One of the discussion panels at the Bloomberg Hedge Fund Start-up Conference on 28 November 2012 in London explored some of the legal issues start-up managers need to think about when establishing both the fund, and the fund management structure. Entitled Legal: Getting it Right from the Start, the panellists included Gus Black, Dechert LLP (pictured); Richard Perry, Simmons and Simmons LLP and Chris Hilditch, Schulte Roth & Zabel LLP.
Structuring the hedge fund
The first and obvious point is that no single fund structure is going to suit everybody. Ultimately, it depends on how the start-up manager envisages the fund-raising process and where his investors are likely to be based: will it be a global strategy that you aim to market to a range of global investors or a targeted European credit strategy with a focus on appealing to European institutions? If that’s where the manager’s network is more fully developed, and they want to appeal to Italian HNW investors through Swiss private banks and start off in Luxembourg with a SICAV structure.
If, like the majority of ambitious start-up managers, they intend to raise money from both European institutions and US tax payers and US tax-exempt investors, the classic Cayman master/feeder structure will likely be necessary.
Cayman Master/Feeder structure
US investors can be split into two categories: US tax payers and US tax-exempt investors; these will typically include pension funds, endowments etc.
“In simple terms, tax-exempt investors will be looking for a tax-opaque structure and will want to be taxed on the returns generated in the fund vehicle whereas tax paying investors will probably want to be taxed as if they were holding the underlying assets directly in a tax-transparent structure,” explains Dechert’s Gus Black.
Any legal vehicle, within certain limits, can elect how it’s going to be classified for US tax purposes. However, what isn’t possible is to have a fund vehicle that is able to do two things at once: that is, be both tax-transparent and tax-opaque.
What a manager therefore needs to do is establish a minimum of two vehicles to support these different investors. These are referred to as feeder funds. A third structure, the master fund, holds the assets and within which all trades with the prime broker(s) are executed. The two feeder funds provide a dual entry point into the master fund.
This is the classic dual-legged feeder model: one is a Delaware limited partnership to support US taxpayers, the other is a Cayman company to support US tax-exempt investors. Both sit in parallel and “feed” the master fund, which is typically a tax-transparent Cayman company.
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.
“This allows you to bring investors straight into a transparent master fund. What you end up with is a single Cayman partnership and a single Cayman corporate (for US tax-exempt investors) feeding into it,” explains Black.
The benefit to investors pursuing this model is that it saves on set-up costs by removing the Delaware partnership. Some managers might be put off because the Delaware LP is the most common hedge fund structure in the US market, but for a sophisticated investor looking to allocate USD100million, it really isn’t a major consideration.
FATCA being on the horizon, however, might tip the balance for some managers who want to keep their US taxpaying investors completely separate from the rest of their global tax-paying investors for accounting purposes.
Onshore European structures
For hedge fund managers who aim to target European investors, the most suitable fund structures are the Irish Qualifying Investor Fund (QIF) and Luxembourg Specialised Investment Fund (SIF). Broadly speaking they are more flexible than UCITS, but not as flexible as a Cayman fund structure.
What is vital is that managers understand what they’re getting in to if they decide to go down this onshore regulated route. There could be a range of unintended consequences that a start-up manager might not be aware of from day one: on the one hand it might benefit the manager in terms of raising capital, but on the other hand they will have to accept that the regulator is potentially going to poke around and tell them to do things differently.
“That might be a day’s irritation. It might be a six-month legal and compliance project that costs USD500K and makes you wish you’d never gone into business in the first place,” states Black.
Structuring the fund management company
It’s easy for a start-up manager to get stars in their eyes when preparing to launch a hedge funds. However, it’s important not to get blind-sided and ignore the work needed in getting the fund management entity properly established; it’s the less glamorous part of being a hedge fund manager, but having a solid management structure in place with a clear partnership agreement can help avoid potentially messy disputes and threats to reputation in future years.
Generally speaking, if one looks at the majority of hedge fund disputes, they tend to originate within the management structure as opposed to the fund.
As an initial point, then, it is advised that all start-up managers place as much emphasis on the management structure as they place on the fund.
