2014 Hedge Funds 101 For Emerging Managers

2. Choosing the right people for your operation:internal staff and external providersIn any organization, getting the right people for thejob is a key requisite for success. But it’s especiallycrucial for the hedge fund startup.First, as noted, investors have become vigilant indelving into all aspects of a fund’s operations tosafeguard their assets and minimize any exposureto operational risk. Having a good team in place iscritical to raising capital.Second, the new fund’s working capital is limited;each employee will have a lot on his or her plateand has to be good at many things — especiallyadministrative staff who will be responsible for awide variety of functions, whether they have toperform them internally or oversee outsourced tasks.Consequently, the exposure for each hire is muchhigher than for a large fund with dozens of employees.In a small firm, staff has to show flexibility and bewilling to take on all necessary tasks.Hiring internal staffThe most important team members are the traders.The exodus of traders from large financial institutionsin recent years has substantially expanded the talentpool of candidates with a wealth of experience whohave managed accounts on their own or traded foranother fund. Funds must critically examine thetrader’s past performance as audited by a reputableaccounting firm.For administrative matters like accounting, legal,compliance and IT, new hedge fund managers aresurprised — and experienced ones dismayed —at how much time they must devote to supportfunctions: They require as much as 30% or more oftheir hours. Like other entrepreneurs emigrating fromthe corporate world, they suddenly find themselvesresponsible for an array of administrative tasks thatare essential to the fund’s success, but have little to dowith the investing skills that gave them the confidenceto open their own shop in the first place.4 Hedge Funds 101 for emerging managersUsing external providersExternal service providers are the solution for many ofthe fund’s operational needs. For startups, third-partyadministrative services often make sense for reasonsbeyond those of efficiency. In the case of accounting,for example, an external administrator providesinvestors with an independent set of eyes that ensuresobjectivity and transparency, such as in calculationsof net asset value (NAV). Hedge funds, of course,are ultimately responsible for the accuracy of theirown records, so many small funds will run a parallelset of books using off-the-shelf accounting software.Overall, the skill set that internal administrativepersonnel must have depends heavily on how muchthe fund relies on external providers.As always, there are numerous trade-offs — quality,cost, control — of hiring internally versus goingoutside. As the fund grows and matures, it mustregularly evaluate its organization to determinewhether it is optimally using internal and externalresources, depending on its current investing,marketing and compliance needs.Among the service providers that funds hire are primebrokers, administrators, legal counsel and auditors.Unfortunately, because the fund manager’s focustends to be on investing, the selection of externalproviders sometimes receives inadequate attention— in some cases, they may be casually chosen on thebasis of a single cocktail party conversation.But first-rate selections in this area are critical. Thefund needs these services to operate successfully.Equally important, however, the strength andreputation of external providers become part andparcel of the image the fund presents to investors inthe marketplace. Hiring the best providers instillsconfidence in investors, while poor choices diminishit. The quality of third-party services is especiallyimportant for gaining the trust of institutionalinvestors, given their strict due diligence requirements.

