The cornerstone of a successful hedge fund is a successful investment strategy. That is self-evident. However, if the managers of the potential hedge fund are not successful in raising capital, this potential will never be tested or realized. We list below the five key points we believe hedge fund managers should take into account when raising capital for their funds.
# 1 Follow the Money
It is critical to be “user-friendly” (a.k.a. “investor-friendly”) in your approach to potential investors. This means that your fund structure should be geared to address your investors’ tax and other possible concerns. To do so, first identify the tax jurisdictions of your main investors. Then consult with your tax adviser to understand better the tax preferences of potential investors. For example, certain types of investors prefer tax flow-through structures while others do not. Experienced tax advisers can assist in planning a single structure that can address seemingly non-congruent concerns of different investor types. Consult your counsel as well for potential non-tax concerns that your structure should also address.
For example, certain types of investors may prefer to make their investments into entities formed in certain jurisdictions. Again, here too, experienced counsel can plan your fund structure in a manner that “follows the money” in the sense that it will be “user-friendly” from your investors’ perspective.
# 2 Keep it Simple
You should aim to present your fund to your investors in a “user-friendly” manner. This means keeping your fund’s financial and legal terms as simple and as mainstream as possible. Think of it this way: your investment strategies, or at least their main principles, are complex enough for your investors to digest and understand. Thus, keep the rest of your “story” (i.e., the fund’s financial and legal terms) as simple as possible.
This also means presenting your fund to your potential investors via clear and concise documents. A super-clear PowerPoint presentation is critical. It is well worth the effort to make this presentation as excellent as it can be. The presentation should be very “strong” and persuasive about your investment strategies, track record, and biographies. For example, while your track record is obviously critical and important to highlight in your presentation, so is the common background of your team. Experienced investors regard management team cohesion as a key due diligence item. The presentation should be followed up with a “statement of terms” or term sheet that summarizes the key financial and legal terms of your fund. It is usually approximately 8-12 pages long, presented in a user-friendly table format, and prepared by your counsel.
You don’t need to nail down every aspect of your fund’s terms at this point. For example, one can remain vague about the fund’s structure if you prefer to keep your structuring possibilities open until you “firm up” your investor base.
After the statement of terms comes the private placement memorandum (PPM). Preparing a PPM is optional in Israel. This is the “private offering” version of a prospectus describing your fund. Some funds prepare them and some do not. The cost-benefit considerations involved are beyond the scope of this article. However, we will point out that there are other ways to obtain the benefits of a PPM without incurring the costs involved (in terms of both management attention and fees). For example, you can attach the risk factors associated with an investment in your fund (usually presented in the PPM) to the other fund documents.
#3 Get “Soft” Commitments
When you present your fund to your potential investors, try to obtain their “soft” commitment to invest in your fund. These commitments are considered “soft” because they are not legally binding. However, they can give you the comfort you are making progress in your capital raising efforts and you are indeed consolidating an investor base on which you can count on to ultimately invest in your fund. There are different ways to evidence “soft” commitments. One way is to add a signature block to your PPP or statement of terms for your potential investors to sign. Both these documents are non-binding by their terms, although these signatures do create a certain level of moral commitment by your potential investors. Just to be clear, your potential investors’ signatures at this stage of your capital raising are not necessary or mission-critical, but they are nice to have.
You can also go after or focus on one to three “anchor investors” for your fund in order to consolidate your investor base. These “anchor investors” may demand that you share with them some of the economics of the management team. These demands may have an impact on the economics of individuals on your management team, so planning for this eventuality can prevent or at least minimize adverse effects on your management team down the road.
#4 Follow the Law
Remember, raising capital for a fund is no different from raising capital for a company. You are offering your investors interest in your fund just like a company offers shares to its investors. Your capital raising process is in fact a “securities offering” that will not be “covered” by a prospectus approved by the Israel Securities Authority. Therefore, Israeli securities laws will regard your capital raising effort as a “private offering.” You have to be careful about complying with the restrictions imposed by these laws.
For example, publishing an advertisement over the Internet announcing your offer is not a good idea. Also, keep in mind that there are legal restrictions on the number of potential investors you can approach in any 12-month period and on the number of overall investors in your fund. In any event, experienced securities counsel can (and should) guide you on the do’s and don’ts in this area.
It should be noted that technological developments have also impacted the regulation of “securities offerings.” In Israel, fund managers may find regulated crowdfunding platforms an effective and convenient way to go when raising money.
#5 Be Ready with the Final Documents When Needed but Not Any Earlier
Your capital raising effort will culminate if and when your investors actually invest in your fund. Your investors will have to sign the formal legal documents of the fund. These formal legal documents are usually the limited partnership agreement (or bylaws/articles of association if the fund is in a corporate form) that forms the fund and sets its terms, the subscription agreement and attached investor questionnaires that focus mainly on the investors’ representations, and perhaps side letters that grant certain investors special rights and benefits. (As mentioned above, your fund may or may not also have a PPM for your investors to review.)
On the one hand, you obviously want to have these documents ready as early as possible in order to “capture” your first committed investors. On the other, you may not want to spend your legal budget too early before you know whether you have successfully consolidated your investor base. Therefore, you can take a modular approach to your fund’s documentation.
First, prepare the presentation referred to above. Second, after you gain some traction with potential investors, prepare a statement of terms. Finally, after you have the commitments all lined up, go ahead and prepare the full legal document package. This approach enables you to control your expenses while not risking “missing out on” investors who are ready to commit.
We hope you find these five points helpful. Just remember the words of Napoleon Hill: “Plan your work and work your plan.”