a jurisdiction outside of the US as a corporation (or other analogous entity). The non-US entity is often referred to as an “offshore fund.” Most offshore funds organized on behalf of US based managers are organized in Bermuda, the British Virgin Islands and the Cayman Islands. US tax-exempt investors typically prefer to invest in an offshore fund set up as a corporation because if the offshore fund purchases securities on margin (often referred to as leverage), an offshore fund which is set up as a corporation blocks the unrelated business taxable income (UBTI) that would otherwise be taxable to the US tax-exempt investor.
Economic Analysis. In determining whether to form both a domestic and an offshore fund, it is advisable to determine the amount of anticipated assets which will be invested in the funds within a few months after the launch of the funds. In short, the anticipated aggregate investment at or shortly after the launch of the business may not justify the formation of both a domestic fund and an offshore fund and to create both may impair the manager’s ability to survive due to the organizational expenses and the costs of maintaining both domestic and offshore funds. With early stage managers, cash burn is often overlooked and can be critical to the survival of the newly formed manager. The manager must have an opportunity to establish a proven track record.
Side by Side, Master Feeder & Mini-Master Structures. Managers seeking to launch both domestic and offshore funds have several options available in structuring. The three most common structures are side by side, master feeder and mini-master. In a side-by-side structure, the domestic fund and the offshore fund make direct investments pursuant to the investment strategy and trade tickets are allocated between the domestic fund and the offshore fund. In a master feeder structure, a third entity is created (master fund) and the domestic fund and the offshore fund, rather than making direct investments, invest all of their assets into the master fund and in turn, the master fund makes the investments on behalf of the domestic fund and the offshore fund (often referred to as the domestic feeder and offshore feeder). The mini-master structure generally is comprised of two entities; an offshore feeder and a master entity. While the offshore feeder is taxed as a corporation to benefit US tax exempt investors and block UBTI, the master entity may be structured for tax purposes as a partnership. Rather than the US based manager receiving its incentive as a fee from the offshore fund and being subject to ordinary income tax, the US based manager may receive the incentive as an allocation from the master entity, in an attempt to benefit from capital gains tax treatment.
There are many legal and commercial drivers in determining the ideal structure. For example, if the strategy calls for significant investment in illiquid or thinly traded positions which are difficult to allocate among two brokerage accounts, a master feeder structure may be preferred as the investments will be allocated on a pro rata basis at the master fund yet only require the manager to purchase and sell the positions through one brokerage account. Also, in many transactions involving early stage or “seed” investment, if the seeder is located offshore, it may prefer a master feeder structure so that all fees and allocations may be taken at the master fund and thus avoid the US tax regime. Conversely, employing a tax efficient strategy for US taxable investors may be of little benefit or detrimental to US tax-exempt investors and non-US persons. Thus, a side by side structure allows the manager the ability to employ tax efficiency with the domestic fund, while maximizing the entry and exit points of securities positions without regard to long term tax gains for the offshore fund.
Structuring & Domicile of the Manager. The structure and domicile of the manager is primarily determined by the citizenship and tax considerations of its principals. The majority of funds which are managed by US domiciled entities are structured as either limited liability companies or limited partnerships which are taxed as flow through vehicles (rather than as corporations). In circumstances involving non-US persons, if the non-US persons own the majority of equity in or receive the majority of the economics from the manager and their interests are controlling, the manager may be organized in an offshore jurisdiction to accommodate the tax needs of the non-US persons.
Regulatory Analysis for the Manager. Managers must also evaluate the various exemptions associated with adviser registration with the SEC and/or the CFTC, depending on the fund’s investment strategy. For example, the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) introduced new registration requirements based on the total amount of assets managed in the US instead of the number of clients advised by the manager. As such, a manager that only manages funds in the US will be required to register with the SEC, appoint a Chief Compliance Officer and implement written compliance procedures subject to review from the SEC, if its “regulatory assets under management,” which includes the assets managed and any leverage utilized by the manager, exceeds $150 million. Non-US based managers may also be required to register with the SEC and/or the CFTC if they cannot rely on exemptions from registration. Likewise, managers are required to verify the tax status of the investors in a fund under the Foreign Account Tax Compliance Act and to comply with the relevant blue-sky requirements for offers made to investors residing in the US
Conclusion. It is important to use law firms with corporate, tax and regulatory experience in connection with structuring and maintaining hedge funds. Failure to properly structure your firm will have material opportunity costs. A firm with structural issues is less likely to attract investment and more likely to be plagued with investor litigation, regulatory prosecution, limitation on capital resources and reputational damage. In many cases, the costs associated with fixing a problem far exceed the costs of doing the job correctly at the outset. In certain cases, the problems cannot be fixed.