Irwin Latner, Partner at Pepper Hamilton LLP, contributed the following article.
My law firm, Pepper Hamilton, regularly advises emerging fund managers on the intricacies of launching a new hedge fund and the various legal structure options and documentation terms. Since we are typically an early touchpoint in the process, we often find ourselves advising on the myriad pre-launch business and strategic issues that new fund managers face in seeking to grow assets and build infrastructure with limited resources. Therefore, rather than mechanistically discussing the legal documents and procedures associated with launching a new hedge fund, this article focuses on certain strategic decisions and challenges faced by many prospective new fund managers. How a manager handles these decisions and challenges is likely to have a significant impact on the ultimate success or failure of the fund.
First Things First — Building Track Record, Basic Infrastructure and SMAs
Many managers have portable track records from prior firms that they can legally use to market their new funds. This means that the manager owns the rights to the supporting data and that the strategy and decision-makers are the same. Certain other managers have demonstrable and verifiable track records from their prior firms, even if they do not meet the legal portability requirements to formally market their prior track records for the new funds. Many of these managers often move directly to building infrastructure and preparing high-end investor marketing materials and, if they are lucky, to establishing relationships with seed or anchor investors who will invest pre-launch. Many other managers, however, do not have portable or demonstrable track records with their current strategies and need to build one before engaging in any serious marketing efforts with outside investors.
In these circumstances, a manager need only form a bare-bones domestic fund entity (typically a Delaware limited partnership) and a domestic general partner management entity (typically a Delaware limited liability company). Because these entities would be formed primarily to manage and trade the proprietary capital of the managing principals, the process should be fairly streamlined and inexpensive. If a small number of friends and family also invested, the fund documents can be slightly enhanced to accommodate such friendly capital, which is often invested on a no-fee basis. The manager’s goal at this point should be twofold: first, to build a verifiable and continuous track record with the new strategy in the same fund entity that will later be opened up to outside investors; and second, to build a management company with branding and operational experience that will satisfy investor due diligence processes and attract additional midlevel management team members and employees.
In conjunction with the foregoing proprietary trading structure, a pre-launch stage manager may also wish to accept mandates for separately managed accounts (SMAs). There are many early-stage investors who prefer to invest through an SMA rather than a commingled fund for a variety of reasons, mainly to retain a greater degree of transparency and control over their assets while taking advantage of the typical outperformance associated with emerging managers. In addition to building a track record for the management company that can be used to market the fund, SMAs can be an important source of initial fee revenues for a new manager. However, managers should be prepared to make fee concessions in connection with early-stage SMA mandates, especially on the management-fee side. A first loss platform (i.e., where the manager co-invests with the platform provider to leverage its own capital and earn a higher incentive fee on the platform provider’s capital) is an example of an early-stage customized SMA mandate that can be used to build a manager’s track record.
Transitioning to Outside Investors — Building Working Capital, Management Team and Strategic Outsourcing Platform
At this point, a manager should have a basic pitch book and tear sheet to provide to early-stage investors, which typically include emerging-manager funds of funds, seeding platforms, family offices, high-net-worth individuals and certain endowments. Given the manager’s relatively small assets under management (AUM) and need to build a degree of infrastructure, it is extremely helpful if the manager has some working capital to meet initial expenses. Whether this capital comes from the principals or from friends and family, a carefully managed, internally funded budget can permit the manager to retain office space, hire administrative personnel, prepare professional marketing documents and engage high-quality core service providers to the fund, including legal counsel, auditors, administrators and prime brokers.
Though a manager will typically start off with a portfolio management team that has come together for the new venture, most successful new fund managers recognize the need for a balanced and complementary management team, which typically includes a COO or CFO who has the ability to run the business side and handle all non-investment-related operations. The COO/CFO typically will also be the point person for initial compliance efforts (i.e., function as CCO) to ensure that the firm adheres to the terms of the fund documents and advice of fund counsel, follows through on developing and implementing appropriate compliance policies and procedures, tracks the impact of new regulations and changes to the firm’s business model, and generally ensures that the firm has the proper culture of compliance that can support its eventual registration with the SEC as an investment adviser. As we have emphasized in many of our legal compliance seminars, fund managers (whether new or established) need to pay careful attention to identifying and managing any conflicts of interests in order to build a solid compliance infrastructure and minimize operational risk.
