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On-Demand: Launching a Fund with Friends & Family Investors

May 28, 2020

This webcast provided insights and considerations to help emerging fund managers with their launch of their funds with “friends and family” capital.



David Goldstein:Thank you especially to my panelists and for everybody that has joined us today and good afternoon or good morning depending on where you are. I'm David Goldstein, I'm director of business development within the financial services vertical of EisnerAmper. I spent a great deal of my time working with managers that are launching their first fund and during the pandemic, one of the main things I have heard from those managers is, "I'm trying to do my capital raising, but at this point I'm only able to get commitments from friends and family" And that is basically the Genesis of our program today. I'd like to now ask Ron Geffner to give a bigger introduction to himself and I'm going to pose the first question which would be, what trends are you seeing with new launches, specifically emerging managers who are launching with friends and family investors? Thank you Ron.

Ron Geffner:A special thanks to David and his colleagues and Eisner for coordinating the webinar and inviting me to participate. I'm a partner of the law firm of Sadis & Goldberg. On average, we launch about 60 to 80 funds per year. I started my career at SCC where I prosecuted money managers in New York city. Our firm represents over a thousand funds and like David, I've heard similar requests with regard to some emerging managers launching with friends and family. While we're going to get to the trends, one of the important things also to recognize is, with your friends and family, emerging manager or an existing manager, whatever it is you do, it's important that you do it correctly. So regardless of the amount of assets and the funds, you still have need to follow fundamentally similar protocols to anybody else setting up a commingled private investment vehicle.

And so we look to trends. Some of those trends are related to strategy, related to the amount of assets that are being started up. And really it's situational trends and it's helping our clients come up with tailored solutions specific to the fact pattern that they're facing. So one of the first things we look at regarding the question of an emerging manager of putting together a product, is really what's their business plan? What is their anticipation with regard to growth and what's their vision? And in any event, we'd start with by ascertaining what their investment strategy is. Are they doing that, are they trading equities, fixed income, is it US domiciled securities? Those are the things that we take into consideration. Are you employing leverage? We also look to see where the initial money's coming from. Is it their money, friends money, immediate family members money?

Is it US taxable dollars, US tax exempt money or non-US persons money. All of that will affect the structure. Whether we go with a domestic fund or an offshore fund. In most cases it's not going to be both. If it's an emerging manager who's looking to just do a friends and family fund, we're going to look to the ideals, explain what those ideals are to the manager. So by way of example, if a manager has US taxable dollars, investing in US securities, it's pretty simple. It's a US domiciled fund, most likely domiciled, if he came to Sadis & Goldberg at Delaware fund, structure as a limited partnership. That being said, if it's all non-US money, we might look to set up a fund in the Cayman Islands or some other non-US jurisdiction.

If it's a manager who's employing leverage, where there's margin indebtedness and it's US money and it's a mix of both taxable and tax exempt, we'll explain to them unrelated business taxable income and the effect that UBTI has a non- taxable money or tax-exempt money, where the investor might be taxed on gains earned off the leverage portion and walk them through the permutations. With regard to some of the trends we're seeing, it's a function of what kind of a discount might you be providing to initial investors. Is it going to be done via side letters? Is it going to be done through a founders class? There are different schools of thought whether you incorporate a founders class, and I'll walk you through briefly what it means, but there's no one right answer.

This is a very subjective opinion. We all have our biases based on prior conversations that had with Peter Tarrant from BTIG, at the sense of what I think his biases are, but I'll leave it to him if he wants to get into that. So the idea with regard to a fund that is cutting investors or breaks. So let's say I'm charging two and 20 to my limited partners coming into my domestic fund and for a period of time I want to offer them one and 10 meeting, 1% match me and a 10% allocation on any gains earned off the portfolio. I might hardwire into the fund, meaning it's in the placement memorandum and it says, and I'm going to make up the terms of this offering saying for the first $20 million coming in for the next 12 months, instead of paying two and 20, you're going to pay one and 10 and that's called the founders class arguably.

The other alternative is I just stick two and 20 in the document and as I have conversations with investors, I will say to them, I will document it and only charge them one and 10. The side letter which is a separate document, it might be one, two or three page agreement, that serves to amend the terms of the limited partnership agreement. Thereby, you're not advertising it to everybody who's getting the confidential private placement memorandum. My preferences usually going with a side letter because the facts and circumstances surrounding the manager may change. So if the manager wanted to offer 12 months of a discount today, but unfortunately 12 months down the road, he or she has not been as successful, they may not want to advertise that this house has been on the market for 12 months and they're extending the sale price.

So it depends on, like I said, the virus fact patterns and specific to the manager. And the other trends we're seeing are, who's helping you manage the portfolio? Are you going to come in with employees or consultants or other people providing you services? Another trend has been outsourcing the C-suite which means outsourcing your CFO, your COO, as opposed to hire somebody full time. So recently we've had a few managers launching with more than friends and family money. It was important for them to institutionalize their business and not be a person with a Bloomberg machine or a terminal running the money, but creating a reduction in operational risk. And creating certain written policies or certain procedures to protect the investor from operational risk.

