Considerations in Domiciling US Fund Management Entities
When launching a new private fund, a prospective hedge fund manager will often need to establish one or more new management entities. Fund management companies are typically formed as limited liability companies, although limited partnerships are suitable (and preferable in certain circumstances) and corporate entities can be used for management and advisory purposes, as well.
While it is traditional to form U.S. private fund entities in Delaware, fund management entities may be formed in Delaware or in the home state of the managing principal(s).
The discussion below explores a variety of considerations that may influence the decision of where to domicile the entity (or entities) that manage a private fund.
Please see our article at this link discussing the typical circumstances that cause our clients to consider establishing more than one fund management entity.
Domiciling Your Management Entities in Delaware
There are pros and cons to domiciling entities in Delaware. However, it is still the most popular location to form U.S. entities for investment and management purposes.
Let’s explore what you can expect when you domicile investment management entities in Delaware:
- As a neutral location, a Delaware entity will not need to be “re-domiciled,” converted or moved if you determine to relocate yourself to a different state of residence. However, depending on the level of activity that you expect your entities to conduct in your home state, your Delaware entities may need to make a qualification filing as a foreign entity operating in your home state.
- Delaware statutes governing the formation and operation of LLCs and other companies are very flexible and allow the drafter of the entity’s charter documents (i.e., the operating agreement for an LLC or limited partnership agreement for an LP) freedom to choose what governing approach makes sense for the particular entity. In contrast, some provisions of state law in other jurisdictions apply regardless of the entity’s charter documents. For example:
- The Delaware Act provides an overall greater freedom of the members to contract with respect to their rights, privileges, obligations, and duties. Some states will require that each member have the right to vote on a dissolution, merger or amendment to the articles.
- Some states will provide detailed guidelines regarding member meetings, voting and approvals, whereas Delaware generally relies upon the governing agreement of the company.
- Differences in inspection rights and rights of creditors of LLC members, will often favor Delaware.
- Delaware expressly sanctions broad delegation of authority by managers to third parties. Whereas other states may provide that managers owe fiduciary duties to an LLC and its members, which could limit the ability of a manager to broadly delegate duties.
- Delaware case law is very well developed with respect to the manner that courts interpret its laws. Parties may be less likely to pursue litigation relating to a Delaware entity’s governance because the statutes and the case law often address many of the issues that may arise in litigation.
- The Delaware legislature continuously modifies the state’s statutes to address new developments because it knows that the state will lose popularity as a preferential domicile if its laws do not evolve to keep up with emerging trends.
- Delaware is a neutral, well-respected jurisdiction. Investment entities, joint venture companies, and even management entities that have owners from different states may choose to domicile entities in Delaware to ease the ability of the parties to agree on negotiated terms. For example, if you are located in California (a state with notoriously particular state laws on entities) and you have a business partner in Nevada (who may have his or her own local counsel), Delaware provides a convenient location to avoid one partner having to get comfortable with the particulars of the other partner’s state company rules. This advantage can become relevant for the entities managing a private fund if the managing principals decide to give equity in the management company to employees, strategic partners, substantial or “seed” investors, or others who may be located in different jurisdictions.
- Delaware offers the assurance of a well-regarded statutory framework and the prospect that internal disputes will be resolved by a judge in Delaware’s Court of Chancery, which specializes in business disputes, rather than a local trial judge and jury (which could render a more arbitrary result).
- Delaware has reasonable annual fees (an annual “franchise” tax fee of $300).
Domiciling Your Management Entities in Your Home State
There are pros and cons to domiciling entities in your home state. However, private fund sponsors looking to save costs and that prefer local entities may choose to form their management entities in the home state of the managing principal(s).
Let’s explore what you can expect when you domicile investment management entities in your home state:
- Using local management entities located in your home state will cause your entity to be governed by your home states default rules for LLCs or partnerships. These state default rules can be more strict than Delaware and may surprise you when an issue arises, if you do not undertake a detailed analysis of these local regulations up front and draft your operating and governance agreements in accordance with such provisions.
- Because of the nuances in various state laws, you will typically need to engage local counsel in your home state to develop a custom operating agreement for your local entities. Our attorneys routinely handle operating agreements and partnership agreements for Delaware but do not have the ability to keep apprised of developments in local state laws applicable in our clients’ home states. As such, a local attorney is generally better-situated to prepare a custom or multi-member operating agreement for entities formed outside of Delaware.
- In New York, Texas, Washington D.C., and certain other jurisdictions, it will make sense to form Delaware entities as part of the usual tax optimization strategies. We can work with your CPA to confirm whether Delaware entities make sense but, in these cases, local entities can jeopardize the normal tax optimization plans that our clients use.
- Formation costs will vary depending on your home state but Delaware is among the cheapest states to form an entity. If your management entities will not be doing business in your home state, a determination you’ll make with your law firm and CPA, it may be cheaper to setup your management entities in Delaware. If you are required to qualify your management entities to do business in your home state, then forming in Delaware will add a few hundred dollars onto your entity setup, but will confer the various benefits of Delaware entities discussed, above.
- Each state entity is required to maintain a Registered Agent to receive service of process and official state communication directed to the company. While third-party registered agents are plentiful and will typically only cost $100 – $150 per year, if you form an entity in your home state, you can serve as your entity’s registered agent, provided that you don’t mind listing your personal address publicly on the website of your state’s secretary of state.
If you have questions about where to domicile your management entities or you want further advice on this topic, please contact us to discuss.