Over the years, offshore hedge funds have become relatively common given their lower levels of regulation and cost. However, there is little information available on how to go about Starting an Offshore Hedge Fund. Subsequently, in this guide I will do my best to cover the major issues you will face and what jurisdictions you can potentially look to form your hedge fund in.
- How Not to Start a Hedge Fund
- Starting an Offshore Hedge Fund – Single Structures
- What is a Single Domestic Fund?
- What is a Single Offshore Hedge Fund?
- The General Partner (GP) and Legal Liability
- What Does it Cost and How Long Does It Take When Starting an Offshore Hedge Fund
- Fund Formation Services
- Other Offshore Articles That Might Interest You
How Not to Start a Hedge Fund
The process of starting a hedge fund has largely been shrouded in mystery until recently. This has meant that the process has been opaque and the costs largely excessive given the lack of competition and information. However, this has changed and there is now healthy competition across both the domestic and offshore fund management sectors.
What this means is that you now have a plethora of options for your fund and a variety of service providers to choose from and play off against each other. So be prepared to not accept anything that you are unhappy with as that is an ingredient for failure in the long term. Truly, there is a new era in hedge fund formation, and you are now in the driving seat.
Typically, the original form of structure was one where the hedge fund manager oversaw both the strategy, as well as all of the operational and management concerns. This would typically require the recruitment of a relatively large staff and management team and came with lots of recruitment and regulatory headaches. Additionally, you would then need to negotiate key leases for office space as well as agreements with a raft of professional advisers, such as accountants, lawyers, auditors, etc.
Thankfully, with modern practices, many of these functions can now be outsourced leaving the fund manager to focus upon their investment strategy and the actual returns of the fund. Although the setup is still not cheap, it is nowhere near as expensive or lengthy timewise as it has been in the past.
Probably, one of the most important pieces of advice I can give you right now is to avoid any of the turnkey solution providers. You will often see someone offering turkey hedge fund setups for $50k but, unfortunately, these types of offerings provide none of the professional advice that is going to be essential for your continued success as you will find as you read on.
Starting an Offshore Hedge Fund – Single Structures
Hedge funds can be formed in a variety of ways including a solely domestic fund or a single offshore fund or they can be fit together as a hybrid with a combined domestic and offshore presence. The choice really comes down to the tax treatment of the hedge fund and should be one of the key aspects you consider when Starting an Offshore Hedge Fund.
What is a Single Domestic Fund?
In short, a single domestic hedge fund is one that is based onshore (in the U.S.) and is typically in the form of a Limited Partnership (LP). The investment manager normally serves as the General Partner and investors typically inject capital into the partnership and, therefore, share in the pro-rata gains and losses.
These sort of hedge funds are normally structured towards sophisticated or high net worth (HNW) individuals who have the required investment experience to satisfy the safe harbor provisions. Normally they would fall under the scope of section 3(c)(1) or 3(c)(7) of the Investment Company Act. In particular, section 3(c)(7) funds have some additional requirements for potential investors and are primarily suited more towards the larger institutional investors. Normally, the investor would need to demonstrate that they are qualified under the act and have at least US$5 million in net investments or some sort of corporate structure with US$25 million in investments. Additionally, you will only be able to take on a maximum of 500 investors with this structure.
What is a Single Offshore Hedge Fund?
Offshore hedge funds can be based in a range of locations, but the primary jurisdictions of choice are the British Virgin Islands (BVI’s) and the Cayman Islands. These countries are effectively no-tax jurisdictions and basically impose almost no taxes upon the fund management companies. However, do note that most investors into these funds will be taxed in their home jurisdictions at their effective marginal rates.
These types of funds are relatively simple to form and, in the case of the Caymans, and the BVI’s, have excellent reputations amongst potential investors. The reputation typically comes from the strength of regulation and investors normally view this as a form of risk mitigation. The Cayman Island’s Monetary Authority and the BVI Financial Services Commission (FSC) have typically taken a well-measured regulatory approach to offshore funds protecting both fund and investor.
The General Partner (GP) and Legal Liability
Normally, as a measure of protection, the General Partner will set up an LLC to act as the GP to limit their liability. Obviously, this provides some level of protection, but the reality is that U.S. security laws are particularly onerous, and you may find that liability can easily pierce that corporate veil. Securities Laws often push obligations onto specifically designated individuals, and this means that you may find yourself carrying personal liability for your fund regardless of having an LLC in-between. I would always advise that you speak to a professional and get advice regarding where you could face potential legal risks.
What Does it Cost and How Long Does It Take When Starting an Offshore Hedge Fund
The cost and time frame really depends upon the sort of fund structure you are looking to achieve and how complex that setup is. The traditional method of formation would require you to sit down and review proposals from 3 to 5 service providers per area and this could take in excess of 100 hours. As mentioned in the introduction, thankfully there are shortcuts now in this process and you may be able to outsource many of the key roles to slim down both your costs as well as the time frame to startup.
In the case of the Domestic Hedge Fund, expect to pay between $20k – $150k for legal advice and fund formation. Additionally, budget around $50k – $100k for general startup expenses and your first-year operational costs are likely to run more than $150k a year. Unfortunately, it isn’t a cheap exercise to form a domestic fund and you can quickly find yourself burning through around $400k in the first year alone.
Offshore funds provide some cheaper options and, depending on the country, you can expect to pay around $75k in startup costs and approximately $100k a year in operating costs depending on your staffing and outsourcing levels.
Fund Formation Services
For Those Looking at Starting an Offshore Hedge Fund
Probably your first task as a hedge fund manager is to pick your professional partners for formation. Whoever you work with should be able to advise you upon your chosen fund structure and recommend a path forward. You need to make sure that they are professional and experienced in forming hedge funds in your jurisdiction of choice.
Their first task, after advising upon your structure, is likely to be drafting the hedge fund offering documents and the Limited Partnership Agreement (LPA). Once this has been completed you can then review your private placement memorandum (PPM) and I would strongly recommend you have this document reviewed by a skilled attorney.
In most cases, your fund formation agent will be able to provide you with perfectly executed documents that have been proven to work. However, it always pays to get a second set of eyes to review the work given the potential legal risk to the GP.
Ultimately, expect the formation service to take anywhere from 2-4 months and expect to be up and operating at the 6-month stage. I would not recommend rushing the formation process because there are some significant steps that need to be correctly executed before moving forward. At this stage, assuming your prime brokerage and other professional services are in place, you can commence the marketing process for the fund.
If you would like to discuss potential fund setups or are looking for a turnkey solution, please speak with us at our consulting arm:
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Steven James
