Private / Hedge Funds Law

Private funds and hedge funds are investment funds that are a part of a diverse market range. In the United States only accredited investors are allowed to participate in Hedge Funds. The term hedge fund is credited to Alfred W. Jones, a financial journalist who first used the phrase “hedged fund” in 1949.

A private / hedge fund is an investment fund that pools capital from accredited investors or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk management techniques. It is administered by a professional investment management firm, and often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds and regarded as alternative investments, as their use of leverage is not capped by regulators, and distinct from private equity funds, as the majority of hedge funds invest in relatively liquid assets. However, funds which operate similarly to hedge funds but are regulated similarly to mutual funds are available and known as liquid alternative investments.

The term “hedge fund” originated from the paired long and short positions that the first of these funds used to hedge market risk. Over time, the types and nature of the hedging concepts expanded, as did the different types of investment vehicles. Today, hedge funds engage in a diverse range of markets and strategies and employ a wide variety of financial instruments and risk management techniques.

Hedge funds are made available only to certain sophisticated or accredited investors, and cannot be offered or sold to the general public. As such, they generally avoid direct regulatory oversight, bypass licensing requirements applicable to investment companies, and operate with greater flexibility than mutual funds and other investment funds. However, following the financial crisis of 2007–2008, regulations were passed in the United States and Europe with intentions to increase government oversight of hedge funds and eliminate certain regulatory gaps.

Hedge funds have existed for many decades and have become increasingly popular. They have now grown to be a substantial fraction of asset management, with assets totaling around $3.235 trillion in 2018.

Hedge funds are almost always open-ended, and allow additions or withdrawals by their investors (generally on a monthly or quarterly basis). The value of an investor’s holding is directly related to the fund net asset value.

Many hedge fund investment strategies aim to achieve a positive return on investment regardless of whether markets are rising or falling (“absolute return”). Hedge fund managers often invest money of their own in the fund they manage. A hedge fund typically pays its investment manager an annual management fee (for example, 2% of the assets of the fund), and a performance fee (for example, 20% of the increase in the fund’s net asset value during the year). Both co-investment and performance fees serve to align the interests of managers with those of the investors in the fund. Some hedge funds have several billion dollars of assets under management (AUM).

Practitioners who represent hedge funds coordinate multiple legal disciplines in order to counsel sponsors and investors concerning all aspects of hedge fund operations and investments. As hedge funds themselves come in a variety of sizes with diverse aims and goals, the exact mix of legal skills required varies from fund to fund. For instance, funds that focus on investing in distressed entities might require more specialized legal counsel in area of restructuring. By and large, however, most funds will require specialized legal counsel in the areas of fund formation, investment transactions, tax law, and securities regulation.

The fund formation aspects of advising hedge funds include how funds are structured and documented, often with an eye toward facilitating the fundraising function. Specific tasks include preparing partnership agreements between the general partner and investors, establishing how the general partner of the fund will be compensated, and preparing the fund’s offering materials.

The investment objectives of hedge funds vary a great deal; therefore, the degree of sophistication they require in executing transactions can vary. While there are a large number of hedge funds that primarily are focused on liquid trading strategies, many hedge funds make illiquid investments, including participating in large, complex leveraged buy-outs or take-private transactions, PIPE transactions, and activist investing.

Hedge funds operating in the U.S. are subject to the full spectrum of securities disclosure and compliance rules and regulations. Regulation of hedge funds has also recently undergone a major overhaul with the passage of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which places new or heightened regulations on hedge funds.

Hedge funds have long been cauldrons of financial innovation, and practitioners advising hedge funds by necessity must be capable of addressing the legal and regulatory issues that impact hedge funds in what can be a quickly evolving business and legal landscape.