This means ensuring that the partnership agreement, from day one, is watertight. If not, says Bruce Gardner, partner at Sidley Austin LLP, and a fall-out occurs between the partners, it can end up being “very expensive for people at a very bad time for the business. The one thing you don’t want two or three years into the launch of your fund is a significant dispute within your management entity.”
The type of vehicle that a typical UK start-up manager would establish is a Limited Liability Partnership (LLP). What this is, in essence, is a tax-transparent corporate entity. This helps to avoid double taxation; the management fees and incentive fees pass straight through to the partners as if they were earning them themselves (and not the fund). Also, the fact that they are partners in the firm, and not employees, means they are classed as self-employed and therefore save National Insurance costs of 12 to 13 per cent per annum.
Furthermore, because people aren’t holding shares in the company, having an LLP structure avoids complicated tax issues arising around “employment-related securities”, which make it difficult to move equity within a limited company.
“In an LLP you can re-allocate profit shares quite easily year on year, depending on how the contribution of partners and other members of the fund team perform so it gives you that flexibility,” explains Gardner.
Drafting the legal document – avoid conflicts
To avoid potential future disputes, the first area to negotiate when preparing the partnership agreement are what are called default provisions. These are contained within the Limited Liability Partnerships Act, on which the LLP concept is founded, and will apply if the manager has not excluded them in the partnership agreement.
Default provisions include the following:
- all members are entitled to share equally in the capital and profits of the limited liability partnership (regulation 7(1));
- every member may take part in the management of the limited liability partnership (regulation 7(3));
- no majority of the members can expel any member unless a power to do so has been conferred by express agreement between the members (regulation 8).
A second difficult area to consider when drafting the agreement is to determine the extent to which duties of good faith are exercised within the partnership. Any partnership arrangement is subject to fiduciary duties (or duties of good faith). However, it is somewhat uncertain the extent to which the partners of an LLP owe duties of good faith either to the entity or to individual members, but in Gardner’s opinion the way things are going it seems to be more applicable to the entity.
Another area to consider in the partnership agreement is what happens when one of the partners decides to leave the firm. Managers should consider buy-out options so that each partner is clear on the financial implications of leaving, either voluntarily to pursue their own interests or because of a dispute. The bottom line is, whatever the circumstances, there should be nothing left open to interpretation in the partnership agreement.
The extent to which the partnership imposes a restriction to protect its business interests will depend on the status of the individual involved. Obviously, a senior partner leaving the firm could potentially do more harm to the partnership than a junior partner but typically speaking the “gardening leave” period tends to be six months.
Finally, another difficult area might arise relating to non-performance of individuals. This can lead to a potentially destabilizing environment but how one defines non-performance is far from straightforward.
Profit arrangements in an LLP
The economic returns of the management company derive from management fees – typically one or two per cent of the fund’s AUM – and incentive fees, which are 20 per cent of the fund’s profits. Those fees go to the LLP, and the LLP agreement would provide for what’s called “residual profit”: the amount left over after operational costs, regulatory capital requirements, remuneration of employees etc.
“That residual profit will then be split across the partners. The percentage allocations can be changed very easily. Each year, the founding partner or senior principal, who generally retains control of the LLP, will determine who gets what allocations, which are the re-set at the end of each calendar year,” says Gardner.
Under the European AIFM Directive, which comes into effect in July 2013, a deferral mechanism will need to be established, which could become an issue. That means that under the partnership agreement rather than each partner having their full profit allocation, it would need to be invested back into the fund and distributed back to the partner over a three- to five-year period.
That raises the final issue of consideration when establishing the management company: regulation. Most sophisticated managers will rarely just have a UK LLP; they will have a Cayman management entity which then appoints a UK LLP in an advisory capacity.
With the AIFM Directive, start-up managers have to therefore decide whether to structure the management company purely as an LLP, and fall under the Directive, or remain outside of it and place the balance of power with the Cayman management entity. This is useful for managers who succeed in building the business and end up with management entities in New York, Singapore, London: all of which would be contracted to the Cayman entity.
“It’s really the strategy that determines where a manager ultimately sets up the management entity,” says Gardner, who concludes:
“It used to be that investors only focused on the fund, now they are concerned to see that proper, stable management arrangements are in place as well.”