David Goldstein:Thank you Ron. I think we're going to ask George shortly to talk a bit more about operational risk and a bit of the institutionalization of a fund. But let me... I'm going to go over to Peter now and Peter if you can give yourself an introduction as well. And then my question for you would be, now that a fund has launched with friends and family investors, what's the next best step and what should a manager have in place in order to move on to that next step? Take yourself off mute, Peter. Peter is having a little technical difficulty, I believe. My apologies. Jorge, let me throw it over to you to see if we can get Peter back on. Choosing the right service providers is something that many managers struggle with right off the bat. Can you talk a bit about best practices in terms of choosing providers and also give yourself an introduction in your firm? Thanks.

Jorge Hendrickson:Yeah, definitely. Thanks David. And thanks for Eisenhower, for hosting this. Jorge Hendrickson from Opus Fund Services. We're a global fund administrator servicing about 600 funds of a wide variety both, domestic and offshore. We've always been very active in the launch space. On a given year we're probably working with 60 to 80 launches as well. And those certainly range and type across the spectrum of open-ended structures, close-ended structures and simply others as well. We're a global forum with about 220 employees. From my seat, overseeing sales and marketing and having been on the admin side now for just over seven years previously saw the industry for the prime brokerage side. Also working with emerging managers. And prior to that I had worked at a startup fund and started my career to a large, well established managers.

So it's been interesting to see the range in what's for the of course institutional managers have put together over time and how you get there. But also in having conversations with the new launches and emerging managers, how they plan for today, pre-launch to the force they want to get into the future, which is one of those large established managers. And oftentimes, a team's coming out of a couple of billion dollar fund and they say, "Okay, let's replicate, the infrastructure that this fund had." And ultimately sort of sticker shock hit. They start to sort of, work their way down until they settle in a place where they say, "Okay, this is the right balance of infrastructure, head count technology and of course the cost relative to AUM.”

And thinking about the management companies, what that AUM needs to be relative to the fees, the income for the management company. Because of course somebody is expensive. They're not going to be covered by the fund. They're going to be covered by the management companies, thinking about office space which is certainly a timely topic. And all their infrastructure costs, they're not going to impact the fund, but the manager on day one needs to think about the overall picture, all of the businesses, all the entities and how they interrelate to each other. And that's something we spend a lot of time talking to managers about. It's kind of put our launch consulting head on is thinking about how the entities collaborate, what the management company books, tend to be versus the fund books.

And then putting together a plan for the overall launch, including fund and non-funded expenses. If their ultimate goal is to sort of get to that couple of billion dollar range, like the former employer and now they need to put a plan in place, to get their infrastructure. And it all starts of course with the portfolio on the strategy on the strategy and to one's point, what is the structural fund entry. Once you've identified that, fortunately for funds these days, there's a lot of great options out there. The industry is very institutional, very efficient. There's providers that come line up with you in all areas. And certainly from a cost perspective. And that's always been our goal, quite frankly, is to provide an institutional product at a price point that makes sense. Essentially, reducing the barrier to entry.

And I think that's one of the interesting advantages that we have in the domestic fund landscape versus, some of the other jurisdictions where that barrier to entry is a pie, which is important difference. But also balancing, the needs of investors and having all the right checks and balances in place. Who is overseeing the fund, who's overseeing the administrator, who's overseeing the prime broker. Of course, from like Eisner coming in at year end and doing their checks all for the benefit of course, of the investors. It's becoming a very efficient marketplace from that perspective. And the key really is, put infrastructure in place together on day one. That makes sense, but one that you can scale into without outgrowing.

If all things go well in year one and you also don't want to live under the gun for the first two years of your business operations needing to raise capital desperately because you cannot afford your current overhead expenses. So again, fortunately there are usually ways for fund managers to scale within their original providers, without having to make those changes because any change is going to trigger questions from investors. But I think knowing who the investor audience is, is so critical on one that we spent a lot of time talking to managers, because this goal of getting to a $2 billion fund certainly is the obvious goal for many, but it's not obvious goal for everyone. And it's certainly not what somebody should be focused on in the first year or two or even five years. If your initial round is to come from family and friends and oftentimes so that friends family around gets described sort of as a negative, but in reality it's very positive in that these are your closest relationships.

You want to manage that money like it's your own as you would with any investor. But you want to get that right. And certainly focusing on that investor based in their requirements is key. But you also want to think, okay, when a fund to fund operations, the diligence team comes in, in year two, am I going to be able to explain what I've put in place? Can I explain the services that I'm getting from my providers? You can't just say, I went with low cost or I think this is right or so and so is reconciling this. You need to be able to walk through that and in a lot of detail. And so our message to funds is do it institutionally from day one. And there's ways to do that so that even if your friends and family investors don't understand about reconciliations of counterparties, it doesn't matter.

You need to still provide it. And you need to put it in place for the next investor conversations. Going to that institutional investor and saying, yeah we don't have that now, but our providers turn it on when we need it. Is not really the right answer. And I think Peter will agree with this as well, is that managers of all sizes from the beginning should be completing their own due diligence questionnaires. EMAG provides a really good one. And sort of industry standard and our message to funds is start filling that out pretty much so that you can understand what you're working towards. And if you can't explain that in detail to an investor, at all parts of your life cycle, then quite frankly, don't expect to raise the capital.

