How to Start a Hedge Fund in Hong Kong: A Legal Primer
October 15, 2007
By Timothy Loh and Gavin Cumming
Hong Kong is a premier centre for hedge fund management in Asia, boasting easy access to North Asia deal flow, world class infrastructure, an internationally regarded regulatory framework and a relatively benign tax environment. This article provides the portfolio manager with an overview of the key legal issues that are likely to arise when establishing and managing a hedge fund in Hong Kong, covering the choice of fund structure, business licensing requirements and capital raising.
TIMOTHY LOH | Financial Services & Law Review
Vol. 1 (2007) at p. 9
For the portfolio manager intent on
establishing and managing a hedge fund in Asia, Hong Kong remains a leading
choice. The reasons include:
- Hong Kong is the leading financial market for the
Greater China Region. It has an
open, developed and sophisticated foreign exchange, banking and securities
infrastructure and serves as the Asian hub for many of the world's leading
prime brokers, custodians and administrators.
- Hong Kong has an established legal system with a stable and business oriented
government and an independent judiciary.
- Hong Kong offers a favourable low-tax environment
which can accommodate tax efficient structures for hedge funds and hedge fund
managers.
- Hong Kong has a rigorous regulatory environment
offering, for those who comply with its standards, international
credibility. At the same time,
Hong Kong provides flexibility for hedge fund managers to select from the full
range of global options for fund structuring to facilitate fund raising and, except
to protect market integrity, does not restrict hedge fund managers in the
strategies they deploy in the management of institutional money.
This article provides guidance to the portfolio
manager on establishing and managing a hedge fund from Hong Kong.
Fund Structure
The target investor base often determines the
basic structure of the fund, regardless of the location of the portfolio
manager.
Each jurisdiction has its own securities, tax and
other regulatory requirements. As
a result, subject to costs, it is generally preferable at the outset to seek
advice from legal counsel in each jurisdiction where the manager expects to
raise significant capital to minimize the risk that the manager will be unable
to market the fund as a result of legal prohibitions.
SIMPLE FUND
In a simple fund, there is a single fund vehicle
which accepts investments from investors around the world. A common form of a simple fund is
described in Illustration 1 below.
As there is only 1 fund vehicle, a simple fund
generally has less flexibility to cater to different requirements of different
investors. In particular, if the
portfolio manager intends to target U.S. investors, a simple fund cannot cater
simultaneously to U.S. taxable investors and U.S. tax exempt investors, such as
pension funds.
U.S. Taxable Investors
U.S. taxable investors investing in a hedge fund
may be subject to onerous tax rules applicable to investments in a passive
foreign investment company ("PFIC"). These rules penalize the sheltering of
passive investment income in a PFIC to defer tax. To avoid these rules, U.S. taxable investors prefer to
invest in flow-through entities such as partnerships or corporations that make
an election to be treated as a partnership for U.S. tax purposes.
U.S. Tax Exempt Investors
U.S. tax exempt investors investing in flow-through
entities on the other hand may be subject to tax on unrelated business taxable
income ("UBTI"). UBTI may arise where the fund earns
income using leverage. As a
result, U.S. tax exempt investors prefer to avoid flow-through entities.
MASTER-FEEDER FUND
A master-feeder fund is often the structure of
choice where the manager expects to raise significant amounts of capital from
both U.S. taxable and U.S. tax exempt investors in the United States and investors
outside the United States ("non-U.S.
investors").
Structure
While the precise structure of master-feeder funds
will vary, in a classic master-feeder fund, there are 3 separate fund vehicles
which comprise the hedge fund: (i) a U.S. feeder fund established as a limited
partnership in the United States, (ii) a non-U.S. feeder fund established as a
corporation in a tax neutral jurisdiction, and (iii) a master fund established
in a tax neutral jurisdiction either
as a limited partnership or as a non per
se corporation that elects to be treated as a partnership for U.S.
tax purposes.
Under these arrangements, U.S. taxable investors
invest in the U.S. feeder fund and non-U.S. investors and U.S. tax exempt
investors, such as pension funds, invest in the non-U.S. feeder fund. Both the U.S. feeder fund and the
non-U.S. feeder fund then invest all their assets into the master fund. A common form of the
master-feeder fund is shown in Illustration 2 below.
Whilst the appropriateness of a master-feeder
structure will depend upon individual circumstances, the master-feeder can
cater to both U.S. and non-U.S. investors.
U.S. Taxable Investors
U.S. taxable investors who invest in the hedge fund
through the U.S. feeder fund may be able to avoid the more onerous PFIC
regime. Assuming the hedge fund
does not itself invest in PFICs and provided that the U.S. feeder fund is a
flow-through entity such as a limited partnership and the master fund is a limited
partnership or a non per se
corporation which has made an election to be treated as a partnership for U.S.
tax purposes even though it is a corporation, U.S. taxable investors should
only be subject to tax on their pro
rata share of the earnings and capital gains of the hedge fund,
whether or not distributed.