Finding the right external providersHedge fund startups — and many large funds as well —look to external service providers to perform many of theadministrative and support functions of the firm. The keyactors include:Prime brokersThe most important responsibility of a prime broker,which is usually a large financial institution, is executingorders. But the prime broker offers many other importantservices, including real-time portfolio reporting; globalcustody; securities lending; portfolio financing andmargining; technology support; and capital introduction.Prime brokers, among other providers, can also furnishoffice space — commonly known as hedge fund hotels— that frees managers from the headaches of setting uptheir own offices.“Some hedge funds were burned during the financialcrisis by the collapse of their prime broker,” saysJayinski. “Since then, many hedge fund managers havedecided to use more than one prime broker to spreadtheir risk.”Legal counselCounsel is especially important in the startup stage, whenthe fund is putting together its formation documents.There is no requirement — legal or otherwise — that alawyer write these papers. But experienced counsel canensure that the company’s legal foundation serves itsbusiness purposes. The attorney’s review for compliancewill also make certain they satisfy relevant securitieslaws, both during the fund’s formation and further downthe road. The slew of new hedge fund legislation andguidance introduced in the wake of the financial crisis hascreated demand for legal advice on a regular,ongoing basis.The key questions in selecting a lawyer are: (1) Howcomfortable do you feel working with the person, and (2)Do they have significant hedge fund experience?AdministratorsExternal administrators handle the fund’s accountingfunction, either exclusively or in parallel with an internalaccountant. Their tasks encompass partnershipaccounting and reporting, which include the calculation ofthe fund’s NAV and the statement of change in partners’net capital and partnership interests in each fund class.Administrators can also provide transfer and custodialservices. Although using an external administrator mayincrease costs, it gives investors added assurance andconfidence that may help in the marketing process.Obtaining SSAE 16/SOC reports on the administrator’ssystems and controls may be necessary and usefulto the governance process. When hiring, funds shouldask candidates to see a list of similar clients as well ascontact references.Even where the fund has outsourced back officefunctions, it still maintains a fiduciary duty to the investor.In-house support must be in a position to analyze thework of the external administrator.AuditorsAn external auditor is required for providing assuranceon the firm’s financial statements. Some fund managersopt for a low-cost provider because they think of an auditsimply as a compliance function rather than a beneficialservice. But an audit firm with a strong reputationis essential when marketing the fund, especially toinstitutional investors. Moreover, auditors ensure that thefund’s internal controls are in place and working, reducingthe fund’s operational risk. As with other functions, fundsshould seek out auditors with experience in the hedgefund industry, especially those who can give you a lot ofattention early on and grow with you. Those funds thatexpect to have significant overseas exposure in theirmarketing, investments, etc., should make sure theirauditors and other service providers can identify issuesin jurisdictions outside the U.S. and have the capability towork with funds on such issues.External marketersExternal marketers and placement agents help thefirm find investors. Opinion varies on their utility – aswith many other hired hands, good ones are worththeir weight in gold, while bad ones can do significantdamage. What is certain is that while acquiring capital isessential, it’s also lots of work. Some fund managers areunderstandably reluctant to contend with what can seemlike constant rejection. If the fund manager does notperform the capital procurement function, for whateverreason, this critical responsibility has to be done bysomeone else. External marketers could be the solution.IT data managersIT data managers who specialize in financial serviceshelp manage the firm’s data and applications on a privatecloud. The cloud environment is available 24/7 andmaintained by a service-level agreement. These providerscan save the firm hundreds of thousands of dollars in ITinvestment and provide unlimited supportand maintenance.Investors are keenly aware of cyber security menaces,and they will want to know your policies and proceduresfor ensuring data safety — including vulnerabilityassessments and penetration tests to identify possiblerisks. “Even a small manager has thousands andthousands of transactions every day, executed throughnumerous third parties,” says Mehta, “all of which aresubject to security threats.” As part of an overall strategy,the firm should have clear, well-articulated policies toshow investors that it implements best practices to helpprevent costly attacks.Hedge Funds 101 for emerging managers 5

3. Sustaining profitability in the face of decliningfees and heightened regulationHedge funds are under margin pressure, squeezedbetween reduced fees and higher costs, especiallyfor compliance.De c l ini ngfeesMore regulationAt the same time, an onslaught of new regulations —SEC registration for advisers stemming from DoddFrank, the Foreign Account Tax Compliance Act(FATCA), anti-money laundering requirements andother regulatory regimes — are raisingcompliance costs.litytionProfitabieMorruegDeclining feesThe traditional “two and twenty” fee structure —management fees of 2% of AUM and performancefees of 20% of investment returns — has beeneroding. Smaller firms are getting heated competitionfrom big funds and are slicing fees to compete. “We’redefinitely seeing fees come down,” says Jayinski.“Management fees are now between 1% and 2%, andfor a small fund trying to attract new clients it mightbe even less than that.” As for performance fees, theaverage for the entire hedge fund industry has fallento about 18%. Moreover, the use of hurdle rates (i.e.,benchmark levels of return that a fund must clearbefore performance fees kick in) has become more4common . Investors willing to lock up their money forseveral years, make a big investment or put money in anew fund can get even better deals on already-reducedfee schedules.laAccording to the Financial Times, “Few financialinstitutions have been hit as hard by the onslaught5of new global regulation since 2008 as hedge funds .”Although in some aspects welcomed by larger fundsseeking greater credibility with institutional investors,the additional rules place a substantial burden onsmaller funds.ProfitabilityGregory Zuckerman, Juliet Chung and Michael Corkery, “Hedge funds cut back on fees,” The Wall Street Journal, Sept. 9, 2013. See 873238930045790549528075563525Sam Jones. “Regulation changes the way hedge funds grow,” Financial Times, Oct. 22, 2013. See 0144feab7de.html#axzz2kOAruHKY46 Hedge Funds 101 for emerging managers