And so that's critical. So the overall messages fill for today plan for tomorrow, but put it in way that's relevant to your investor base which in reality is your client base, your target audience. Like any business you need to think about, who your clients are, and that they are paying for it as well. And then of course, thinking for the future.

David Goldstein:Yeah, definitely. I think you've hit a very good point. I'm frequently asked what's the best piece of advice you could give me? And I'm always telling the managers, I mark with to make sure that you do it right the first time. You don't want to have to reinvent the wheel as you go along and hit an investor that says, "Oh, I don't know that service provider or I'm not comfortable with that service provider." And in the end, in order to get the better capital, you could end up having to switch service providers, which is more painful than it is to just select the right ones right from the beginning.

Jorge Hendrickson:I was just going to say, Ron, even to your point, David, even within the known service provider space I think the main question is what services are you getting from them and can you explain them? So certainly a known name refers to no name is relevant, but certainly understanding exactly what you're getting, even those names.

David Goldstein:Absolutely. Ron, did you want to say something?

Ron Geffner:Well that's a given, I always have something I want to say David, so thanks. Going back to what you touched on getting it right the first time. Service providers is step one of getting it right and it's... There are obviously choices available to people, but it's not ubiquitous. In other words, each place, each firm, each person has its own cadence, has its own style. Some of us are more commercial than others. Some of us have had different types of experience than others as well. And it's a function of who you are most comfortable regardless of what guidance you get from your friends or what you read on the internet, you really need to pick somebody you're most comfortable with. And can you see yourself working with them for the next 10 years?

Are they not only fit for you, but are you a fit for them? Are you working with somebody who is at the low end within their firms organization and you're not going to get the resources of that organization? That's important. If you're picking a prime broker, we'll say for example, during lean times, many prime brokers are willing to take out smaller funds, only to find during boom times, they may kick those funds out of their stables there by sending them to pick a new prime broker and that can have a domino effect on their business as well. It can raise questions, whether the manager's judgment was good or if there's something wrong with the manager. Also, sometimes people are penny wise, pound foolish, not just with selecting their service providers but for properly structuring their management entity or entities.

And that's going to be specific. In some case for tax purposes to where the manager is domiciled and when I say the manager not domiciled, it's not only where they have a physical primary office, but if they have consultants, anybody they're paying any kind of money to for some service, whether it's a true employee or a friend, you have to look to see whether, if I'm in New York and I'm paying somebody for some service that's not a third party, but I don't want to have. It's a full blown employee, that might be located in other state. It can have a disastrous tax effect on me if, I don't take that into account or whether I'm documenting my relationship with my partners or with my employees, with my counterparties. Especially when we're going through a vital time like we are now, counterparty risk is a big issue. So it's really taking into account that and it's not necessarily your job to know it all because you can't know it all.

Your auditor is your partner, your prime broker is your partner, your administrators is partner. So Jorge and his firm routinely issue spot on behalf of their clients where they may directly say, "Go talk to your lawyer because we noticed this." And that's the value in experienced firm has by being invested in you and having the experience with regard to other funds. And so offsite we were talking about cannabis and different opportunities within cannabis. But picking a right administrator, you don't want to be the first cannabis fondant administrator claims to take on despite what they say because you get to the one yard line and we've had this happen, we're also in the administrator decides they don't want to go forward, they don't want the risk, whether or cryptocurrency.

So if you're not only an emerging manager but with an emerging strategy, you want people that have the requisite experience but there are also professional enough to guide you. But I don't want to take away from Peter's time.

Peter Tarrant:My name's Peter Tarrant. I run Business Development and Capital Introduction for BTIG. BTIG is a 640 person global broker dealer with businesses rolled in. To this call, prime brokerage and outsource trading. We're very focused on the new launch market. I'd say we're ultra-focused on emerging managers. We're located in eight countries, 18 cities. We started in San Francisco back in 2002. That's when I joined. It's been an incredible journey. And one of the areas that I've been super passionate about is, this challenge of raising money for new funds. So going back to David's question, what does a fund need after a friends and family Launch? I just want to back up a little bit and talk about the pre-launch. In my seat and my team, we have the benefit of watching a hundred to 200 funds launch a year.

You compound that with the 17 years that I have been here. I've seen tons of things done right and I’ve seen tons of things not done well. And obviously I think there's a strong correlation to doing it right and succeeding. Before the launch, super important to get ready, before you talk to investors you want to be ready. A lot of times people will feel like they can give something different to friends and family and they'll set up to talk to institutional later. We, as in my team, we think it's a much better plan to get all your ducks in the row, before you talk to friends and family, before you talk to institutional investors and that document said, should be consistent. There is no reason you should give something different to your aunt, uncle, former colleague, then you're going to give to a family office.

So that means like coming to the table with the DDQ, which is a due diligence questionnaire. Coming to the table with a professional pitchbook, right? 99% of the competition out there has a pretty professional pitchbook. Nobody bought a hedge fund because of the pitchbook, but you need to be at least in mind with everyone else. A tear sheet is a one page or two page on the hedge fund. It's usually the communication document that managers use to communicate monthly performance. The tear sheet is as important as a business card for somebody coming out of business school with their first high level job there. You really need it. It's a mistake not to have it. Your cap intro teams can't forward your pitchbooks, but they can forward your tear sheets if they have the proper disclosures on it.

