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Hedge Fund Offering Documents Operating a hedge fund entails significant legal exposure, with substantial liability for improper disclosure. Even inadvertent mistakes can lead to substantial personal liability.  The private placement memorandum (PPM) is a disclosure document that provides potential investors with the terms and conditions of the hedge fund.  A PPM includes a discussion of the terms of the offering, the allocation of proceeds, and the risk factors inherent in the business and industry.  The offering documents must contain all information about the fund, the fund manager, and the securities offered, as well as any other information that would be considered "material" by a potential investor.

Hedge Fund Risk Disclosures Hedge fund PPMs not only require specific disclosures of present information about the fund and its managers, but also requires a recitation of potential risks of the investment (known as risk factors). Risk factors vary significantly from one fund to another and require the drafting attorney to foresee potential contingencies and assumptions that may result in unfavorable investment outcomes.  A hedge fund PPM requires specific language, drafting style, and disclosures.  Unintentionally deviating from the disclosure requirements can result in serious consequences for the issuer and its directors, officers, and managers. An experienced hedge fund attorney by your side will guide you through the complex regulations promulgated by the SEC, FINRA and the states, and help you minimize tax liability.  Contact Us for Assistance

Poor Offering Documents Could Result in Liability for Fraud  The disclosures in a PPM furnished to investors serve as protection to the principals against liability under the anti fraud provisions.  The SEC, the CFTC, the NFA and state securities commissions have a web of regulations with which you have to  comply.  Failure to properly navigate this web exposes you to liability, including personal civil liability and criminal penalties.  

Section 10(b) of the Securities Exchange Act of 1934 imposes liability on a person who misrepresents or omits a material fact in connection with the sale of securities. If the SEC proves that the material omissions or misstatements in your offering documents were willful, a court can impose fines on individuals for millions of dollars and/or imprisonment. Similar to the SEC, each state has its own securities laws that impose civil liability on those who misrepresent or omit material facts.  After the SEC is done with you the states can impose additional penalties against the directors and officers of the hedge fund. The primary penalty imposed is a rescission of the investor’s contract to purchase the security and in some cases a fund manager has to disgorge profits, repay the purchase price of the investment made, together with interest, attorney fees, and other costs. Learn More About Hedge Fund Regulations and Contact Us for Assistance

Contribution/Withdrawal Contribution and withdrawal provisions in hedge fund offering documents vary greatly.   Hedge fund offering documents contain minimum investment thresholds as a condition to investment.  Generally the investment minimum amounts are set in the discretion of the fund manager.  The fund manager always has discretion to accept lesser amounts.

Lock-up Period Some hedge funds require an initial lock-up period of one year or more before investors can withdraw invested funds. The lock-up period can be shortened or lengthened depending on the fund's investment strategy. Lock-ups usually range from three months to two years. If a fund strategy involves fairly illiquid investments, such that a one to two year lock-up period is not long enough, you should consider a closed-end fund.

Gate Provisions To prevent funds from being forced to inconveniently liquidate investment positions to satisfy large redemption requests, many hedge funds limit the percentage of the portfolio that can be withdrawn in any given redemption period (often 10%-25%).

Fund Expenses  The offering documents specify which of the expenses of the fund will be borne by the manager and which will be borne by the fund. Typically, the fund bears expenses directly related to forming and operating the fund, including: legal formation costs, accounting and administrative services, regulatory filings, brokerage costs, clearing costs, etc.  Many funds amortize startup costs over a 60 month period, to prevent early investors from being unfairly impacted, even though it is not in alignment with GAAP.

High Water Mark To prevent a manager from receiving duplicate performance compensation following periods of volatility, most funds allow investors to recoup past losses before the fund manager is entitled to receive additional performance compensation. To accomplish this, a high water mark (or loss carry forward provision) is established immediately following the allocation of incentive compensation.  Learn More About Hedge Fund Fees

Closed Ended Funds A closed-end fund is an investment fund intended to last for a fixed term, usually between five and ten years.  Investors in a closed-end fund generally do not withdrawals or additional capital contributions during the life of the fund (although you may allow withdrawals and contributions).  Private equity funds, venture capital funds, real estate funds and other funds investing in illiquid assets are structured as closed-end funds.  Closed-end funds typically have a fixed duration.  Investors are redeemed on a pro-rata basis upon the sale of assets and liquidation of the fund.  Some closed end funds require investors to make a legal commitment to invest in the fund (a capital commitment) at a future date.

