Akin, Gump, Strauss, Hauer & Feld, L.L.P. (reprinted with permission)    
1700 Pacific Avenue, Suite 4100
Dallas, Texas 75201-4675
Telephone: (214) 969-2800

by Ford Lacy, P.C. ([email protected]) and Eliot D. Raffkind, P.C. ([email protected])    

Q: What sort of legal structure should be used?    

A: The simplest, least expensive, least complicated form for an investment limited partnership (“Hedge Fund”) is a limited partnership with an individual general partner. Many investment managers do not like this form because it does not offer the “appearance” of limited liability. Many prefer a limited partnership with a limited liability company as the general partner or even a limited partnership with a limited liability company as its general partner serving as the general partner of the Hedge Fund. The use of a limited liability company as a general partner of the Hedge Fund or as the general partner of the general partner of the Hedge Fund gives the “appearance” of limited personal liability. We use the word “appearance” in quotation marks because many of the unexpected liabilities which a general partner might have in running a Hedge Fund are liabilities under the securities laws for which he or she can be held to be personally liable irrespective of the legal form of the entity which serves as the general partner. One advantage of a limited liability company or limited partnership as a general partner is the opportunity it offers for estate planning provided one wishes to take advantage of such opportunities. These entity general partners also provide the opportunity to offer equity interests to employees or to create certain incentive compensation arrangements for employees.    

Q: What securities laws are applicable?    

A: Historically, the offer and sale of securities within the United States has been subject to concurrent federal and state regulation under the Securities Act of 1933 (the “Securities Act”) and state blue sky laws. In order to avoid the registration and prospectus delivery requirements of the Securities Act, securities of hedge funds and offshore funds are typically offered in private placement transactions which rely on the private placement “safe harbor” provisions of Regulation D or the safe harbor for offerings outside the United States contained in Regulation S. Until the passage of a recent law, however, a separate exemption from state registration or qualification requirements needed to be perfected under the blue sky law of each state where the securities were offered. Pursuant to recent legislation, states are prohibited from imposing their blue sky laws relating to registration or qualification of securities with respect to securities offered in a private placement pursuant to Rule 506 of Regulation D. States are still permitted to require notice filings which are similar to the Form D that is filed with the SEC pursuant to Regulation D, and to collect filing fees. The new law prohibits states from regulating the content of offering documents or the terms of securities being offered. Certain states may regulate general partners and their employees (if applicable) as brokers and require certain filings under their broker-dealer regulatory schemes prior to the offer of any securities in their jurisdictions. These filings can be burdensome and time consuming.    

Q: Should I register under the Investment Advisers Act?    

A: Most hedge fund managers or general partners choose not to register under the federal Investment Advisers Act as a result of an exemption from registration because they have fewer than 15 clients (because the Hedge Fund is deemed, under certain circumstances, to be one client) and do not hold themselves out to the public as investment advisors. Under current interpretations of Texas law, all Hedge Fund managers based in Texas must register as investment advisors under Texas law. An exemption from federal registration, however, does not exempt a fund or fund manager from the anti-fraud provisions of the federal Investment Advisers Act. Some managers feel it is easier to get investors to invest in the Hedge Fund if they register, but doing so limits (if the manager charges an incentive fee [and most Hedge Fund managers do]) potential investors to people with a net worth over $1,500,000, or people who invest more than $750,000, Qualified Purchasers (as described below) and certain “knowledgeable employees” of the investment manager. (Registered investment advisors who act as advisors to offshore funds and “Qualified Purchaser Funds” described below are not subject to these restrictions on incentive fees.) Certain institutional investors will only place funds with registered investment advisers. Should one choose to register under Federal law, one can only do so after the Hedge Fund (or other assets under management) exceeds $25,000,000 in size. Individual states regulate investment advisors who have $25,000,000 or less under management.    

Q: How can I sell interests in my funds?    

A: Very carefully. The private placement rules severely limit what you can do to sell units in the fund. Generally speaking, you should have a pre-existing relationship with every offeree. You may send private placement memoranda to as many people as you have pre-existing relationships with provided they meet the sophisticated investor requirements of an accredited investor. Furthermore, to sell securities in a private placement to accredited investors requires a very low key selling effort which is subject to numerous restrictions. To remain exempt from registration as an investment advisor one cannot hold oneself out “publicly” as an investment advisor. The SEC has taken the position, except in certain special circumstances, that providing information to organizations that track hedge funds constitutes “holding oneself out to the public” as an investment advisor and, accordingly, requires registration under the advisers act. One should be even more careful if one is soliciting unaccredited investors.    

