By Ron Geffner – Investors and regulators continue to evolve, becoming more sophisticated and asking more probing questions. Now more than ever, successfully launching a hedge fund is dependent upon selecting the proper structure and complying with the ever changing federal and state regulations governing hedge funds.
Structuring a hedge fund involves both the creation of one or more entities through which investments will be made (domestic and offshore hedge funds), as well as the management entities through which the advisory services will be provided to the hedge funds (the general partner and/or the investment manager). The structure and domicile of the hedge fund is primarily dependent upon two variables: (i) the nature and demographics of the prospective investors, and (ii) the investment strategy employed by the investment manager. The structure and domicile of the investment manager is primarily determined by the citizenship and tax considerations of its owners.
Structuring the hedge fund
Investors can be divided into three categories: (i) US taxable investors, (ii) US tax exempt investors, and (iii) non-US persons. In the majority of circumstances, if investors are US taxable investors, the fund will be formed as a US limited partnership or limited liability company and is often referred to as a “domestic fund.” Most domestic funds are organised in Delaware. If the investors are US tax-exempt investors or non-US persons, the fund generally will be formed outside of the US as a corporation (or other analogous entity) and is often referred to as an “offshore fund.” Most offshore hedge funds organised on behalf of US based investment managers are organised in Bermuda, the BVI and the Cayman Islands. US tax-exempt investors typically prefer to invest in an offshore fund organised as a corporation because if the strategy utilises margin (aka leverage), an offshore fund organised as a corporation blocks the unrelated business taxable income (“UBTI”) that would otherwise be taxable to the US tax-exempt investor.
In deciding whether to form both a domestic and offshore fund, the manager should determine the amount of assets that will be invested in the funds within a few months after the launch to determine whether the amount of assets justifies the formation of both a domestic and offshore fund. Otherwise, the launch of both funds may impair the manager’s ability to survive due to organisational and operational expenses. Cash burn is often overlooked and can be critical to the survival of an emerging 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 structuring options available. The three primary structures are side-by-side, master feeder and mini-master. In a side-by-side structure, the domestic fund and offshore fund make direct investments and trade tickets are allocated in advance between the domestic and the offshore fund.
In a master feeder structure, the domestic and offshore fund, rather than making direct investments, invest all of their assets in a third entity known as the “master fund.” The master fund invests on behalf of the domestic and offshore fund. The mini-master structure has two entities; an offshore fund and a master fund. While the offshore feeder is taxed as a corporation to benefit US tax exempt investors and block UBTI, the master fund is structured as a partnership.
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 are allocated on a pro rata basis at the master fund yet only require the investment 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 investment manager the ability to employ tax efficiency with the domestic fund, while maximising the entry and exit points of securities positions without regard to long term tax gains for the offshore fund.
Structuring & domicile of the investment manager
The structure and domicile of the investment manager is primarily determined by the federal and state tax and regulatory considerations of its principals. The majority of hedge funds managed by US domiciled entities are structured as either LLCs or LPs. If non-US persons own the majority of equity or receive the majority of economics from the investment manager, the investment manager may be organised in an offshore jurisdiction to accommodate the tax needs of the non-US persons. Occasionally, federal and state regulation often impact the location at which the investment manager maintained its office in the United States. Certain states have compulsory registration requirements which require an investment manager with an office in those states to register as an investment adviser prior to the launch of the hedge fund.
While cash burn is critical to an emerging manager, the quality of the firm’s infrastructure should not be sacrificed. Having spent over two decades practicing law in this industry, both as an enforcement attorney with the SEC and in private practice, I have witnessed many successes and failures. It is important to use service providers who have corporate, tax and regulatory experience in connection with structuring 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. The costs associated with fixing a problem far exceeds the costs of structuring the firm correctly at the outset.
Ron S GeffnerPartner, Sadis Goldberg LLP
Ron S Geffner is a founding member of the firm’s Executive Committee and also oversees the Financial Services Group. He regularly structures, organises and counsels private investment vehicles, investment advisory organisations, broker-dealers, commodity pool operators and other investment fiduciaries. Mr. Geffner also routinely counsels clients in connection with regulatory investigations and actions. His broad background with federal and state securities laws, and the rules, regulations and customary practices of the SEC, Financial Industry Regulatory Authority, Commodities Futures Trading Commission and various other regulatory bodies, enables him to provide strategic guidance to a diverse clientele. He provides legal services to hundreds of hedge funds, private equity funds and venture capital funds organised in the United States and offshore.