www.cummingslaw.comIntroductionWhen setting up a hedge fund, you will need toconsider the following matters:• Jurisdiction• Fund structure• Eligible investors• Authorisation and regulation• Directors and other service providers• Share classes• Fees• Equalisation or series accounting• Lock up, redemption periods and gates• ListingIn order to determine these issues, you willneed to seek professional advice from your taxadvisors and legal counsel.JurisdictionA standard hedge fund will generally be basedin an offshore jurisdiction, such as the CaymanIslands, the British Virgin Islands, Bermuda,Guernsey or Jersey, so that the investor, ratherthan the fund, pays tax on the increase in valueof the fund’s portfolio. However, jurisdictionssuch as Luxembourg, Malta and Ireland arebecoming increasingly more attractive, due toperceived EU advantages and, in the latter’s case,for example, to the relatively recent introductionof its flexible, regulated Qualifying Investor Fund.Which jurisdiction you choose will often dependupon the type of fund structure used and isusually determined by the tax environment ofthe fund’s potential investors. Fund StructureThe types of hedge fund structure mostcommonly seen are: stand-alone, master/feeder and umbrella funds, segregated portfoliocompanies (SPCs) and side-by-side.Stand-alone fundA stand alone fund is a single fund in whichinvestors invest by purchasing shares and thesubscription monies are then traded by the funddirectly in the markets. This is explained in theAppendix in diagrammatic form.Master/feeder fundA master/feeder structure is generally used ifthe fund is being promoted to two separatecategories of investor: (i) US taxable investors;and (ii) US non-taxable and non-US investors.These two categories will, for US tax andcompliance reasons, wish to invest in separateentities and this is generally achieved by settingup a master/feeder structure with two feeders,one for each category, which both feed into themaster fund. Investors subscribe for shares in therelevant feeder and each feeder then subscribesfor shares in the master fund, which then tradeson behalf of the feeder funds. This is explainedin the Appendix in diagrammatic form.Umbrella fundAn umbrella fund is a single legal entity whichhas several distinct sub-funds, each of whichare traded in effect as individual funds. Thisallows a fund to create different classes ofshares, which generally trade different strategiesby investing in underlying companies whichconduct all trading. By this use of subsidiaries,the assets and liabilities of each share class aregenerally segregated from those of the otherclasses of shares. This type of structure is oftenused, for example, if the fund wants to applyleverage to some shares and not to others andthe segregation means that any downside (orupside) as a result of a riskier strategy will, inmost circumstances, only affect that share classand not those share classes pursuing a less riskystrategy. The umbrella fund can also be themaster fund in a master/feeder structure. Thisstructure, without the master feeder element, isexplained in the Appendix in diagrammatic form.SPCsAn SPC, referred to as a protected cell companyor similar in certain jurisdictions, is a fundwhich segregates the assets and liabilities ofdifferent portfolios, or cells, from each otherand from the general assets of the SPC itself.The segregated portfolios (or cells) are each aseparate legal entity with the effect that only theassets of each segregated portfolio are availableto meet liabilities to creditors in respect ofthat segregated portfolio i.e. where there areliabilities arising from a matter attributable to aparticular segregated portfolio, the creditor mayonly have recourse to the assets attributableto that segregated portfolio. A point to note,however, that although SPCs are found in anumber of jurisdictions, in one form or another,the concept of segregation has not yet beentested in the courts and it is uncertain how itwould be treated in an onshore bankruptcy, forHow to start a Hedge Fund