We meet a lot of managers that don't have tear sheets and we try to get them to do the tear sheet. Once you're pass launch with friends and family, you've gotten past an incredible business hurdle. A lot of people spend a lot of time, with friends and family commitment and then they're out looking for institutional capital and they're delayed in their launch. So the people who get launched with friends and family I think they're competitively in an awesome position compared to the people who are on hold. They're selling an idea and they're looking for either strategic capital or seed capital or they think they're going to get endowment money and they delay launching. We've got awesome success stories of guys that have launched with friends and family. It depends on who you are.

Some people have friends and family and that means they've got 3 million bucks and other people, it means they have $50 million. But the truth is in our prime brokerage client base, I can look back and see men and women that started with 2 million that are at 4 million in today, 5 million that are at 350 in close. It's so important to get started. There was very little day one money, that friends and family category is crucial. We think that a fund needs to be around 20 or 25 million to really start to access institutional capital on a broader basis. But we've had plenty of guys and women that have had less than 10 and they get a $3 million allocation or a $5 million allocation or a $500,000 allocation. All of those are building blocks. Every dollar you raise makes the next dollar easier to launch.

As far as like things to think about after launch, you want to commit to getting a monthly letter out, not a letter, a tear sheet every month. That's really important. People look at that. They're going to track your performance. They're going to track your AUM. It should have all your service providers on it. It should have your net performance on it. It should have your AUM on it. And people will notice when you go from three to five or five to eight or eight to 13. And it really is important to be consistent about that. Most managers are getting their letter out by the 15th of the following month. There is a competitive advantage to putting your letter out as soon as possible. First of all, there's reading exhaustion, right? So if you're an allocator you're getting hundreds and hundreds of these tear sheets a month.

So like anything, the first effort is the most enthusiastic effort. I would say that the people that get their letters in first have a higher probability of them getting looked at. Secondly you should think about having a launch letter. It doesn't have to be the day that you launch, but I think within 30 days of launching, it's a great discussion of the journey of the team you put together of the infrastructure. Right now, what's your work from home set up? How are you communicating with the team? How is it flowing? It's a really nice moment for you to sort of talk about, a year ago when you started planning this to execution now. And it sets up the tone and dialogue for the first quarterly letter. We think it's a mistake to report only quarterly.

Even if your strategy is long biased and you have a three to five year horizon, we meet a lot of managers that don't want to put out monthly numbers. We really feel strongly that's a big mistake. That's how allocators are tracking you and maybe that's okay for your friends and family. But it's absolutely not okay for family offices, endowments, foundations. And so if you're only reporting returns quarterly or you're reporting returns on a gross basis and not a net basis, you're really not easily compared to or whatever they're looking at or whatever they own. And I think you have a good chance of being put in maybe not focused on your bucket. So just remember that, there's a lot of consistency that I think you need to match with your peer group that will make it better for you.

Quarterly letter, it's an advertisement of your IP, that your chance to talk about what's different about you. Feedback I've gotten from allocators on quarterly letters is don't waste your time summarizing the market. Everybody knows what the market did. Focus in on the polio, focused in on ideas, risk management, a success, a problem, staff changes, AUM growth. Talk about what you see as opportunities like in today's market, right? How do you feel? Are you waiting? Are you cautious? Have you changed the way you've done things. It's a real opportunity for you to get people to follow you. You write a good letter and people are going to keep reading it. You write bad letters, terrible letters, uninteresting letters. They're not going to get read.

So I think that's pretty intuitive. I think that covers a lot of it. Last thing I just want to say is just process, right? Everybody launching has a prime broker for the most part. That means that you have access to cap intro. Everyone that launches that has outsourced trading, that's another cap intro team that you have access to. You want to huddle with them. You want to definitely get sync up with them, make sure that they have your marketing material, make sure that they do a dry run through with you, they make sure that your pitch is tight and that what you're saying is consistent with what's in your pitchbook, they do hundreds and hundreds of days a year. The minute you step out of line or say something weird, they kind of notice it and they're there to help you.

Absolutely embrace that. Keep in mind that they're working with hundreds of funds. You have to think about a way to work in that context and keep them up but realize that they probably can't call you every day. But there's a natural cadence of staying in touch that I think is really healthy. Your tear sheet and putting them on the distribution is a really good thing. If you're interested in being in an event, you should express that to them and tell them what kind of event you'd like to do. And if you don't know, ask them and they'll run you through all the content of the various events. Sign up for cap intro conferences. Anyone can join basically. There's entities like TABOR and context and there's a new charity, one that I think is pretty cool called, Funds for Food.

These are awesome opportunities for people that are launching funds and looking for either their first institutional capital or building their base of institutional capital. Like in the case of, Funds for Food, I know that they are anticipating 200 allocators. And it's a conference that lasts two weeks. You're going to have somewhere between, call it five and 15 meetings that are going to be one or two a day, it's not a big burden and you're going to get a ton of practice, even over zoom, how to interact with people one-on-one. I have seen some absolute disasters. So you need to know what people expect of you and you need to know what are the boundaries and what are the things that can get you in trouble.

