What are the main legal considerations in choosing a structure for a hedge fund?
Brian McDermott and Siobhan Moloney at A&L Goodbody say agility, in terms of industry, investor and regulatory demand, should be considered when selecting a fund structure. They note that Irish qualified investors fund (QIF) allows the use of the most complex investment strategies. The Irish regulator’s usual requirements regarding leverage and diversification do not apply as few investment restrictions are imposed on QIFs. There are also a number of structures that can be used to mitigate difficulties in obtaining tax treaty relief.
They have also seen an increasing trend in hedge fund managers launching UCITS funds. The convergence of these two spheres is linked to the extended scope of eligible investments under UCITS III, in particular, relating to the use of derivatives as well as the ability to use an advanced or sophisticated risk measurement methodology such as value at risk (VaR).
Nora Bullock and Simon Atiyah at Lovells believe that funds should take into account several issues – where the investments are based/will be traded, where the targeted investors are based (for example, if there will be both US and non-US investors), whether these investors would be interested in an offshore or onshore hedge fund product, what legal structure (such as company or partnership, single portfolio, umbrella fund or protected cell company and open-ended or closed-ended) would be most attractive and what kind of distribution channels to use.
In terms of choice of fund vehicle, they think it needs to achieve limited liability to investors and not increase the amount of tax investors pay on the underlying investment. The overall aim is not to place the investor in a different position than if it were to invest in the underlying investment directly. Fund vehicles/structures all have advantages and disadvantages, comment Bullock and Atiyah.
In Malta, Omar Zerafa at Aequitas Legal thinks most funds look for a flexible and strong mechanism. He, too, believes that tax is an important factor. “Bearing in mind the international nature of the fund, double-taxation treaties are crucial in determining how a particular income from the fund is to be treated in another jurisdiction,” says Zerafa, agreeing with his colleagues at Lovells. “The chosen structure of the fund ultimately depends on the investors and the type of investment. It is important for the hedge fund to make this decision correctly from the moment of incorporation, as this could have serious repercussions afterwards,” he concludes.
John Langan at Withers believes there can sometimes be a crucial marketing advantage in being able to offer investors better tax treatment than similar fund vehicles. “In most well-established types of fund, such as hedge and private equity, there is an accepted ‘standard’ structure and the client’s main concern will be the lawyer’s degree of knowledge of such structures and familiarity with the standard documentation,” notes Langan.
Joey Garcia at Isolas in Gibraltar says a hedge fund’s structure should be primarily based on the needs of the target investors. An influencing factor would be any potential restrictions associated with the fund and its investors, such as being able to promote the fund to a specific group of people or restrictions on eligible assets. “If any potential obstacles are not identified at the outset, no matter how good the investment strategy is, the fund could run the risk of not receiving enough subscriptions to allow it to commence trading,” says Garcia.
Frances Watson at Ogier’s Guernsey office agrees with others that the principal considerations are the flexibility of fund structure and the ease with which it can be distributed. “Where the hedge fund runs a multi-strategy approach, the availability of protected cell companies or similar could be relevant,” she says, picking up Garcia’s point.
“Regulatory considerations are equally important and in particular, seeking a balance between regulation of an internationally acceptable standard and flexibility. It is a given that the structure must be tax-efficient,” she concedes.
In the British Virgin Islands office, Simon Schilder also believes that the starting point for any structuring is the hedge fund’s potential investor base. “This will inextricably influence both how a hedge fund is practically structured (master-feeder, side-by-side, offshore/onshore), the types of entities used in the structure and the jurisdictions which will be utilised for these purposes,” he says.
The right legal advice for the relevant jurisdiction is crucial, declares Jon Fowler at Maples and Calder. “Issues affecting structure include tax and regulatory restrictions, location of the fund manager or the main part of the fund’s investments, geographic spread of investor base and simple preference or familiarity of managers and investors. The predominance of certain types of structure in different jurisdictions can be a more influential factor,” he says.
Fowler has spotted trends for jurisdictional bias, such as partnerships for the US market, companies for the UK and unit trusts for Japan.
Cayman, he says, has become the domicile of choice for international hedge funds and private equity funds because it is a tax-neutral jurisdiction, serving as a platform for funds targeted at institutional investors with a wide geographic spread, where otherwise, it would be impossible or unduly burdensome to reconcile different tax codes. “Cayman fund structures are widely acknowledged by institutional fund managers, investors, lenders and swap counterparties as the product of a tried-and-tested legal system. Cayman also benefits from stable government and a deep bench of professional and legal expertise,” he concludes.
Tania Dons and Richard Finlay at Conyers Dill & Pearman both agree with the view that structure is generally driven by the type of investors the fund is targeting and/or its proposed investment strategy. So funds that want to market into Japan will often be established as unit trusts for tax reasons. The majority of offshore hedge funds are still set up as exempted companies, they note. Whether or not a master-feeder structure is needed depends on the particular client. They are aware of an increase in the use of managed accounts and single-investor funds for large institutional investors who can dictate terms and not have to compete for liquidity.
Gray Smith at Appleby in Cayman says power has “shifted hugely to the investor and funds will have to ensure that any structure works for the investor in terms of tax, liquidity and transparency.”
Catherine Gardner and Fred Levy in the Washington office of Brown Rudnick believe that tax and regulatory issues should determine the choice of jurisdiction for a hedge fund. They say that the main consideration for most hedge funds in choosing a jurisdiction in which to domicile are the location of investors and fund managers. The jurisdiction should provide the most advantageous tax scheme for the investors as well as a well-developed regulatory and legal scheme for hedge funds, they add.
Ron Geffner at Sadis & Goldberg says there are three primary considerations that determine the structure of any hedge fund – the investment strategy to be used, the type of investment (taxable or tax-exempt) and domicile of investors (US and non-US) and tax and regulatory matters.
A set of questions is the starting point for Steven Nadel at Seward & Kissel. Who are the investors? What is the strategy? What is the liquidity make-up of the portfolio? Any unique tax or other operational issues? What will the fund and manager domicile be? “Once all these items are discussed, the law firm should walk the manager through all the possibilities and suggest the best course of action,” he says.
“The structure should facilitate the efficient and effective delivery of the chosen investment strategy to the targeted investors,” explains Mitch Nichter, a partner at Paul Hastings. “The primary attributes of the strategy, such as use of leverage, location of primary investment markets and investor requirements and expectations, for example, domicile, tax status and liquidity expectations of the investors, should drive the structure of the product,” he concludes.