www.cummingslaw.comexample. An SPC can also be the master fundin a master/feeder structure. This structure,without the master feeder element, is explainedin the Appendix in diagrammatic form.NB. An SPC differs from the umbrella fund abovein that, unlike the segregated portfolio, a sub-fund is not a separate legal entity and, despitethe segregation of share classes and strategieswithin the umbrella fund itself, a creditor wouldhave recourse to all the assets of the umbrellafund and not only to the assets in the relevantsub-fund.Side-by-side fundA side-by-side fund structure comprises twosingle funds, each of which takes a differentcategory of investor but trades the same strategy.Again, investors invest by purchasing shares andthe subscription monies are then traded by thefund directly in the markets. This is explained inthe Appendix in diagrammatic form.Eligible investorsThe promotion of hedge funds is restricted bylaw and they may only be promoted to certaincategories of investors as set out under relevantlaw; as a result they are generally directed atinstitutional investors, such as pension funds,and sophisticated high net worth individuals and,save with the exception of UCITS funds, are notavailable to the general public. The investmentmanager and/or any other distributor of a hedgefund is responsible for ensuring that shares in thefund are being offered only to eligible investors.UCITS may be offered to retail clients, but this isdue to the fact that a UCITS fund incorporatescertain investor protection mechanisms.Authorisation and regulationThe fundUnless the hedge fund is exempt from regulationin the relevant jurisdiction (due to its size or thenumber of its investors, for example), it will benecessary to register the fund with the relevantauthority, such as the Cayman Islands MonetaryAuthority (CIMA), the Central Bank of Ireland orCSSF (the Luxembourg regulator), for example,and will be regulated by that authority accordingly.Depending on the type of fund, this regulationcan range from paying a prescribed annual feeand submitting the fund’s prospectus to obtainingapproval of the service providers and anysubsequent changes to those service providers.The investment managerIn the EU and the USA, an investment manager isrequired to be authorised to carry out regulatedactivities and most investment managers willusually be based in these jurisdictions. In theUK, an investment manager must be authorisedby the Financial Conduct Authority and it cantake up to 6 months for an application to beapproved. As part of the approval process, theinvestment manager has to demonstrate that ithas adequate financial resources, has determinedthe systems and controls it will need to put inplace and has appropriate staff carrying outcontrolled functions.AIFM DirectiveThe Alternative Investment Fund ManagersDirective (AIFMD) is a European Directive whichis due to be transposed in UK law by 22 July 2013and will affect an investment manager based inthe EU.The AIFMD seeks to regulate the non-UCITSfund sector, in particular hedge funds, privateequity funds and real estate funds. All investmentmanagers established in the EU, whether theymanage EU or non-EU funds, are subject to theAIFMD. In order to get permission to market theirfunds in the EU, an investment manager mustbe authorised by the regulator in the EU countryin which it is established. Once the investmentmanager is authorised, it can then market itsfunds throughout the EU. Investment managersbased outside the EU will be prohibited frommarketing their funds in the EU, unless theymeet various fiscal and regulatory requirements.Investment managers based in the EU who runfunds established outside the EU are also subjectto additional restrictions. Investment managerswill need to have submitted an application forauthorisation to the appropriate regulator by 22July 2014. The Directive contains provisions on:• Scope• Organisational requirements• Leverage• Depositary• Delegation• Risk management• Liquidity management• Reporting/disclosure requirements• Annual reportFurther regulation is planned from 2015 whena parallel passport regime is to be introducedwhich will permit non-EU funds to be distributedby non-EU based managers on a pan-EU basis,
www.cummingslaw.comprovided certain criteria are met. Thesecriteria have not yet been finally established,but are likely to include appropriate regulatorcooperation agreements, appropriate AML andanti-terrorist financing laws and regulations andtax information exchange agreements with EUmember states. There will also be a requirementfor the local manager to fully comply with theAIFMD regime and have authorisation froma relevant member state for the purposes ofsupervision of EU focused activities.Directors and other serviceprovidersDirectorsThe fund will require at least two directors, whofor a listed fund must be independent and this isoften required for governance issues. For UK taxreasons they must be based offshore of the UKand if the fund has more than two, the majoritymust be based offshore of the UK. This is toensure that central management and control isexercised, and is seen to be exercised, offshoreof the UK for tax purposes and there is no dangerof the fund being regarded as resident onshoreor having inadvertently created a