Starting a Hedge Fund in 2009

Bart Mallon, Esq.

Mallon P.C.

bmallon@mallonpc.com

For 40 minute voice presentation with this presentation, please visit

www.hedgefundlawblog.com

Overview

• Initial Considerations• Fund Characteristics• Basic Structure• Structural Issues• Laws• Regulation D• Investors• Registration• Service Providers• Timeline• Offering Documents• Costs• Raising Capital• Other Issues• Disclaimer

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• Who will be your investors?

• How will you get to where you want to go?

Initial Items to Consider

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Hedge Fund Characteristics

• Trading Strategies– Traditional– Non-Traditional– Other Pooled Investment Vehicles

• Fees– 2 and 20

• Taxation– “pass-through” taxation– tax benefit of “allocation” of performance fees

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Basic Fund Structure

Hedge Fund (LP)

(Bank Account)

Hedge Fund Investors

(Limited Partners)

Management Company

(LLC)

Hedge Fund (LP)

(Brokerage Account)

1 Investors make investment in the Fund, payment to the Fund’s bank account*

2 Manager wires money to the Fund’s brokerage account*

3 Fund is managed by the Management Company

4 Fund makes investments5 Fund pays Management Company a

management fee (or may be paid from brokerage account)*

6 Fund allocates Management Company a performance allocation

7 If Investors make withdrawals, the Fund will make a distribution to investors*

* Indicate where there would likely be wire fees

Investments

Fees

Allocations

Management

Movement of money

Withdrawal

1.

7.5. 6.

3.

2. 7.

4.

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Structural Issues

• Fund structure/ Investors

• Minimum Investments– Initial, Subsequent, In-kind, Maximum

• Withdrawal and Contribution Periods– Monthly, Quarterly, Yearly; Lock-up; Gate Provision; In-kind; Distributions

• Fees – Management and Performance; High Watermark; Hurdle Rate

• Management registration status

• Reports to investors

• Selling commissions

• Expenses

• Asset valuation practices

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Hedge Fund Laws

• Securities Act of 1933– Interest in a fund are “securities”– Regulation D “safe harbor”

• Securities Exchange Act of 1934– Funds with 500 investors and $10 million in equity must register

• Investment Company Act of 1940– Hedge funds exempted under Section 3(c)(1) and Section 3(c)(7)

• Investment Advisers Act of 1940– Requires investment advisers to register with the SEC– Exemption under Section 203(b)(3) for advisers who have less than 15 clients over a 12 month period

• Commodities Exchange Act– CPO and CTA Registration

• Other Laws– Internal Revenue Code of 1986– “Blue Sky” Laws

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Regulation D

• Rule 506– No limit on amount of sales– Generally only sold to “accredited investors”– Can have up to 35 non- “accredited investors”

• Definition of “accredited investor”– $1 Million Net Worth– $200,000 in income in last 2 years

• No General Advertising– No newspaper ads– No radio shows

• File Form D with SEC within 15 days of sale8 of 18

Hedge Fund Investors

Section 3(c)(1) Funds

• Limited to 99 investors• Accredited Investor• Qualified Client

– Natural person with a net worth of $1,500,000

– Note: may be dependant on state law

Section 3(c)(7) Funds

• Limited to 499 investors • Qualified Purchaser

– Natural person with a liquid net worth of $5,000,000

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Registration

• Investment Advisor Registration– State vs. Federal

• Under $25 million – State only• $25 - $30 million – SEC or State• Over $30 million – SEC

– SEC• Section 203(b)(3) exemption• Generally 2-4 weeks• Compliance manual

– State• Exemption depends on state laws• Generally 2-8 weeks• Series 65• Potential net capital requirements• Compliance procedures including potentially a compliance manual

• CTA or CPO Registration– Registration with CFTC through the NFA– Potential CTA and CPO Exemptions (but potential state issues)– Series 3 – Various compliance requirements

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Hedge Fund Service Providers

• Lawyer – drafts offering documents; entity formation; registration; strategic and legal

advice

• Administrator – provides fund NAV calculation; fee calculations; investor reporting; etc.

• Auditor/ Accountant – provides yearly fund audit; prepares tax forms for the manager and investors

• Prime Broker – provides execution and/or clearing services for trades; custodian of assets

• Consultant – provides consulting services to management company re: fund raising,

marketing, operational guidance etc

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Hedge Fund Timeline

• Week 1 – discuss fund structure in depth, organize legal entities (management company, fund), begin

talking with outside service providers

• Week 2 – receive draft of offering documents, begin thinking about operational issues which may arise

– are your computers ready, is office space secured?

• Week 3 – discussion and revision of offering documents with attorney, begin finalizing outside service

provider contracts, establish bank account, establish brokerage account

• Week 4 – tie up loose ends, finalize offering documents, begin to get ready for trading or selling

interests in your fund

• IA registration and CTA/ CPO registration will affect this timeline – usually add about 2-4 weeks to the schedule assuming that the principals have all required regulatory exams and also provided that there are no prior regulatory actions

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Offering Documents

• Private Placement Memorandum (PPM)– Similar to mutual fund prospectus– Discussion of important structural terms– Discussion of investment program– Information on management company and managers

• Limited Partnership Agreement (LPA)– Governing legal document

• Subscription Documents– Subscription agreement– Investor suitability questions

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Costs to Start a Fund

• Lawyer– Range from $17,000 (boutique) to $35,000+ (BigLaw) for a basic domestic long-short fund;

registration extra– My firm will be about $13,000 for a basic domestic long-short fund; registration from $3,500 if

necessary

• Administration– Range from $750 - $1,500 per month; Initial one time set-up fees range from $500 - $1,500– Larger funds may also pay a fee (x bps) on AUM

• Audit– Audit: $5,000 – 15,000 depending on a number of factors including Audit firm– Tax Prep: $4,000 - $10,000 depending on a number of factors including number of investors

and the Audit firm

• Prime Broker– Varies depending on strategy, investments, trading volume

• Business Expenses – office rent, compliance costs, telephones, computers and IT, office equipment, staff salary, etc.

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Raising Capital• Must be done pursuant to Regulation D

• Who– Friends and Family– Institutional Investors

• Marketing Materials– Powerpoint Pitchbooks– One Page Tearsheets– Appropriate Disclosures/ Disclaimers

• Outside Marketing– Hedge Fund Databases– Hedge Fund Industry Events– Capital Introduction Services– Third Party Marketers

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Other Issues

• “Incubator” hedge funds• Offshore hedge funds• Taxation• ERISA and IRA investments• “New Issues” Rule• Soft Dollars• Side Letters• Due Diligence• Blue Sky Filings

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Disclaimer• This presentation was made for informational purposes only.

• I am not providing legal advice to any user.

• I am not providing tax advice. Presentation is subject to the Circular 230 Notice on the disclaimer portion of my blog.

• This presentation does not establish an attorney-client relationship between myself and the user.

• Any discussion herein is not a substitute for seeking actual legal advice from a licensed attorney with knowledge of the rules and regulations governing the industry.

• I make no representations, guarantees, or warranties as to the accuracy, completeness, currency, or suitability of the information provided via this presentation.

• This may be considered to be “attorney advertising” in some jurisdictions.

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For Voice Presentation, please see:

www.hedgefundlawblog.com

Please send questions, comments or suggestions to

Bart Mallon at bmallon@mallonpc.com

© www.hedgefundlawblog.com