Establishing a Hedge Fund Key Structuring Considerations

This guide seeks to address certain key establishment considerations for managers seeking to launch a hedge fund.

Establishing a Hedge Fund: Key Structuring Considerations

Contents 1. Introduction

3 3 3 3 3 4

2. Investors

a. Initial and Target Investor Base

b. Investor Jurisdiction and Tax Preferences c. Other Investor Type Considerations d. Accessing Capital and Marketing Considerations

3. Key Structural Considerations

a. Open-Ended or Closed-Ended; Liquidity b. Standalone or Master-Feeder Structure

4 4 5 5 6

c. Single Cell or Umbrella Structure; Single vs. Multiple Strategies

d. Third-Party Fund Platforms

e. Managed Accounts

4. Jurisdiction; Where Should the Fund be Domiciled?

a. Overview

6 7

b. Key Fund Jurisdictions

5. Fund Directors and Service Providers

a. Fund Directors

8 8

b. Certain Key Service Providers

6. UCITS

7. Hedge Fund Offering Terms

a. Accumulation/Distribution Policy

b. Base Currency of Account and Currency Classes

11 11

c. New Issues

d. Management Class

12 12 13 13

e. Fee Structure

f. Frequency of Dealing

g. Managing Exceptional Circumstances

8. Contact

Introduction Despite the benefits offered by new and emerging managers, investor concentration levels have grown significantly in recent years, with investors increasingly displaying a preference for managers with a longer track record and a “brand name” that inspires confidence from a risk management and governance perspective. Further, the rise and success of “multi-managers” continues to attract assets away from start-up managers, and increasingly, a desire to invest in hedge fund strategies on a capital-efficient basis has driven significant growth in separately managed accounts as an alternative to the traditional fund investments. Ultimately the success of the hedge fund industry relies on its ability to remain diversified, innovative and competitive. New launches and the establishment of new managers are crucial to ensuring this. Hedge fund structuring is often perceived as a well-trodden path and largely a simple exercise of replication. This is often misjudged. While there is certainly a degree of consistency

in the structuring of many hedge fund products, there is a range of considerations a prudent hedge fund manager should take into account in determining the most appropriate structure for their first or subsequent product – and a range of different possible outcomes. The route to launch has also become increasingly complicated by a variety of market developments, including the blurring of liquid and illiquid strategies (particularly in the credit/ debt space) and the increasingly onerous regulatory framework in which hedge fund managers must operate. This guide seeks to address certain key establishment considerations for managers seeking to launch a hedge fund. This paper has been primarily prepared for UK-domiciled managers seeking to establish a hedge fund. Managers in other jurisdictions are invited to contact the authors to discuss any jurisdiction specific differences that may impact the guidance provided herein. (e.g., a corporate) or as a transparent entity (e.g., a partnership or an entity treated as a partnership for U.S. tax purposes). It is possible to satisfy the tax requirements of each type of investor in a single fund structure by using a “master-feeder” fund structure (see “Standalone or Master-Feeder Structure” below). Other Investor Type Considerations The needs and wants of hedge fund allocators can vary considerably, depending on what type of entity they are, which funding sources they are using and to which tax, legal and regulatory regimes they are subject. Familiarity with and the ability to deal easily with different types of investors on a global basis (e.g., pension funds, endowments, private banks, fund of funds, insurance companies, foundations, family offices and any number of other possibilities) is one of the things a new hedge fund manager should consider when selecting its service providers, amongst other matters.

Investors Initial and Target Investor Base

The fund’s initial and target investor base should be the starting point. Ideally, a fund structure should be established that meets the needs of both (including from a jurisdictional, regulatory and tax perspective). If this is not possible, a balance will need to be struck between meeting the needs of the fund’s initial investors, who will likely be critical in terms of the fund reaching a viable size, and the fund’s longer-term target investors. Investor Jurisdiction and Tax Preferences Generally, investors will seek to invest in a fund vehicle that ensures little or no tax leakage at the fund level and does not place them at an undue disadvantage in terms of their own taxation. From the perspective of investors in the U.S. and certain other jurisdictions, the character of the fund from a tax perspective is highly relevant. The fund may be regarded as an opaque entity

Accessing Capital and Marketing Considerations

However, allocations to the Cayman Islands on the part of certain types of European investors are limited. A manager wishing to raise a significant amount of capital from within Europe should carefully consider how appropriate a Cayman-only structure will be (see “Jurisdiction; Where Should the Fund be Domiciled?” below).

