How to Start a Hedge Fund

Starting a hedge fund can seem like a daunting process for first time fund managers.  In practice, forming a hedge fund is a relatively straightforward process, provided the manager has a reasonable understanding of the steps involved to successfully launch a fund.  This article summarizes the hedge fund formation process from inception to launch.

Preliminary steps

First and foremost, the manager should develop a clear vision of the investment strategy and overall structure of the fund.  Will the fund be a traditional hedge fund, a commodity pool, a forex fund, etc.?  Will the fund be geared towards private equity and/or real estate based investments?  Will capital be allocated to short-term trades or long-term investments?  Will the fund be a domestic fund or an offshore fund (typically domiciled in the British Virgin Islands or Cayman Islands)?  What will be the fees and withdrawal terms?  What differentiates the fund from existing fund strategies?  Have any assets from family and friends been soft-circled for the fund?  The more thought given to overall fund structure and investment strategy on the front-end, the easier the process will be going forward.

The next step in the hedge fund formation process will be selecting a hedge fund attorney.  Choosing appropriate legal counsel is critical, as the hedge fund attorney will assist the manager with fleshing out the structure and terms of the fund, as well as guide the manager through the overall process of launching the fund.  Qualified legal counsel should be able to assist the manager with each of the steps outlined below.

Entity formation

The hedge fund lawyer will help form the fund and the management company.  The fund is typically established as a Delaware limited partnership, whereas the management company is typically established as a limited liability company in the manager’s state of residence.  The respective entity formation documents for the fund and the management company (along with the respective tax identification numbers for each entity) can then be used to open bank accounts for both the fund and the management company, as well as a brokerage account for the fund.

Preparing Offering Documents: Private Placement Memorandum, Limited Partnership Agreement and Subscription Documents

Preparing appropriate offering documents for the fund is the primary legal work involved with starting a hedge fund.  Only an experienced hedge fund attorney with a clear understanding of the structure and terms of the fund should draft the offering documents for the fund; poorly drafted offering documents will not only be a major hurdle towards attracting outside investors, but can expose the manager to significant liability in connection with the offering of interests in the fund.  The offering documents consist of:

1)      The private placement memorandum (“PPM”).  The PPM serves two purposes: (1) it is a marketing material for the fund; and (2) it should disclose to potential investors all facts material to a decision whether to invest in the fund.

2)      The limited partnership agreement (“LPA”).  The LPA is the governing contract for the fund between the management company and the investors.  Much of the LPA will mirror the structure and terms of the fund disclosed in the PPM.

3)      The subscription documents.  The subscription documents include the terms of an investment in the fund, representations and warranties that the investor is qualified to invest in the fund, and general representations and warranties pertaining to applicable securities, anti-money laundering and other laws and regulations, as appropriate.  The subscription documents are oftentimes bifurcated into two separate booklets for individual and institutional investors, respectively.

Registration

For domestic funds, depending on the types of instruments traded, assets under management, and place of business of the management company, the management company may need to register as (i) an investment adviser with the U.S. Securities and Exchange Commission or one or more state securities divisions; and/or (ii) a commodity pool operator with the U.S. Commodity Futures Trading Commission and National Futures Association.  Qualified legal counsel should be engaged to advise the manager as to whether registration is necessary (including applicable proficiency requirements) and, if so, manage the registration process on behalf of the manager.

Other Service Providers

The hedge fund attorney should also be able to assist the manager with the selection of other service providers for the fund, including a hedge fund administrator, a prime or introducing broker, and an auditor (if required) for the fund.

Marketing the Fund and Raising Capital

Once all previous steps have been completed, the fund is ready to be launched.  Initially, the manager will typically focus on raising capital from friends, family and other members of the manager’s personal network.  Eventually, third-party marketers may be used to raise capital for the fund provided each such individual is properly licensed to sell interests in the fund.  All marketing activities should be discussed beforehand with the hedge fund attorney, and all marketing and promotional materials (including websites) should be reviewed by the hedge fund attorney to assure compliance with applicable federal and state law.

Assuming there are no registration requirements, the entire process of launching a hedge fund can be completed in less than one month, depending on the complexity of the fund and the manager’s timeframe.  The keys to a successful launch are acquiring a keen understanding of the process on the front-end and hiring an experienced hedge fund attorney to assist with the launch each step of the way.

Please contact us for a free consultation if you are interested in starting a fund or would like to discuss the hedge fund formation process in greater detail.