Establishing A Hedge Fund Structure
An important thing to note in structuring funds is that there is no specific strategy designed for everyone. The structure should ideally be based on the manager’s vision for the fund raising process and the base location of investors.
A case example is when the target is a global strategy geared towards a certain range of investors or European institutions. A network of that breadth would be suited with appealing to Italian NWH investors using Swiss private banks as a medium. They can also start with a SICAV structure in Luxembourg.
A large number of ambitious startup managers aim for European institutions, US tax-exempt investors, and US tax payers. These managers are more likely to find advantages in a classic Cayman master/feeder structure.
The Cayman Master/Feeder Structure
This structure is best for managers who target US investors – US tax payers and US tax-exempt investors.
Panelist Gus Black discusses that tax-exempt investors would generally prefer a tax-opaque structure. They will want to be taxed for returns from the fund vehicle. Tax payer types would like taxation as if they held underlying assets in a direct tax-transparent structure. Legal vehicles may choose its preferred classification for US tax purposes. It cannot hold both a tax-transparent and tax-opaque structure.
A manager would need at least two vehicles to respond to the preferences of both investor types. These will be the feeder funds, while a master fund will be the one to hold assets and mainly be the medium for prime brokerage trades are executed. The feeder funds utilized will give a point of dual entry towards the specified master fund.
The classic dual-legged feeder model is an illustration of the model. A Delaware limited partnership for US taxpayers is one structure. A Cayman company for US tax-exempt investors will serve as the second structure. The master fund is typically a tax-transparent Cayman company.
The Dechert model does not utilize the double layer of transparency that the first model has. A Delaware fund feeds a tax-transparent Cayman master fund. Black states that this allows bringing investors straight into a transparent master fund. The end result is “a single Cayman partnership and a single Cayman corporate (for US tax-exempt investors) feeding into it.”
The Dechert model helps investors save on setup costs as it removes the Delaware partnership. Some investors are more comfortable with having the common Delaware LP structure, but sophisticated investors may not find it as necessary. The presence of FATCA might affect the balance for managers who prefer to separate US tax-paying investors from other investors for accounting reasons.
Onshore European Structures
The Irish Qualifying Investor Fund and the Luxembourg Specialized Investment Fund are appealing fund structures for managers who aim for European investors. These structures do not have as much flexibility as a Cayman structure but are more so than UCITS.
This structure has a range of potential consequences that can affect a manager. Regulations may interfere with operations and request different courses of action. Black says there may be costly compliance projects or a constraint that creates delay. A manager should consider these and be ready to face them before going through with the structure. They should understand that it can either be a beneficial capital raising effect, or it can be an irritating or material constraint.
The Fund Management Company Structure
A launch can be exciting for managers but it’s important to acknowledge the necessity of effectively establishing the management entity. A solid structure and detailed partnership agreements will help reduce potential disputes and constraints in the long term. A large number of disputes are actually more concentrated on the management structure rather than the fund itself.
Agreements are advised to be crystal clear and detailed from early on. Bruce Garner, a partner at Austin LLP, says that failing to do so can result in disagreements between partners. It may result to being “very expensive for people at a very bad time for the business according to Garner. “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.”
A UK startup general would want to create a Limited Liability Partnership to help avoid double taxation. An LLP is a tax-transparent corporate entity in its most basic sense. Management and incentive fees are passed directly to partners in the semblance that they earn it themselves rather than the fund. The partners are not classified as employees and will be thus seen as self-employed. The classification assists in a saved amount of up to 12-13% per annum on National Insurance Costs.
People do not hold shares in an LLP and thus steers clear of complex tax issues revolving around employment related securities.
Legal Document Drafting
Default provisions help avoid possible disputes in the future. These provisions are contained in the Limited Partnerships Act and will naturally be applied if not excluded in the partnership agreement. Default provisions include entitlement to equal capital and profit shares among members and inclusion of members in the management of the LLP. It also states that no majority of the members may expel any member, except in the case of the power being conferred through express agreement between members.
The manager should consider the extent on duties of good faith in the partnership depending on the applicable variables on the entity. The provisions in the case that a partner exits the firm is another consideration. This includes buy-out options for the sake of clarity on financial implications. The manager should also create provisions regarding restrictions on guarding business interests in the case of partner exits. The manager should also seek the definition of non-performance of individuals as the general concept may be too broad.
A management company’s economic returns arises from management fees and incentive fees. Such fees go to the limited liability partnership and the agreement would provide for residual profit. Residual profit is the amount remaining after deducting operational costs, employee compensation, regulatory capital requirements, and other variables. Gardner explains that this is divided across partners, whose allocations can easily change. “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,” Garner states.
The European AIFM Directive states the need for a deferral mechanism. The implications is that residual income would be invested back into the fund and distributed to partners over a 3-5 year period rather than the regular full profit allocation.
This new directive raises a concern on regulation especially for sophisticated managers who possess a Cayman entity as well as a UK LLP. The AIFM Directive forces managers to decide on two choices. They will either structure the management entity as an LLP and fall under the directive, or place the power balance with a Cayman management entity.
Gardner says that “It’s really the strategy that determines where a manager ultimately sets up the management entity.” He also finishes with the conclusion that investors are now encouraged to ensure “proper, stable management arrangements” and not only focusing entirely on the fund itself.