The Cayman Islands remains one of the most popular jurisdictions for hedge fund managers seeking to raise capital on a global basis. U.S. investors, who remain the largest source of capital for hedge funds, are familiar with Cayman Islands-domiciled fund structures, as are institutional investors in many other jurisdictions. Key Structural Considerations Open-Ended or Closed-Ended; Liquidity Funds can be open-ended or closed-ended. Open-ended funds allow investors to subscribe for and redeem their investment in the fund on a regular basis (pursuant to the terms of the fund’s governing documentation). Closed-ended funds generally limit investment to one or more initial subscription dates, and thereafter investors are generally unable to redeem their interests at will (with returns of capital being made at set intervals or at the end of the life of the fund). A hedge fund will typically be open-ended due to most strategies being relatively liquid in nature (and because hedge fund investors will expect similar liquidity in their investment terms). Closed-ended structures are more typically used for private strategies or other specialist and less-liquid strategies, including real estate, infrastructure investment or debt (including direct lending funds). In recent years, there has been some convergence between liquid and illiquid strategies, in particular in the context of credit funds. There have been different approaches to these hybrid structures, with some funds combining traditional elements of both open- ended and closed-ended structures. When setting up an open-ended fund to manage illiquid assets, managers will need to carefully manage liquidity and consider carefully how they will meet redemption requests in a range of different scenarios (e.g., through the use of run- off or liquidating classes).

Standalone or Master-Feeder Structure As discussed under “Investor Jurisdiction and Tax Preferences” above, the types of investors the fund wishes to target will determine whether the fund is structured as a standalone fund or as a master-feeder fund. U.S. taxpayers will generally require a tax transparent fund vehicle through which to invest, while non-U.S. investors and U.S. tax- exempt investors will require a tax-opaque fund vehicle. Both types of tax treatment can be accommodated in a master-feeder fund structure. The typical master-feeder structure will be comprised of a tax-transparent master fund with one or more feeder funds. Non-U.S. investors and U.S. tax-exempts will invest through a tax-opaque feeder, and U.S. taxpayers will invest through a tax-transparent feeder (or alternatively in the tax-transparent master fund directly). Other feeders, or alternative forms of the master fund, can be structured for other reasons or other types of investors, as required.

Investors - Non-US and US Tax Exempt

Investors - US Taxpayers

Onshore Feeder

Offshore Feeder

Master Fund

While the different needs of investors for tax- opaque and tax-transparent vehicles could be achieved by running parallel funds, a master- feeder fund structure enhances the critical mass of investable assets (which will be managed at the level of the master fund), and avoids the need for the investment manager to split trades or engage in rebalancing trades between the parallel structures (and for the fund to enter into duplicate arrangements with service providers and counterparties). Additionally, it creates greater economies of scale for the day-to-day management and administration of the fund, which generally leads to lower operational and transaction costs. If only a tax-opaque or tax-transparent vehicle is required in light of the intended initial and longer-term investor base, then a standalone vehicle with the appropriate tax characteristics should be sufficient and simpler. Single Cell or Umbrella Structure; Single vs. Multiple Strategies If the fund will have one investment strategy and one portfolio of assets, a single portfolio vehicle will likely be appropriate. If the fund is to run multiple portfolios of assets, an umbrella structure may be more appropriate (though in certain cases this could also be achieved through the establishment of differing classes and portfolios within the same structure). The umbrella structure allows an investment manager to run multiple strategies through one fund structure (with one set of service providers) without the need to establish separate fund structures for each strategy. Umbrella structures can reduce costs and documentation. However, in some situations, it will be more efficient (and attractive to investors) to run the different strategies through different fund vehicles, rather than an umbrella structure.

A number of jurisdictions have introduced structures that, as a matter of local law, offer segregation between different portfolios (or sub funds) and their assets and liabilities. Not all of these structures have been tested in the courts of other jurisdictions, including in the U.S. Where this is the case, there is a residual risk that such structure will not be enforceable. Another factor to consider is investor perception. Regardless of actual risk, investors might be cautious as to the risk of contagion between different portfolios or sub-funds where a portfolio or sub-fund suffers a loss and the ability for counterparties to claim against the The increase in hedge fund regulation and the associated costs of establishing a hedge fund management business have increased barriers to entry. This has encouraged a growing number of would-be start-up managers to use a third-party fund platform as an alternative to establishing their own fund structure. The term “platform” can be used simply to refer to multi-manager platforms where the portfolio manager joins an existing investment management business as a partner or employee to run a portfolio of assets or a fund. However, it can also be used to describe a third-party offering one or more of the following: ^ a fund vehicle, either a standalone fund or (more typically) a sub-fund of an umbrella fund structure, or the right to umbrella structure as a whole. Third-Party Fund Platforms manage a portfolio of assets within a fund “housing” multiple managers. In each case, the sub-fund or portfolio is likely to use common service providers and trading counterparties appointed over the structure as a whole; ^ initial seed capital; ^ business support, through shared resources and personnel, and perhaps office space; ^ marketing and distribution services for the fund; and/or

