Articles By Topic
By Topic: Due Diligence
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From Vol. 5 No.4 (Jan. 26, 2012)
Recent SEC Enforcement Action Against Private Fund Manager Underscores Importance of Identifying and Understanding Money Transfers Between a Hedge Fund and the Hedge Fund Manager During the Investor Due Diligence Process
On January 17, 2012, Judge Carol E. Jackson of the U.S. District Court, Eastern District of Missouri granted the SEC’s request for emergency injunctive relief (including an asset freeze and appointment of a receiver) against Burton Douglas Morriss as well as several investment management companies and private equity funds operated by Morriss in response to the SEC’s complaint alleging that Morriss misappropriated more than $9 million in investor assets from 2005 through 2011. See generally “Key Legal Considerations in Connection with Loans from Hedge Funds to Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 3, No. 28 (Jul. 15, 2010). This article describes the SEC action brought against Morriss and the investment management companies and private equity funds he operated. The article also provides several recommendations to assist hedge fund investors in identifying and understanding asset transfers between a hedge fund manager and its hedge funds. See also “Ten Steps That Hedge Fund Managers Can Take to Avoid Improper Transfers among Funds and Accounts,” The Hedge Fund Law Report, Vol. 4, No. 13 (Apr. 21, 2011).
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From Vol. 5 No.1 (Jan. 5, 2012)
Legal and Operational Due Diligence Best Practices for Hedge Fund Investors
In the wake of the financial crisis in late 2008, many investors were left trapped in suspended, gated or otherwise illiquid hedge funds. Unfortunately, for many investors who had historically taken a passive role with respect to their hedge fund investments, it took a painful lesson to learn that control over fundamental fund decisions was in the hands of hedge fund managers. Decisions such as the power to suspend or side pocket holdings were vested in managers either directly or through their influence over the board of directors of the fund. In these situations, which were not uncommon, leaving control in the hands of the manager rather than a more independent board gave rise to a conflict of interest. Managers were in some cases perceived to be acting in their own self-interest at the expense, literally and figuratively, of the fund and, consequently, the investors. The lessons from the financial crisis of 2008 reinforced the view that successful hedge fund investing requires investors to approach the manager selection process with a number of considerations in mind, including investment, risk, operational and legal considerations. Ideally, a hedge fund investment opportunity will be structured to sufficiently protect the investor’s rights (i.e., appropriate controls and safeguards) while providing an operating environment designed to maximize investment returns. Striking such a balance can be challenging, but as many investors learned during the financial crisis, it is a critical element of any successful hedge fund program. The focus on hedge fund governance issues has intensified in the wake of the financial crisis, with buzz words such as “managed accounts,” “independent directors,” “tri-party custody solutions” and “transparency” now dominating the discourse. Indeed, investor efforts to improve corporate governance and control have resulted in an altering of the old “take it or leave it” type of hedge fund documents, which have become more accommodative towards investors. In short, in recent years investors have become more likely to negotiate with managers, and such negotiations have been more successful on average. In a guest article, Charles Nightingale, a Legal and Regulatory Counsel for Pacific Alternative Asset Management Company, LLC (PAAMCO), and Marc Towers, a Director in PAAMCO’s Investment Operations Group, identify nine areas on which institutional investors should focus in the course of due diligence. Within each area, Nightingale and Towers drill down on specific issues that hedge fund investors should address, questions that investors should ask and red flags of which investors should be aware. The article is based not in theory, but in the authors’ on-the-ground experience conducting legal and operational due diligence on a wide range of hedge fund managers – across strategies, geographies and AUM sizes. From this deep experience, the authors have extracted a series of best practices, and those practices are conveyed in this article. One of the main themes of the article is that due diligence in the hedge fund arena is an interdisciplinary undertaking, incorporating law, regulation, operations, tax, accounting, structuring, finance and other disciplines, as well as – less tangibly – experience, judgment and a good sense of what motivates people. Another of the themes of the article is that due diligence is a continuous process – it starts well before an investment and often lasts beyond a redemption. This article, in short, highlights the due diligence considerations that matter to decision-makers at one of the most sophisticated allocators of capital to hedge funds. For managers looking to raise capital or investors looking to deploy capital intelligently, the analysis in this article merits serious consideration.
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From Vol. 5 No.1 (Jan. 5, 2012)
Ernst & Young Survey Juxtaposes the Views of Hedge Fund Managers and Investors on Hedge Fund Succession Planning, Governance, Administration, Expense Pass-Throughs and Due Diligence
Ernst & Young (E&Y) recently released the 2011 edition of its annual hedge fund survey entitled, “Coming of Age: Global Hedge Fund Survey 2011” (Report). The Report conveys and compares the views of hedge fund managers and investors on topics including succession, independent board oversight, use of administrators, expense pass-throughs and due diligence. This article summarizes the more salient findings from the Report. One of the Report’s many interesting insights is that managers frequently receive little in the way of feedback when a potential investor declines an investment. The Report partially fills this “feedback gap” by offering generalized insight on what matters most to investors. For example, managers may be surprised to learn that the absence of a robust and reliable succession plan may have played as much or more of a role in a lost investment as performance or even operational issues. (The HFLR will be covering succession planning for hedge fund managers in an upcoming issue.) More generally, the depth of the disparity in perception between managers and investors on a range of topics, as found by the Report, is at times startling. The Report therefore offers a sobering reality check for both managers and investors. Both sides need one another, albeit for different reasons, and the lifecycle of an investment can be significantly more productive if expectations and assumptions are better aligned.
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From Vol. 4 No.43 (Dec. 1, 2011)
Third Party Marketers Association 2011 Annual Conference Focuses on Hedge Fund Capital Raising Strategies, Manager Due Diligence, Structuring Hedge Fund Marketer Compensation and Marketing Regulation
Changing investor expectations and heightened regulation of hedge fund marketing has ushered in a new era for hedge fund managers seeking to raise capital. Hedge fund managers must continuously keep abreast of the issues that will impact their ability to effectively raise capital, particularly from institutional investors. Additionally, recent regulatory developments have created new challenges for fund managers that use third party marketers to assist in raising capital. This “New Normal” was the backdrop of the 2011 annual conference of the Third Party Marketers Association (3PM) in Boston on October 26 and 27, 2011. This article focuses on the most important points for hedge fund managers that were discussed during the conference. The article begins with a discussion of how fund managers can enhance their marketing efforts to raise more capital by understanding various aspects of the capital raising cycle, including the changing request for proposal (RFP) process, product positioning, the investor due diligence process and the manager selection process. The article then moves to a discussion of the regulatory challenges facing hedge fund managers using third party marketers, including a discussion of third party marketer due diligence of fund managers and appropriate compensation arrangements for third party marketers in light of lobbying law changes and pay to play regulations. The final section discusses impending and existing rules that will have a significant impact on hedge fund marketing.