permanentestablishment in the UK (and taxed accordingly).This must be adhered to strictly, as a tax authority,such as HMRC, will examine the position carefullyand if they consider that acts of controlling powerand authority are exercised to a substantial degreeonshore, then despite the fund’s jurisdiction, itwill be taxed as resident wherever the person orpersons exercising that control actually exercisesit. This means that all meetings and conferencecalls should be held offshore and no decisiontaken without a majority of the board offshoreand no UK based director may act or think inthat role while in the UK. The directors arepermitted to delegate certain duties, such asthe discretionary investment management andadministration, but must realise that they retainultimate responsibility for management of thefund. The directors will commonly hold quarterlymeetings, meetings at least once a year in person,and meetings may be required at other times; itis important to choose directors who will makethemselves available and will execute documentspromptly and efficiently and are fully suitable.The Investment Manager ExemptionThe Investment Manager Exemption (IME) allowsa hedge fund to appoint a UK-based investmentmanager without creating a risk of UK taxationfor itself. Through a series of qualifying tests,the IME ensures that overseas investors arenot charged to UK tax in relation to investmenttransactions conducted on their behalf and thatany fees received by a UK-based investmentmanager for services performed for the non-resident are fully chargeable to UK tax. The IMEonly applies to certain ‘investment transactions’set out in government regulations. In additionto a transaction being an investment transaction,there are several conditions which must be metwithin a specific time limit for the IME to besatisfied. Broadly, these are as follows:• the UK investment manager is in the businessof providing investment managementservices;• the transactions are carried out in theordinary course of that business;• the investment manager acts in relation tothe transactions in an independent capacity;• the requirements of a ‘20% test’ (ie theinvestment manager and associates do notmake up 20% or more of the fund investors)are met; and• the investment manager receivesremuneration for provision of the services atnot less than the rate that is customary forsuch business.Other Service ProvidersIn addition to an investment manager, a hedgefund requires an independent administrator,an independent auditor, and, depending on theinvestment strategy, a custodian and/or primebroker. Some funds appoint a manager as wellas an investment manager and this is often donefor tax reasons, as the manager is usually basedoffshore.The fund will also require legal counsel, whowill be responsible for establishing the fundand preparing and negotiating the variousfund documents, including the prospectus, thematerial contracts between the fund and itsservice providers and incorporation documents.The fund will also need to consult tax advisors toenable the relevant parties to determine whichstructure is suitable in their own circumstances.Share classesIt is common for a hedge fund to createmanagement shares and investment shares.The management shares hold the voting rights,but do not participate in the profits of the fund,while the investment shares are non-voting, butdo participate in the profits and are redeemable.The reason for this is to avoid having to seek
www.cummingslaw.comthe consent of the investors, who could benumerous, for decisions arising in the day today management of the fund. The managementshares can be held by the investment manageror, as is commonly found in Cayman funds, by astar trust.Within the investment shares, the directors canchoose to create any number of share classes.All the shares in the same class must be treatedequally, thus it is necessary to create differentshare classes to accommodate varying rights,such as different redemption rights, differentfees, the use or non-use of leverage or, mostcommonly, alternative currencies. A hedgefund will often offer a separate share class forinvestment solely for the officers and employeesof the investment manager, which will not besubject to any management or performance feesso as to avoid the investment manager chargingitself fees.Funds may also consider establishing a classof share for UK taxable investors which couldbenefit from the reporting regime.FeesIn addition to the fund start up costs (as to whichsee below), the investment manager will chargemanagement and performance fees. Thesecan range between 1% - 5% and 10% - 25%respectively, but a typical fee structure for ahedge fund