Master Fund Umbrella Vehicle

Portfolio 1

Portfolio 2

Portfolio 3

^ regulatory cover such that the manager does not need to obtain its own regulatory authorisation. The key advantage of these third-party platforms is that they reduce cost in the short term and allow the manager to maintain a small operation in its formative years. Further, the use of a platform allows the manager to build a track record that, if successful, may enable the manager to spin-off the platform and go it alone in the future (in which case, it is important that managers using such platforms seek appropriate rights over the track record at the outset). The downsides of launching on a platform include longer-term cost (with costs calculated on an AUM basis, platforms can be more expensive for larger funds), a lack of control (an investment manager is a service provider and so is unlikely to have any representation on the platform’s board), the investment manager may have limited (or no) choice in terms of service providers, and difficulties may arise if the investment manager wishes to move to its own platform or the platform itself goes out of business (for example, where moving the fund to another vehicle, there is a risk that an investment gain will be crystallised for tax purposes).

In summary, platforms can be a simpler and cheaper way of getting started and building track record, but over the long term, the economics and lack of control is often not viable or acceptable for some managers. Managed Accounts Increasingly, a desire to invest in hedge fund strategies on a capital-efficient basis by an increasingly sophisticated investor base has driven significant growth in the use of managed accounts as an alternative to investing in a fund. This model has enabled investors to increase the amount of capital they are able to put to work with multiple managers through the investment of capital in a number of strategies on a non- segregated basis, allowing for the netting off of margin and collateral required to be posted with trading counterparties. Such investors may seek or require, inter alia, greater control and transparency in relation to the management of their assets and have particular commercial requirements (e.g., as to strategy and leverage), which means it is either not possible or desirable for them to invest in a manager’s main fund vehicle. ^ whether laws and regulatory requirements governing the fund and service providers, investment and borrowing powers and restrictions, custody arrangements, confidentiality laws, banking-secrecy laws, foreign exchange limitations, etc., might make one jurisdiction more desirable in a particular case than another; ^ the nature and extent of anti-money laundering measures in any particular jurisdiction, which will go to its reputation and credibility; ^ whether the manager has pre-existing relationships in the jurisdiction – for example with service providers or directors; ^ whether the manager intends to build any management company substance in or near that jurisdiction and would therefore benefit from co-locating the manager and fund;

Jurisdiction; Where Should the Fund be Domiciled? Overview

There is considerable competition between leading jurisdictions. Popular jurisdictions include, amongst others, the Cayman Islands, Ireland, Luxembourg and the U.S. (commonly Delaware when targeting U.S. investors). In choosing a fund domicile, issues for consideration include the following: ^ the tax efficiency of establishing the fund in a jurisdiction, including how it will be regarded by tax authorities in investor jurisdictions; ^ the familiarity of the jurisdiction to the target investor base; ^ whether the jurisdiction will enhance or

restrict the fund’s ability to be marketed into certain jurisdictions or to certain target investor types;

^ other proximity and time zone issues, depending on the manager personnel location and strategy; ^ whether there are sufficient local accountancy firms and law firms (and, if a fund is to be administered or have its assets custodied locally, banks, local directors, custodians and administrators) to support the operation of the fund; ^ establishment costs, expenses and ongoing maintenance of the fund; ^ time to market, i.e., how long it will take to establish the fund; and ^ whether the jurisdiction chosen is politically stable, and the attitude and familiarity of authorities in the jurisdiction towards hedge funds. Key Fund Jurisdictions Cayman Islands. The Cayman Islands remains the jurisdiction of choice for most U.S. and UK-based managers. The Cayman Islands is very familiar to institutional and international investors and offers flexible yet well-developed accounting, legal and tax structures for funds backed up by a recognised legal system for resolving disputes. There are no restrictions on the strategies that may be implemented through a Cayman fund and no limits on the types of investors that may invest in such a fund (provided that the fund may not be marketed to the public in the Cayman Islands). A Cayman hedge fund can be established as a body corporate, limited partnership, unit trust or segregated portfolio company. Master-feeder fund structures can be established using all of these entities/structures with and without a Delaware feeder. These structures all benefit from tax exemptions. The Cayman Islands offers a significant collection of local and experienced hedge fund directors, as well as high-quality local service providers. It also permits Cayman funds to use administrators, custodians and other service providers based outside the Cayman Islands. Thus, many Cayman structures are serviced by administrators and custodians based in jurisdictions such as Ireland