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From Vol. 4 No.42 (Nov. 23, 2011)
Private Lawsuits Against Hedge Fund Managers Can Be Important Sources of Examination and Enforcement “Leads” for the SEC
On November 10, 2011, the Securities and Exchange Commission (SEC) announced the simultaneous filing and settling of charges against investment adviser Lilaboc, LLC d/b/a ThinkStrategy Capital Management, LLC (ThinkStrategy) and its founder and managing director, Chetan Kapur (Kapur, and together with ThinkStrategy, Defendants). The SEC’s Complaint in the action (Complaint) alleges that over nearly seven years the Defendants made false statements to investors in ThinkStrategy Capital Fund (Capital), a hedge fund managed by the Defendants, and TS Multi-Strategy Fund (Multi-Strategy, and together with Capital, Funds), a fund of funds managed by the Defendants. Those allegedly false statements related to the Funds’ performance, longevity and assets under management (AUM), as well as the credentials of Kapur and his management team. Moreover, with respect to Multi-Strategy, the Complaint alleges that the Defendants failed to perform due diligence commensurate with their representations to investors before investing with underlying managers. As a result of such inadequate due diligence, Multi-Strategy invested in notorious Ponzi schemes such as Bayou, Valhalla/Victory Funds and Finvest Primer Fund. See “Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices,” The Hedge Fund Law Report, Vol. 4, No. 25 (Jul. 27, 2011). Allegations in the SEC action incorporate and expand upon allegations in a private civil action recently filed against the Defendants, and – as discussed more fully in this article – highlight the interaction between private claims and SEC enforcement actions. See “Federal Court Decision Holds that a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally,” The Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).
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From Vol. 4 No.41 (Nov. 17, 2011)
SEC Commences Fraud Action against a Purported Hedge Fund Manager for Providing False Background Information and Including False Information on a Website
On October 26, 2011, the Securities and Exchange Commission (SEC) filed suit against Andrey Hicks and the hedge fund manager he ran, Locust Offshore Management, LLC (LOM), alleging that they defrauded investors by fabricating the existence of a British Virgin Islands-incorporated pooled investment fund. The SEC’s complaint (Complaint) also names the purported fund, Locust Offshore Fund, Ltd. (LOF), as a relief defendant. The Complaint, among other things, sheds new light on an old due diligence verity – the imperative of thorough background checks. See “In Conducting Background Checks of Hedge Fund Managers, What Specific Categories of Information Should Investors Check, and How Frequently Should Checks be Performed?,” The Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).
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From Vol. 4 No.40 (Nov. 10, 2011)
Principals of Paron Capital Management Sue Rothstein Kass for Negligence, Fraud and Breach of Contract Based on Alleged Failure to Obtain Third-Party Verification of Performance Results
Plaintiffs Peter McConnon (McConnon) and Timothy Lyons (Lyons) are the current principals of plaintiff investment manager Paron Capital Management, LLC (Paron). In April 2010, McConnon and Lyons were introduced to James Crombie (Crombie), who claimed to have run a successful commodity futures trading business and desired to form a new trading business with McConnon and Lyons. McConnon and Lyons claim that Paron retained defendant accounting firm Rothstein, Kass & Company, LLP (Rothstein Kass) to verify Crombie’s claimed returns. In particular, they asked Rothstein Kass to obtain third-party confirmation of data provided by Crombie. According to the complaint, Rothstein Kass never did so. It turned out that the historical performance data supplied by Crombie was a complete fabrication. That false data formed the basis of Paron’s marketing materials. Following investigations and enforcement actions by the National Futures Association and the U.S. Commodity Futures Trading Commission, Paron and Crombie were banned from futures trading and Paron’s business collapsed. The plaintiffs seek damages from Rothstein Kass for negligence, fraud and breach of contract. We detail the plaintiffs’ allegations and the allegations and findings in the enforcement actions. Rothstein Kass told The Hedge Fund Law Report with respect to this matter: “We have no comment on these meritless claims.”
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From Vol. 4 No.39 (Nov. 3, 2011)
Anti-Bribery Compliance for Private Fund Managers
Managing the risks inherent in dealing with foreign officials should be a top priority for managers of hedge funds and private equity funds. This is especially true in the current climate of expansive government interpretations of anti-bribery laws, new incentives for whistleblowers and the recent government scrutiny of the inner workings of fund managers. It has become standard fare for fund managers to have regular interactions with foreign officials or their representatives in the ordinary course of raising capital and making investments. There is nothing inherently wrong with such interactions. Still, those dealings need to be informed by a heightened sensitivity to the possible appearance that something of value was given to a foreign official in connection with a particular investment or transaction. The risk is that, regardless of the intent of the fund manager, certain conduct may be viewed in hindsight as an effort to improperly influence the actions of a foreign official. As a result, a fund manager needs to focus on more than just the substance of the transaction and needs to consider both how the transaction might be perceived and the record that is being created. As cross-border investments continue apace, fund managers can protect themselves by having adequate policies and procedures in place to identify potential bribery risks and to prevent violations from occurring. Aggressive enforcement of the Foreign Corrupt Practices Act (FCPA) by U.S. authorities and the comprehensive overhaul of anti-corruption laws in the U.K., culminating in the new Bribery Act 2010 (Bribery Act), highlight the importance of implementing effective anti-corruption compliance policies and procedures. In these circumstances, fund managers must do more than assure themselves that they are not acting with a corrupt intent; they also need to be alert to the risk of misunderstandings and to be diligent in creating a record of compliance. In a guest article, Paul A. Leder and Sarah P. Swanz, partner and counsel, respectively, in the Washington D.C. office of Richards Kibbe & Orbe LLP, outline steps to take to identify and manage the compliance risks faced by fund managers both directly (through their own dealings with foreign officials) and indirectly (through investments in operating companies that operate overseas). Specifically, Leder and Swanz identify conduct at the fund manager level that can put the manager at risk; discuss the importance of strong internal controls and compliance programs to mitigate corruption risks; and highlight categories of conduct at the portfolio company level that can put the manager at risk. The authors then make specific suggestions for identifying potential bribery risks and managing such risks. They conclude with a case study of a criminal prosecution that demonstrates the potential exposure for managers when making foreign investments.
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From Vol. 4 No.36 (Oct. 13, 2011)
What Should Hedge Fund Investors Be Looking for in the Course of Operational Due Diligence and How Can They Find It?
