Starting a Hedge Fund in 2009 Bart Mallon, Esq. www.hedgefundlawblog.com Hello and thank you for watching this presentation called Starting a Hedge Fund in 2009. I have produced this presentation to give start up managers an overview of the hedge fund formation process. I have included general overviews of the laws involved and the major items a manager will need to consider when starting a fund. This is not designed to be an exhaustive presentation and I will try to proceed as quickly as possible. Even so, the presentation is 18 slides long and will probably run about 20 minutes long. As there is so much material to cover, I am leaving longer explanations for the blog. I have linked to resources on my blog which will provide further background information. Please also note that I have a disclaimer at the end as well as my contact information. With that, let’s proceed to the overview….

Overview Initial Considerations Fund Characteristics Basic Structure Structural Issues Laws Regulation D Investors Registration Service Providers Timeline Offering Documents Costs Raising Capital Other Issues Disclaimer We do not cover every aspect of the hedge fund formation process – we have, at the very end, identified issues which you will likely discuss with you hedge fund attorney and other service providers. X slides long and will be about s____minutesdf 2 of 18 © www.hedgefundlawblog.com

Initial Items to Consider Who will be your investors? How will you get to where you want to go? When you are initially thinking about establishing your hedge fund I recommend you sit down and think about the many logistical issues involved with starting a fund. You may want to sketch out an initial business plan, but there are a couple of centrally important items to think about – First, who will be your investors? The second thing you will want to examine is where do you want to go with your fund? size, scale, time commitments how will you raise money in the future? 3 of 18

Hedge Fund Characteristics Trading Strategies Traditional Non-Traditional Other Pooled Investment Vehicles Fees 2 and 20 Taxation “pass-through” taxation tax benefit of “allocation” of performance fees Hedge funds defined by a few major things - thier trading strategies, What is a hedge fund? Hedge funds, contrary to their name, do not always have hedged investment programs. A good general definition of a hedge fund is any sort of pooled investment vehicle where a management company makes the investment decisions on behalf of the fund Different funds have different types of trading stragies Traditional Long/short equity, Market Neutral, Biased (short or long), Macro, Sector, Convertible Bond and Convertible Arbitrage, Event-Driven Strategies, Distressed Assets, Emerging Markets and Managed Futures Non-Traditional Forex, Life Settlement Funds, Asset Based Lending Funds, Green Funds, Horse Racing Funds, Gambling Funds, Sports Betting Funds, and Charitable Funds Other Pooled Investment Vehicles Real Estate, Private Equity, VC, Fund of Funds, and Hybrid Fees Management Fees and Performance Fees Historical “2 and 20” fee structure Taxation no “double taxation” like in a corporation Fund Manager receives tax benefit of “allocation” of performance fees allowing manager to be taxed on this income pursuant to the underlying tax attributes of the income (long term or short term capital gain) as opposed to simple ordinary fee income 4 of 18

Basic Fund Structure Fees Allocations Management Movement of money Investors make investment in the Fund, payment to the Fund’s bank account* Manager wires money to the Fund’s brokerage account* Fund is managed by the Management Company Fund makes investments Fund pays Management Company a management fee (or may be paid from brokerage account)* Fund allocates Management Company a performance allocation If Investors make withdrawals, the Fund will make a distribution to investors* * Indicate where there would likely be wire fees Hedge Fund Investors (Limited Partners) Management Company (LLC) 1. 5. 6. 7. Hedge Fund (LP) (Bank Account) 3. 2. 7. Fees Allocations Management Movement of money Withdrawal Hedge Fund (LP) (Brokerage Account) 4. Investments 5 of 18

