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    Jun. 3, 2009

Certain Hedge Funds are Using Enhanced Investor Liquidity as a Marketing Tool

The credit crisis has been caused in large part by financial market participants assigning too great a value to assets.  In the hedge fund context, however, the crisis has also highlighted an asset to which managers and investors historically have assigned too little value: liquidity.  As formerly liquid markets froze in late 2007 and 2008, liquidity assumed a more prominent place in the total mix of value offered by certain hedge funds.  Along with absolute return, diversification, low correlation with traditional asset classes and access to unique strategies, liquidity became something many investors wanted but only a handful of managers could deliver.  In a word, during the crisis, liquidity was in high demand and short supply.  As markets have begun to thaw – or at least the perception of a thaw has become more widely held among market participants – supplying liquidity has become more feasible, yet the demand for liquidity remains every bit as strong (and shows little sign of abating).  Where practicable (an important caveat), hedge fund managers are meeting this demand with new or restructured funds with enhanced liquidity terms.  In particular, managers are enhancing liquidity by: (1) shortening the initial lock-up period, that is, the period during which an investment cannot be redeemed or can only be redeemed subject to a significant penalty; (2) offering redemptions without penalties at more frequent intervals following the initial lock-up period; (3) shortening the notice required in connection with redemption requests; and (4) restricting the range of tools available to the manager to suspend or delay redemptions (such as gates or suspensions).  The primary goal of offering increased liquidity is raising and retaining assets at a time when the balance of power still tips in favor of institutional investors.  We detail specific terms that managers are changing to enhance liquidity, and explore how to manage redemptions in light of enhanced liquidity, what types of funds can offer enhanced liquidity and potential detriments for the manager and non-redeeming investors.  In addition, we highlight two benefits to the manager of enhanced liquidity that have received little attention to date.

Hedge Fund Managers Using “Mini-Master Funds” to Retain Favorable Tax Treatment of Performance-Based Revenue from Offshore Funds

With the passage last year of legislation eliminating the ability of U.S. hedge fund managers to defer taxes on fee income from their offshore funds, managers are increasingly employing so-called “mini-master funds” to obtain a different kind of favorable tax treatment for the same revenue.  Traditionally, in a master-feeder structure, managers would enter into an investment management agreement with the offshore fund, which in turn would invest substantially all of its assets (from non-U.S. and U.S. tax-exempt investors) in a master fund.  The investment manager would charge the offshore fund a “performance fee” of 20 percent of the gains on its investment in the master fund.  Before last year, managers were able to defer tax on the performance fee by reinvesting it in the offshore fund.  However, Internal Revenue Code Section 457A, adopted as part of the Emergency Economic Stabilization Act of 2008, disallows such fee deferrals and requires hedge fund managers to take all existing deferrals into income by 2017.  Mini-master funds seek to circumvent this rule by converting the performance “fee” into a performance “allocation.”  We explain precisely how mini-masters can accomplish this, and in the course of our discussion explore traditional fee deferrals, the operation of Section 457A, the tax effect of mini-masters, jurisdictional issues and what proposals relating to the taxation of carried interest may mean for the continued utility of mini-masters.  See “IRS Releases Further Guidance Affecting Offshore Hedge Fund And Other Pooled Investment Vehicle Deferrals,” Hedge Fund Law Report, Vol. 2, No. 6 (Feb. 12, 2009).

Bill Requiring Hedge Fund Managers to Disclose “Material Conflicts of Interest” Passes Connecticut State Senate

On May 26, 2009, Connecticut’s Senate passed a bill that, if passed by the House and signed into law by the Governor, would require investment advisers to hedge funds and other private investment funds, whether or not registered with the Securities and Exchange Commission (SEC), to disclose “material conflicts of interest.”  The heart of Connecticut Senate Bill No. 953, “An Act Concerning Hedge Funds,” is Subsection 1(b), which provides: “Any investment adviser to a private investment fund, regardless of whether such investment adviser is registered with the United States Securities and Exchange Commission, shall comply with the disclosure requirements of Rule 204-3 under the Investment Advisers Act of 1940 . . . provided nothing in this subsection shall require the disclosure of any information other than material conflicts of interest of the investment adviser.”  We explore the bill’s legislative history, likelihood of passage, interaction with federal bills covering substantially similar substantive areas, the role of the Connecticut Banking Commissioner and the operation of Advisers Act Rule 204-3.