As previously reported in The Hedge Fund Law Report, on September 13, 2011, ALM Events hosted its fifth annual Hedge Fund General Counsel Summit at the Harvard Club in New York City. See “Fifth Annual Hedge Fund General Counsel Summit Covers Insider Trading, Expert Networks, Whistleblowers, Exit Interviews, Due Diligence, Examinations, Pay to Play and More,” The Hedge Fund Law Report, Vol. 4, No. 33 (Sep. 22, 2011). One of the panels at that Summit dealt with operational due diligence, an increasingly important topic in the hedge fund world. See “Six Principles of Operational Due Diligence,” The Hedge Fund Law Report, Vol. 4, No. 34 (Sep. 29, 2011). One of the participants on the due diligence panel was William Woolverton, Senior Managing Director and General Counsel at fund of funds manager Gottex Fund Management. We reported on some of Woolverton’s insights in our article on the Summit. Following the Summit, we had the privilege of digging deeper into Woolverton’s thinking on operational due diligence in the form of an interview. Gottex is a major investor in underlying hedge funds, and Woolverton participates materially in the operational due diligence process. He speaks, accordingly, with the authority of experience, and his insights are relevant to investors honing their approach to due diligence, managers refining their responses to due diligence and others concerned with the hedge fund due diligence process. This issue of The Hedge Fund Law Report contains the full transcript of our interview with Woolverton, which covered the following topics, among others: the specific non-investment aspects of the hedge fund business covered by operational due diligence; how managers can maintain the consistency of answers across people and documents; how managers can address requests for proprietary or confidential information; whether a manager should disclose an important disciplinary event, even if an investor does not ask about it; what investors can get from on-site visits that they cannot get remotely; whether integration clauses in fund documents have any value in light of the apparent ability of investors to sue based on oral representations by managers; the interaction among side letters, disclosure and certain regulatory developments; and what specific items investors should be looking for in background checks of managers.
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From Vol. 4 No.34 (Sep. 29, 2011)
Six Principles of Operational Due Diligence
Hedge funds have progressively moved into the mainstream of institutional investing. While even ten years ago, hedge funds were still largely the “secret club of the super rich,” sophisticated investors such as pension funds, sovereign wealth funds and large endowments now embrace the absolute return and diversification benefits available from hedge funds. Retail investors are also exposed to hedge funds as never before: many corporate pension schemes have added hedge fund exposure, and more generally, the movements of both stock and bond markets are now heavily influenced by hedge fund investment decisions and capital flows. Since the 2008 market crisis – thanks in part to Bernie Madoff, Lehman and numerous funds gating and suspending redemptions – operational due diligence has become much more significant to the hedge fund selection process. See “What Are Hybrid Gates, and Should You Consider Them When Launching Your Next Hedge Fund?,” The Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011). While performance and strategy remain central to every decision to allocate to a fund, investors large and small must also ensure that they have selected a manager with sufficient controls and infrastructure to safeguard assets. In a guest article, Christopher J. Addy, President and CEO of Entreprise Castle Hall Alternatives Inc., focuses on several more qualitative aspects of the hedge fund due diligence process, highlighting six principles which can guide the development of an effective due diligence function.
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From Vol. 4 No.33 (Sep. 22, 2011)
Fifth Annual Hedge Fund General Counsel Summit Covers Insider Trading, Expert Networks, Whistleblowers, Exit Interviews, Due Diligence, Examinations, Pay to Play and More
On September 13, 2011, ALM Events hosted its fifth annual Hedge Fund General Counsel Summit at the Harvard Club in New York City. Participants at the event discussed how the changing regulatory landscape is impacting the day-to-day policies, procedures and practices of hedge fund managers. Of particular note, discussions focused on insider trading in the post-Galleon world; best compliance practices for engaging and using expert network firms; how to motivate employees to report wrongdoing internally rather than filing whistleblower complaints; the interaction between non-disparagement clauses in hedge fund manager exit agreements and the whistleblower rule; best practices for exit interviews; best practices for responding to initial and ongoing due diligence inquiries; consistency across DDQs and other documents; standardization of DDQs versus customized answers; whether to disclose the existence or outcome of regulatory actions; how to deal with government investigations and examinations; and strategies for complying with the pay to play rule. This article summarizes the most noteworthy points made at the event.
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From Vol. 4 No.33 (Sep. 22, 2011)
An Investment Adviser May Not Call Itself Independent If It Receives Fees from Underlying Managers
The SEC recently commenced administrative proceedings against an investment adviser that allegedly received undisclosed fees for channeling over $80 million into SJK Investment Management, LLC (SJK). As previously reported in The Hedge Fund Law Report, on January 6, 2011, the SEC filed an emergency civil injunctive action charging SJK and its principal, Stanley Kowalewski, with securities fraud, and obtained a temporary restraining order and asset freeze against SJK and Kowalewski. See “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” The Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011). The order in this administrative proceeding (Order) is interesting to hedge fund and hedge fund of funds managers primarily in helping clarify the circumstances in which managers may and may not claim to be “independent.” The facts alleged by the SEC are rather egregious, and thus the Order itself does not make noteworthy new law. However, the Order does raise close and interesting questions regarding the language of representations that hedge fund of fund managers and other investment advisers may make to investors with respect to independence; the channels through which such representations are made (including websites); how to approach disclosure with respect to conflicts and independence in Form ADV; and how to move client assets from one investment manager to another without breaching fiduciary duties or running afoul of the antifraud provisions of the federal securities laws.
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From Vol. 4 No.32 (Sep. 16, 2011)
Are Hedge Fund Managers Required to Disclose the Existence or Outcome of Regulatory Examinations to Current or Potential Investors?