I don't have enough time here to tell you all the things that people have done. But your meetings with institutional investors are really important and imagine that they're basically being recorded, they're taking notes on you. And so you want to get plenty of practice so that you don't say something that they take note of in a negative way and that your touch points with them are consistent. The very last thing I want to talk about is marketing and process. You need at least an Excel spreadsheet to track everything. You should have a CRM. They're really helpful. You can't afford to let anything fall through the cracks. You might have to cap intro teams. You might have BTIG for prime brokerage and someone else that's your outsource firm or BTIG is the outsource firm.

And someone else is your prime brokerage. And you're getting ideas from two different sources. You need to track that and you need a system to track it. You can't simply get 20 introductions and not follow up with five of them. You'll get overwhelmed pretty fast. Given the fact that you're doing, a hundred different things. Think about hiring a marketer. A marketer is the person that is going to run that entire process. It is a full time job. They can talk to other marketers in the market. They can work with your cap intro teams more effectively than you can. It's nice to have I think when you're just off friends and family but it's pretty close to need to have. And the people that are serious about fundraising, they have marketers. So that's it. I've talked to enough. I'm going to hand it back to David and sorry for the technical delays.

David Goldstein:Yeah. Thank you, Peter. That was some really solid advice. A couple of things that I want to throw in. Interestingly enough, I hear quite frequently for managers on launching with $5 million, I know I'm not going to get institutional investors until I've been around at least two years and I hit a $100 million mark. And I think what you've said shows that, that is not true. And I think what we've seen a lot in the past couple years, especially from family offices is a huge appetite for emerging managers with different strategies, different ways of looking at the market.

The other thing that I want to mention, you talk about basically practicing your pitch is, we've all seen managers that are phenomenal at trading and generate tremendous returns, but they can't relate to their investors. And I think that it's very important that not only somebody, a good money manager, but somebody has to be socially sharp, they've got to be able to relate with their investors and connect with their investors because it's a very strong relationship. So with that being said, Katie, thank you so much for waiting in the wings. Sorry. I'll throw to you for a few minutes, if you could briefly introduce yourself and then talk a bit about some of the tax considerations that a first time manager should take into account as they go ahead and launch their funds.

Katie Brandtjen:Sure. Thanks, David. My name is Katie Brandtjen and I'm a tax partner in EisnerAmper's financial services group. I lead the firm's San Francisco tax practice and I've spent the vast majority of the past 15 years working with a variety of funds from emerging managers to establish managers. There's a few tax issues I want to touch on that are important to be aware of when you're in the process of launching a fund. The first is the distinction between trader and investor. Each fund makes an annual determination as to whether they will be treated as a trader or an investor for the purpose of their tax return filings. Why is this classification even important? It's important because the treatment of fund expenses, professional fees, management fees is very different depending on whether you're a trader or an investor. The expenses of a trader fund are fully deductible above the line, 162 trader business expenses for all investors.

Expenses of an investor fund on the other hand, are nondeductible as of January 1st, 2018 for federal purposes. I've already said this is annual determination. There's no bright line test in this area. All of the cases in this space really look at individuals who are trading or investing personally. And while there's not a bright line test, the service seems to be looking for holding periods around 30 days or less. So traders are trading frequently. They have a strategy that aims to profit from short term market swings. They have a substantial number of trades per year, they're trading consistently throughout the year and their holding period again is very short, generally aiming for around a 30 day time period or less. investors on the other hand, have a strategy that aims to profit from dividends, interest and capital appreciation.

So that's one thing to be aware of when starting a fund is that each year you'll need to make a determination on whether you are a trader or an investor for tax purposes. What other issues come into play once you've made this determination for the year, you may have heard of section 163(J), business interest expense limitations. This code section applies a potential limitation on the interest expense that can be deducted currently by trader funds. It does not impact investor funds. There have been some modifications to these limitations in the cares act that was just passed in March. And I promise not to dig into all the lovely details of 163(J) on this webinar. But the important thing to note is that if you are a trader fund and you are generating interest expense, that interest expense might be subject to limitations in the current year.

Another item that impacts trader funds, not investor funds is the access business loss limitation for non-corporate taxpayers. So the tax cuts and jobs act amended, section 461 and disallows excess business losses, if the amount of those losses are an excess of 250,000 or 500,000, if married filing joint. So if you're a married filing joint taxpayer, and you have net business losses that exceed $500,000, you can use up to $500,000 of those losses to offset investment income, interest, dividends, et cetera. But business losses in excess of that 500,000 would be carried forward to future years as an NOL. So losses from trader funds would be included in this calculation, but losses from investor funds would not. Important note, the cares act passed just this last March of this year, suspends these rules until 2021, but 2021 is just around the corner. So it's something to be aware of as they're launching, coming in close to launch this year or next year.