and the U.S. and prime brokers based in the UK and the U.S. In addition, the Cayman Islands has been efficient at ensuring that it keeps up with important developments in the U.S. and Europe affecting alternative investment funds, including international tax-information exchange regimes (FATCA in the U.S. and CRS outside the U.S.) and regulatory developments in the EEA. The Cayman Islands also remains a relatively quick (and generally very cost-effective) jurisdiction in which to establish a hedge fund. Delaware. The hedge fund industry has its roots in Delaware. U.S. investors (from whom the vast majority of hedge fund allocations still come) are well familiar and comfortable investing through a Delaware established fund. Further, U.S. taxable investors requiring a tax-transparent vehicle in which to invest will typically prefer to invest in a Delaware feeder (normally in the form of a limited partnership or LLC). Delaware remains a quick (and cost-effective) jurisdiction to establish a fund, which can take advantage of relatively flexible structures. Europe. Generally, funds established outside the EEA may currently only be marketed into EEA countries (or the UK) in accordance with each jurisdiction’s own national private placement regime. Certain EEA jurisdictions do not permit private placement or impose requirements that make it costly or complex to undertake marketing on a private placement basis. In contrast, funds established in the EEA may be marketed into all EEA jurisdictions to professional investors using the AIFMD “passport.” 1 Broadly speaking, this allows an EEA fund to be marketed throughout the EEA by reference to a single set of rules with limited gold-plating on a jurisdiction-by- jurisdiction basis. Aside from the benefits of marketing a European hedge fund, many European investors may suffer regulatory or other consequences by investing in an “offshore” jurisdiction or may be concerned with the perception of investing in such. Ireland and Luxembourg are the most popular EEA jurisdictions for those seeking investment from European investors. Both jurisdictions offer a range of fund products, including corporate structures, partnership vehicles, funds established under contract (such as common

1 There are also passports available for non-professional investors that are based on special fund regimes available EEA wide such as the ELTIF, EuVECA and EuSEF.

unit funds for Luxembourg and common contractual funds for Ireland) and, in Ireland, unit trusts. Both jurisdictions also offer master- feeder structures and umbrella/segregated sub- fund/compartment options. Funds domiciled in EEA countries such as Ireland and Luxembourg are required to use local depositary service providers. Ireland also requires a local administrator and that

at least two of the fund’s directors be Irish residents. While Luxembourg does not have a strict legal requirement as such, the fact that the central administration is required to be in Luxembourg for corporate and tax purposes makes it a practical requirement to use a local administrator and structure the board with a majority of directors resident in the greater Luxembourg region.

Fund Directors and Service Providers Fund Directors Companies (including general partners of

Prime brokers, depositary and trading counterparties. The fund’s prime brokers will custody, clear and settle trades entered into by the fund as well as providing access to financing and securities lending. Hedge funds will often appoint more than one prime broker as well as a number of other trading counterparties, allowing them to access liquidity more effectively and also trade in a wide range of securities and through a wide range of derivative instruments. Prime brokers extend capital so as to enable funds to acquire securities on a leveraged basis. Assets of the fund are used as collateral against the loan, and the prime broker will have the right to rehypothecate the assets, usually up to a certain percentage of the amount borrowed. Prime brokers can extend the capital in a number of ways. This may include the simple extension of credit to allow a fund to acquire an asset as well as the provision of credit through the leverage inherent in derivative instruments. Prime brokers may also undertake the role of clearing, settling and safe-keeping of the fund’s assets. The ability for a prime broker to custody a fund’s assets will depend on the country-specific rules and regulations for the holding of assets, and the scope of a prime broker’s market coverage, including from a geographical perspective. Prime brokers may operate a sub-custodial network to provide coverage in the jurisdictions in which it does not have custody capabilities. One of the most important factors to consider is the manner in which assets are held in custody, in particular as to whether assets are segregated from those of other clients.

partnerships) are required to appoint directors (or in the case of a limited liability company, managers). Such directors will be subject to a number of statutory and fiduciary duties and be required to approve certain corporate and other actions taken by the company (or the company on behalf of the partnership to which it acts as general partner), including the appointment of service providers to the fund. Fund directors do not typically make investment decisions, responsibility for which is usually delegated to an investment manager. Likewise, day-to-day administration of the fund is delegated to the fund’s administrator, and custody is delegated to an appointed prime broker or custodian. The directors are required to maintain oversight of delegated activities. While it is common for a representative of the investment manager to sit on the board of directors, a company should look to appoint a majority of independent and non-UK-based directors. This is usually fundamental to the tax structuring of a UK-managed hedge fund in the context of a UK investment management business and is also important for a range of other reasons. Certain Key Service Providers A hedge fund’s key service providers are broadly as follows: Investment manager. An investment management agreement will be entered into between the fund and the manager pursuant to which the manager is appointed on arm’s length terms to provide portfolio management, risk management and marketing services.

