Go to Page Section:
- What are Private/Hedge Funds?
- Where Does Private/Hedge Funds Law Fit?
- Primary Areas of Private/Hedge Funds Law
- Important Regulations
- Private/Hedge Fund Strategies
- Legal Foundational Structure
- Modern Legal Issues
- Other Jurisdictions
- Frequently Asked Questions
- Where is the term "hedge fund" comes from?
- Who practices private/hedge fund law?
- How do Private/Hedge Funds Legally Differ from Other Investments?
- Why is specialized legal counsel required for this type of law?
- What are "qualified purchasers"?
- What are "accredited investors"?
- How does the law regulate private/hedge fund fees?
Within the high-stakes finance world are private and hedge funds that act as sophisticated investment options for those of high net worth, accredited entities, and institutional investors.
Although these are incredible financial opportunities, they are accompanied by complicated legal regulations.
To navigate the labyrinth of laws and regulations, there are private fund and hedge fund attorneys and support staff who specialize in the financial services regulations that govern the creation, operation, marketing, and management of these fund types.
Keep reading to learn more about private/hedge funds, the most important areas of this law specialty, essential regulations, the legal foundational structure of the investing corporations, modern legal issues, strategies, and other jurisdictions that impact the United States!
What are Private/Hedge Funds?
Although commonly grouped, private and hedge funds have different definitions according to the Securities and Exchange Commission (SEC), as listed below.
Private Funds
Private funds are comprised of hedge funds, private equity funds, real estate funds, and venture capital funds.
According to the Investment Company Act of 1940, private funds are excluded from registration, assuming they meet specific SEC requirements.
Private funds pool investor capital to invest in a portfolio of assets, but have restrictions on who is eligible to invest, specifically reserved for qualified and accredited investors.
Hedge Funds
Hedge funds are subsets of private funds that boast unique characteristics.
The goal of hedge funds is to earn absolute returns, even if the market is struggling.
As such, investors utilize aggressive strategies like arbitrage, derivatives trading, leverage, and short selling to meet those returns.
Hedge fund investors commonly charge “2 and 20” fees, comprising a 2% management fee while earning 20% of profits.
Hedge funds continue to be lightly regulated, but are facing increasing scrutiny after the 2008 Recession, due to risk concerns.
Where Does Private/Hedge Funds Law Fit?
Private/hedge fund law is the governing specialization from ongoing compliance to fund formation.
Legal staff involved in this type of law work to avoid misrepresentation and fraud, comply with know-your-customer and anti-money laundering rules, and follow exemption and registration regulations.
They also maintain fiduciary duties and properly highlight risks to investors.
Primary Areas of Private/Hedge Funds Law
The most important legal tasks within private/hedge funds law include the following:
Fund Compliance and Governance
Since investors and their private funds are subject to government regulations through the SEC and local agencies, attorneys must ensure fund compliance and governance.
Fund Formation and Structuring
Fund formation and structuring set up the legal framework of the fund while ensuring regulatory compliance.
This area of private/hedge funds law drafts critical documentation like a limited offering memorandum or a partnership agreement.
Fund Operations and Dispute Resolution
Fund operations relate to the daily management of a private fund, including investor relations, compliance, fund structure, operational management, and investment cycles.
This is a critical role to ensure all aspects of the funds are responsibly managed, according to the law.
Investment Agreements and Contracts
Investment agreements and contracts include ensuring disclosure requirement compliance, managing relationships with investors, handling investor inquiries, and all documented contracts between the parties involved.
Regulatory Record Keeping and Reporting
Regulatory record keeping and reporting is a critical aspect of private/hedge funds law since it reports earnings, losses, trades, how funds raise money, and other aspects of the investment to governing bodies like state securities agencies and the SEC.
The purpose is to protect investors and ensure proper compliance with the law.
Taxation
Private/hedge fund legal staff are also heavily involved in taxation and ensuring the latest rules are being followed.
This area greatly ties in with regulatory reporting.
Important Regulations
Although the regulations are limited specifically to private and hedge funds, there are several regulatory frameworks overseeing this segment of investment.
These include:
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
Following the 2008 financial crisis, the Dodd-Frank Act was expanded to oversee private funds.
Additions to this act include filing Form Private Fund (P) to systematically monitor transactions, increased reporting and transparency, and mandatory registration for private equity and hedge fund managers.
Investment Advisors Act of 1940
Investment advisers are also called fund managers and must register with the SEC unless they qualify for exemptions.
These may include a venture capital adviser or private fund adviser exemption.
Investment Company Act of 1940
This Act imposes strict regulations on investment firms to ensure the proper documentation, registration, and reporting of information.
Know Your Consumer and Anti-Money Laundering Laws
Private fund firms are required to identify investors, document their information, and monitor any suspicious activity, then report it to the proper authorities.
Securities Act of 1933
The Securities Act of 1933 requires all securities offerings to be registered unless there is an exemption.
Hedge fund investors attempt to utilize Rules 506b or 506c within Regulation D offerings to find exemptions to this act.
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 imposes anti-fraud provisions under Rule 10b-5 and regulates secondary securities trading.
Private/Hedge Fund Strategies
Private/hedge fund strategies are most commonly classified into four categories:
Directional
Directional investment strategies utilize market inconsistencies, trends, and movements to select stocks across a range of markets.