Open Ended Funds Hedge funds that invest primarily in liquid assets are structured as open-end funds, allowing investors to make periodic redemptions and contributions (subject to limitations in the fund’s offering documents).

Funds The Investment Company Act of 1940 generally requires investment companies to register with the SEC. Hedge funds can be structured under one of two exemptions from registration under the Investment Company Act of 1940. Section 3(c)(1)  allows a fund to have up to 100 investors. Section 3(c)(7) allows a fund to have up to 2,000 investors, but requires a significantly higher net worth suitability requirement for each investor.

3(c)(1) Funds A 3(c)(1) fund is limited to 100 investors, all of which should be “accredited investors” pursuant to Regulation D.  Most startup funds are structured as 3(c)(1) funds because of the lower investor suitability requirements.

3(c)(7) Funds A 3(c)(7) fund must be owned by "qualified purchasers."�  A qualified purchaser (if an individual) must have a minimum of  $5 million in net investments, or (if an entity or trust) a minimum of  $25 million in net investments.  Section 3(c)(7) funds may technically have unlimited investors but typically limit the number of investors to 2,000 to avoid registration under the Securities Exchange Act of 1934 as a publicly traded partnership.  Because of the high barrier to investment, the 3(c)(7) exemption is typically used only by established funds backed by institutional investors.

Hurdle Rate Some funds require the investment manager to achieve a certain level of return, either as a fixed percentage or a benchmark rate (such as LIBOR or the S&P 500) before managers are entitled to receive performance compensation.  Hurdle rates can be either a “hard hurdle” or “soft hurdle.” A hard hurdle means that the manager only receives performance compensation that exceeds the hurdle rate.  A soft hurdle means that no performance compensation is received if performance falls short of the soft hurdle rate, but once the soft hurdle rate is exceeded, the manager is entitled to the entire performance compensation. Learn More About Hedge Fund Fees

Performance Allocation The performance allocation is one of the defining characteristics of hedge funds and private equity funds and distinguishes them from mutual funds, which charge only a management fee. A performance allocation is a percentage of the increase in the value of the fund assets (usually around 20%) allocated to the fund’s general partner as an incentive for positive performance. The performance allocation is intended to align the interests of the fund manager with that of the investor and provide significant upside potential for fund managers. Learn More About Hedge Fund Fees

UBTI Tax The Unrelated Business Taxable Income (UBTI) Tax applies to income generated by a tax-exempt organization by means of taxable activities. This type of income is generated outside of normal business operations.  US tax-exempt investors, including RIAs and pension plans, may be subject to UBTI if the fund employs certain types of leverage as part of its investment strategy.  To avoid UBTI, such investors should invest through a tax-exempt offshore investment fund, most commonly through a master-feeder or side-by-side structure.  Learn More About Hedge Fund Tax

Side Letters Most offering documents allow the management team to negotiate special terms (side letters) that are not applicable to other investors.  Often the special arrangement involves better economic terms, such as reduced management or performance fees, or more convenient withdrawal terms.  Care must be taken, however, not to allow side letters to prejudice other investors.  For example, side letters that provide additional information rights or preferential liquidity treatment should be avoided.  The proliferation of side letter agreements has further complicated matters for both funds and potential and existing investors. Aside from the risk of side letter arrangements being held void from the beginning, grounds for challenge from other shareholders may exist if a side letter creates enhanced class rights that are detrimental to their own share holdings. The scope for litigation in the event of a dispute is also widened by the existence of a side letter – especially if it contains a choice of law clause.  As a matter of good practice, the following conditions are crucial for the drafting of side letters.  A side letter should:  satisfy the relevant requirements and formalities needed for any contractual agreement to be binding; and be drafted so as to be governed by the same law as the memorandum and articles of association and formation. With respect to offshore funds, a review of the actual terms of a custodian/nominee agreement should be conducted in order to ensure that an agreement between the beneficial owner and the fund does not conflict with the original subscription agreement and the articles of association such that would render it ineffective.  It is also necessary to ensure that parties to a side agreement have the necessary authority to enter into binding agreements; that a side letter does not conflict with the main contract (the memorandum and articles of association of the company); and the memorandum and the articles reference the validity and legal effect of any side letter.  We drafts side letters!  Contact Us For Help