I'm going to take just a minute to touch on carried interest. So section 1061 enacted with the tax cuts and jobs act effectively changes the way that carried interest is taxed. The legislation increases the holding period required for long-term capital gain treatment on carried interest from more than one year to more than three years. So if you're receiving carry and that carry includes an allocation of long-term capital gains, if the underlying assets that generated that gain were not held for more than three years, the general partner's share of that gain will be reclassified to short term capital gain. It does not impact limited partners whose allocation of income is based on their contributed capital.

I'm going to make a quick side note on investing in other partnerships. This is somewhat basic, but remember, if your fund is investing in another partnership, you will receive a K-1 from that partnership. Timing is important here. So we all know there's a lot of pressure on fund managers to deliver K-1s to investors in a timely fashion and investing in underlying partnerships leaves a piece of this timing out of your control. Doesn't mean you can't make the investment, but you need to get out in front of it. You need to understand when your fund will be receiving its K-1s. And if estimates will be provided in advance of the actual K-1s, factor this into how you communicate with your investors, when you anticipate delivering K-1s to your investors.

And a quick side note on that, you may also be subject to potential state filings if you're investing in other partnerships. As a partner in an underlying partnership, you'll receive an allocation of each item of that partnership's tax components. So if you're investing in an operating business, there will likely be state tax implications. Your fund will likely have to file additional state returns. Your investors will likely have a filing obligation for state returns as well. Quick note on tax exempt investors. So obviously knowing who will comprise your investor base is pretty critical to understanding what types of tax issues may come into play for a particular fund. If you have tax exempt investors coming into your fund, which includes retirement accounts, you may receive questions as to whether or not your fund will be generating you UBTI, which Ron mentioned earlier in this call.

The short for unrelated business taxable income. So unrelated business taxable income is essentially income from any trader business, which is not substantially related to the tax exempt purpose, whether that's charitable, educational, retirement funding, something else. The tax code imposes a tax on the unrelated business taxable income of exempt entities. So the overall intention here is that tax exempt entities should not be able to do the same things the taxable business entities can do and circumvent paying tax on their earnings. So how has UBTI typically generated in a fund context? The first, I've already mentioned, which is investing in partnerships that are operating businesses. So as a partner in that partnership, the underlying owner is allocated operating income, that is subject to tax even if the partner is tax exempt.

The other main area this comes into play in a fun context is by using leverage. So trading on margin creates you UBTI for tax exempts, even if there's no operating income generated within the fund, a portion of the funds interest, dividends and other items of income will be classified as you UBTI, to the extent leverage has been used. Some tax exempt investors will be extremely sensitive to UBTI exposure. Others might be much less sensitive depending on what's in their portfolio and what their overall strategy is. One solution if you anticipate admitting tax exempt investors, and also think the fund might generate UBTI is to have your tax exempts, your IRAs subscribed through a corporate blocker. If invested through a corporation, the UBTI issue is blocked and goes away altogether.

Probably the most cost effective option here for an emerging manager, if you're in this situation is the mini master, where the trading partnership is a domestic partnership. The tax exempt investors can come into the offshore feeder, which is structured as a corp and the offshore feeder invest into domestic partnership, it blocks you UBTI to the tax exempt partners. As Ron mentioned earlier, if you're going to keep your structure as simple as possible really and if you're not going to find yourself in this situation from day one, you can always consider adding a blocker in the future when you get there. David, I'll toss it back to you.

David Goldstein:Thank you very much, Katie. Very good. So that was the end of the real formal questions that I had for our panel. Why I've got Katie, I'm going to throw one more question at her which is, can you touch a bit and I realize that taxes, your specialty not necessarily audit, but if you can talk a bit about the possibility of a new fund manager, especially one launching the second half of the calendar year about doing an extended audit and what that really means?

Katie Brandtjen:Sure. So just to start, a registered investment advisor with a hundred million or greater in AUM, will not be able to file an extended first year audit. Custody rules require financials to be issued within 120 days of year end. However, most emerging managers launching with friends and family money will not be required to register with the SCC on day one and may want to consider an extended first year audit to cut back on costs in the first year. Extended audits are not uncommon for funds launching in the last quarter of the year, but they become very uncommon once you get over 15 months. I think I've seen one in the 15 to 18 month timeframe. From a compatibility standpoint, the audited financials will lose value the longer your extended audit period goes on. Now for some managers, a separate audit of the first year period still makes the most sense from a marketing perspective, especially if they anticipate growing the fund through ongoing fundraising in year two, and want to have that data readily available in an audited financial format.

David Goldstein:Thank you very much. Jorge, just wanted to throw a quick question over to you. We've talked obviously about prime broker, we've talked about legal, we've talked about audit and administrator, can you touch a bit upon what other service providers you think are essential, right from the beginning?

Jorge Hendrickson:Yeah, clearly for hedge funds, you've got your core for legal audit tax fund administration and prime brokerage. And the industry has evolved where there's a lot of other potential options outside of that, but it all makes it all has to be correlated to and fit your fund. Certainly as a few others have touched on. There's the outsource you potential of some of the internal roles which is a topic we spent a lot of time talking about. And one that I think creates a lot of confusion for day one managers, because ultimately they start hearing a lot of the same terms and compensations, terms such as middle office and it causes confusion. When you're outsourcing a role it's by definition, what you potentially would do internally via a hire or might do in the future via a future hire. And so while, a portfolio and fund structure might be straightforward, maybe outsourcing the out the CFO role might be interesting. And certainly it's more cost sensitive.

