What Is A Hedge Fund?
Hedge funds can be profitable investment options for experienced managers and wealthy investors. Because they are more sophisticated investment vehicles than mutual funds and other offerings, hedge funds generally face less SEC regulation than other, similar business structures.
But hedge funds still require compliance with hedge fund laws, and they also require significant legal protections. Without these protections, hedge fund members risk serious liability. All hedge funds must be created and run in partnership with an experienced hedge fund lawyer. A Priori hedge fund lawyer can assist you at every stage of your business -- from formation to ongoing compliance.
How To Invest In A Hedge Fund
For investors wondering how to invest in a hedge fund, it is important to understand why hedge funds are often attractive investments. Hedge funds are popular mainly because they offer investors an opportunity to diversify their exposure. Hedge funds use pooled funds for diversified strategies to earn active returns for hedge fund investors. Generally, hedge funds are legally set up as private investment limited partnerships with a limited number of accredited investors who put in a large, illiquid initial minimum investment and build upon these investments. Hedge funds are generally built by an experienced manager and cater to very wealthy, experienced investors. Because of this, they are somewhat less regulated than traditional mutual funds, which means that you can invest more easily if you are a qualified buyer.
The Investment Company Act of 1940 and Legal Issues Related to Forming a Hedge Fund
When you are forming and running a hedge fund, you must carefully consider the impact of the Investment Company Act of 1940. The Investment Company Act of 1940 governs businesses that engage primarily in investing, reinvesting, and trading in securities. Because of this, hedge funds generally fall under the jurisdiction of this act. However, these regulations can be quite strict and often conflict with the goals of hedge funds. For this reason, most hedge fund managers and lawyers take advantage of two statutory exceptions to the Investment Company Act of 1940 and design their hedge fund's structure to exempt the hedge fund from the restrictions placed on most mutual funds and other investment vehicles.
Section 3(c)(1) Exclusion
Section 3(c)(1) of the Investment Company Act excludes from the purview of the Investment Company Act of 1940 any issuer whose outstanding securities are owned by no more than 100 accredited investors and that makes a public offering of its securities through general solicitation. Thus, most hedge funds are private and limited to a relatively small number of investors.
Section 3(c)(7) Exclusion
Section 3(c)(7) of the Investment Company Act excludes from the purview of the Investment Company Act of 1940 any issuer with securities that are owned exclusively by “qualified purchasers” and that is not making public offerings of its securities. Qualified purchasers are defined as purchasers falling into one of these four categories:
- any person with at least $5 million in investments;
- any family-owned company that owns at least $5 million in investments;
- any other trust in which the trustee and settlors are qualified purchasers; and
- any person who owns and invests at least $25 million in investments on a discretionary basis on his own behalf or on behalf of other qualified purchasers.
Other Legal Issues for Hedge Fund Managers to Consider
Of course, even if exempt from the Investment Company Act of 1940 by legal design, hedge funds are still subject to a number of compliance issues under hedge fund laws. The following are some of the most important to consider, but hedge fund lawyers will be able to more fully define the compliance issues facing any particular hedge fund based on its specific investments and structure.
Securities Act of 1933
Hedge funds, like any other investment vehicle, are subject to the Securities Act of 1933. While most hedge funds are exempt from registration requirements if executed correctly, hedge fund lawyers must still approach disclosure carefully, especially since there is generally more risk involved in hedge funds than in other similar vehicles. This requires legal precision and clear documentation.
Regulation D, Rule 506, & Accredited Investors
As with any securities offerings, Reg D offerings may be made to an unlimited number of accredited investors. Many hedge funds make use of this exemption under Rule 506, as hedge funds are almost always made up exclusively of accredited investors. This offers hedge funds some flexibility, but this exemption must be executed correctly or the hedge fund will face compliance risks.
Public Placement Memoranda
Not all legal issues that hedge funds face are as broad as the issues mentioned above. Sometimes, hedge funds must be prepared to draft legal documents as a part of the hedge fund's daily operations. One important everyday document is the public placement memorandum. Hedge funds must be prepared to regularly create public placement memorandums (PPMs) when making a private offering on behalf of a company or themselves on a smaller scale than an IPO.
A PPM includes all the information about the offering that an investor may need to make an informed decision, including the offering structure, share structure, SEC disclosures, company information, information on company operations, risks involved with the investment, management information, use of proceeds, information on certain transactions that could affect the investor, and investor suitability data. Essentially, the PPM is an incredibly detailed document that serves as a business plan, disclosure document, and subscription agreement for purchasing shares. You must be prepared to work with counsel to prepare these documents for your hedge fund.
Depending on your needs, the cost of hiring a lawyer for your hedge fund can vary. Hourly rates for Priori lawyers who are experienced working with hedge funds range from $225 to $450 per hour. In order to get a better sense of cost for your particular situation, put in a request to schedule a complimentary consultation and receive a free price quote from one of our lawyers.
What is a hedge fund and how is it different from a mutual fund?
Both mutual funds and hedge funds are managed portfolios, but hedge funds are managed much more aggressively and speculatively. Generally, hedge funds are only available to investors with high net worth who are willing to take bigger risks, while almost anyone can invest in mutual funds.