Structural Issues Fund structure/ Investors Minimum Investments Initial, Subsequent, In-kind, Maximum Withdrawal and Contribution Periods Monthly, Quarterly, Yearly; Lock-up; Gate Provision; In-kind; Distributions Fees Management and Performance; High Watermark; Hurdle Rate Management registration status Reports to investors Selling commissions Expenses Asset valuation practices The two major considerations for the manager with the hurdle rate is: What should the rate be? How will the rate be calculated? Obviously the named hurdle rate is a business point, not a legal point. The manager should consider who his potential investors would be and what they would like to see. Obviously also, the rate should relate, if applicable, to the investment program. If you have a bond program and your investment objective is to exceed the lehman aggregate bond index, a natural hurdle rate would be that index. For funds with a blue chip bias, a hurdle might be the return of the S&P 500 or the DJIA. However, in these instances it is more likely to see something like LIBOR or LIBOR plus one or two percent as the hurdle rate. There are three ways to calculate the hurdle rate: a hard hurdle, a soft hurdle or a blended hurdle. The hard hurdle – the hard hurdle is calculated on all profits above the hurdle rate. The hard hurdle is the most investor friendly of the three and provides the manager with limited upside. The soft hurdle – the soft hurdle is calculated on all profits IF the hurdle is achieved. In this instance, in certain situations, if the hurdle rate is achieve, the investor actually would have a higher return if the partnership had a lower return. The soft hurdle is the least investor friendly. The blended hurdle – the blended hurdle is calculed on all profits if the hurdle is achieved, however, if the hurdle rate is achieved, the return to investors cannot dip below the hurdle rate. The blended hurdle rate has the upside of the soft hurdle (see difference below if a 10% return is achieved) but protects the investor from the undesirable consequences, in certain instances, of the soft hurdle (see 9% return for the soft hurdle). The chart below shows the mechanical application of the hurdle rate at various return levels. It contemplates a yearly application of a 20% performance allocation and a 8% hurdle rate. In addition to the hurdle rates named above, a fund might also have a negative hurdle rate. The negative hurdle rate comes into play when the hurdle rate is actually below zero. Say for instance if the S&P is down 10% for the year and the fund returns 0%, the manager would actually earn a 2% performance allocation, even though the fund did not return anything. For various reasons the negative hurdle rate is rarely done. There are plenty of issues with this type of hurdle rate, the most important being the fact that it is going to be hard to tell investors that the fund lost money and owes a performance allocation. In practice funds with the negative hurdle rates have tended, over time, to drop this provision. The negative hurdle rate 6 of 18

Hedge Fund Laws Securities Act of 1933 Interest in a fund are “securities” Regulation D “safe harbor” Securities Exchange Act of 1934 Funds with 500 investors and $10 million in equity must register Investment Company Act of 1940 Hedge funds exempted under Section 3(c)(1) and Section 3(c)(7) Investment Advisers Act of 1940 Requires investment advisers to register with the SEC Exemption under Section 203(b)(3) for advisers who have less than 15 clients over a 12 month period Commodities Exchange Act CPO and CTA Registration Other Laws Internal Revenue Code of 1986 “Blue Sky” Laws There are six basic groups of laws which apply to hedge funds in one respect or another. Fund managers should be aware of the major ways in which these groups affect the structure and operations of hedge funds. Securities Act of 1933 Interest in a fund are “securities” Regulation D “safe harbor” Securities Exchange Act of 1934 B/Ds must be registered with SEC Requires issuers with 500 shareholders and $10 million in equity to register as a “reporting company” Investment Company Act of 1940 Requires mutual funds to register (very onerous) Hedge funds exempted from definition of mutual fund under Section 3(c)(1) and Section 3(c)(7) Investment Advisers Act of 1940 Requires investment advisers to register with the SEC State vs. Federal jurisdiction Exemption under Section 203(b)(3) for advisers who have less than 15 clients over a 12 month period Commodities Exchange Act Regulates commodities and futures trading Requires managers trading commodities and futures to register with the CFTC as Commodity Pool Operators Internal Revenue Code of 1986 US tax laws Long term capital gains taxed at a rate lower than the ordinary income rate “Blue Sky” Laws State laws which may apply to hedge fund managers in certain circumstances 7 of 18

Regulation D Rule 506 Definition of “accredited investor” No limit on amount of sales Generally only sold to “accredited investors” Can have up to 35 non- “accredited investors” Definition of “accredited investor” $1 Million Net Worth $200,000 in income in last 2 years No General Advertising No newspaper ads No radio shows File Form D with SEC within 15 days of sale Safe harbor under Section 4(2) of the Securities Act… Discuss safe harbor Rule 506 No limit on amount of sales Generally only sold to “accredited investors” Can have up to 35 non- “accredited investors” Definition of “accredited investor” $200,000 in each of the two most recent years (or joint income with that person’s spouse in excess of $300,000 in each of those years) and has a reasonable expectation of reaching the same income level in the current year. File Form D with SEC within 15 days of sale No General Advertising Section 502(c) provides that “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising” Broadly construed – no website (unless password protected and other measures), no 8 of 18

Hedge Fund Investors Section 3(c)(1) Funds Section 3(c)(7) Funds Limited to 99 investors Accredited Investor Qualified Client Natural person with a net worth of $1,500,000 Note: may be dependant on state law Limited to 499 investors Qualified Purchaser Natural person with a liquid net worth of $5,000,000 Limited to 100 investors Investor qualifications Accredited Investor Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000 Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year Qualified Client Natural person with a net worth of $1,500,000 9 of 18