Nowadays, a manager can effectively outsource the COO/CFO/CCO functions to well-qualified firms, which is an acceptable strategy until the manager can afford to staff the positions internally. Another approach is to have someone wear the COO/CFO/CCO hat internally and outsource a portion of their responsibilities to outside firms, including middle and back office, compliance consulting, internal accounting and tax oversight, trade processing and valuation support, as appropriate. In addition to the above, efficient outsourcing of other fund operations may also include trade execution, IT infrastructure, HR/payroll/benefits, portfolio management system (PMS), order management system (OMS) and investor relations/marketing (IR).
Preliminary Marketing Activities and Capital-Raising Focus
While capital raising is a critical business objective, a new manager is often in a quandary to fill this role with appropriate staff and/or capabilities. Although employees are generally capable of handling internal IR responsibilities (including developing basic marketing materials and a website), they often are not qualified or sufficiently connected to develop and build the long-term relationships needed to successfully raise capital from institutional or family office investors. In addition, there are regulatory risks for in-house marketing departments that effectively operate as unregistered broker-dealers. While many quality third-party placement agents and marketing firms are available for larger hedge fund managers, most of these capital-raising firms do not take on new fund managers with relatively small AUM. Similarly, while many prime brokers offer capital introduction services, they are typically geared to larger managers with more established track records.
Based on our experience with emerging managers, there is no magic bullet to ensure that a good track record and a quality infrastructure will translate into successful capital raising. In many cases, investors are simply looking for a different strategy fit or they are just not comfortable being an early-stage investor. New managers who have taken the time to build the proper foundation can nevertheless employ a variety of approaches to increase their odds of raising seed or early-stage capital, including:
- Employing quality marketing consultants to create and/or enhance marketing materials, website content, PR opportunities and overall client messaging. These consultants can also help refine a manager’s “elevator pitch” and other verbal presentation skills for clearly and concisely describing what the manager does, what differentiates the manager from its competitors, and why investors should care.
- Publishing white papers, articles and research, and participating in online forums, webcasts and blogs to increase branding and demonstrate thought leadership.
- Networking and speaking at family office events and investor conferences.
- Talking with prime brokers and placement agents to get ideas on business development strategies, even though a manager may be too small for direct referrals to their clients at this time.
- Reaching out to as many seed and early-stage investors as possible (i.e., those family offices, seeders and emerging-manager funds described above, not pensions and other large institutions that are unlikely to make early-stage investments). Even if not the right fit, a manager may learn a lot about what early-stage investors are looking for and how to manage investor meetings and due diligence requests (e.g., many investors have war stories about managers coming on too strong and not taking the time to research the investor and understand how the manager can fit into the investor’s portfolio).
- Online platforms for emerging managers, such as Hedge Connection, Seeking Alpha, Alternative Capital Advisers, Sumzero and Darc Matter, are growing in number and technological capability. These platforms are a good way for emerging managers to increase their exposure and communicate their message directly to a wider body of potential investors, often bypassing traditional brokers and intermediaries. However, using such online platforms is more productive in conjunction with live interactions, relationship building and effectively managing the overall investor due diligence process.
A note on website content — websites are viewed as advertising by securities regulators. If a manager intends to advertise its SMA capabilities, it must first consider whether that advertising would trigger a requirement to register as an investment adviser with the relevant state or states in which the manager is located. If the manager also intends to use a website or any of these other speaking engagements to promote a private fund, in addition to the state investment adviser registration analysis, the manager must either password protect the website and allow access only to those potential investors who have been precleared by the manager or the manager must do a general solicitation within the context of a private placement for the fund under Rule 506(c) of Regulation D. That will limit investors who can be accepted into the fund to verified accredited investors only.
Building the Right Fund Structure and Terms
Before going out to market, a manager should carefully consider the optimal fund structure for its intended investor base, investment program and long-term business goals. For example, we often counsel new managers to defer employing a full onshore/offshore master feeder fund structure if their initial investor base consists of mostly onshore investors or mostly offshore investors. In these circumstances, it is often more economical to start out with either an onshore standalone fund or an offshore standalone fund, and to build out the additional offshore or onshore feeder, as appropriate (perhaps in a mini-master fund structure), when the manager’s AUM and investor base are sufficiently developed. Similarly, a fund’s liquidity terms should correlate to the duration of its underlying investment portfolio. Very liquid portfolios should generally accommodate monthly or quarterly redemptions with 30-to-60-day notice periods without the need for extended lock-ups (i.e., beyond one year) or fund level gates. Less liquid portfolios (e.g., certain types of structured credit or direct lending funds) may warrant less frequent redemption dates and/or longer notice periods, perhaps coupled with an investor-level gate to minimize any adverse NAV or other portfolio impact of redemption requests concentrated on a single date or over a short period of time. Side pocket mechanisms can also be a useful feature for managers that seek to deploy a small bucket of illiquid private-equity-type investments without creating undue liquidity or valuation risks.
