If you’re starting a hedge fund, you may be tempted to jump directly into building your portfolio, but you must first think about building the infrastructure of your firm. A hedge fund, like any financial services organization, is first and foremost a business, and in order to meet the needs of investors and regulators, you must first meet the requirements of that business. For startups entering a competitive marketplace, expectations are especially high. These high expectations mean that you must demonstrate to investors that you have designed and implemented an infrastructure in your firm that will provide a solid foundation for investment success.
The decisions you make from the outset will define how your investors and competitors within the industry regard your firm. By considering the business needs of your firm and relying on trusted service providers to support your operations, you will prove to the greater investment industry that you can operate successfully in a challenging environment and that they should take you seriously. To avoid conflicts of interest and to establish adequate checks and balances within your firm, these service providers should be independent. In order to help a firm reach its fullest potential, four service providers in particular play a critical role in the creation and operation of a hedge fund.
- Law Firm
To ensure the long-term viability and marketability of a fund and its manager, it is critically important to properly structure both the business and fund from the outset. To create a proper structure, you must ensure that your fund’s operating and offering documents are properly drafted and that you have complied with all regulatory requirements. Therefore, by choosing a law firm that specializes in hedge funds and securities law, you can ensure that you are partnering with lawyers who work daily on these kinds of “alternative assets” and are up-to-date on the latest information relevant to the needs of hedge funds. Operating a hedge fund entails significant legal exposure, with considerable liability for improper disclosure. Even inadvertent mistakes can result in substantial personal liability. Hiring good legal counsel is an investment, and an experienced hedge fund lawyer can help you avoid pitfalls and help you properly structure your relationships with other service providers.
In order to start a hedge fund in the United States, you must first form at least two business entities. The first entity you create supports the hedge fund’s investment manager (the management company), and the second entity you create supports the hedge fund itself. It is imperative that you retain experienced and knowledgeable legal counsel to help you determine and establish the most appropriate structure for both business entities. By taking the time to understand the objectives and needs of both the management company and the hedge fund(s), your law firm can help you decide on the type of entities and structure that will best meet your needs as you seek to launch your new firm and ensure ongoing success as you grow.
The structure of a hedge fund is dependent on a number of tax, regulatory, and financial considerations. Fund structure is also driven in large part by the fund’s strategy, such as the liquidity of the portfolio investments. You should develop the fund structure through careful and thorough analysis with the assistance of an experienced fund attorney. Your organizational structure will typically reveal itself as a limited partnership (LP) or limited liability company (LLC). You may also consider a potentially beneficial master-feeder fund structure or a domestic or offshore choice. In general, your structure will largely depend on the assets with which you plan to launch or whether you’re planning to solicit seed or acceleration capital.
Your law firm will also play a key role in helping you navigate a labyrinth of regulatory and compliance issues. Depending on your hedge fund manager’s business location, the location of investor solicitation activities, and applicable state (and federal) rules, you may be required to register the fund’s management company as an “investment adviser,” even prior to the fund’s launch. Only a handful of jurisdictions are “friendly” to startup hedge fund managers and do not require registration until the fund’s adviser accumulates a significant number of clients or level of assets under management. However, in the past few years, many states and the Securities Exchange Commission (SEC) have adopted “private fund adviser” exemptions to allow investment advisers whose only clients are private funds (and not separately managed accounts) to avoid registration. In a post Dodd-Frank world, compliance is king. For the founder of a new hedge fund, partnering with a law firm that has experience in this area will be critical.
- Prime Broker
The prime broker relationship is arguably one of the most important relationships you will need to establish before starting your fund. In broad terms, the prime broker acts as a conduit between hedge funds and the financial marketplace by providing transaction execution, clearing, and settlement services. These settlement services give hedge funds access to a wide range of markets and products, such as equities, fixed-income securities, commodities, and currencies, as well as derivative products, including options, futures, and swaps. Importantly, hedge funds also rely on their prime brokers for leverage, whether in the form of loans, lines of credit, or margin financing. While hedge funds can gain leverage from several brokers and banks, prime brokers have a distinct advantage because they have direct access to a hedge fund’s accounts and assets, which are the collateral prime brokers use when they extend credit.
Prime brokers keep it simple and consolidate all the fund’s investment activity on a single platform. Large investment firms offer prime brokerage services to provide hedge funds with a centralized clearing facility where all executing brokers settle their trades. Since the prime broker holds the role of “custodian” of the fund’s cash and securities, this centralized facility keeps trade information in one place. Such an arrangement makes it easier for the fund to report key, timely financial information to internal parties, including portfolio managers and traders, as well as to other service providers and regulatory bodies.
Prime brokers also lend stock shares to hedge funds for use in shorting stock. Through an arrangement known as “securities lending,” prime brokers arrange to borrow shares from large institutions such as mutual funds, pension funds, and insurance companies. Finally, prime brokers will often provide fundraising assistance to hedge funds through a service known as “capital introduction,” where they will introduce their hedge fund customers to potential investors, including high-net-worth individuals, fund of funds, and institutional investors.