Generally, two categories of hedge fund managers will be required to register with the SEC as investment advisers by March 30, 2012: (1) managers with assets under management (AUM) in the U.S. of at least $150 million that manage solely private funds; and (2) managers with AUM in the U.S. between $100 million and $150 million that manage at least one private fund and at least one other type of investment vehicle, such as a managed account. See “Will Hedge Fund Managers That Do Not Have To Register with the SEC until March 30, 2012 Nonetheless Have To Register in New York, Connecticut, California or Other States by July 21, 2011?,” The Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011). Registration will trigger a range of new obligations. For example, registered hedge fund managers that do not already have a chief compliance officer (CCO) will have to hire one. See “To Whom Should the Chief Compliance Officer of a Hedge Fund Manager Report?,” The Hedge Fund Law Report, Vol. 4, No. 22 (Jul. 1, 2011). Also, registered hedge fund managers will have to complete, file and deliver, as appropriate, Form ADV. See “Application of Brochure Delivery and Public Filing Requirements of New Form ADV to Offshore and Domestic Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011). But perhaps the most onerous new obligation for newly registered hedge fund managers will be the duty to prepare for, manage and survive SEC examinations. Most hedge fund managers facing a registration requirement for the first time have hired high-caliber people and completed complex forms. Therefore, hiring a CCO and completing Form ADV will exercise existing skill sets. But few such managers have experienced anything like an SEC examination. On the contrary, many such managers have spent years behind a veil of permissible secrecy, disclosing little, rarely disseminating information beyond top employees and large investors and interacting with the government only indirectly. Examinations will change all that. The government will show up at your office, often with little or no notice; they will ask to review substantially everything; and a culture of transparency will have to replace a culture of secrecy, where the latter sorts of cultures still exist. (The SEC does not appreciate secrecy and has any number of ways of demonstrating its lack of appreciation.) Hedge fund managers facing the new examination reality will have to think about two sets of issues. The first set of issues relates to examination preparedness, and The Hedge Fund Law Report has written in depth on this topic. See, e.g., “Legal and Practical Considerations in Connection with Mock Examinations of Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 26 (Aug. 4, 2011). The second set of issues relates to examination management and survival, and that is the broad topic of this article. Specifically, this article addresses a question that hedge fund managers inevitably face in connection with examinations: What should we tell investors and when and how? To help hedge fund managers identify the relevant subquestions, think through the relevant issues and hopefully plan a disclosure strategy in advance of the commencement of an examination, this article discusses: the three types of SEC examinations and similar events that may trigger a disclosure examination; the five primary sources of a hedge fund manager’s potential disclosure obligation; whether and in what circumstances hedge fund managers must disclose the existence or outcome of the three types of SEC examinations; rules and expectations regarding responses to due diligence inquiries; selective and asymmetric disclosure issues; how hedge fund managers may reconcile the privileged information rights often granted to large investors in side letters with the fiduciary duty to make uniform disclosure to all investors; whether hedge fund managers must disclose deficiency letters in response to inquiries from current or potential investors, and whether such disclosure must be made even absent investor inquiries; whether managers that elect to disclose deficiency letters should disclose the letters themselves or only their contents; best practices with respect to the mechanics of disclosure (including how and when to use telephone and e-mail communications in this context); and whether deficiency letters may be obtained via a Freedom of Information Act request.
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From Vol. 4 No.32 (Sep. 16, 2011)
Nine Due Diligence Lessons Arising Out of the SEC’s Recent Enforcement Action Against the Manager of a Purported Quantitative Hedge Fund
On August 10, 2011, the SEC filed a complaint (Complaint) against a hedge fund management company and its principal, generally alleging that the defendants solicited a $1 million investment based on five categories of misrepresentations. The management company purported to manage a hedge fund with a quantitative investment strategy, and the investment came from an individual bond fund portfolio manager at a prominent New York hedge fund management company. The misrepresentations in this matter highlight a number of pitfalls that hedge fund investors should avoid. More generally, the matter highlights a number of due diligence points for investors to add to their DDQs – if the points are not there already. This article describes the factual and legal allegations in the Complaint, then discusses the nine key lessons from the Complaint.
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From Vol. 4 No.31 (Sep. 8, 2011)
Spreadsheets Can Stunt a Hedge Fund Manager’s Growth
Prime broker and technology provider Merlin Securities recently published a white paper entitled “The Importance of Business Process Maturity and Automation in Running a Hedge Fund.” Broadly, the white paper does four things. First, it identifies business process automation as fundamental to various aspects of the hedge fund management business, including growth (in assets, strategies, personnel, etc.), marketing and avoidance of major mistakes. Second, it provides a framework for determining a manager’s level of business process automation. Third, it offers a method for assessing whether a manager’s level of business process automation is too much, too little or just right in light of where the manager is in its lifecycle. And fourth, for managers with too little or too much automation in light of their stage of growth, the white paper examines the three primary strategies for getting to what it terms the “automation sweet spot.” The fundamental insights of the white paper are that the hedge fund management business is becoming more “institutional,” and that business process automation is an important element of institutionalization. It is hard to say whether managers are becoming more institutional because more assets are coming from institutional investors (as opposed to, for example, high net worth individuals), or whether institutional investors are becoming more open to investments in hedge funds because managers are becoming more institutional. The answer is probably a bit of both, but for practical purposes, the answer is moot: managers that seek assets from major institutional investors have to “act institutional.” What this Merlin white paper adds to the discussion is a way of thinking about what it means to act institutional from a business process perspective. This white paper is the latest in a series of white papers from Merlin Securities, and we at The Hedge Fund Law Report have reported on prior Merlin white papers. See, e.g., “Eight Refinements of the Traditional ‘2 and 20’ Hedge Fund Fee Structure That Can Powerfully Impact Manager Compensation and Investor Returns,” The Hedge Fund Law Report, Vol. 4, No. 17 (May 20, 2011) (discussing, among other things, the Merlin white paper entitled “The Business of Running a Hedge Fund: Best Practices for Getting to the ‘Green Zone’”); and “Prime Broker Merlin Securities Develops Spectrum of Hedge Fund Investors; Event Hosted by Accounting Firm Marcum LLP Examines Marketing Implications of the Merlin Spectrum,” The Hedge Fund Law Report, Vol. 3, No. 39 (Oct. 8. 2010) (discussing, among other things, the Merlin white paper entitled “The Spectrum of Hedge Fund Investors and a Roadmap to Effective Marketing”).
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From Vol. 4 No.29 (Aug. 25, 2011)
How Should Hedge Fund Managers Account for Organizational Expenses and Fund Loans, and What Role Should Such Accounting and Manager Solvency Play in Operational Due Diligence?
A recent federal court judgment against the manager of hedge funds purporting to follow a socially responsible investment strategy yields a number of important lessons for hedge fund investors when conducting due diligence. Among other things, the judgment highlights the relevance of the financial condition of the manager and its principals; how managers should account for organizational expenses; how managers should account for fund loans, if they are used at all; and the perils of guaranteed returns. See “Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011).
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From Vol. 4 No.27 (Aug. 12, 2011)
Federal Court Decision Holds That a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally
A recent federal district court order (Order) described the range of legal claims available to an investor in a hedge fund of funds for alleged inconsistencies between the fund of funds manager’s representations and actions regarding due diligence and monitoring. Read narrowly, the Order may merely stand for the proposition that a fund of funds manager may not promise to undertake specific actions in the course of due diligence and monitoring, accept investor money based on those representations then fail to take those actions. Read more broadly, the Order may foreshadow a heightening of the legal standard to which hedge fund of funds managers are held when conducting due diligence and monitoring. That is, the Order may presage a decision on the merits to the effect that fund of funds managers have a legal duty more or less consonant with industry best practices regarding due diligence. That would constitute a significant increase in the level of legal obligations applicable to fund of funds managers, but would not enhance the commercial standard of care, which already demands best practices.