The Dodd-Frank ActThe piece of legislation that has most affected thehedge fund industry is the Dodd-Frank Act. Keychanges brought about by the Act include:Adviser registrationThe Investment Advisers Act of 1940 included anexemption from registration for an investment adviser— including those to hedge funds — with fewer than15 clients and which did not hold itself out to thepublic as such. Under Dodd-Frank, that sweepingexclusion has been eliminated. Hedge funds withmore than 150 million in regulatory assets undermanagement (RAUM) now have to register.Among the requirements of a registered investmentadviser filing with the SEC are:– Filing disclosures on Form ADV– Designating an individual as chiefcompliance officer– Maintaining financial books and records tofacilitate SEC examinations– Keeping client assets with a qualified custodian– Adopting a written code of ethics, which includesstandards for personal securities tradingForm PFForm PF is a joint initiative of the SEC and theCommodity Futures Trading Commission. Itspurpose is to allow the Financial Stability OversightCouncil (FSOC) to monitor risks to the U.S. financialsystem. In general, all private fund advisers have tofile an annual Form PF if they advise private fundsgreater than 150 million in RAUM.A hedge fund is defined for purposes of Form PF tobe generally “any private fund that has the ability topay a performance fee to its adviser, borrow in excessof a certain amount, or sell assets short.” Large hedgefund advisers above the 1.5 billion RAUM thresholdhave additional reporting obligations, includingquarterly filings for some data.Hedge funds may be required to provideinformation on:– Gross and net assets of each private fund– The aggregate notional value of the fund’sderivative positions– Performance– Counterparty credit risk exposure– Trading practices– Percentages of fund ownershipAdvisers with less than 25 million are prohibitedfrom registering with the SEC; unless an exemptionapplies, they will register with state regulators, ifapplicable. The rules for midsized advisers with 25million to 100 million are more complex, but ingeneral, they will register with state regulators, exceptfor those in New York and Wyoming, which willregister with the SEC.– Financing (including secured and unsecuredpositions)– Valuation and methodology– Liquidity of holdings– Portfolios of insidersSuch an abbreviated listing understates thecomplexity of Form PF, which requires extensive dataidentification, collection, verification and aggregation.Much of the information has never been required onany form, and simply locating and gathering the datahas been a major challenge for some funds.Hedge Funds 101 for emerging managers 7

Anti-money launderingThe Securities Industry and Financial MarketsAssociation (SIFMA), an association of severalhundred securities firms, banks and asset managers,has released a suggested AML due diligence practicesguide for hedge funds. The SIFMA documentprescribes two regimes, simplified and increased, ofprocedures, based on the level of risk, adherence to anequivalent AML regime, and other factors.Blue sky lawsHedge funds will also have to make blue sky filings ineach state where they have investors. Blue sky laws arestate regulations designed to protect investors againstfraudulent sales practices by requiring sellers of newissues to register their offerings. These generally runno more a few hundred dollars, but in the case ofNew York, where a filing is required before the initialinvestment, it will be over 1,000.Additional regulationsOther regulatory regimes that affect hedgefunds include:– As noted, regulation of the CFTC is, in part,aligned with that of the SEC. For example,CFTC registration requirements may requirefunds to complete Form CPO-PQR, which is thecounterpart of the SEC’s Form PF. Hedge fundswould also be subject to rules in markets regulated6by the CFTC, such as swap transactions .– FATCA requires all non-U.S. hedge funds to7report information on their clients .– The Alternative Investment Fund ManagersDirective (AIFMD) has rules that apply to anyfund, no matter where it’s based, if it takes anymoney from an EU-based investor. Most existingAIFMs have until July 21, 2014, before theapplication of8the provisions .– When the SEC lifted the ban on hedge fundadvertising, it also issued regulations thatdisqualify felons and other so-called bad actorsfrom participating in hedge fund offerings. Badactors are primarily officers, 20% owners and fundmanagers who engage in “disqualifying events,”including criminal convictions, court orders,final orders and other orders in connection withviolations of securities laws.With expenses rising and fees dropping, hedge fundshave their work cut out to maintain profitability.“The current cost structure of the industry is toughon smaller funds. Firms need to grow so that theygenerate sufficient income,” says Jayinski. But costcutting has to be done with a scalpel, not a saw:Choosing bargain-basement services and staff mayinitially help the bottom line, but in the long run it canhurt the firm’s reputation and back-office operations.“New CFTC rules on swaps challenge offshore funds,” Grant Thornton, September 2013. See re-funds.aspx7“Understanding FATCA: Know the implications for your business,” Grant Thornton, July 2013. See 3.aspx8“What hedge funds need to know about the Alternative Investment Fund Managers Directive,” Grant Thornton. June 2013. See es/financial-services/2013/AM/AM-06-AIFMD.aspx68 Hedge Funds 101 for emerging managers