Prime brokers may also provide a capital introduction service, which can be useful in helping a hedge fund manager raise capital in the fund’s early years. Capital introduction may be wider than just introducing investors to hedge funds and includes providing strategic assistance to a fund manager seeking to market the fund as well as feedback on current market trends, investor sentiment, fund terms and other matters. Administrator. The fund’s administrator will typically be appointed to provide the following services: (i) registrar and transfer agent, responsible for the issue, redemption and UCITS Traditionally, UCITS were used as investment vehicles by managers pursuing long-only and relative return strategies (and that overwhelmingly remains the case today). However, as interest in absolute return strategies has increased, asset managers pursuing “traditional” investment strategies have increasingly developed their own absolute return type strategies. Hedge fund managers have also increasingly used UCITS to access greater distribution potential with different investors. This has led to a convergence between traditional long-only asset management and absolute-return asset management. The attraction of UCITS as a way of structuring absolute-return strategies derives from its marketability. The increased marketability of UCITS is largely a result of its liquidity and regulated status, which gives many investors a certain level of comfort (and a perception that UCITS offers a safer product in which to invest). UCITS benefit from a marketing passport that makes it relatively simple to market the product across Europe (and a number of other jurisdictions outside of Europe have made it relatively simple to register UCITS for public distribution). Many European investors may be limited in their ability to invest in offshore hedge fund products as a matter of local law or regulation, or alternatively as a result of internal policy

transfer of fund shares or interests and ensuring that all subscription and redemption forms have been completed in full and in compliance with applicable anti-money laundering requirements; (ii) calculation of the fund’s net asset value and management fees and performance fees (using series or equalisation accounting as applicable); (iii) general communication with investors, including the circulation of updated fund documentation and notices to investors (including ahead of shareholder meetings); and (iv) preparation of the fund’s financial statements and providing assistance with the fund’s audit. requirements. Many institutional investors are also limited as to the level of allocation they can make to alternative strategies – and UCITS are often deemed not to be “alternatives” whether or not they pursue an absolute return strategy. As such, UCITS have a wider investor potential in Europe than traditional hedge fund products. As a result of the foregoing, many hedge fund managers run absolute-return strategies alongside their traditional hedge fund strategies. However, there are a number of restrictions and requirements of which managers should be aware before deciding whether or not to establish a UCITS. These include: ^ restrictions on permitted assets ^ concentration limits ^ counterparty exposure limits ^ limits on risk exposure/leverage ^ restrictions on short selling ^ collateral management obligations ^ liquidity requirements A number of strategies, including less-liquid, highly leveraged or highly concentrated strategies, will not be suitable.

Hedge Fund Offering Terms The terms upon which interests in a hedge fund are issued to investors define both the commercial terms upon which investors participate in investment returns and the rights of investors in respect to their investment. The nature of the interests held by an investor in a hedge fund will reflect the legal form of the fund. For example, investors in a fund established as a body corporate will generally be issued with shares in the fund and have the status of shareholder; investors in a unit trust will generally be issued with units (representing a beneficial interest) in the trust and have the status of unit holder; and investors in a limited partnership will be issued with limited partnership interests (generally representing a capital account in the name of the investor) in the limited partnership and have the status of limited partner. The precise voting and other rights granted to the investor are set out in the constitutional documents of the fund. In common with many other types of funds, investors tend to participate in hedge fund structures through multiple classes (and, in the case of a company, series within a class) so as to give effect to the different terms upon which investors participate in the fund profits. Accumulation/Distribution Policy A typical hedge fund will adopt an accumulation or “roll up” policy. In such circumstances, the fund does not seek to distribute net income or capital profits, whether by way of dividends (in the case of a fund in corporate form) or distributions (in the case of a limited partnership or unit trust). Instead, profits are retained within the fund and reinvested as part of its ongoing investment strategy. As a result, the standard approach is to issue to investors accumulation (i.e., non-distribution/ dividend paying) shares or interests. This is also consistent with the tax requirements of many types of investors, particularly those who invest in a hedge fund via a non-tax-transparent entity. Such investors may prefer not to realise a tax event until their interests in the relevant fund are redeemed/withdrawn (and thus any investment gain is realised).