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From Vol. 4 No.26 (Aug. 4, 2011)
SEC Wins Summary Judgment in Its Fraud Suit Against Investment Adviser Locke Capital and Its Principal, Leila C. Jenkins, Who Fabricated a Non-Existent “Massive Swiss Banking Client” to Attract Investors
Defendant Leila C. Jenkins (Jenkins) was the founder and sole owner of investment adviser Locke Capital Management, Inc. (Locke). In 2009, the Securities and Exchange Commission (SEC) brought a civil enforcement action against Locke and Jenkins, alleging that they had fabricated a “massive Swiss banking client” to trick potential investors into believing that they had more than a billion dollars under management, when in fact they did not. The initial misstatement of assets under management by the defendants, along with Jenkins’ clumsy efforts to conceal the deception, supported fraud and other charges under the Securities Act of 1933, the Securities and Exchange Act of 1934 and the Investment Advisers Act of 1940. The U.S. District Court for the District of Rhode Island granted the SEC’s motion for summary judgment on all charges, directed the defendants to disgorge profits, imposed penalties and enjoined them from future securities laws violations. This article summarizes the decision, which has important implications for hedge fund operational due diligence.
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From Vol. 4 No.25 (Jul. 27, 2011)
Recent Bayou Judgments Highlight a Direct Conflict between Bankruptcy Law and Hedge Fund Due Diligence Best Practices
The United States District Court for the Southern District of New York recently issued judgments in favor of three bankrupt hedge funds in fraudulent conveyance actions against investors that redeemed within two years of the funds’ bankruptcy filings. The hedge funds were members of the Bayou group of hedge funds, which – as the hedge fund industry knows well – was a fraud that collapsed in August 2005, resulting in bankruptcy filings by the Bayou funds and related entities in May 2006. These judgments are very important for hedge fund investors because they illustrate what appears to be a direct conflict between bankruptcy law and hedge fund due diligence best practices. In short, hedge fund due diligence best practices currently counsel in favor of redemption at the first whiff of fraud on the part of a manager. However, bankruptcy law appears to require a hedge fund investor to undertake a “diligent investigation” when it obtains facts that put it on inquiry notice of insolvency of the fund or a fraudulent purpose on the part of the manager. The immediacy of a prompt redemption is directly at odds with the delay inherent in a diligent investigation. How can hedge fund investors reconcile the practical goal of prompt self-help with the legal obligation of a diligent investigation? To help answer that question, this feature length article surveys the factual and procedural history of the Bayou matters, then analyzes the arguments and outcome in the recent Bayou trial. The primary question at the trial was whether certain investors that redeemed from the Bayou funds could keep their redemption proceeds based on “good faith” defenses to the Bayou estate’s fraudulent conveyance actions. In the absence of a court opinion, The Hedge Fund Law Report analyzed the 142-page transcript of the closing arguments, as well as the motion papers filed by the parties and four prior bankruptcy court and district court opinions. This article embodies the results of our analysis. The article concludes by identifying five ways in which hedge fund investors may reconcile hedge fund due diligence best practices with the seemingly draconian outcome in these recent Bayou judgments.
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From Vol. 4 No.25 (Jul. 27, 2011)
Fourteen Due Diligence Lessons to Be Derived from the SEC’s Recent Action against a Serial Practitioner of Hedge Fund Fraud
On July 13, 2011, the SEC issued an Order making findings and imposing remedial sanctions against an individual hedge fund manager. The Order describes a career involving modest and infrequent investment successes, and predominantly characterized by repeated, serial and egregious frauds. The diversity and audacity of the frauds make for lurid reading, but the relevance of the Order for The Hedge Fund Law Report and our subscribers resides in the due diligence lessons to be derived from the factual findings. This article details the factual findings in the Order, then extracts 14 distinct due diligence lessons from those facts. Many of our institutional investor subscribers will read the factual findings and say, “This could never happen to me.” And they may be right. But we never cease to be amazed by the level of sophistication of investors caught up in even the most crude and simple frauds. Perhaps this is because our industry is based on trust, and despite the salience of fraud, fraud remains (fortunately) the exception to the wider rule of ethical conduct. Perhaps it is because frauds that look simple in retrospect were difficult to discover in the moment. Regardless of the reason, hedge fund investors of all stripes and sizes can benefit from ongoing refinement of their due diligence practices. And we continue to believe that the best way to refine due diligence practices is to look at what went wrong in actual cases and to revise your list of questions and techniques accordingly. Here is a useful test for hedge fund investors: read the facts of this matter, as described in this article, then pause to ask yourself: Would our current due diligence practices have discovered all of these facts and caused us to pass on this investment or to redeem? If the answer is yes, you can stop reading. But if the answer is no – that is, if your due diligence practices may have missed any aspect of this fraud – we strongly encourage you to read and incorporate our fourteen lessons. We would also note that we have undertaken similar exercises with respect to prior SEC actions. That is, we have reviewed allegations of hedge fund manager fraud and detailed the due diligence steps that may have uncovered such frauds. All of our thinking on this topic is available in the “Due Diligence” section of our Archive.
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From Vol. 4 No.19 (Jun. 8, 2011)
Alternative Investment Management Association Publishes Institutional Investor Guide Covering Hedge Fund Governance, Risk, Liquidity, Performance Reporting, Investor Relations, Marketing, Operations, Valuation, Due Diligence and Other Topics
On May 31, 2011, the Alternative Investment Management Association (AIMA), published a guide aimed at communicating institutional investors’ views, expectations and preferences to the hedge fund industry. As described by AIMA Chairman Todd Groome, the guide was published “[i]n light of the ongoing ‘institutionalisation’ of the hedge fund industry and the growth of institutional investor participation.” The authors of the guide, members of the AIMA Investor Steering Committee, and “some of the most influential investors and advisors in the industry,” include Luke Dixon of Universities Superannuation Scheme, Andrea Gentilini of Union Bancaire Privée, Kurt Silberstein of the California Public Employees Retirement Scheme, Michelle McGregor-Smith of British Airways Pension Investment Management and Adrian Sales of Albourne. See “CalPERS ‘Special Review’ Includes Details of Misconduct and Recommendations That May Fundamentally Alter the Hedge Fund Placement Agent Business,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011). The guide covers a range of increasingly relevant operational and organizational issues that institutional investors consider in their due diligence reviews, including: hedge fund governance, constitutional documents, the role of the board of directors, performance reporting practices and transparency, counterparty risk, operations, fund liquidity, risk controls, ownership of the management company, sales and marketing, valuation, business continuity planning, compliance, service provider relationships and more. This article offers a comprehensive discussion of the key principles, ideas and recommendations presented in the guide.
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From Vol. 4 No.18 (Jun. 1, 2011)
Is a Hedge Fund Manager Required to Disclose the Existence or Substance of SEC Examination Deficiency Letters to Investors or Potential Investors?
