HF Start-Ups: Think Like An Owner

Date: Monday, June 16, 2008
Author: Emii.com

The best part of creating a new hedge fund may be the entrepreneurial spirit of the endeavor, yet that very mindset can result in a host of legal headaches for funds not careful from the outset. While there are a plethora of legal complexities related to the tax implications of the fund structure and advisor incorporation that fill legal tomes longer than any hedge fund manager could ever want to understand on their own, lawyers say the most critical issue for first-time managers is often more basic: the change of mindset from an employee of a corporation to a business owner.

Prior to starting up their new hedge funds, most managers were traders at an investment bank or junior managers and analysts at an established hedge fund. Therefore, lawyers stress that, while these managers may be investment geniuses and whizzes with complex derivatives, their biggest legal issue is transitioning into the mindset of running a business on their own.

“Most new managers are largely clueless when it comes to regulatory issues and structuring concerns,” said George Mazin, partner in charge of the hedge fund practice at Dechert. “They know how to put in buy and sell orders, but everything else has been done for them.”

Case in point, many traders come out of a bank or larger hedge fund where they were part of a team, and they start advertising the performance of that team as if it was their own, placing it up on web sites or in marketing materials. This is the type of basic mistake that is obvious to lawyers and seems as if it should be obvious to hedge fund managers, but often it is not because they have never had to concern themselves with running their own business. The good news from the standpoint of hedge fund lawyers is that legal and regulatory risk are two risks that funds can actually have control over and can do a lot to minimize. In other words, while minimizing these risks will never make a fund a lot of money, it may very well save the fund a lot of money when considered from a more nuanced, long-term perspective.

David Nissenbaum, a partner at Schulte Roth & Zabel, said the number one issue for new hedge funds is to make sure they understand what it means to operate as a fiduciary. By law, this means they have to act in the best interest of investors, and that is very different from the environment most new managers come from, working for an investment bank or hedge fund shop that has been the fiduciary assuming all of the risk related to managing clients’ assets. The fiduciary responsibilities under investment law are unique and distinct from the environment in which these traders have come up. “When you are the fiduciary yourself, your thinking has to be permeated by much more careful analysis, whether it is related to making a trade, hiring a service provider or managing pools of money on behalf of multiple clients,” Nissenbaum said.

Furthermore, when a trader, analyst or junior manager is working for a larger institution, all of the reputation risk also is at the level of the corporation. Proper understanding of reputation risk and client trust is a critical mindset shift for new funds. All of the decisions made by hedge fund managers - from their approach to client disclosures to due diligence on investments and service providers - circle back to the heart of the risks of starting up your own investment business. “Many new managers don’t fully realize that even if they are doing the same type of trading they were doing at another fund or investment bank, it is completely different in the context of their own shop,” Nissenbaum said.

The fiduciary equation also means preparing yourself for investor challenges unrelated to actual fraud. Ron Geffner, a partner with Sadis & Goldberg, explained that one of the key initial components of shifting the mindset of start-up fund managers is getting them to understand that legal challenges are likely when investors lose money. This is not limited to cases in which the manager has committed securities fraud, but also cases in which a manager may have a bad stretch of performance or made overly aggressive bets. Traders do not come out of a background where they have had to assume this risk themselves and, as a result, it is critical to prepare the hedge fund for times when investors may try to legally attack it in response to poor performance.

Pre-Nups for Start-ups

Beyond the shift of the legal and reputational burden away from a large corporation to the start-up fund, another critical aspect of forming a hedge fund business is settling on an appropriate operating structure for key personnel and an appropriate structure for relationships with third-party marketing firms and seed capital providers. Lawyers stress that these are decisions that many first-time managers will not be at all familiar with, but if they are not dealt with in a proactive way, they can come back to haunt the fund with a vengeance.

Structuring the hedge fund in the context of long-term business planning probably has changed the most in recent years. Before the last decade, hedge funds were most often synonymous with the individual managers, and therefore there was no real exit strategy put in place from a legal perspective. Over the past few years, as large institutions have gobbled up hedge fund shops—most notably the watershed deal by JPMorgan for Highbridge Capital Management—the issue of exit strategies has become a critical part of the legal framework for new funds, and not an issue that can be easily tackled retroactively. As institutions remain as hungry as ever for alternative investment acquisitions, deciding on an ownership structure that is prepared for the long-term future of key personnel is increasingly important. Furthermore, as competition for hedge fund talent is intense, deciding on an exit strategy for key personnel at the firm, as well as the firm as a whole, also is an important issue on the legal checklist from day one.

“The most prevalent issue for start-up funds launched by more than one individual is that they fail to execute a well thought out agreement among principals and, in the event of a divorce, don’t know how to extricate themselves,” Geffner said. “There is a misconception out there that these legal documents are boilerplate. They are not, and you can’t go back and easily modify them either.”

Not long ago, it was just the year-to-year income of key personnel that hedge funds had to be concerned with, but now they are following the path of the brokerage industry two generations ago, with various legal approaches to partnerships, participation in firm equity and the need to prepare for the exit of senior managers, as well as the potential sale or merger of the firm. Lawyers stressed that not proactively dealing with these issues at the time of structuring the business often means having to buy out officials, and that is never profitable. “No one wants to be part of these back-end divorces, and it can be nasty from the perspective of your investors as well,” said Jamie Nash, an associate with Kleinberg, Kaplan, Wolff & Cohen. This is part one of a two part story. Part two will run tomorrow.