Perhaps the most significant component of a new manager’s effort to incentivize and align interests with early-stage investors in a new fund is the fund’s fee terms. One increasingly common approach is founders’ share classes that offer lower management and performance fees to investors who subscribe before the fund reaches a certain threshold AUM (e.g., $100 million or $500 million). These incentives are sometimes also accomplished through side letter agreements with certain anchor or strategic investors, which provide similar fee discounts and are often coupled with additional negotiated terms, such as more extensive and frequent investor reporting, notices of certain material events, clarification of the manager’s expense policies, consent rights to certain major actions, tax covenants and/or more explicit time commitment undertakings from the principals.
In addition, many new managers have opted for tiered management fee structures that step down in percentage once the fund reaches certain AUM thresholds — in most cases nowadays, even the higher tier management fee percentage is less than 2 percent per year. Others net out cumulative management fees from performance fee waterfalls so that management fees are essentially treated as a hurdle rate that net returns must exceed in order for the manager to receive performance fees. Some managers have agreed to forgo an asset-based management fee altogether in favor of an expense reimbursement formula intended to reimburse the manager for its operating and overhead costs and other management company expenses, subject to an agreed-on budget and/or expense cap. The common denominator of these approaches is to remove or reduce the profit component from management fee revenues in order to better align manager interests with investors who want emerging managers to be focused on returns, not asset gathering.
On the performance-fee side, we have been seeing less variation than on the management-fee side — i.e., a 20 percent annual performance fee with a high water mark is still very common. That said, the more customized, investor-driven new fund structures often involve extended performance measurement periods intended to address investor concerns that they might pay significant incentive fees for short-term returns that could be offset by losses in subsequent periods. Such structures often involve a rolling two-to-three-year measurement period (sometimes combined with a hurdle rate) with partial vesting and a clawback for unvested portions to account for subsequent losses over the extended measurement period. Similarly, certain managers have adopted back-ended performance fee structures, whereby a portion of the performance fee (typically one-half or greater) is taken on redemption, with performance measured from the date of investment through the date of redemption in order to create a more long-term alignment of interests with investors. Overall, the current trend for emerging managers seeking to raise capital from increasingly sophisticated early-stage investors is to tie more of the manager’s compensation to fund performance, rather than to fixed asset-based management fees.
“Between you and every goal that you wish to achieve, there is a series of obstacles, and the bigger the goal, the bigger the obstacles. Your decision to be, have and do something out of the ordinary entails facing difficulties and challenges that are out of the ordinary as well. Sometimes your greatest asset is simply your ability to stay with it longer than anyone else.”
~ Brian Tracy
This is true with new fund managers seeking to compete with larger established firms for limited amounts of investor capital. Despite the growing number of seed and early-stage investors and the recent uptick in overall hedge fund performance, emerging managers still face many formidable obstacles to launching a new fund, raising capital and building infrastructure with limited resources. In our experience, managers would be wise to consider the strategic approach outlined above, rather than adopt a mechanistic “build it and they will come” approach. This type of strategic approach, plus a lot of hard work and perseverance in the face of adversity, is a sound blueprint for turning a new fund into a successful established asset management business.
About Pepper Hamilton
Pepper Hamilton LLP is a multi-practice law firm with more than 450 lawyers nationally. The firm provides corporate, litigation and regulatory legal services to leading businesses, governmental entities, nonprofit organizations and individuals throughout the nation and the world. Drawing on our lawyers’ varied knowledge and experience in all areas vital to the success of funds, Pepper’s Investment Funds Industry Group (IFIG) helps various types of funds navigate the issues that may arise throughout a fund’s life cycle. IFIG’s bench of attorneys across our offices assists clients in funds services, including fund formation and operation; fund transactions, including acquisitions, investments and financings; and fund regulation and regulatory compliance.