Long/Short Equity One of the most commonly used strategies for startup hedge funds is the long/short equity strategy.  As the name suggests, the long/short equity strategy involves taking long and short positions in equity and equity derivative securities.  Funds using a long/short strategy employ a wide range of fundamental and quantitative techniques to make investment decisions.  Long/short funds tend to invest primarily in publicly traded equity and their derivatives, and tend to be long biased.  Long/short funds also tend to have fairly straightforward investment fund terms.  Accordingly, lock-ups, gates and other withdrawal terms in long-short funds are usually on the more permissive side because of the ease of liquidating positions to facilitate investor withdrawals.

Credit Funds Credit funds make debt investments based on lending inefficiencies.  Credit funds include distressed debt strategies, fixed income strategies, direct lending and others.

Distressed Debt Distressed debt involves investment in corporate bonds, bank debt, and occasionally common and preferred stock of companies in distress.  When a company is unable to meet its financial obligations, or is in a liquidity crisis, its debt is devalued.  Distressed debt funds use fundamental analysis to identify undervalued investments.  Hedge funds that invest in distressed debt need to employ more stringent lock-up and withdrawal terms, including side pockets (accounts to separate illiquid assets).  A fund sponsor looking to form a distressed debt fund should speak with a hedge fund attorney to determine whether a private equity fund would be more appropriate.  Unlike hedge funds, which allow regular withdrawals, private equity funds are usually closed-ended and have a finite duration, usually between five and ten years.

Fixed Income Fixed income funds invest in long-term government, bank and corporate bonds, debentures, convertible notes and capital notes, and their derivatives, which pay a fixed rate of interest.  Many fixed income funds have lower risk tolerances than distressed debt funds and place capital preservation as a higher priority, leading to more diversification and volatility-reducing strategies. A common fixed income hedge fund strategy is fixed income arbitrage, discussed below.

Arbitrage Arbitrage strategies seek to exploit observable price differences between closely-related investments by simultaneously purchasing and selling related investments, while minimizing volatility.  When properly used, arbitrage strategies produce consistent returns with relatively low risk.  However, because price inefficiencies between investments tend to be slight, arbitrage funds must rely heavily on leverage to obtain substantial returns. 

Fixed Income Arbitrage Fixed income arbitrage seeks to exploit pricing differences in fixed income securities, most commonly by taking various opposing positions in inefficiently priced bonds or their derivatives, with the expectation that prices will revert to their true value over time.  Common fixed income arbitrage strategies include swap-spread arbitrage, yield curve arbitrage and capital structure arbitrage.

Relative Value Arbitrage Relative value arbitrage, or “pairs trading” involves taking advantage of perceived price discrepancies between highly correlated investments, including stocks, options, commodities, and currencies.  A pure relative value arbitrage strategy involves high risk and requires extensive expertise.

Merger Arbitrage Merger arbitrage involves taking opposing positions in two merging companies to take advantage of the price inefficiencies that occur before and after a merger.  Upon the announcement of a merger, the stock price of the target company typically rises and the stock price of the acquiring company typically falls.  Merger arbitrage is a form of event-driven hedge fund strategy, discussed below.