Following an examination of a registered hedge fund manager by the SEC staff, the staff typically issues a deficiency letter to the manager listing compliance shortcomings identified by the staff during the examination. See “What Do Hedge Fund Managers Need to Know to Prepare For, Handle and Survive SEC Examinations? (Part Three of Three),” The Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011). Quickly, comprehensively and conclusively remedying compliance shortcomings identified in a deficiency letter should be a first order of business for any hedge fund manager – that is the easy part, a point that few would dispute. However, considerably more ambiguity surrounds the question of whether and to what extent hedge fund managers must disclose to investors and potential investors various aspects of SEC examinations – including their existence, scope, focus and outcome. More particularly, hedge fund managers that receive deficiency letters routinely ask: must we disclose the fact of receipt of this deficiency letter or its contents to investors or potential investors? And does the answer depend on whether potential investors have requested information about or contained in a deficiency letter in due diligence or in a request for proposal (RFP)? The answers to these questions generally have been governed by a “materiality” standard – the same standard that, at a certain level of generality, governs all disclosure questions. The consensus guidance has been: disclose whatever is material. But this is more of a reframing of the question than an answer. The practical question in this context is how to assess materiality in the interest of disclosing adequately, avoiding anti-fraud or breach of fiduciary duty claims and ensuring best investor relations practices. A recently issued SEC order (Order) settling administrative proceedings against a registered investment adviser provides limited guidance on the foregoing questions. This article describes the facts recited in the Order, the SEC’s legal analysis and how that analysis can inform decision-making of hedge fund managers considering whether and to what extent to disclose the existence or substance of deficiency letters to investors or potential investors. This analysis has particular relevance for hedge fund managers seeking to grow institutional assets under management by responding to RFPs.
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From Vol. 4 No.11 (Apr. 1, 2011)
Twelve Operational Due Diligence Lessons from the SEC’s Recent Action against the Manager of a Commodities-Focused Hedge Fund
On March 15, 2011, the SEC filed a complaint the U.S. District Court for the Southern District of New York against Juno Mother Earth Asset Management, LLC (Juno) and its principals, Arturo Rodriguez and Eugenio Verzili. The complaint alleges that Juno and its principals started selling interests in the Juno Mother Earth Resources Fund, Ltd. (Resources Fund) in late 2006, and by the middle of 2008, substantially all of the Resources Fund's investors had requested redemptions. The SEC alleges that during the short life of the Resources Fund, Rodriguez and Verzili engaged in a range of bad acts, including misappropriation of fund assets, inappropriate loans from the fund to the management company, misrepresentations of strategy and assets under management and disclosure violations. Assuming for purposes of analysis that the allegations in the complaint are true, the complaint illuminates a variety of pitfalls for institutional investors to avoid. This article describes the factual and legal allegations in the complaint, then details twelve important lessons to be derived from the complaint. Similar to other articles we have published extracting due diligence lessons from SEC complaints, the intent of this article is to serve as a tool for institutional investors or their agents that can be used directly in performing due diligence, or can be used to update a due diligence questionnaire. Our hope in publishing this article (and others of its type) is that at least one of the twelve lessons that we extract from the complaint enables an investor to identify a due diligence issue that it otherwise would have missed. We think that there is no better way to identify future hedge fund frauds than to understand the mechanics and lessons of past frauds.
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From Vol. 4 No.11 (Apr. 1, 2011)
Survey by SEI and Greenwich Associates Identifies the Primary Decision Factors and Concerns of Institutional Investors When Investing in Hedge Funds
A survey of 97 institutional investors and 14 investment consultants conducted by SEI Knowledge Partnership in collaboration with Greenwich Associates last October, and released earlier this year, identifies the hierarchy of considerations and concerns of institutional investors when investing in hedge funds. One notable finding of the survey – especially for a publication, like the HFLR, focused on regulation – is the view of most institutional investors with respect to regulation. That view is discussed in this article. In addition, this article discusses the survey’s findings on the following topics: statistics with respect to hedge fund returns, assets under management, launches and liquidations during the last three years; plans with respect to hedge fund allocations during 2011; objectives of institutional investors when investing in hedge funds; most significant challenges in hedge fund investing; experience with and perceptions of liquidity; the 16 factors that investors consider most important when selecting among managers; four key takeaways for hedge fund managers from the survey findings; breakdown of hedge fund allocations by institutional investor type; trends with respect to fees; the role of consultants; the success rate of negotiations on liquidity terms; and trends with respect to the resources dedicated by institutional investors and consultants to hedge fund due diligence and monitoring.
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From Vol. 4 No.4 (Feb. 3, 2011)
Eight Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Hedge Fund Manager Alleging Misuse of Hedge Fund Assets to Make Personal Private Equity Investments
On January 28, 2011, the SEC obtained a court order freezing the assets of Stamford, Connecticut-based, unregistered hedge fund manager Michael Kenwood Capital Management, LLC (MK Capital Management) and Francisco Illarramendi, who indirectly owns and controls MK Capital Management. On January 14, 2011, the SEC had filed a complaint in the United States District Court for the District of Connecticut generally alleging that Illarramendi caused hedge funds managed by MK Capital Management to invest in private companies, with the shares of those private companies registered to advisory or investment entities indirectly owned and controlled by Illarramendi. That is, the SEC essentially alleges that Illarramendi used fund assets to make personal private equity investments. Moreover, the SEC alleges that a non-U.S. corporate pension fund was the source of approximately 90 percent of the assets in the two hedge funds involved in the matter. The SEC’s allegations regarding misuse of fund assets shed light on the variety of things that can go wrong in a hedge fund investment, and how some of those wrong turns can be avoided. Working from the allegations in the SEC’s complaint, we derive eight distinct due diligence lessons that investors can apply directly to their evaluation and monitoring of hedge fund managers. This article details the eight lessons. Before proceeding, a caveat is in order. We have published a number of articles that analyze SEC complaints against hedge fund managers and extract due diligence lessons from the allegations in those complaints. See “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out Of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” The Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011); “Ten Due Diligence Questions that Might Have Helped Uncover the Fraud Described in the SEC's Recent Administrative Proceeding against Subprime Automobile Loan Hedge Fund Manager and Its Principals,” The Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010). But it is important to note that our articles of this type do not and are not intended to endorse or support SEC’s allegations or positions in the various matters. For purposes of these articles, we do not undertake an independent investigation into the veracity of the SEC’s allegations. Rather, we assume for analytical purposes that the SEC’s allegations are true, and we aim to be explicit about the procedural posture of covered matters. We do not believe that this approach undermines the relevance or applicability of the due diligence lessons we describe. Quite the contrary: we believe that our due diligence lessons are based on expressed concerns of the SEC, and thus are valid, generalizable and useful. At best, these lessons can help our subscribers avoid investment and operational missteps. However, in fairness to the defendants in these matters, we consider it important to emphasize that our analysis is based on allegations that remain to be proven or disproven.
