Hedge Funds: Five mistakes to avoid at start-up

The initial set-up phase of an investment vehicle is critical to its success, and setting up a hedge fund has many complexities. While proper organization does not guarantee success, avoiding common mistakes at the start can prevent costly errors.

The most common mistakes we see involve five areas: your internal team, your service providers, entity type, structure and offering document.

Don’t cut corners when selecting your internal team.
A competent team will make your job easier, and contribute to your success. First, you’ll need traders capable of implementing the fund’s strategy. You’ll want to find someone who has managed accounts on his or her own, or traded for another fund.  This could be the most important hire you will ever make, so don’t take any shortcuts: make sure to review each trader’s audited performance history before committing. If you’re considering a trader who has managed accounts with a similar trading strategy for several years but doesn’t have an audited history available, ask your auditors to perform performance audits.

You’ll also need an internal administrative group. The skills required here will differ depending on how much you rely on your external administrator. A good way to determine a candidate’s competence for this role is to have your administrator participate in the interview process.

Finally, you’ll need someone capable of raising money and being the public face of the fund. If this isn’t your own role, make sure you select someone you can really trust.

Demand experience in your service providers.
Selecting the wrong service providers is another easy mistake to make.   You’ll need a prime broker, an administrator, a placement agent, an attorney, and an auditor.    Avoiding errors here is critical for two reasons. Obviously, these people are providing services that your fund needs to operate successfully. But they’re also part of the image you present to the marketplace.

If you choose providers who are inexperienced or have negative reputation, their character will tarnish yours. Selecting respected professionals with industry experience and solid reputation provides prospective investors with confidence that you’ve done your best to create an environment for success.

When selecting an auditor, for example, you may be tempted to try to minimize cost. After all, auditing is a compliance function – you have to do it, but it doesn’t seem to have an upside benefit, so why not choose the cheapest alternative? Here’s why: your auditor is documenting your track record. If you’re starting your first fund with internal money, this may seem less important. But once you start marketing to investors, you must have auditors who are recognized in the industry. This is particularly true if you are dealing with institutional investors.

As with your internal team, you’re looking for proven experience. Check reputations by searching the internet for any news articles. Run background checks. Ask to see a list of similar clients, and check references. Make sure to get – and call – contacts for at least two former clients.

Consider the tax implications of entity type selection for U.S. domiciled funds.
You’ll need to select entity types for the Fund, the General Partner, and the Investment Advisor. Choosing the wrong entities could have significant tax implications.

Typically, your Fund will be a pass-through entity for U.S. income tax purposes, generally a limited partnership (L.P.) or a limited liability company (L.L.C.)

The General Partner should be a pass-through entity as well: partnership, L.L.C., or S-corporation. You will probably want to establish a separate entity for the Investment Advisor, because the Investment Advisor may have to register with the SEC.

This has other advantages in terms of compensation and taxation. The General Partner can receive performance allocation with the income allocated maintaining its character for tax purposes, such as dividends or capital gains taxed at lower rates. The Investment Advisor would earn management fees, considered ordinary income for tax purposes and usually taxed at higher rates. It also allows you to have different sets of people in each entity, or different ownership percentages, to suit the operational needs of the fund’s sponsor. 

Choose a structure that supports the needs of your target investors.
By understanding the fund manager’s investment strategy and targeted investors, attorneys and accountants can help select the right structure. For example, if you expect to target a large percentage of offshore investors, you might be well advised to set up an offshore feeder fund that would house all the tax exempt and foreign investors. This would avoid issues your offshore investors could encounter with Unrelated Business Taxable Income (UBTI) and help manage dividend withholding issues for the fund and its investors. But there are costs associated with establishing an offshore fund, so careful consideration is needed.

Seek knowledgeable, independent review of your offering document.
The offering document is where these and many more decisions must be finalized. Having counsel who is knowledgeable in the industry is critical, but errors often occur because no independent review is completed. Whatever you decide to include, make sure your auditor and tax accountant review the document before it is finalized. This can help you avoid issues and capitalize on opportunities.

This independent review may address questions like these:

·         What are the potential tax implications of trading strategies for the fund and your investors?  For example, offshore investors may have withholding issues. You’ll need a mechanism to track this.

·        Is the fund set up in way that may be deemed a trade or business? A trade or business would be subject to a different set of tax implications.

·         Is the fund is going to generate UBTI? This would have tax impact on tax exempt investors.

·        Should certain tax elections be made up front, based on the strategy and the impact on investors?  For example, making a Mark-to-Market election at the outset instead of at the end          of the year may have positive impact for investors with up-front knowledge.

·         Does the fee structure operate as the parties intended? Does the math work? The structure should include an allocation and not a fee, for the benefit of the General Partner with respect to performance compensation.

·         Are all the conditions in the document consistent? Are there any contradictions?

·        Is the document flexible enough to allow potential future strategies?    For example, a trading fund presented with an unexpected opportunity might decide to enter a private equity investment as a one-time deal, perhaps only available to certain investors. Creating a mechanism to allow for these “side pocket investments” in the initial offering makes that possible without creating a separate legal entity or amending the original document.

Successfully starting and managing a hedge fund requires more than the ability to produce spectacular returns. Investing the time and energy to avoid these common errors at the outset may save pain and money in the long run.

Robert A. Kaufman is a principal in Kaufman Rossin’s hedge fund audit practice. The Firm audits more than 100 hedge funds, and provides tax preparation, planning and compliance services for more than 200 funds. Rob can be reached at rkaufman@kaufmanrossin.com.