The two key questions that will drive fund structuring decisions are: Where is the money coming from and what do you want to do with it?
This will determine whether the start-up manager launches a domestic Delaware LP structure, which might be the case if his investors will only be US taxable investors, or whether he chooses a more traditional offshore master feeder structure to accommodate US tax-exempt investors and non-US investors as well as US taxpayers.
"An offshore fund is typically organised as a corporation and functions as a blocker of taxable income to the foreign investor. Domestic investors, on the other hand, prefer the flow through of a partnership as it avoids the double taxation if it was organised as a corporation and they may get beneficial long-term gains treatment. You always need to analyse where the money is coming from, and what the investors' tax considerations are.
"Where the offshore investor is domiciled will have an influence on where you organise the offshore vehicle. You ultimately want to minimise the tax consequences to specific classes of your investors, which might require having multiple offshore vehicles to minimise the foreign tax withholding requirements," explains Jeffrey I Rosenthal CPA, Partner-in-Charge of the Financial Services Group at Anchin Block & Anchin LLP.
Delaware master or Cayman master?
Most new start-ups will look to establish the classic Cayman master feeder structure, simply because it is so well recognised and understood by investors and managers alike. One reason the master fund typically is located in a tax haven jurisdiction and not Delaware is because US regulations encourage it to organise offshore.
"A fund that is organised in Delaware doesn't get the benefit of the ‘Touche Remnant doctrine'," explains James Munsell, a partner at leading US law firm Sidley Austin LLP. "This doctrine stands for the proposition that an offshore fund can make an offering of its securities outside of the US whilst simultaneously making a private placement of its securities within the US, and the two will not be integrated for purposes of the Investment Company Act."
A Delaware fund must comply with US private placement rules and the requirements of the available exceptions from registration and regulation as an investment company in respect of all its investors, both US and non-US. An offshore Cayman fund, by contrast, has to comply with those requirements only in respect of its US investors.
And that, says Munsell, is one factor "that pushes funds offshore".
Master-feeder structure
The master fund is where the assets are aggregated and traded as a single pool. The feeder funds are typically hardwired, meaning they have no purpose other than to aggregate subscriptions from investors and funnel capital into the master fund.
"The master fund and Delaware feeder fund for US taxable investors are classified as partnerships for US federal income tax purposes, while the offshore feeder fund for US tax-exempt investors and non-US investors is classified as a corporation for US federal income tax purposes," says Munsell.
The two feeder funds provide a dual entry point into the master fund.
There is, however, a second model for managers to consider. This does away with the double-layer of transparency where a Delaware fund is feeding into a tax-transparent Cayman master fund and instead uses a single-legged master feeder structure, also referred to as the `Dechert Model'. In this arrangement, US taxable investors go straight into the master fund.
But Munsell makes two points as to why this might not be optimal for a start-up.
First, start-ups have a limited amount of time to talk to a potential investor. If they have to spend time explaining why their fund structure is different from other fund structures the investor is seeing, they lose precious time that would be better spent explaining their investment strategy.
"Second, the master feeder fund structure has proven to be resilient in litigation. The investors are a layer removed from the master fund, where the assets are. Leaving aside its derivative nature, if an investor seeks to cause the master fund to bring a suit against its investment adviser, he will have difficulty establishing standing, because he isn't a shareholder of the master fund. It's a robust structure," comments Munsell.
Offering memorandum
What will often drive timing with respect to drafting the fund's legal documentation is securing that first investor. Once they are in place, the appointed legal counsel will work with the manager to finalise the documentation, which usually takes from six to eight weeks, from start to finish. The most important document is the Offering Memorandum, which has the dual functions of marketing the fund and protecting the fund and the investment adviser from liability.
Investors are increasingly institutional and want to be able to classify managers by investment strategy and investment style. As such it has become necessary, from a capital raising perspective, to be precise in describing the fund's investment strategy.
Within a fund's strategy and style, investors will typically want to see additional limitations such as concentration limits (by position, by sector or some other metric), leverage limits, etc.
"If you are a proven manager with a strong track record you will be able to command more flexible terms. It's a negotiation; the manager will want to have as much flexibility as possible, while the investor will want the manager to stick to a clearly articulated and limited strategy and style. The limitations have to be reasonable, though. Markets are constantly changing, and the terms and limitations should not be so strict as to tie the manager's hands," remarks Munsell.
Fund manager structure
Generally speaking, most US investment advisers organise themselves as limited partnerships or limited liability companies. If the manager is to be based in New York City, it is recommended that the investment adviser that collects the management fee be a separate entity from the entity that collects the carried interest (performance fee).