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From Vol. 4 No.3 (Jan. 21, 2011)
Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets
The SEC recently obtained an emergency asset freeze and temporary restraining order against a hedge fund of funds manager, Stanley J. Kowalewski (Kowalewski), and his management entity, SJK Investment Management LLC (SJK). The SEC’s complaint, filed in federal district court in Atlanta, generally alleges that Kowalewski and SJK engaged in two categories of conduct in violation of federal securities laws. First, Kowalewski and SJK allegedly used fund assets to pay management company and personal expenses. Second, Kowalewski allegedly launched a hedge fund in which his fund of funds invested, but failed to disclose to his fund of funds investors either the existence of the underlying hedge fund or the investment by his fund of funds in it. Neither the dollar values nor the creativity in this matter are particularly noteworthy. The alleged fraud itself was trite, brief and straightforward. However, a close reading of the SEC’s complaint offers a veritable treasure trove of insight into how investors in hedge funds and funds of funds can sharpen their due diligence practices. We have extracted 13 key lessons from the matter that investors can use to revise their approach to hedge fund due diligence – or, even better, to confirm that their approach reflects current best practices. This article details the SEC’s factual and legal allegations against Kowalewski and SJK, briefly discusses the procedural posture of the matter, then discusses in detail the 13 key lessons.
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From Vol. 3 No.50 (Dec. 29, 2010)
Ten Due Diligence Questions that Might Have Helped Uncover the Fraud Described in the SEC's Recent Administrative Proceeding against Subprime Automobile Loan Hedge Fund Manager and Its Principals
On December 21, 2010, the SEC instituted and settled administrative proceedings against a San Francisco-based hedge fund management company and its principals. A hedge fund managed by that company purported to invest almost exclusively in subprime auto loans, but in fact wound up "investing" largely in debt owed to the fund by entities controlled by principals of the management company and other hedge funds managed by the management company. The SEC's Order in the matter is a study in conflicts of interest, strategy drift, material misstatements and omissions in offering documents and Form ADV and improper principal trades. Working from the alleged facts of this matter, we derive ten due diligence questions that any investor should add to its questionnaire or incorporate into in-person meetings with managers. Importantly, these are questions that should be asked periodically, not just prior to an initial investment.
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From Vol. 3 No.49 (Dec. 17, 2010)
Settlement of SEC Fraud Charges by Small San Francisco-Based Hedge Fund Manager Highlights Importance of Valuation Checks and Balances
On December 1, 2010, the SEC instituted and simultaneously settled fraud charges against an individual hedge fund manager based in San Francisco. (This matter is further evidence of reinvigorated enforcement efforts by the SEC's San Francisco office. For a discussion of another matter recently initiated by that office, see "SEC Commences Civil Insider Trading Action Against Deloitte Mergers and Acquisitions Partner and Spouse Who Allegedly Tipped Off Relatives to Impending Acquisitions of Seven Public Companies," The Hedge Fund Law Report, Vol. 3, No. 48 (Dec. 10, 2010).) The allegations in the SEC's Order tell a familiar story: a young manager raises, at peak, $30 million; while the Order does not specify, the money likely came from friends and family. The manager experiences losses in a relatively conservative investment strategy. The manager, presumably embarrassed, tells his investors that everything is fine, while trying to make up those losses by taking on slightly more risk. But instead, the manager loses more money, and his misrepresentations to investors depart to a greater extent from the facts. Eventually, the manager comes clean, the fund is liquidated and the manager is charged by the SEC with civil fraud. What is noteworthy about this matter are two statements in the SEC's order.
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From Vol. 3 No.27 (Jul. 8, 2010)
Legal, Operational and Risk Considerations for Institutional Investors When Performing Due Diligence on Hedge Fund Service Providers
The old paradigm of hedge fund due diligence focused on the hedge fund manager and the new paradigm focuses on hedge fund service providers. That is, the purpose of hedge fund due diligence used to be (broadly, pre-2008) to ensure that the hedge fund manager itself had, internally, sufficient people, process and plant to maintain its return and risk profile. However, the credit crisis that began in 2008, and the frauds it brought to the fore, highlighted the franchise risk posed by service providers to hedge funds and managers. Consequently, post-crisis hedge fund due diligence has focused more squarely and thoroughly on service providers. For example, in a June 2010 study, hedge fund operational due diligence consulting firm Corgentum Consulting analyzed data from over 200 hedge fund allocators and concluded that hedge fund “investors are focusing the bulk of their due diligence efforts on legal, compliance and regulatory risks.” The primary reason for this shift in focus – from managers and performance (then), to service providers and operations (now) – relates to the estimated harm from adverse outcomes. In relative terms, most investment losses are high probability, low magnitude events, while most operational failures are low probability, high magnitude events. The chief goal of due diligence is to avoid low probability, high magnitude events; and, moreover, the credit crisis taught that the probability of some operational failures may not be so low after all. Lehman Brothers provides the most sobering example. Hedge funds that used Lehman’s U.S. or U.K. brokerage entities as their only prime brokers and that did not perform adequate due diligence on Lehman’s custody and cash management arrangements – or that did perform such diligence but did not incorporate its lessons – wound up with significant investor assets tied up for long periods in bankruptcy, SIPA or administration proceedings. The purpose of service provider diligence is to identify operational issues that can have a material adverse effect on investment outcomes – issues such as the commingling of hedge fund customer assets by certain Lehman brokerage entities. With the twin goals of providing guidance to investors conducting due diligence on hedge fund service providers, and to hedge fund managers and service providers anticipating such diligence, this article: identifies key hedge fund service providers; details ten specific areas on which investors should focus when conducting service provider diligence; highlights areas of diligence specific to certain service providers; discusses strategies for accessing the data necessary to perform adequate due diligence; and incorporates recommendations regarding the timing and frequency of service provider due diligence.
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From Vol. 2 No.52 (Dec. 30, 2009)
Why Are Most Hedge Fund Investors Reluctant to Sue Hedge Fund Managers, and What Are the Goals of Investors that Do Sue Managers? An Interview with Jason Papastavrou, Founder and Chief Investment Officer of Aris Capital Management, and Apostolos Peristeris, COO, CCO and GC of Aris
An article in last week’s issue of The Hedge Fund Law Report detailed a ruling by the New York State Supreme Court permitting a lawsuit by funds managed by Aris Capital Management (Aris) to proceed against hedge funds in which the Aris funds had invested and the managers of those investee funds. See “New York Supreme Court Rules that Aris Multi-Strategy Funds’ Suit against Hedge Funds for Fraud May Proceed, but Negligence Claims are Preempted under Martin Act,” The Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009). That lawsuit is one of various suits brought by Aris and its managed funds against hedge funds or managers in which the Aris funds have invested. The Aris suits allege a variety of claims in a variety of circumstances, but collectively are noteworthy for their mere existence. In the hedge fund world, there has been a conspicuous absence during the past two years of legal actions by hedge fund investors against hedge fund managers, despite the coming-to-fruition of circumstances that industry participants thought, pre-credit crisis, would augur an uptick in litigation: the imposition of gates, suspensions of redemptions, mispricing of securities, large losses, etc. Jason Papastavrou, Founder and Chief Investment Officer of Aris, appears to have broken ranks with what seems like an unspoken agreement in the hedge fund world to avoid the courthouse steps, and he has done so with a considerable degree of thoughtfulness, for specific reasons and with particularized goals. In an interview with The Hedge Fund Law Report, Papastavrou and Apostolos Peristeris, COO, CCO and GC of Aris, discuss certain of their lawsuits, why they brought them, what they seek to gain from them and what the relevant managers might have done differently to have avoided the suits. They also discuss: seven explanations for the reluctance on the part of most hedge fund investors to sue managers; the fund of funds redemption process; how their lawsuits have affected their due diligence process; in-house administration; background checks; the importance of face-to-face meetings; side letters; how Aris investors have reacted to the lawsuits; and Aris’ transition to a managed accounts model from a fund of funds model.