4. Organizing effectively for tax efficiencyWhen setting up a hedge fund, there are many factorsto consider from organizational, regulatory and taxstandpoints. Organizing a hedge fund for maximumefficiency is a task of considerable, sometimesenormous complexity. The following discussionserves only as a brief overview.Tax status of investorsA key factor in organizing and structuring a hedgefund is the tax status of the investor the fund seeksto attract.– Individuals and for-profit institutions based in theUnited States. They pay U.S. taxes based on theirworldwide income.– Tax-exempt U.S. investors, including pensionplans and charitable entities. They do not pay U.S.income taxes. Importantly, a U.S.-based nonprofitcannot invest in an onshore hedge fund withoutaddressing the unrelated business taxableincome (UBTI).– Non-taxable offshore investors (i.e., individualsand institutions not based in the United States);they do not pay U.S. income taxes.Hedge Funds 101 for emerging managers 9

Common hedge fund structuresMaster-feeder fundsMaster-feeder is the structure most often used byhedge funds. Investors put their money in feederfunds, which in turn supply it to a master fund. Allthe investing and trading is done by the master fund,which is typically an offshore corporation taxed as apartnership — a flow-through entity — for UStax purposes.Usually, the master fund receives capital from:– A U.S. domestic feeder (typically a partnershipcalled the “onshore”), with funds from U.S.taxable investorsThe master fund is often incorporated in placesfriendly to alternative investment entities, especiallythe Cayman Islands, Bermuda and the British VirginIslands (BVI), although there are numerous locationsoutside the Western Hemisphere. These jurisdictions,where offshore funds represent a significant part ofthe local economy, offer well-established investmentlaw, a strong infrastructure of service providers, andno- or low-tax favorable tax treatments — investorsare taxed where they live. Regulatory bodies, suchas the Cayman Islands Monetary Authority (CIMA)and the Bermuda Monetary Authority (BMA),maintain strong policies and guidelines. Investors seethese regimes as underpinning risk management, andmanagers accordingly select these jurisdictions.– An offshore feeder (usually a corporation), withfunds from U.S. tax-exempt and non-taxableoffshore investorsThe master-feeder fund structureMaster-feeder funds consolidate trading activities into a single portfolio, while allowing managers toaccumulate funds from U.S. taxable, U.S. tax-exempt and foreign investors. This commonly used structurecreates a critical mass of tradable assets, improves the economies of scale and helps to reduce costs.Management feeInvestmentmanagerManagement fee10 Hedge Funds 101 for emerging managersOnshorefeederU.S.investorsPerformance feeMasterfundOffshorefeederForeign or U.S.tax-exemptinvestorsGeneralpartner

Single domestic hedge fundsMost U.S. startups begin with investors solely fromthe U.S., so the hedge fund may be structured as aU.S.-based limited partnership (LP) or limited liabilitycorporation (LLC). Generally, each fund will haveits own management company and general partner(GP); the manager establishes an LLC to serve as thefund’s GP. Onshore funds are usually domiciled inDelaware, because of the state’s long tradition of welldeveloped and generally business-friendlycorporate laws.Single foreign hedge fundsAn offshore hedge fund, such as a foreign corporationthat trades securities for its own account, is notconsidered to be engaged in a trade or business in theU.S. Thus its investors are exempt from U.S. taxes.For a few selected funds in their initial stages, this mayprovide a less costly solution than the more complexmaster-feeder and side-by-side structures.Incubator hedge fundsAs the name implies, an incubator fund provides acontrolled environment for investment managers totest out strategies and show what they can do beforehiring an administrator and launching the actualfund. The incubator fund has a simple organizationstructure, usually comprising: (1) an LP or LLC forthe fund, and (2) an LLC as the investment manager/general partner of the fund (or managing member ifthe fund is an LLC). An incubator doesn’t provide al

hedge fund seeders, and funds of funds. Since the financial crisis, two major changes in the hedge fund landscape have altered the pursuit of capital: (1) the rise of institutional money, and (2) the freedom given to hedge