This is because New York City imposes an `unincorporated business tax'. A limited partnership, or limited liability company that is classified as a partnership for tax purposes, is considered an unincorporated business and is subject to this tax.
Fund managers generally will want to avoid paying NYC unincorporated business tax on the carried interest by directing it to an entity that does not conduct business in NYC.
There are other reasons to use multiple entities. Many investment funds are organised as limited partnerships. Limited partnerships can have as many or as few limited partners as they choose, but they must have at least one general partner, which controls the limited partnership and manages its business. In a limited partnership, limited partners have limited liability. They can only lose the amount they invested. General partners in a limited partnership have unlimited liability. It is sensible to isolate this liability in a separate entity.
In the US, fees for services (in this case the management fee) are taxed at ordinary income rates. Hedge fund managers generally prefer not to charge performance fees, but rather are entitled to performance allocations, which are made at the fund from the capital account of each investor to the capital account of the fund's general partner, which is an affiliate of the investment adviser.
Because the fund is a partnership, the tax characteristics of the income of the partnership flow through to its partners. The general partner typically is itself a partnership for tax purposes, and the tax characteristics of the performance allocation flow through the general partner to its owners, the managing principals.
Say a fund has had a profitable year and half the fund's profits are long-term capital gains and half are ordinary income. In this case, the general partner will be entitled to a performance allocation. Fifty per cent of that allocated amount will be taxed at ordinary income rates and 50 per cent will be taxed at long-term capital gains rates. To the extent the fund is generating long-term capital gains, the lower income tax rate is preserved.
Budget your expenses
Start-ups can break down their expenses as follows:
Fund expenses: Legal organisational costs, audit/tax and fund administration and other disclosed fund expenses. It is important to have proper disclosures in place. For prime brokerage this will include trading commissions, market data fees, financing costs etc. These have to be disclosed in the fund expense section of the Offering Memorandum.
Generally, the fund expenses should aim to be below 50bps for a new launch.
Firm expenses: Technology, payroll/payroll taxes, healthcare, business insurance, rent and marketing expenses (websites, marketing collaterals). These expenses typically are paid by the manager out of the management fee.
"Investors have really squeezed on the 2 per cent management fee. Typically we see a 1.5 per cent management fee, not inclusive of founder shares. However, we also see approximately 60 per cent of start-ups using a founder share class to entice investors, which will range anywhere from 1/10 to 1.25/12.5 per cent and 1.5/15 per cent," says Frank Napolitani, Director, Financial Services at EisnerAmper LLP.
If at the pre-launch phase the numbers don't stack up, an alternative is to set up a single member LLC and defer thoughts of a standalone fund. Set up a brokerage account and trade your capital as if it were a fund. The benefit to doing this is that it avoids all of the fund and manager costs detailed above.
All too often, managers rush into things. They want to do well and they may get things wrong. The market timing might be wrong. Then they panic; they may lose their conviction or start to double down. And ultimately fail.
"If the single member LLC is successful it can be converted into a standalone fund with a track record. Then you will be in a better position to spend the money on legal fees and everything else associated with running a hedge fund business," suggests Rosenthal.
Tax considerations
It is a sensible idea to think about tax planning at the pre-launch phase.
For most managers, this will be their most significant appreciating asset. They may decide to slice and dice the General Partnership to allocate to a family partnership. If so, it is prudent to do this as early as possible when the value of the entity is negligible, and before the management entity attracts assets and builds a track record in the fund.
In the United States, where the fund manager chooses to domicile will also be an important tax consideration. New York City imposes its own income tax in addition to New York State income tax. Other states such as Texas and Florida have no state income tax; moreover Florida has no estate tax so this makes it quite appealing to managers who wish to operate as tax efficiently as possible. Indeed, David Tepper, founder of Appaloosa Management, and one of New Jersey's biggest income tax payers, recently relocated from New Jersey to tax-friendly Florida.
Anchin Block Anchin sits with new managers to discuss their short-term and long-term tax structuring objectives and uses a custom tax layering programme with respect to a fund's tax allocations. If a manager invests into a long-term trading fund, which has a significant amount of unrealised gains, how does the partnership allocate those gains once they are realised?
"We analyse each security such that the tax allocations mirror the economic allocations made to each investor. Therefore, that new investor won't be allocated a portion of those unrealised gains for securities that appreciated prior to them entering in to the fund when the gains or losses become realised. It provides a much better allocation between tax and book for the manager and a more equitable tax arrangement for the investor," concludes Rosenthal.