Q: Should I limit my offering of limited partnership interests to accredited investors only?    

A: The traditional wisdom is that accredited investors are less likely to sue than non-accredited investors and that juries are less sympathetic to accredited investors than they are to non-accredited investors. The traditional wisdom is probably right.    

Q: Can I take pension plan money?    

A: Yes, but generally speaking no more than 25% of the value of the fund can be held by employee benefit plan investors of any description including ERISA plans, IRA’s, 401(k) plans, state funds, or other employee benefit plans unless the Hedge Fund goes to great effort (usually at great expense) to comply with ERISA.    

Q: Do I have to wait until I have a PPM prepared before I can talk with people about the fund?    

A: Although there is no per se requirement that a PPM ever be prepared in a private placement, as a matter of practice the whole point of having a PPM is to minimize one’s liability under the securities laws and to make an offer (and it is hard to imagine that “talking to someone” who later buys would not be making an offer) without delivering a PPM to some degree acts to defeat that purpose. The most that can be said for making an offer before a PPM has been prepared to a person one reasonably believes to be an accredited investor is that the subsequent delivery of a PPM should cure any liability resulting from the premature offer. No attempt should be made to “pre-sell” a fund prior to the delivery of a PPM. Non-accredited investors should not be contacted prior to delivery of a PPM. Furthermore, Rule 506 of Regulation D requires the delivery of a PPM to non-accredited investors and compliance with Rule 506 is required in order to be exempt from certain state blue sky law restrictions.    

Q: Can I use third parties to sell the fund?    

A: Yes, you can use third parties to sell the fund, but typically substantial investors will not.


2 Comments so far

  1. Paul Sinclair on October 7, 2008 3:22 pm

    I want to do like Warren Buffett did starting out, which is to pool amounts of as little as $5000 from his friends and family and invest it for them. He started out with a simple partnership agreement. I want low start up costs and to keep it simple, but no one I ask to join the partnership will have the money to be worth 1.5 mil. or to put up $750K. I looked into ‘investment clubs’ but I read that the IRS wants you to have meetings and everybody provide input into what stocks the ‘club’ will buy and vote on it. I won’t be doing that. I don’t want to offer investment advice or be an advisor. If Texas law says I must, maybe I need to move to another state. If I stay here, what designation must I have, and how do I accept smaller amounts of capital? I won’t surpass the max. allowed number of investors or fund value anytime soon. I don’t require that it be called a ‘hedge fund.’ I just want to get a good performance record established, then those participating will tell people they know, and I can expres to others that we have a real partnership going (2 or more people) What kind of organization should I start? How much would it cost to get going?

  2. admin on October 24, 2008 4:13 am

    From what you are describing, it sounds like you want to set up an investment pool, but just keep it small and under the radar of regulators. All states allow you to engage in this type of activity, subject to a de minimus threshold - for example, you may be limited to $5 million and 10 people. You can easily determine this by going to the Texas government agency that deals with registering investment advisors. Once you get to $25 million, you generally need to register with the SEC and you would almost certainly be required to register as an investment advisor. As to your point that you don’t want to provide investment advice, unfortunately the services you provide is considered an investment advisory function, even though you don’t really give “advice” to people on what stocks you buy - you are doing this by buying and selling the stocks on someone’s behalf who has entrusted you with their money. One other note of caution, most of the brokerage firms are wise to this and generally do not accept accounts from unorganized groups of individuals (and even many do not allow investment clubs anymore), so just make sure that you are aware of that when filling out applications. Finally, certain of the investment advisor rules relate to custody of assets - it is another safeguard set up such that if you were operating as a hedge fund, you would not be able to take control of the assets yourself, sell them and take off to the Bahamas. So, if you are indeed found to be operating as an unregistered investment advisor, you could also be faulted for violating the custody rule, which says that the accounts have to be registered in the names of your clients and be kept segregated from your own personal assets. So, at a minimum, I would set up a separate account and not mix it in with any of your own personal funds (unless you are planning on investing in your own fund, too.)




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