It's certainly not something that you want to have forever because eventually institutional investors are going to want to have, that internally, but the industry has evolved in a way where that's become an attractive option. And I think, some institutional investors and the prime brokerage consulting teams and teams like Peter, and you can come out, this sort of okay, that structure over the last few years and if done properly. So there's the outsourcing of a CFO, COO role. I think you're looking at the internal team and it's maybe heavy on the investment side, portfolio manager and an analyst and having somebody there to be another resource in dealing with your service providers, tracking workflows, and reviewing NAV packages at the end of the month.

Playing a role in treasury or cash movement which I noticed, I think more and more critical parts of the funds infrastructure that falls within the fund administrators world. You spend a lot of time talking to managers about, but one that oftentimes gets ignored. Any investor wants to see a third party administrators overseeing any money leaving the fund. So the idea is that this account gets used to subscription money then moves to prime broker, a PB will only receive or send money back to and from this fund bank account. It is typically used for fund expenses and to pay out management fees from the fund to the management company. There's a small side note that I want to touch on is the importance of that oversight. That outsource CFO might play a role there in additional checks balances.

The more you can wrap your arms around the infrastructure via outsourcing or insourcing, the better. And then there's also Outsourced Trading. If your focus as a portfolio manager is more coming at from a research perspective, you may not want to spend your time not trading executing trades internally. You may be better suited doing research, or on earnings calls and what not. If you don't want to think about the trading, so you can efficiently outsource the trading. It's trade execution, but ultimately you build a deep relationship with that counterparty as if they were your internal trader. You're paying them through commissions rather than a salary, which potentially attractive. Obviously it needs to be disclosed. But, that's an interesting way for managers to be able to focus a hundred percent on or as close to a hundred percent as possible on the investment side of things and raising additional capital rather than on the day to day operations.

But there may be not potentially adding to value. Clearly these are firms that have years of experience on executing orders and the more that they know you and your portfolio, the closer that relationship, but eventually mimics what an internal traders would do. And to Peter's point outsourced trading has become a really big growth area outside the core service provider buckets. And I think that's something that managers should always look at when looking at any of these potential roles is to think how close can I get to a hundred percent of my time being spent on a portfolio while not ignoring the operations of the rest, because it'll never get point where you're just going to fly blind and your providers are going to handle it all while they will, but you're never going to get to a hundred percent.

But you want to through, it's close to the ideal state of managing money and of course telling the story properly to existing, and of course a potential investor. And so the outsourcing of those areas. And then another one of course is client doesn't necessarily apply in some ways to day one managers are not registered and friends, family but when you are getting there, you need to think about, who's doing that properly, giving your head trader the slash CCO title, maybe not the best way to go especially if there's required experience there. So you don't want to cut corners, but unfortunately there's a whole suite of other providers out there that if done properly, your fund and your portfolio strategy can certainly make a lot of sense relative to cost.

And then from another infrastructure perspective, I talked earlier about sort of counterparties and reconciliations in the portfolio. Whether you're doing one trade a day, or you're doing 500 trades a day, you need to be able to explain to your day one investors and your other service providers what the workflow is. Are you executing on OMS and the trade fog its bloated PB and the administrator, the administrator should then be pulling that trade file to their portfolio accounting system. So they're essentially loading trades and positions in independent portfolio accounting system. That's both, they going to independently calculate P and L, reconcile back to the OMS, to the custodian prime broker and also independently price portfolio using a Blomberg or IDC.

Is that happening daily? That's key. And it's key whether you're doing one trade a month or 500 trades a day. What we've rolled out recently at Opus to sort of help clients think about this, not only prelaunch, but also to sort of let them know that these are things we should be talking about together at all parts of their life cycle is a consulting group or we're going to work with funds to have these conversations, because what happens ultimately is two or three years in, a firm realizes that they're still doing the same thing that they did it at day one. And maybe that process is sort of just become dated relative to the industries so you must keep up with trends, best practices but also they need to keep relevant with their new investor base is going to be.

And so what we're pro-actively telling funds, and this is what they should also be doing with all their providers and their capital teams and PB consulting groups. Here's my current fund status. Here's what I'm doing. What do you guys think? What should I be tweaking? What should I be sort of investing in? What has maybe gotten stale for my structure? And what changes should I make? So as opposed to letting clients realize, Hey, maybe I should make changes. Let me talk to providers. But we're saying is, when we're seeing changes in your infrastructure and investor base, we're going to come to you as part of that dialogue. And we've done this as a result of, examples of firms falling behind in growth and in their own infrastructure. But fortunately there's all these, ways to put the right pieces together. But keeping in mind, what makes sense for your ex firm or your buddy running out of credit fund may not make sense to you as a long run.

David Goldstein:Great. Thank you, Jorge very much. Excellent advice. So we just have a few moments left and I have saved the final question, and I apologize to the audience members that have sent questions, we will definitely address those offline, but I'm going to throw the last question to Ron. And I'm going to give you about two minutes to answer. In that question, in your experiences, what are the biggest mistakes that you find managers make? Some of that was obviously covered already, but your two sense would be appreciated on this one.

