In connection with the establishment of a private fund management enterprise and one or more private funds, there are common issues that the private fund manager must confront early on in the development of its business. This article briefly examines several of the most important initial issues a private fund manager should seek to resolve as early as possible. It is very helpful to involve legal counsel early on in the process to help identify and collaborate on the resolution of these matters.
Implications of the Investment Strategy
The private fund manager must first identify whether the private fund's strategy would generate certain types of income that may require some additional structuring. For instance, if the strategy will generate any U.S. effectively connected income such as a loan origination strategy, it would be important to modify the fund structure to accommodate non-U.S. investors if the private fund manager expects to target such investors. In addition, if the fund will employ leverage in connection with its investment strategy, the fund structure should include an offshore blocker entity if U.S. tax-exempt investors are part of the contemplated investor base, to avoid the receipt of unrelated business taxable income by any such investors since some of them may be sensitive to the receipt of such income.
Jurisdiction of Establishment
For both onshore and offshore funds, the regulatory environment of the chosen jurisdiction will impact the timing and cost of establishment and the burdens of continuing obligations in operating the fund. In the U.S., Delaware has established itself as the jurisdiction of choice for the majority of managers establishing onshore funds due to its convenience, flexibility and tax advantages. The decision on where to domicile an offshore hedge fund will be guided by a number of considerations, including, without limitation, the location of the investor base, tax treatment of the fund entity and the investors, regulatory regime, the availability of high-quality service providers and a business-friendly environment. The Cayman Islands, Bermuda, the British Virgin Islands, Luxembourg and Ireland are among the preferred locations for managers establishing hedge funds outside the U.S.
Prior to launching a fund, a manager must determine a number of key items, including the level of management fees and performance fees/ allocations (and the ability to allow reductions, waivers or rebates), the base currency (including the ability to issue classes in currencies other than the base currency, if applicable), the use of hedging, minimum investment and/or holding amounts, and liquidity terms. The liquidity terms will encompass a broad range of considerations, including the frequency of withdrawals, notice periods for withdrawals, the use of a lock-up (which may be a specified lock-up period with no withdrawals or a specified lock-up period with withdrawals permitted subject to the imposition of a withdrawal fee), the use of a gate (which may be imposed on either a fundwide basis or on an investor-by-investor basis), the suspension of withdrawals, subscriptions, the calculation of net asset value and/or the payment of withdrawal proceeds under certain circumstances, and the ability of the fund or the manager to cause an investor to mandatorily withdraw from the fund. The offering documents should include a detailed description of all fees and expenses that the fund will bear. If the fund or the manager would like to retain the flexibility to deviate from the terms of the fund with respect to one or more investors, the potential use of side letters should be disclosed.
Potential Investor Base
In tandem with considering the issues identified above, the private fund manager needs to identify the types of investors the private fund manager is seeking to solicit for his or her private fund. Often the tax preferences of U.S. taxable investors are in conflict with the preferences of U.S. tax-exempt and non-U.S. investors. As a result, it is ideal to segregate these classes of investors into separate investment funds that may invest in parallel or may participate through a shared investment vehicle commonly referred to as a master fund.
In addition, if the private fund manager is seeking to raise capital from benefit plan investors, the fund manager will need to monitor compliance with the Department of Labor rules and regulations to ensure that the fund is able to remain exempt from such rules or regulations or, if it is subject to them, that it complies with such rules and regulations. Further, will the fund include investors that are subject to the U.S. Bank Holding Company Act or that are registered investment companies? If so, the private fund manager should ensure that the fund documents provide the flexibility to issue nonvoting interests. Finally, will the fund include investors that are subject to ERISA? When ERISA plans invest in a pooled fund, that fund's assets will not be deemed to include plan assets if "benefit plan investors" do not own 25% or more of the value of any class of equity interests in the fund. The manager should decide in advance whether it will stay below the 25% threshold and should monitor compliance on an ongoing basis.
Now that the fund has been structured and the considerations triggered by the contemplated investors and investment strategy have been resolved, the private fund manager needs to consider how it will market the fund. In this regard, the private fund manager should ensure that its marketing activities do not violate the private placement exemption on which the fund will rely to issue its interests and should consider whether to engage a placement agent to assist with the marketing effort. It can be quite advantageous to employ a placement agent in order to utilize the placement agent's list of potential investors. However, a placement agent, as an agent of the fund, can cause the fund to violate the private placement exemption and, as a result, care should be taken in the placement agent agreement to ensure the placement agent pursues appropriate undertakings to avoid the violation of this exemption. In addition, to the extent the private fund manager seeks to solicit investors outside the U.S., consideration needs to be given to the requirements of the laws and regulations of those jurisdictions.
Another aspect of the marketing effort involves determining whether the fund will offer founders' share classes (i.e., share classes that generally provide for reduced fee rates for the initial investors) or whether the fund manager is interested in permitting an anchor investor to take a significant stake in the fund manager's business through an ownership interest or revenue share in the fund manager's business. These approaches can accelerate the growth of the fund manager's business but at a cost of some reduction in revenue received by the fund manager and its principals and in control over their business.
As part of the rollout of the fund manager's business, the fund manager must confront issues such as whether the fund manager's business might require registration as (i) an investment adviser with the Securities and Exchange Commission (the "SEC") or any state regulatory authority, or (ii) a commodity pool operator and/ or commodity trading adviser with the Commodity Futures Trading Commission. For example, to the extent the private fund manager has "Regulatory Assets Under Management" (as defined on SEC Form ADV) of less than $150 million and its only clients are private funds (as defined in SEC guidance), the private fund manager will be able to rely upon an exemption from registration with the SEC. However, the fund manager will need to ensure it is not otherwise required to register with any state in which it conducts its advisory activities.
Relationship Among the Principals
Finally, the private fund manager will need to determine how the partners of the firm will organize their relationship with each other and with their employees as part of the governing documentation of the fund manager and/or employment agreements. In this regard, some items that are typically debated among the principals are (i) whether there will be vesting provisions associated with the receipt of the carried interest or performance allocation; (ii) what happens in the event of the departure of a member where such departure is voluntary, involuntary (including for cause or not for cause) or due to death or permanent disability; and (iii) whether the governing documentation of the private fund manager will impose noncompetition and nonsolicitation provisions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.