At the same time, U.S. tax exempt investors may
invest in the hedge fund without being subject to tax on UBTI even though the
master fund is a limited partnership or a non per
se corporation which has made an election to be treated as a
partnership for U.S. tax purposes.
As the non-U.S. feeder fund is a corporation and hence, is not a
flow-through entity, the income which flows from the master fund to the
non-U.S. feeder fund does not flow through down to the U.S. tax exempt
investors and non-U.S. investors invested in the non-U.S. feeder fund.
PARALLEL FUND
A parallel fund, also known as a side-by-side fund,
comprises at least 2 fund vehicles, each catering to the requirements of
different investors. For example,
one fund vehicle may be designed for U.S. taxable investors and a different
fund vehicle may be designed for U.S. tax exempt and non-U.S. investors.
In a parallel fund, each fund vehicle has its own
portfolio but the fund generally shares similar investment strategies across these
vehicles.
The disadvantages of a parallel fund are that the
assets under management are split amongst different portfolios, necessitating
separate accounts for each fund with each service provider (e.g. each fund would need
to appoint a prime broker and an administrator) and splitting of deal tickets
between those accounts. As a
result, additional expenses may be incurred.
Taxation
The portfolio manager will typically wish to
minimize his or her own tax liabilities and, to facilitate capital raising,
ensure that the fund's profits themselves are sheltered whenever possible from
tax.
STRUCTURE
For portfolio managers based in Hong Kong, the
traditional approach (as shown in the illustrations above) calls for the
portfolio manager to establish an asset management company ("investment manager") in a
tax neutral jurisdiction and a sub-management company ("sub-manager") based in Hong
Kong. Under this arrangement:
- The investment manager delegates investment
discretion to the sub-manager which in turn employs the portfolio manager to
manage the fund.
- Investment management and performance fees accrue to
the management company in the tax neutral jurisdiction. The investment manager pays the
sub-manager a small fee which will cover the costs of the sub-manager plus a
pre-determined markup.
TAXATION OF THE MANAGER
Provided certain limits established under the law
are respected, this structure shelters the investment management and
performance fees from taxation. Hong Kong only taxes the sub-manager on the fees earned by it from the
asset management company. The tax
neutral jurisdiction is selected because it does not tax the investment
management and performance fees earned by the investment manager.
TAXATION OF THE FUND
In structuring management arrangements, it is
important to ensure that the arrangements do not subject the fund itself to
taxation in Hong Kong.
Exemption
In broad terms, a fund will be considered to be
non-resident for Hong Kong tax purposes and thus, exempt from Hong Kong profits
tax where the central management and control of a fund is exercised outside
Hong Kong and transactions are executed through SFC regulated intermediaries in
specified asset classes such as securities, futures and foreign exchange.
Effect of Hong Kong Base
The presence of a sub-manager in Hong Kong who
makes investment decisions on behalf of the fund is unlikely by itself to
result in the central management and control of the fund being exercised in
Hong Kong.
Nevertheless, steps should be taken to ensure that
the central management and control of the fund lies outside Hong Kong. These steps include appointing a
majority of non-Hong Kong directors, holding board meetings outside of Hong
Kong and ensuring that the board has a real function.
Regulation of Manager
In the common fund structures described above,
the sub-manager is based in Hong
Kong and will be subject to the
requirement under the Securities and Futures Ordinance ("SFO") to obtain a license
for Type 9 (asset management) regulated activity from the Securities and
Futures Commission ("SFC").
However, variations on these common structures may
dictate requirements for Type 4 (advising on securities) or Type 5 (advising on
futures contracts) licenses instead. These variations are sometimes attractive in that they may offer lower
regulatory hurdles in Hong Kong.
OVERVIEW OF LICENSING
The process of applying for a license from the SFC
involves completing prescribed forms for the firm, be it a sub-manager or
otherwise, and its individual representatives. This is because under the SFO, licensing requirements extend
to both the firm and its individual representatives.
FIRM
Generally, to license the firm, the SFC forms are
supplemented with a business plan and compliance manual. These supplements set out the nature
and scope of the business, operational work flow, organization structure and
internal controls. They are
intended to demonstrate to the SFC that the firm understands its business, that
it has the experience and systems to manage the business and its attendant
risks and that it will be able to comply with applicable regulatory
requirements.
Internal Controls
In this regard, the SFC has historically
scrutinized the firm's risk management, compliance, valuation and conflict of
interest policies and procedures with some vigour. However, the SFC has recently offered to streamline
applications from firms (i) who are, or whose parents are, licensed or
registered by the U.S. Securities and Exchange Commission or the U.K. Financial
Services Authority, or (ii) who have, or whose parents have, proven track
records.