Event-Driven Event-driven strategies are closely related to arbitrage strategies, seeking to exploit pricing inflation and deflation that occurs in response to specific corporate events, including mergers and takeovers, reorganizations, restructuring, asset sales, spin-offs, liquidations, bankruptcy and other events creating inefficient stock pricing. Event-driven strategies require expertise in fundamental modeling and analysis of corporate events.  Examples of event-driven strategies include: merger arbitrage, risk arbitrage, distressed debt, and event-based capital structure arbitrage.

Quantitative (Black Box) Quantitative hedge fund strategies rely on quantitative analysis to make investment decisions.  Such hedge fund strategies typically utilize technology-based algorithmic modeling to achieve desired investment objectives.  Quantitative strategies are often referred to as “black box” funds, since investors usually have limited access to investment strategy specifics.  Funds that rely on quantitative technologies take extensive precautions to protect proprietary programs.

Global Macro Global macro refers to the general investment strategy of making investment decisions based on broad political and economic outlooks of various countries.  Global macro strategy involves both directional analysis, which seeks to predict the rise or decline of a country’s economy, as well as relative analysis, evaluating economic trends relative to each other.
Global macro funds are not confined to any specific investment vehicle or asset class, and can include investment in equity, debt, commodities, futures, currencies, real estate and other assets in various countries. Currency traders rely heavily on global macro strategies to forecast relative currency values.  Likewise, interest rate portfolio managers, who trade instruments that are keyed into sovereign debt markets are heavily involved with global macro fundamental analysis.

Multi-Strategy Multi-strategy funds are not confined to a single investment strategy or objective, but instead use a variety of investment strategies to achieve positive returns regardless of overall market performance.  Multi-strategy funds tend to have a low risk tolerance and maintain a high priority on capital preservation.  Even though multi-strategy funds have the discretion to use a variety of strategies, fund managers tend to focus primarily on one or more core investment strategies.

Private Placement Memorandum (PPM) Checklist

Description of Interests.  Although there are no specific disclosure requirements for offering documents, basic information about the hedge fund’s manager and the hedge fund itself typically, in fact is disclosed.  The information provided is general in nature and it normally discusses in broad terms the hedge fund’s investment strategies and practices.  For example, disclosures generally include the fact that the hedge fund’s manager may invest fund assets in illiquid, difficult to-value securities and that the hedge fund manager reserves the discretion to value such securities as it believes appropriate under the circumstances.

Investment Objective and Strategy

Fees and Expenses.  The fund's offering materials and legal documents must clearly spell out the manager's approach to charging performance and management fees and include a description of the fee schedule; the exact formula used to calculate fees owed, and where appropriate, example calculations.  Hedge fund fees should be calculated based on audited portfolio valuations.  Where the period of audited financial valuations does not coincide with the fee calculation period, investors should familiarize themselves with the hedge fund manager's portfolio valuation methodologies and the processes used to prepare the fee calculation.  Once audited financials become available, the fee calculations should be reviewed and adjusted for any valuation differences.   Performance fees should be based on dollars of value added, not percentage returns or average capital invested for the calculation period.  Performance fees computed as carried interest should be calculated on net value added as opposed to gross value added. Offering documents should adequately define "net value added" upon which performance fees are calculated (gross value added less any other expenses charged to the hedge fund).  Learn More About Hedge Fund Performance Fees 

IMPORTANT GENERAL CONSIDERATIONS

SUMMARY OF OFFERING AND PARTNERSHIP TERMS MANAGEMENT

Role of the General Partner and the Investment Manager
Background of Management
Other Activities of General Partner, Investment Manager and Affiliates
Investments by General Partner and Affiliates

INVESTMENT PROGRAM

Purpose Features of the Partnership’s Trading Strategy

BROKERAGE PRACTICES

Brokerage Arrangements
Soft Dollar Arrangements
Referral of Investors
Broker and Custodian

RISK FACTORS AND CONFLICTS OF INTEREST

Partnership Risks
Market Risks
Regulatory Risks
Conflicts of Interest

ERISA CONSIDERATIONS

General Fiduciary Matters
Plan Assets
Plan Asset Consequences

TAXATION

Introduction
Classification of the Partnership
Taxation of Partnership Operations
Tax-Exempt Investors
Other Taxes
Tax Elections; Returns; Tax Audits
Other Matters
Special Considerations for Limited Partners who are not U.S. Citizens or Residents
State Taxation
Future Tax Legislation
Collection of Investor Information
Disclosure of Nonpublic Personal Information
Protection of Investor Information
Changes to Privacy Policy