SIFMA and MFA Object to Proposed NASDAQ Sponsored Access Rule 4611

On January 22, 2009, the Nasdaq Stock Market LLC published proposed amendments to Nasdaq Rule 4611(d) to modify the requirements for members who provide “sponsored access” to Nasdaq’s execution system.  Sponsored access occurs when an exchange member provides its clients, often hedge funds, with direct electronic access to the exchange using the member's identifier.  Under this arrangement, the customer receives a dedicated line or port to the exchange's execution system, so that its orders do not first pass through the member's systems before reaching the exchange.  Nasdaq’s proposed amendments aim to ensure that the exchange, as well as members assuming responsibility for their customers’ trading activity, retains effective oversight.  Key industry groups, however, have voiced objections.  Those industry groups include The Managed Funds Association and The Securities Industry & Financial Markets Association.  We detail the proposed rule and the industry response.

Proposed Model Act Would Severely Undermine Participation by Hedge Funds as Sellers of Protection Under Credit Default Swaps

The National Conference of Insurance Legislators is circulating a draft of a model act (Model Act) that would have the adopting states regulate credit default swaps under provisions patterned on New York State’s current regulation of financial guaranty insurance.  The Model Act would provide that “credit default insurance may be transacted in this state only by a corporation licensed for such a purpose,” and it imposes a variety of requirements upon the licensees.  This article reviews the draft, analyzes how it would operate and then discusses the conflict between an approach to regulation that would empower the insurance departments of 50 states and one that would employ a single regulatory policy.

Committee on Capital Markets Regulation Releases Report on How to Reduce Systemic Risk in the American Financial System

On May 26, 2009, the Committee on Capital Markets Regulation, an independent and nonpartisan research organization made up of 25 industry leaders, released a report entitled, “The Global Financial Crisis: A Plan for Regulatory Reform.”  The report outlines the committee’s plans for creating a more effective and more investor-friendly American financial regulatory structure.  The Committee posits that the most effective system of regulation must achieve four critical objectives: (1) reduced systemic risk; (2) increased investor protection through greater transparency; (3) a unified financial regulatory system with greater accountability; and (4) a coordinated international approach based on globally coordinated rules.  We offered a detailed synopsis of the report.

“A Failure of Capitalism: The Crisis of ‘08 and the Descent into Depression,” by Richard A. Posner; Harvard University Press, 368 pages

The Honorable Richard A. Posner, a judge of the United States Court of Appeals for the Seventh Circuit and Senior Lecturer in Law at the University of Chicago Law School, first gained prominence in the 1980’s as a leader of a scholarly movement that analyzed legal questions through the prism of free-market economics.  In his latest book, “A Failure of Capitalism,” he offers a meticulous overview of the recent financial crisis and attributes its origins to the absence of rational government oversight, and to the rational (and to be expected) self-interest of private actors who took advantage of the economic environment and deficient regulatory framework.  To resolve the crisis and prevent its repetition, Posner advocates that the government should impose more intensive regulation, substantially increase deficit spending, prop up the banking industry, reform the current regulatory framework and relieve mortgagors of some of the burden of their mortgages.  We provide a detailed review of Posner’s book.

Aladdin Capital Holdings Appoints Stephen Mandella Chief Operating Officer/Chief Financial Officer

On June 1, 2009, Aladdin Capital Holdings announced that it had appointed Stephen Mandella as its Chief Operating Officer/Chief Financial Officer.

Northern Trust Announces New Feature to Enable Funds of Funds to Assess the Impact of Gates on Their Liquidity In Real Time

On May 21, 2009, Northern Trust announced that it had enhanced its offering to funds of hedge funds (FoHF) clients with a new feature that enables FoHF managers to assess the impact of gates on their liquidity in real time.

HedgeOp Compliance Announces Release of ComplianceTrak Adviser Platform

On May 19, 2009, HedgeOp Compliance, LLC, a provider of specialized compliance software and consulting services for asset managers, announced the release of the ComplianceTrak Adviser Platform, a tool designed to help small and mid-size registered investment advisers meet the continually evolving demands of today’s regulatory environment.

European Covered Bond Dealers Association Covered Bond Survey Shows Sustained Investor Appetite for Covered Bonds

On May 19, 2009, the European Covered Bond Dealers Association released its first Annual European Covered Bond Investors Survey.  Completed by key European covered bond investors over the course of Q1 2009, the survey broadly represents the market with responses from 65 investors spanning 18 different countries.

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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