Ron Geffner:So that's a great question. What are the biggest problems we see with managers launching funds? And this applies also for managers who have funds in existence. Going back to something Peter said to start there, Peter had focused on tear sheets and communications with investors or prospective investors. This is one of the greater areas of risk managers face with regard to managing third party capital. With regard to communications, you don't have any obligation to communicate your performance or other information, but once you do, you have an obligation to present balanced information so that it's not deemed to be misleading or hyperbolic or exaggerated. Why would a thought prior to practicing law, this would have been based on a common sense analysis.

Unfortunately, reality has taught me that it's different things. So fundamental, you need to review your communications. Most not investors expect routine communication, whether it's a monthly or quarterly letter on top of performance. If you're going to describe actions you've taken or haven't taken while it might seem self-serving, I recommend you run it past legal counsel to make sure that there's nothing in there that puts you at risk. Also, when you're writing communications, you should compare it to all other forms of written communication provided in the past. What do I mean by that? I mean, the tear sheet, the pitchbook, the marketing piece, everything should be consistent. So to give you a war story that really sends this message home is, we had a client called me up and said, five years ago, they had a pitch book or marketing deck. They gave to an investor, they'd sent... Five years later, routine communication to the investor with regard to an event of a drawdown, meaning a loss of return.

And the investor had asked questions, "Did you do X, Y, and Z?" And what the manager then learned was they had made representations in their marketing material that indicated that in the event, in certain situations, they would take following actions, which they did not do, which puts the manager at risk for a law suit. The other areas worth noting are your greatest areas of risk is a fight with a partner. Partner not being an investor, partner being somebody who has ownership interest in any of the management companies. What we often see with early stage managers is, in an effort to save money, they don't properly document the nature of their relationship or the use something that we would refer to as boilerplate.

Something that really is not tailored to the situation, it's a standardized document and it's not one size fits all. The other area of risk has to do with employees or consultants or anybody that you're compensating for some sort of service. Either the manager has written the relationship, many cases it's verbal. Once we get past the shock of people having long-term relationships on a handshake or a verbal understanding, we get to the written communication. A lot of times managers in an effort to save money, not realizing how they can mitigate problems, right until you've gone through a life experience where you get burned, you sometimes really don't know how valuable that protection is worth.

So making sure you document the relationship with an employee, consultant, anybody you're paying some form of compensation for service to your business. That's another important thing. And it merits the review every few years at the very least because commercial terms change, the way of the world changes, think about COVID, how people are applying for PBP with regard to whistle blowers. That had an effect on relationships between employer and employee and the ability for the employee to be able to become a whistleblower without worrying about some sort of retribution. And I'll bring it home with these are the final areas of risk, a regulatory and counterparty risk. So counterparty risk, if you go back to 2008 some people had the misfortune of having to deal with Lehman Brothers or Bear Stearns and having their assets frozen.

Some of them, we've had clients where they had a short position where they could never leave the short position, and they were stuck in perpetuity paying a rate of interest for the Barra. So those reviews of relationships with counterparties is also good housekeeping. The army has something we call red dogging, where they have somebody in the army, one or two people from what I understand, that will be part of a group and they will then try to act as if they were the enemy. And what would they do to find areas of weakness that would be well-served for anybody running a business, trying to understand what your weaknesses are, and then getting to regulatory, it's making sure that whether it's today hence revisiting this, because fact and circumstances change, whether you have to be registered as an investment advisor, whether you to register as a commodity pool operator.

And with regard to most funds, if you're type accepting private funds, accepting money from US persons, most states take the position that you're required to do what's called the Blue Sky notice filing. Not every law firm follows this. Some find comfort in this white paper that was written many, many moons ago in which you didn't have to do this notice filing. At Sadis & Goldberg, we take a conservative approach, which we find is very valuable because protects you further from litigation, from either a disgruntled investor or from a state government. You do a notice filing in the states in which your investors resigned. Something that the law firm or another firm can do the paperwork for you and a filing fee. But the filing fee is very de minimis and it's a firm expense.

But in many cases, while managers might have it done initially correctly, they then go into the world and they forget about doing this on an ongoing basis. And then the final point, as we mentioned early, the very beginning of my first question, side letters versus founders class. If you're engaging in side letters, tracking those side letters is really important because after several years, you may have side letters that may be in conflict of one another. And what do I mean by conflict with one another, one side letter might have a most favored nations clause, which means that they get the best terms. And then three or four years later, the manager may enter to a side letter that might provide preferential terms forgetting to go back and check a side letter they entered two, four years ago.

We're not all going to remember the terms of every contract we've signed. So having it organized in a simple way and getting into a pattern and a process. And I think other panels have mentioned this concept of process before. This is one more process from an operational perspective that serves good for the manager.

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Katie Brandtjen

Katie Brandtjen is a Partner in the Financial Services Group providing tax compliance and tax planning services to hedge funds, venture capital, private equity funds, funds of funds, broker-dealers and investment advisors.

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