EXHIBITS

Limited Partnership Agreement

Subscription Documents.  The PPM is accompanied by a subscription agreement and investor questionnaire.  The subscription agreement is a contract to purchase a specified amount of securities at an agreed price, and contains a statement that the investor has received and reviewed the PPM, is aware of the risk factors, and is a suitable investor.  The investor questionnaire elicits information about the investor's background, employment and investment or business experience.  It is used, in part, to confirm the investor's accreditation and sophistication.  This document should be professionally prepared.

Form ADV Part II of the General Partner

Would Your Hedge Fund Survive a Fiduciary Audit? PPMs should be written with accountability in mind.  Consider the PPM that states that “the goal of the fund is capital preservation.” Unless capital preservation is clearly defined in terms of asset allocation, one might expect that all of the fund’s assets consist of principal protected investments with specific maturity dates as such investment would most likely preserve capital.  Given this PPMs should not state capital preservation as a goal unless the fund invests in items that return the principal investment.  When used in a PPM, the terms “capital preservation,” “liquidity and marketability,” “risk aversion” need to be defined (and adhered to by the hedge fund manager) with a future audit in mind. In the future, there may be a trend toward investment policy audits (at the top levels of the hedge fund industry).  An investment policy audit evaluates whether the hedge fund manager is in compliance with the statements made in the investment policy and investment strategy section of the PPM.  An asset allocation audit examines whether the fund’s portfolio is within the range of a PPMs stated asset allocations percentages.  Contact Us for Assistance

Capital Management Service Group, Inc. is dedicated to providing the highest quality of services on a personal level and in a timely manner. We offer flat-fee engagements, which include start-to-finish legal services and counsel with all aspects of launching a domestic or offshore hedge fund. No two funds are identical.  We use a client-based approach to our fund structuring and analysis. Our clients routinely comment on the excellence of our personal service and the time we take to properly understand and implement the client’s unique circumstances and objectives. Call Us at +1 (307) 213-4732, Email Us and Read What Our Client Say About Us on LinkedIn

Capital Management Services Group, Inc. is recognized by discriminating business owners as being the foremost tax and legal authority in the hedge fund industry.  Attorney Hannah Terhune's education and experience are unsurpassed in the area of hedge fund creation, development and launch. Ms. Terhune's extensive international tax knowledge and hedge fund experience have made her an indispensable resource for serious hedge fund and business professionals.  Ms. Terhune's numerous articles on the subjects have appeared in over 100 publications worldwide. Read Our Leading Media Content and Articles by Hannah Terhune on Hedge Funds and International Tax Planning, Chances are, if you have read anything related to the hedge fund business, Ms. Terhune wrote it. Read Our Client Comments and Read About Hannah Terhune on LinkedIn,

Why Hire Us?  When you engage us you get a unique combination of securities, tax, and global business experience.  We think we have the best set of offering documents in the industry for hedge funds based on current and ever changing laws.  We aim to deliver quick turnaround times because we understand that our customers want to begin their money management business as soon as possible.  We conceive, structure and deploy the best tax saving strategies for your hedge fund business.  We will help you start your business as soon as possible and continue to assist you. 

Give us the opportunity to use that knowledge and experience for you.  Each client receives personalized attention from our attorneys and staff.  No client is too large or small for us.  We pride ourselves in providing personal attention to each client.  We provide the best services and support needed for hedge funds and business projects.  No need to coordinate work between accounting, administrative and law firms--we handle the entire hedge fund business process from start to finish.  We offer legal services, accounting services, tax planning services, tax return preparation services, business consulting services, and U.S. and offshore company formation services.  We provide high quality services at  competitive rates.  But don't take our word for it, give us a call and let us prove what we can do for you.

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