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From Vol. 2 No.50 (Dec. 17, 2009)
Speakers at Walkers Fundamentals Hedge Fund Seminar Outline Hedge Fund Due Diligence and Financing Trends, as well as Predictions for 2010 and Beyond
On December 2, 2009, international law firm Walkers Global held its Walkers Fundamentals Hedge Fund Seminar in New York City. Speakers at this event addressed various current issues, including: the evolving nature, rigor and focus of hedge fund due diligence; renewed scrutiny of custody arrangements in the course of due diligence; post-investment due diligence and monitoring; financing for hedge funds and due diligence with respect to collateral; the regulatory outlook (with insight from Todd Groome, Non-Executive Chairman of AIMA); the duty of care applicable to hedge fund directors; Cayman Islands law with respect to indemnification of directors; and the outlook with respect to near-term fund-raising and a potential new government levy on hedge fund managers. This article summarizes the key points discussed at the conference on each of the foregoing topics.
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From Vol. 2 No.44 (Nov. 5, 2009)
How Can Hedge Fund Investors Hone Their Due Diligence in Light of Alarming Rate of “Verification Problems” Discovered in Recent Study of Hedge Fund Due Diligence Reports?
In a draft paper dated October 16, 2009 and titled “Trust and Delegation,” four scholars analyzed the frequency of misrepresentations and inconsistencies on the part of hedge fund managers in the course of due diligence performed by institutional investors. They did this by analyzing hundreds of due diligence (DD) reports prepared by a DD firm. Most notably, they found that 21 percent of the hedge fund managers described in the reports they sampled misrepresented their past legal and regulatory history; 28 percent made incorrect or unverifiable representations about other topics; and 42 percent had had “verification problems” including either misrepresentations or inconsistencies. This article describes in detail the more salient findings of the study and, more importantly, explores how hedge fund investors and managers can put those findings into practice. For investors, this entails reviewing current approaches to DD to refocus on the most common categories of verification problems. For managers, this involves focusing on knowledge management in order to avoid accidental or negligent misrepresentations, and recognizing the heightened importance of transparency and specificity in responding to DD inquiries.
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From Vol. 2 No.24 (Jun. 17, 2009)
Interview with Duff & Phelps Director Eric S. Lazear on Operational Risk Due Diligence
Amid the backdrop of recent high profile frauds, unprecedented market declines, poor hedge fund performance and resulting closures, hedge fund investors are placing heightened emphasis on due diligence. In particular, investors are focusing in the course of due diligence on operational risks and business infrastructure. Last month, independent financial advisory and investment banking firm Duff & Phelps Corporation created an Operational Risk Due Diligence (ORDD) practice to provide investors with an independent third-party assessment of their hedge fund managers’ operating policies and procedures. The Hedge Fund Law Report spoke with Duff & Phelps Director Eric S. Lazear about the new ORDD practice; trends in operational risk due diligence; specific risks he has seen in the course of his practice (including risks relating to trading practices, valuation of illiquid assets, cash management, fund structuring and allocation of trades); and solutions recommended to institutional investor clients to address those risks. The full text of the interview is available in this issue of The Hedge Fund Law Report.
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From Vol. 2 No.22 (Jun. 3, 2009)
Protean Fraud Risk Appraisal Launches Hedge Fund Fraud Risk Certification
On June 2, 2009, Protean Fraud Risk Appraisal announced that it had launched the investment industry’s first hedge fund fraud risk certification. Protean Fraud Risk Appraisal is an independent risk certification firm specializing in the alternative investment sector.
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From Vol. 1 No.29 (Dec. 24, 2008)
Involvement of Funds of Funds in Alleged Madoff Fraud Reemphasizes Importance of Due Diligence
As Warren Buffett famously said in his 2001 Chairman’s Letter, “you only find out who is swimming naked when the tide goes out.” According to a criminal complaint and press reports, the tide has clearly gone out on Bernard L. Madoff Investment Securities LLC and its founder Bernard Madoff, and a number of prominent funds of hedge funds have been caught swimming sans bathing trunks. Specifically, a significant part of the value proposition of funds of funds is the ostensibly rigorous due diligence they perform on underlying managers. Yet some of the biggest names in the fund of funds world appear to have invested in Madoff investment vehicles without performing adequate due diligence. The anticipated losses of such names from the Madoff scandal emphasize the central importance of due diligence, especially for funds of funds, and the inadequacy of exclusive or near-exclusive reliance on personal relationships in making investment decisions. We explore the implications of the Madoff scandal on the rigor and content of due diligence that should be performed by funds of funds prior to and after investing in underlying funds.
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From Vol. 1 No.24 (Nov. 12, 2008)
Petters’ Fraud Underlines Need for Vigilant Due Diligence
Several hedge funds have been caught in a large-scale fraud alleged against Tom Petters, former CEO of Petters Companies Inc. Based on a review of court filings and interviews with managers and attorneys at or representing funds who declined investments in Petters Co., we offer specific suggestions on how hedge funds can approach pre- and post-investment due diligence to avoid getting caught in fraudulent situations.
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From Vol. 1 No.21 (Sep. 22, 2008)
Interview with Kenneth Springer of Corporate Resolutions Inc. on Hedge Fund Manager Due Diligence
An investment in a hedge fund is more than just an investment in assets or instruments in which the fund invests. It’s also an investment in the managers of the fund – and not just in the investment prowess of the managers, but also in their integrity, transparency and forthrightness. An analysis of these factors should figure prominently into initial investment due diligence and ongoing investment monitoring, yet many investors pay inadequate attention to managers’ backgrounds, or lack the tools or know-how to adequately gather and evaluate such information. In this exclusive interview, Kenneth S. Springer, a Wall Street private investigator, former FBI agent and founder of Corporate Resolutions Inc., discusses hedge fund manager due diligence with The Hedge Fund Law Report.
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