Legal Issues Of Structuring The Fund
Building a solid legal and tax foundation is essential for your hedge fund. The fund’s documentation and tax structure are some of the main building blocks in its creation.
Documentation: More than Boilerplate
Setting up a hedge fund entails more than 100 legal documents. One of the most important is the offering memorandum or private placement memorandum (PPM), which is central to the success of the fund. It spells out the fund’s strategy, the risks and constraints of the strategy, the team members and their histories, the fund’s governance and its legal underpinnings. It outlines the guts of the fund: how it will function as a legal entity; how to subscribe to the private placement; redemptions; and risk warnings.
It’s tempting to think of it as boilerplate, but investors spend a great deal of time going through the offering memorandum because it lays bare the framework, discusses the rights of investors and addresses such matters as founder shares. And, when the PPM gets reviewed, if the risk warnings are out of sync with the alpha proposition or the redemption mechanics don’t square with the liquidity, then it’s unlikely to pass muster with investment consultants and advisers.
Balancing the rights of the investors against the tools needed by the manager to steer the fund requires experienced counsel. So, when choosing a lawyer to draft the PPM, make sure to hire someone with experience.
In thinking about your tax structure, you need to take a two-pronged approach: What works best for the manager side and what works for the fund side?
Fund side: The tax structure must start with the investors. Accordingly, knowing your investors is critical: Are they U.S. or non-U.S. investors? Are they U.S. taxable or tax-exempt investors? Is the fund structured as an efficient vehicle from the investors’ perspective?
The three categories of investors all have competing needs. The non-U.S. investor wants to avoid paying tax on a current basis, while the U.S. taxable investor has to pay income tax on a current-year basis. Finally, the U.S. tax-exempts wish to accumulate gains and pay tax only upon redemption of the shares.
A master fund fed by an offshore corporate fund for non-U.S. and U.S. tax-exempts and an onshore partnership for the U.S. taxable investors is able to satisfy the competing tax needs—with the partnership set up in Delaware and offshore fund domiciled in the Cayman Islands.
Manager side: The limited liability partnership and the partnership agreement are the cornerstones of any manager’s legal infrastructure. The LLP serves to future-proof the fund against changes in the regulatory or tax landscape and retain fees for marketing shares in the fund. The partnership structure also allows for a lower tax rate.
If the LLP can be thought of as a kind of marriage license, the partnership agreement serves as the “pre-nup,” spelling out the terms of the dissolution of the partnership, covering everything from a falling out between partners to retirement to death. Arguably, from the manager’s perspective, it’s the most important document—and it’s important to have the discussion at the beginning.