While computer models are often used to gather this data, this strategy is more subject to market fluctuations compared to a market-neutral strategy.
Event-Driven
Event-driven strategies relate to the underlying risk and investment opportunity associated with an event.
The fund manager finds investment opportunities in corporate transactions like liquidation, bankruptcies, recapitalizations, acquisitions, and consolidations.
Global Macro
The Global Macro strategy involves taking large positions in currency, bond, or share markets to anticipate global macroeconomic events that generate a risk-adjusted return.
Managers utilize macroeconomic analysis of global market trends to find investment opportunities.
Relative Value
Also known as arbitrage, the Relative Value strategy takes advantage of price discrepancies between securities.
This can occur due to the market, underlying security, or mispricing of securities compared to others.
Legal Foundational Structure
Private and hedge funds are commonly structured as offshore partnerships or corporations in countries with a lax regulatory environment, limited liability companies, or limited partnerships.
The most important documents when forming one of these legal foundations are as follows.
Lawyers are responsible for ensuring these documents are compliant with offshore laws, state laws, and U.S. federal securities laws.
- Investment Management Agreements – These agreements govern the relationship between the investment manager and the fund.
- Limited Partnership Agreements – A Limited Partnership Agreement documents the relationship between partners.
- Private Placement Memoranda – PPMs are disclosure documents.
- Subscription Agreements – These are signed by investors who wish to join the fund.
Modern Legal Issues
Cryptocurrency
Cryptocurrency and digital assets are a rather new area of investing that many hedge funds are exploring.
Given the newness of the investment type, the challenge for attorneys is the uncertainty of regulatory environments, specifically related to anti-fraud standards, valuation, and custody.
Environmental, Social, and Governance (also known as ESG) factors have become essential within the private/hedge fund sector.
ESG-compliant funds are required by the SEC to avoid greenwashing, which is false claims about the sustainability of the fund.
Private Fund Standards
The creation of private fund standards continues to be a challenging landscape for attorneys due to the lack of regulations.
However, with increased scrutiny by the SEC, more robust standards are beginning to emerge and be enforced.
SEC Enforcement
The SEC continues to focus on private fund management, which has increased the number of investigations and resulting fines.
The most commonly enforced areas include conflict of interest, inaccurate valuations, and misleading key performance metrics.
Other Jurisdictions
The United States is the leading private and hedge fund market, but several other jurisdictions have a significant impact on trading and the law.
First, the Cayman Island is a popular offshore fund registration destination because of the country’s flexible regulations.
Second, Luxembourg boasts numerous multi-national private investment vehicles that target European markets and investors.
Third, after Brexit, the United Kingdom’s regulatory updates have impacted fund distribution and passporting.
Most important to note is that every jurisdiction has local, state, and federal rules related to compliance, taxation, investor eligibility, and fund registration, making them attractive alternative options, which are within the law, for investors in the United States.
Frequently Asked Questions
Where is the term "hedge fund" comes from?
The term hedge fund is credited to Alfred W. Jones, a financial journalist who first used the phrase “hedged fund” in 1949.
Who practices private/hedge fund law?
Since this is a highly specialized area of law, attorneys typically have backgrounds in compliance, tax law, corporate law, and securities regulation.
They also must possess a strong knowledge of cross-border and domestic finance.
Many private/hedge fund lawyers work at major international firms like Ropes & Gray, Simpson, Thatcher & Bartlett, and Kirkland & Ellis.
There are also in-house counsel teams that work at private equity and hedge fund companies to manage risk mitigation, contract negotiations, and daily compliance.
How do Private/Hedge Funds Legally Differ from Other Investments?
The primary differences between private/hedge funds and other investments are that they are only offered to qualified or accredited investors and have more exemptions based on the Investment Company Act of 1940.
Additionally, these funds require significantly more complicated strategies, such as short-selling, derivatives, and leverage, and have lighter regulatory requirements.
The SEC has implemented heavier scrutiny of these funds in recent years.
Why is specialized legal counsel required for this type of law?
Private/hedge funds involve cross-border transactions and have complicated legal structures.
Specialized counsel ensures investors are protected, fiduciary requirements are fulfilled, regulatory filings and documentation are maintained, materials are lawful and accurate, and funds are properly formed.
The attorneys complete these tasks while working to minimize enforcement and litigation risks from the government and other parties.
What are "qualified purchasers"?
Qualified purchasers are those with the highest wealth threshold that allows them to invest in funds with specific legal exemptions, which limits fund participation to the more financially savvy investors.
These investors must own at least $5 million in investments or be an institutional investor with over $25 million in investments.
What are "accredited investors"?
Accredited investors must meet specific net worth thresholds or income that is defined by the SEC and allows them to invest in private funds.
These individuals must have a net worth of over $1 million, and individual income of at least $200,000, and can be an executive officer of the security, a trust with over $5 million, or an entity comprised of equity owners.
How does the law regulate private/hedge fund fees?
Fund managers are required to disclose all fund expenses, performance fees with interest, and management fees in documents.
Since the SEC is increasing scrutiny of private/hedge funds, fee arrangements have been developed to prevent misleading performance reporting, improper allocation of expenses, and hidden charges, which could violate fraud laws.
This law is a specialized area of legal practice that involves advising investment funds, fund managers, and investors on regulatory compliance and investment strategies.