Registration Investment Advisor Registration CTA or CPO Registration State vs. Federal Under $25 million – State only $25 - $30 million – SEC or State Over $30 million – SEC SEC Section 203(b)(3) exemption Generally 2-4 weeks Compliance manual State Exemption depends on state laws Generally 2-8 weeks Series 65 Potential net capital requirements Compliance procedures including potentially a compliance manual CTA or CPO Registration Registration with CFTC through the NFA Potential CTA and CPO Exemptions (but potential state issues) Series 3 Various compliance requirements Investment Advisor Registration State vs. Federal SEC Section 203(b)(3) exemption Generally 2-4 weeks Compliance manual State Exemption depends on state laws Generally 2-8 weeks Series 65 Potential net capital requirements Compliance procedures including potentially a compliance manual CTA or CPO Registration CFTC and NFA Potential CTA and CPO Exemptions Series 3 Various compliance requirements 10 of 18

Hedge Fund Service Providers Lawyer drafts offering documents; entity formation; registration; strategic and legal advice Administrator provides fund NAV calculation; fee calculations; investor reporting; etc. Auditor/ Accountant provides yearly fund audit; prepares tax forms for the manager and investors Prime Broker provides execution and/or clearing services for trades; custodian of assets Consultant provides consulting services to management company re: fund raising, marketing, operational guidance etc 11 of 18

Hedge Fund Timeline Week 1 Week 2 Week 3 Week 4 discuss fund structure in depth, organize legal entities (management company, fund), begin talking with outside service providers Week 2 receive draft of offering documents, begin thinking about operational issues which may arise – are your computers ready, is office space secured? Week 3 discussion and revision of offering documents with attorney, begin finalizing outside service provider contracts, establish bank account, establish brokerage account Week 4 tie up loose ends, finalize offering documents, begin to get ready for trading or selling interests in your fund IA registration and CTA/ CPO registration will affect this timeline – usually add about 2-4 weeks to the schedule assuming that the principals have all required regulatory exams and also provided that there are no prior regulatory actions 12 of 18

Offering Documents Private Placement Memorandum (PPM) Similar to mutual fund prospectus Discussion of important structural terms Discussion of investment program Information on management company and managers Limited Partnership Agreement (LPA) Governing legal document Subscription Documents Subscription agreement Investor suitability questions 13 of 18

Costs to Start a Fund Lawyer Administration Audit Prime Broker Range from $15,000 (boutique) to $30,000 (BigLaw) for a basic domestic long-short fund; registration extra My firm will be about $10,000 for a basic domestic long-short fund; registration from $2,000 if necessary Administration Range from $750 - $1,500 per month; Initial one time set-up fees range from $500 - $1,500 Larger funds may also pay a fee (x bps) on AUM Audit Audit: $5,000 – 15,000 depending on a number of factors including Audit firm Tax Prep: $4,000 - $10,000 depending on a number of factors including number of investors and the Audit firm Prime Broker Varies depending on strategy, investments, trading volume Business Expenses – office rent, compliance costs, telephones, computers and IT, office equipment, staff salary, etc. 14 of 18

Raising Capital Must be done pursuant to Regulation D Who Friends and Family Institutional Investors Marketing Materials Powerpoint Pitchbooks One Page Tearsheets Appropriate Disclosures/ Disclaimers Outside Marketing Hedge Fund Databases Hedge Fund Industry Events Capital Introduction Services Third Party Marketers 15 of 18

Other Issues “Incubator” hedge funds Offshore hedge funds Taxation ERISA and IRA investments “New Issues” Rule Soft Dollars Side Letters Due Diligence Blue Sky Filings 16 of 18

Disclaimer This presentation was made for informational purposes only. I am not providing legal advice to any user. I am not providing tax advice. Presentation is subject to the Circular 230 Notice on the disclaimer portion of my blog. This presentation does not establish an attorney-client relationship between myself and the user. Any discussion herein is not a substitute for seeking actual legal advice from a licensed attorney with knowledge of the rules and regulations governing the industry. I make no representations, guarantees, or warranties as to the accuracy, completeness, currency, or suitability of the information provided via this presentation. This may be considered to be “attorney advertising” in some jurisdictions. 17 of 18

www.hedgefundlawblog.com Please send questions, comments or suggestions to Bart Mallon at bartmallon@gmail.com © www.hedgefundlawblog.com