Hedge Fund Structures

Typically, all types of structured entities provide a degree of liability, tax benefits, and control. Depending on the purpose, it is up to the fund sponsor to decide which entity structure will benefit both the operators of the fund as well as the investors.

Let us first look at the most popular U.S. structures for managing a hedge fund: The Limited Liability Company (LLC) and the Limited Partnership (LP).

Liability

Both the LLC and the limited partnership have one thing in common: limited liability. Liability is of particular importance when the fund manager-member is directly involved with the day-to-day management of the company. With an LLC, liability can be increased or decreased by determining who is running the company. Investors are considered members of an LLC, while the investment manager outside the LLC is hired to manage it. That firm is called a manager; a member may also serve as manager. An LLC can be composed of managers, members, and members/managers. Managers and members/managers take on the greatest liability since they are involved with the day-to-day management of the company.

In a limited partnership, the limited partners have minimal liability to the extent of their involvement in management. Limited partners are not supposed to be involved with management. It is the general partner's responsibility to operate the partnership following the limited partnership agreement. Since the general partner is directly involved with managing the company partnership, the liability falls on him.

Unlike a corporation, which pays its taxes on earned income, a limited partnership and an LLC both have pass-through income or loss features. Every partner or member receives a K-1 form from his respective general partner or manager stating the total earnings minus total expenses and the pro-rata share distribution or loss of the company. Each partner or member then reports his distribution or loss on Schedule E form in his yearly 1040 tax return.

Formalities

The General Partner of a limited partnership is responsible for filing a certificate of limited partnership with the secretary of state in the state where the limited partnership is domiciled. The manager of an LLC is required to file Articles of Organization with the secretary of state in the state in which the LLC is domiciled.

Capital accounts, which identify partners/members contributions and distributions, are required to be current and adjusted for both the limited partnership and LLC.

Filing Costs

Fees vary among states. For example, in Florida, the cost to form an LLC is about $100 for filing and an additional $25 for a certificate designating a registered agent. For a limited partnership, the filing costs are $7.00 per $1,000 of invested capital with a maximum fee of $1,785.

Delaware Limited Partnership

As part of the formation of your hedge fund that will be structured as a limited partnership in Delaware, you must select a name for your fund. The name cannot be the same or related to another company operating within the state unless you receive the written approval of that company. Also, the name must include the words "Limited Partnership" or "L.P." and must not contain the word "bank" or allude to being in the banking business, unless operating under the supervision of the state bank officials. You may check the availability of any name through the website of the Delaware Department of State, Corporations Division. Once selected, the name may be reserved by filing a name application with the department and including the required fee.

Delaware Formation Process

A Delaware limited partnership hedge fund can be formed by its investors/partners entering into a limited partnership agreement and filing a separate certificate of limited partnership in the Office of the Delaware Secretary of State. A certificate of limited partnership must be signed by all the general partners and state their names and addresses. Hedge fund limited partnership agreements are not required to be publicly filed or recorded and the names of the limited partners are not required to be outlined in the certificate of limited partnership. A Delaware limited partnership must maintain a registered agent and a registered office in Delaware.

The general partner of a hedge fund may also be a limited partner, however, the limited partnership must have at least one limited partner who or which must be different from the general partner.?Limited partners have the same limited liability as a stockholder in a corporation existing under the Delaware General Corporation Law or a member of a Delaware LLC, Sec. 17-303(a).

U.S. or Offshore Investors

The question I always ask my hedge fund clients first when they are deciding on which hedge fund structure is: “Where will your investors be coming from?” If they are coming from the U.S. then it makes practical sense to set up the fund in the U.S. Otherwise, it’s best to structure the fund in a tax-free offshore jurisdiction such as the British Virgin Islands.

Offshore Fund – Ltd

?The British Virgin Islands?(BVI) is an attractive jurisdiction for hedge funds. The legislative structure in the BVI?is modern and internationally recognized. The authorities have successfully created a framework that is rigorous in terms of anti-money laundering and know-your-customer requirements. It is considerably less expensive to establish a fund in the BVI than comparable jurisdictions such as the Cayman Islands. Hedge funds domiciled in the BVI would benefit from the availability of higher quality banking and custody services in the jurisdiction.

Currently, The British Virgin Islands (BVI) has approximately 3,000 investment funds registered by the BVI Financial Services Commission (FSC). The most popular fund structures are a Closed-ended company (fund) and a licensed Professional Fund.