is 1.5% to2% and 20% respectively.Other on-going fees for the fund includeadministration fees, regulatory fees, auditor fees,custody and brokerage costs, directors’ fees andother professional costs.Equalisation and seriesaccountingEqualisation or series accounting ensures thata performance fee is charged only to thoseinvestment shares which have appreciated invalue and which equates precisely with eachshare’s performance. Both methods are used byhedge funds and most administrators are ableto offer both. Under the equalisation approach,there is one NAV per share for the entire fundand individual adjustments are made to eachshareholder’s account by issuing a small numberof equalisation shares each month, if necessary.Series accounting uses multiple series of shares(one for each period of issue), each with adifferent NAV per share and each series has itsown high water mark.Lock up, redemption and gatingTraditionally, a hedge fund is relatively liquid andinvestors are able to redeem their shares upon acertain notice period, which could range between30 and 180 days and in the event that insufficientnotice is given, the investor could be charged aredemption fee (usually between 1% and 5% ofthe amount being redeemed).However, some funds (increasingly so afterthe recent financial crisis) may choose to putan initial lock up in place, which means thatno share can be redeemed within that lock upperiod, which could, for example, range from 6months to 3 years. A hedge fund with a lock upis understandably less attractive to investors asits liquidity is compromised and its impositionwill therefore depend on the strategy pursuedand, in some cases, the agreement of the seedinvestor(s).There has been a recent increase in the useof “investor gates” which impose a gate onredemptions at investor rather than fund level.This can be seen as a compromise to allow afund to impose a gate but ensure that it does notadversely affect small investors who might beaffected if a large investor were to seek to make aredemption which is over the fund’s gate.Side pocketsWhere a hedge fund holds assets that are hardto value reliably or are relatively illiquid (incomparison to the redemption terms of the funditself), the fund may employ a “side pocket”. Aside pocket is a mechanism whereby the fundsegregates the illiquid assets from the mainportfolio of the fund and issues investors witha new class of shares which participate only inthe assets in the side pocket and which cannotbe redeemed by the investor. Once the fund isable to sell the side pocket assets, the fund willgenerally redeem the side pocket shares and payinvestors the proceeds. Side pockets thereforeallow a fund to ensure that all investors in thefund at the time the relevant assets becameilliquid will bear any loss on them equally andallow the fund to continue subscriptions andredemptions in the meantime in respect of themain portfolio. Side pockets are generally usedas an emergency measure only.
www.cummingslaw.comListingSome hedge funds list their shares or certainshare classes on smaller stock exchanges, suchas the Irish Stock Exchange, as this provides alevel of regulatory oversight required by someinvestors. In order to list, a hedge fund must fulfilcertain notification requirements of the exchangeand submit to certain investment restrictionsand its prospectus will be subject to approval.The fund will need to appoint a listing sponsor,which liaises between the fund and the relativeexchange, and will incur additional fees imposedby the exchange. At least two independentdirectors are required, counterparties mustmeet certain criteria, investment restrictions areimposed and certain changes must be reportedto the exchange.TimingA hedge fund can take an average ofapproximately three months to set up, but thistiming depends on a number of factors, notleast the responsiveness and co-operation ofthe relevant parties and whether the investmentmanager is authorised or not.
www.cummingslaw.com1. Stand alone fund:2. Master/feeder fund:APPENDIXDiagramatic examples of Fund StructuresinvestorsStand Alone fundinvestors investorsUs Feeder Fundoffshore feederfundoffshore masterfund
www.cummingslaw.com3. Umbrella fund:4. SPC fund:investorstradingsubsidiary atradingsubsidiary ctradingsubsidiary bumbrela fund withthree share classesinvestorsspc fund with threeportfolios or cells
www.cummingslaw.com5. Side-by-side fund:investorsinvestorsside-by-side fundside-by-side fund
42 Brook Street, London W1K 5DB +44 20 7585 1406 | Neuhofstrasse 3d, CH-6340 Baar +41 41 544 5549Regulated by the Solicitors Regulation AuthorityThis document is for general guidance only. It does not constitute adviceMay 2013