There are circumstances, however, where it may be appropriate to structure the fund so as to pay distributions by way of dividend or similar arrangement. Some of these circumstances are outlined below. ^ Funding Tax Charges. Certain categories of investor can be subject to tax on the underlying income or gains of the hedge fund as they arise. This is more typical of investors in tax-transparent structures. It is usually less of an issue for investors in non-tax-transparent structures who are generally only taxed when they realise their interest in the fund; although it should be noted that certain categories of investor can still be treated as subject to tax on the underlying activities of a corporate fund. Typically, a hedge fund will permit relatively regular redemptions and investors who are taxed on a transparent basis in relation to the underlying profits and income of the fund will be able to help fund tax charges in this way. However, in circumstances where: • a hedge fund strategy is relatively illiquid and, as a result, redemptions of interests are limited or restricted; or • the hedge fund imposes long “lock up” periods on investors, during which redemptions are not permitted, it may be important to offer investors the option of receiving regular distributions and/or dividends through holding distributing interests in a fund. Often, this is linked to the net income generated by the fund’s portfolio. However, sometimes dividend and/or distribution rights are required to be extended to cover some part of the capital profits of the fund. ^ Reporting Fund Status. Under the UK’s offshore fund tax rules, any gains realised by a UK taxable individual investor on the redemption or disposal of an interest in an offshore fund will be treated as “offshore income gains” subject to income tax at up to 45% (rather than capital gains at a maximum rate of 24%) unless the relevant fund (or share class) is approved by HM Revenue & Customs as a “reporting fund.” Approval as a reporting fund requires the

relevant fund (or share class) to “report” 100% of its income to UK investors in respect of each accounting period, with such investors being taxable on their share of such reported income (even if no income is actually distributed). In overview, if the fund is likely to generate significant capital gains and is targeting UK individual investors or other classes of investor for whom capital gains treatment is favourable (such as UK-authorised funds and investment trusts that are exempt from tax on capital gains), the fund may wish to consider seeking approval as a reporting fund (which can be done on a class-by-class basis).

the fund’s base currency and the currencies to which its underlying assets are exposed. Such provisions can also be extended to permit the manager to hedge other potential exposures, including interest rate and other macro and micro risks. The costs, profits and/or losses attributable to such transactions are generally borne by all the investors in the fund. Many hedge funds offer investors the opportunity of investing in multiple currencies (i.e., currencies other than the base currency of account) represented by different classes or series of shares or interests in the fund. The value of such classes will be affected (positively as well as negatively) by foreign exchange movements between the currency of the relevant class and the fund’s base currency and underlying currency exposures. Hedge fund terms often entitle the manager to conduct hedging transactions in relation to the relevant class. The costs, profits and/or losses attributable to such transactions are generally borne by the relevant currency class and the investors invested in that class. New Issues A fund may need to have separate classes for persons who are limited in their ability to invest in “new issues,” which is a U.S. concept, although the restrictions will apply to both U.S. and non-U.S. investors meeting the relevant definitions under the applicable rules. “New issues” are initial public offerings ( IPOs ) of equity securities made pursuant to a registration statement or offering circular. As a general rule, members of the U.S. Financial Industry Regulatory Authority ( FINRA ) are prohibited from allocating new issues to restricted persons 2 and covered persons, 3 and such persons are restricted in their ability to invest in new issues. 4

Base Currency of Account and Currency Classes

In common with other types of funds, the currency in which a fund is valued and in which it reports its performance is important to investors and the manager. A fund whose investments are largely traded or valued in a particular currency (such as U.S. dollars or euro) may choose to value its portfolio and report its performance in that currency. This is usually termed the “base currency” or “currency of account” of the fund. Where a fund is exposed to multiple currencies, the chosen base currency tends to be the primary currency to which the performance of the fund is exposed, although sometimes managers will adopt a base currency that equates to the currency in which investors are primarily investing in the fund. Hedge funds often include, as part of their investment strategy, efficient portfolio management powers entitling the manager to enter into forward foreign exchange and derivative transactions to hedge against (or mitigate) the risk of adverse foreign exchange movements between