BVI Closed-end Fund

For emerging managers and traders, a low-cost option to set up an offshore hedge fund is to structure it as a closed-ended investment vehicle. This type of entity does not allow investors to call for the redemption of their fund interests or shares. However, there can be language in the offering documents which states that at some point the company (fund) may convert over to a licensed registered fund. This would enable the investors to redeem their shares. A closed-end company/fund is simply a company that issues "x" number of shares. This type of company/fund is not required to register with the FSC. It is also important to note that the term "fund" cannot be included in the company name. Currently, there are no regulatory rules applicable to closed-ended funds domiciled in the BVI.

BVI Professional Fund

The majority of BVI funds are professional funds. To qualify as a professional fund, fund interests may only be made available to investors who are “professional investors”, with the minimum initial investment by each such investor being not less than U.S. $100,000 or its equivalent currency. Also, the fund sponsors would be required to have an administrator, auditor (optional but recommended), custodian bank, and two (2) directors minimum (need not be located in the BVI).

A “professional investor” is defined as a person (i) whose ordinary business involves, whether for its account or the accounts of others, the acquisition or disposal of property of the same kind as the property, or a substantial part of the property, of the fund; or (b) who has signed a declaration that he, whether individually or jointly with his spouse, has a net worth over the U.S.$1,000,000 or its equivalent in any other currency and that he consents to be treated as a professional investor.

Fund Structure

U.S. fund. For investors residing in the United States, an onshore fund is usually organized as a limited partnership. By purchasing an interest in the partnership, an investor becomes a limited partner of the partnership.

Offshore fund. An offshore fund is organized to make it possible for investors residing outside the United States to invest in a hedge fund. U.S./Offshore funds are typically structured in two ways:

Side-by-side. In a side-by-side structure, US investors typically invest in a limited partnership organized in the United States and offshore investors invest in an offshore corporation. The prime broker typically allocates trade tickets between the domestic fund and the offshore fund.

Master Feeder. This structure allows both investors residing in the United States and investors residing offshore to indirectly invest in the same offshore corporate entity commonly known as the “master fund.” Onshore and offshore feeders are used to invest assets in the master fund. The most common U.S./Offshore structure is the Master feeder. See diagram below.

With a Master Feeder?structure, your U.S. Feeder Fund (LP) will accept U.S. investors.?At that point, the U.S. feeder fund would then subscribe an equal amount of shares/dollars to the Master Fund?located offshore (i.e. BVI). Likewise, your Offshore Feeder Fund?(i.e. BVI fund) will accept non-U.S. investors. At that point, the Offshore Feeder Fund subscribes to an equal amount of shares/dollars to the Master Fund.

For U.S. tax purposes, the Master Fund located offshore would apply for an entity classification?change by filing IRS form 8832 making it into a U.S. limited partnership. This way all net profits/losses will flow back to the U.S. Feeder Fund down to its U.S. investors. There is no adverse effect for non-U.S. investors under this arrangement.

The advantage of having a Master Feeder Fund structure is that you will only need one prime brokerage account to trade out of. The Master Fund will hold that account. U.S. and Offshore Feeder funds will have separate subscription/expense accounts to facilitate subscriptions and redemptions as well as paying out the fund expenses.?

With a Master Feeder?structure, your U.S. Feeder Fund (LP) will accept U.S. investors.?At that point, the U.S. feeder fund would then subscribe an equal amount of shares/dollars to the Master Fund?located offshore (i.e. BVI). Likewise, your Offshore Feeder Fund?(i.e. BVI fund) will accept non-U.S. investors. At that point, the Offshore Feeder Fund subscribes to an equal amount of shares/dollars to the Master Fund.

The advantage of having a Master Feeder Fund structure is that you will only need one prime brokerage account to trade out of. The Master Fund will hold that account. U.S. and Offshore Feeder funds will have separate subscription/expense accounts to facilitate subscriptions and redemptions as well as paying out the fund expenses.?

With a global network of third party service providers, Frank Nagy Financial Services can provide introductions and advise you in choosing administrators, auditors, prime brokers, bankers and legal counsel who can work side-by-side with you ensuring that you and your fund comply with state and federal tax rules and securities regulations. In addition, we are committed to provide ONE (1) year consultation and continual support regarding fund operations, trading, compliance and marketing.