By establishing a relationship with a prime broker with a longstanding, formidable reputation in the hedge fund industry, firms can increase their chances of positive outcomes. J.P. Morgan, UBS, Goldman Sachs, Morgan Stanley, and others all provide such services. Obviously, no prime broker can guarantee success, but your firm is more likely to succeed if you choose to work with an experienced prime broker that you and your investors recognize.
- Fund Administrator
Every hedge fund needs an administrator to satisfy the needs of investors and regulators. Fund administrators accurately maintain the official books and records of the fund and provide investors and regulatory bodies with transparent information on the fund’s holdings and the value of each partner’s share in the fund. In this role, an administrator works closely with the fund manager, prime broker, and audit/tax firm to provide a variety of services on behalf of the investor.
The administrator begins this process by maintaining the shareholder register, reviewing all subscription, redemption, and transfer requests, and performing the required anti-money laundering (AML) checks. As they receive completed subscription/partnership agreements, the administrator will review them to ensure they are completed accurately. As the administrator receives subscription funds, they complete the AML controls. Once the administrator completes their AML checks, they will move the investors’ funds to the prime brokerage account for the investment manager to begin trading.
One of the administrator’s primary responsibilities is to independently calculate the net asset value (“NAV”) of the fund. To further ensure an accurate and independent NAV, the administrator must have the capacity to accept and reconcile daily trade files from both the investment manager and the prime broker. At set valuation dates (generally month, quarter, and year-end periods), the administrator must obtain prices from independent third parties. If the fund holds unlisted or complex securities, the administrator must get a fair value for the securities. Finally, the administrator will calculate management and performance fees in order to provide the shareholders with an accurate statement of profits and losses and ending account balances.
Hedge fund managers will typically base their evaluation of their administrator’s performance on the timely and accurate delivery of the NAV to their underlying investors. In order for the administrator to deliver a quality product, they must have strong technology skills and superior personnel. Hedge fund managers need to ensure that the administrator has a track record of supporting their particular asset class and that they have staff that are able to recognize potential issues and deal with them efficiently and appropriately. Ultimately, the fund administrator should be well versed in the manager’s product, structure, and strategy.
- Audit and Tax
Because firms perform fund audits and tax work at year end, many hedge fund managers work under the assumption that they don’t need to search for an accounting firm to perform audit and tax services until later in the year. For many reasons, it’s actually in a hedge fund manager’s best interest to select their audit and tax service provider as soon as they launch their firm. A certified public accounting (CPA) firm that has specific experience dealing with hedge funds can play a critical role in guiding a firm through the crucial start-up and formation phase. By partnering with a strong accounting firm, you can give your fund an added layer of legal and compliance protection by reviewing legal documents from a tax and accounting standpoint. In some cases, these firms optimize tax efficiency by using separate structures for specific transactions and/or jurisdictions. Additionally, you can provide assurance to prospective investors by providing them offering documents and marketing materials that demonstrate how your audit and tax providers will maintain a culture of checks and balances within the firm.
It is important to note that while administrators produce NAV calculations and financial statements, only a hedge fund auditor who is registered with organizations such as the Public Company Accounting Oversight Board (PCAOB) and a member of the American Institute for Certified Public Accountants (AICPA) can provide the services your firm will need to address ongoing reporting requirements to investors. These requirements include financial statement audit and reporting under U.S. Generally Accepted Accounting Principles (GAAP), and International Financial Reporting Standards (IFRS).
Throughout the year, and particularly during the audit period, the auditor will work with the hedge fund manager to review the hedge fund’s valuation methodology as well as the implementation of that methodology. The auditor will also review the fund’s account statements including the profits and losses, trading records, calculation of fees and expenses, and investor activity. Working closely with the fund administrator, the auditors seek assurances that the accounting practices of the hedge fund meet all financial and regulatory standards while providing their professional opinion on whether the fund’s financial statements and control measures are complete.
It is critical that your tax service providers understand the tax rules unique to alternative investments while providing full-service tax reporting and compliance. These tax reporting services include the preparation of partnership income tax returns for the fund, each limited partner, and the general partner as well as preparation and compliance for foreign investments and foreign partnerships. They must also analyze investments to comply with wash sale, constructive sale, and straddle rules, and proactively report state and local income tax information. In minimizing the tax liabilities of your fund, a qualified tax professional can help you drive investment performance and manage profitable growth.
The Bottom Line
While many people focus on building their hedge fund’s portfolio, there are four service providers that enable a fund to reach its fullest potential. If a firm fails to design and implement proper business operations, the firm’s leaders will, at best, find themselves distracted from investing and, at worst, lose complete control over the firm or fund.
If you feel overwhelmed by the plethora of service providers or if establishing relationships with these four hedge fund service providers sounds daunting, check out Arootah’s Hedge Fund and Family Office Advisory Services. Our experienced team of advisors can help you expertly navigate a course of action to help you meet your business needs.
Which service provider are you most excited to include in your firm? Let us know in the comments below.
Disclaimer: This article is for general informational purposes only and does not constitute legal, investment, financial, accounting, or tax advice, or establish an attorney-client relationship. Arootah does not warrant or guarantee the accuracy, reliability, completeness, or suitability of its content for a particular purpose. Please do not act or refrain from acting based on anything you read in our newsletter, blog, or anywhere else on our website.