2 The term “restricted person” generally includes any of the following: (i) broker-dealers; their officers, directors, general partners, associated persons and employees; their agents engaged in the investment banking or securities business; and their immediate family members, except for broker-dealers and their employees who limit their business to the purchase and sale of investment company, variable contract or direct participation securities; and owners of a broker-dealer and their immediate family members; (ii) finders and fiduciaries and their immediate family members, but only with respect to initial public offerings in which they are involved; (iii) portfolio managers (e.g., any person with authority to buy or sell securities for an investment manager or any collective investment account (even if it is not the account for which the new issues are being purchased)) and their immediate family members. See FINRA Rule 5130. 3 Covered Persons are, generally, directors and executive officers of certain public companies and covered non-public companies that may be investment banking clients of the allocating broker, as well as persons materially supported by such executive officers or directors. See FINRA Rule 5131(b). 4 However, note that as an exception to the general rule, a fund that has restricted persons as investors can invest in new issues provided that the level of restricted persons investing in the fund does not exceed the threshold level of 10 percent of the beneficial interests of the fund. Similarly, a de minimis exception is available for a fund having covered persons investing in the fund below the threshold of 25 percent of the fund’s beneficial interests.

The two primary mechanisms used to ensure performance fees are not paid twice in respect of the same performance in a unitised structure are: ^ Series accounting. This methodology provides for the issuance of a new series of a class of shares as of each investment by each investor on each dealing date in respect of which shares are issued, which provides for a different net asset value for each series. This solution, traditionally more common, is relatively easy to understand and administer, and the results closely match partnership accounting with less complexity than equalisation accounting. ^ Equalisation accounting. Equalisation is more common in European-managed funds, although it is complex, difficult to apply without the appropriate computer programs and can be difficult to explain to investors. It involves investors paying an additional sum at the time of their investment equal to the existing accrual per share in respect of the performance fee where the fund is above its most recent high-water mark, or, where an investor invests in the fund when the fund is below its most recent high-water mark, to make provision for a partial share redemption to fund the performance fee in respect of any application of the net asset value up to the point where the high-water mark is again reached. Dependent upon fund performance, the equalisation amount is subsequently returned to the investor (directly or via additional interests in the fund) or paid to the investment manager. It is not unusual in hedge fund structures for managers to offer multiple classes of share to which different levels of management fee and/ or performance fee apply. Typically, such funds offer investors the opportunity of investing in regular share classes that are subject to standard liquidity terms (e.g., regular redemptions on monthly or quarterly redemption dealing days on thirty days’ notice). As an alternative, investors may be permitted to invest in share classes that are subject to more constrained liquidity terms in return for more attractive (i.e., lower) rates of management and/or performance fees. Such classes may be subject to a minimum “lock-up” period during which redemptions are not permitted, longer notice periods and/ or more limited redemption dealing days. They may also be subject to a higher minimum level of investment per investor. Variants can involve

Accordingly, a fund wishing to invest in new issues may need to establish restricted and unrestricted classes of shares (for restricted and unrestricted persons) in order to allow unrestricted investors to participate in such new issues for so long as such securities remain new issues. Management Class The manager, its personnel and their connected persons may wish to invest in the fund through a “management” class reserved for them (indeed it is usually the case that the lead portfolio manager invests in the fund so as to ensure an alignment of interests). Such management classes often benefit from no management or performance fees or allocations but are otherwise generally subject to similar terms to other investor classes. Fee Structure One of the key aspects of the terms of issue of any hedge fund is fees. Hedge funds typically pay their appointed investment manager a management fee and a performance fee/allocation. The management fee is generally paid monthly or quarterly and is calculated with reference to a specified annual percentage rate of the fund’s net asset value. The annual percentage rate can vary between strategies and share classes. The principle underlying a performance- related fee or allocation (referred to here as a “performance fee”) is that the investment manager should be incentivised as to, and rewarded for, its level of absolute performance calculated by reference to the net asset value of the fund over specified performance periods. Historically, performance periods have been 12-month periods ending on the annual accounting date of a fund, which is often set as December 31 in each year so as to tie in with U.S. tax reporting. However, performance periods can be more or less frequent. Given that the performance fee is calculated with regard to realised and unrealised profits of the fund (as reflected in its published net asset value), most hedge fund terms will provide for underperformance in respect of an investor’s holding in the fund to be carried forward so that performance fees are not paid twice in respect of the same performance. This is generally expressed in terms of a high-water mark or “loss carry forward.”