Capital Requirements
Under the SFO, a firm licensed for asset management is normally required to
have paid-up capital of HK$5,000,000 and to maintain liquid capital of at least
HK$3,000,000. However, if the firm
does not hold client assets, there are no paid-up capital requirements and
liquid capital requirements can be reduced to as low as HK$100,000.
RESPONSIBLE OFFICERS
The most important representatives for a firm will
be the responsible officers. Every
firm applying to be licensed must have 2 individuals who are approved by the
SFC as responsible officers.
At least 1 of these individuals must fully satisfy
the SFC that he or she has adequate local regulatory knowledge, industry
knowledge, relevant experience and management experience.
Generally, the portfolio manager himself will be a
responsible officer.
Licensing Examination
To satisfy the requirement for local regulatory
knowledge, the individual must pass a regulatory examination unless otherwise
exempted. Individuals who are, or have previously been,
licensed as a responsible officer are normally exempt from the regulatory
examination.
Furthermore, individuals may be exempted from the
regulatory examination at the discretion of the SFC if:
- the individual is licensed or registered for
investment management or advisory business in the U.S. or U.K. or has over 8
years of relevant experience in recognized markets;
- the firm for which the individual will act as
responsible officer will only serve professional investors;
- the firm is able to confirm that regulatory and
compliance support will be provided to the individual; and
- the individual takes a post-licensing refresher
course on local regulations.
Relevant Experience
To satisfy the requirement for relevant experience,
the SFC generally requires a responsible officer to have at least 3 years of
experience in the management of public funds (i.e.
collective investment schemes sold to the public), proprietary trading,
alternative investments or investment research.
ALTERNATIVE LICENSING APPROACHES
In light of difficulties sometimes encountered in
applying for a Type 9 license, a firm may consider avoiding a Type 9 license
altogether. Whilst a license from
the SFC is still required under these fund structures, the license will be for
Type 4 or 5 regulated activity instead. These alternatives may be suitable, for example, for persons who do not
have experience considered to be relevant by the SFC.
Broadly, there are 2 alternatives. In one alternative, investment
discretion is exercised outside of Hong Kong by an investment manager. The portfolio manager himself remains
in Hong Kong as an employee of an adviser to the investment manager. While the
recommendations made by the adviser are in theory not binding, they are invariably followed.
In another alternative, investment discretion is
exercised by the fund itself. The
fund is advised by an investment adviser. The portfolio manager remains in Hong Kong both as an employee of the
fund and a sub-adviser. The
portfolio manager makes recommendations as an employee of the sub-adviser to
the investment adviser and implements those recommendations as an employee of
the fund.
Marketing Arrangements
In broad terms, securities laws of key capital
raising jurisdictions generally restrict offers or invitations to the public to
acquire shares or other interests in hedge funds. Specific jurisdictions may establish further restrictions on
top of these restrictions.
For example, where capital is raised from U.S.
pension funds, the assets may be subject to requirements of the Employment
Retirement Income Security Act ("ERISA "). Unless appropriate legal measures are
taken, the manager of a hedge fund which accepts ERISA assets may become
subject to onerous duties under ERISA.
AUTHORIZATION
In Hong Kong, offers and invitations to the public
to acquire shares or other interests in hedge funds are subject to regulatory
authorization requirements unless exempted. Whilst the SFC has established a regulatory framework for
the authorization of hedge funds, both in the interest of time and maximizing
flexibility in capital raising, investor reporting and investment strategy,
portfolio managers tend to prefer to avoid authorization by relying on
exemptions. The most commonly used
exemptions are set out below.
PROFESSIONAL INVESTORS
SFC authorization may not be required if the hedge
fund is sold only to professional investors ("SFO
professional investors").
SFO professional investors include institutional investors and
non-institutional investors. The
former include bankers, dealers, insurance companies and certain regulated
collective investment schemes. The
latter include:
- High net worth individuals, meaning individuals with
a portfolio of not less than HK$8 million;
- Corporations whose sole business is to hold
investments and which are wholly-owned by high net worth individuals (as
defined above);
- Corporations or partnerships with a portfolio of not
less than HK$8 million or total assets of not less than HK$40 million;
- Trust corporations registered under the Trustee
Ordinance or regulated under the laws of a place outside Hong Kong having total
assets under trust of not less than HK$40 million.
Marketing
materials for a hedge fund structured as a company may be exempt from the
authorization requirements if the shares are offered only to persons whose
ordinary business is to buy or sell shares or debentures, whether as principal
or agent.
MINIMUM SUBSCRIPTION
Marketing materials of a hedge fund structured as a
company may be exempt from the authorization requirement if (i) the materials
contain a prescribed warning statement, and (ii) the minimum denomination or
the minimum consideration payable by any person for the shares to be subscribed
is not less than HK$500,000.
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