Managing Exceptional Circumstances In normal market conditions, redemptions will typically be effected as of the relevant dealing day and redemption proceeds calculated and paid in cash within a pre-agreed timeframe thereafter. However, the governing body of a fund (e.g., the board of directors) may conclude that it is no longer possible or fair to all investors to satisfy redemptions in accordance with normal arrangements. In reaching such a conclusion, the governing body must have due regard to the interests of continuing investors as well as those seeking to redeem their interests. The governing body may reach such a view where, for example: ^ due to liquidity concerns relating to the assets of the fund, it is not possible to easily realise those assets to provide cash to satisfy a redemption; ^ as a result of realising liquid assets to satisfy redemption proceeds, the proportion of the fund’s portfolio represented by less- liquid assets would rise to a level that is not compatible with the investment strategy of the fund, or would otherwise be unfair to continuing investors; ^ assets are likely to be realised at prices detrimental to investors (which may include both redeeming and continuing investors, depending on timing); ^ taking into account the legitimate cash requirements of the fund, the fund would be prevented from meeting its continuing obligations and maintaining a solvent position; or ^ the fund is subject to other events that may affect its ability to satisfy redemption requests (such as political or economic

“softer” lock-up provisions whereby investors may redeem their shares before the expiry of the relevant lock-up period subject to the deduction of a fee from the redemption proceeds payable to the fund and/or the manager. Frequency of Dealing Hedge funds pursuing a reasonably liquid investment strategy will generally be expected by investors to permit the regular subscription and redemption of interests in the fund. Many will offer monthly or quarterly dealing days and require investors to give the fund not less than 30, 45 or 60 days’ prior written notice of redemption requests. Subscriptions and redemptions tend to take effect as of specified dealing days on which banks in specified jurisdictions are open for business. AIFMD requires managers to ensure consistency between the investment strategy, liquidity profile and redemption policy. For less-liquid strategies, funds can impose more constrained dealing terms. Examples include: ^ longer notice periods and/or a reduction in the frequency of dealing days; ^ hard-lock provisions whereby investors are not permitted to redeem their interests for a specified “lock-up” period; ^ soft-lock provisions whereby investors that redeem interests within the specified “lock-up” period are permitted to redeem but pay an “early redemption” charge set at a rate designed to incentivise investors to hold their interests for the full “soft-lock” period (and may be used to compensate continuing investors for the impact that the early redemption has on the fund); and ^ gating or staged redemption provisions whereby investors submitting a redemption request have their interests realised over a number of dealing days, whereby the redemption of interests may be limited on a particular dealing day to a stated maximum (usually a percentage of an investor’s total holding in the fund (an investor-level gate), or the interests in issue or of the net asset value in the fund, or a particular class (a fund- or class-level gate)).

factors affecting its ability to trade in certain markets or to repatriate or transfer moneys).

If it is concluded that it is not appropriate to meet redemptions on a given dealing day in full on a cash basis, then the fund’s governing body should have in place sufficient liquidity management arrangements at its disposal to be able to manage the situation effectively and fairly. Such arrangements should be properly

Historically, side pockets have tended to be used to deal with assets that have become hard to value and where a decision has been taken to write down their value in the books of the fund. By using a side pocket, investors of record who have borne the write down are able to take advantage of any future recovery in the value of the asset(s) rather than subsequent subscribers acquiring that opportunity at an undervalue at the expense of those investors. sanction available to the governing body of a fund is to suspend redemptions. It is long-established practice for the terms of issue of all open-ended funds to include provisions permitting such a suspension in a range of circumstances. The terms of issue of most hedge funds also permit the governing body to suspend the calculation of the fund’s net asset value (which may in turn necessitate a general suspension of subscriptions and redemptions).

disclosed to investors in the information memorandum of the fund. Arrangements of this nature typically include: ^ Satisfying redemption proceeds in specie or in kind. Many private investment funds include provisions permitting redemption proceeds to be satisfied by the transfer to the investor of assets of the fund having an equivalent value as determined in accordance with the normal valuation provisions of the fund (a redemption in specie ). ^ Side pockets. Side pockets are often used as a mechanism for a fund to separate assets or positions that have become illiquid and/or hard to value from the fund’s general portfolio. The relevant assets are managed and realised as a separate pool either within the fund (in which case they tend to be represented by a separate class of interests in the fund issued to investors) or are transferred to a separate liquidating vehicle. The attraction of a side pocket arrangement is that all investors of record at the time of imposition of the side pocket participate in the side pocket, while subsequent investors in the fund do not.

^ Suspension of dealing. The ultimate

Contact

Craig Borthwick Partner, Financial Services London craig.borthwick@dechert.com +44 20 7184 7631

Craig Borthwick advises on the formation and structuring of a variety of investment funds and fund platforms as well as providing ongoing advice on general corporate, compliance and regulatory issues.

Freddie Newman Associate, Financial Services London frederick.newman@dechert.com +44 20 7184 7664

Freddie Newman focuses his practice on alternative asset management matters with an emphasis on the structuring, management and marketing of investment funds across a broad range of asset classes.

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