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    Dec. 17, 2009

How Can Start-Up Hedge Fund Managers Use Past Performance Information to Market New Funds?

Recent market dislocations have given rise in the hedge fund industry, as in other industries, to an increasing crescendo of entrepreneurship.  According to data from Hedge Fund Research Inc., 224 hedge funds launched worldwide during the third quarter of this year, while 190 closed in the same period – the first time since early 2008 that the number of new launches exceeded the number of closures.  While compensation has come down on average, especially at firms under their high water marks, so has the opportunity cost of casting out on one’s own.  See “How Are Hedge Fund Managers with Funds Under their High Water Marks Renegotiating Performance Fees or Allocations?,” Hedge Fund Law Report, Vol. 2, No. 33 (Aug. 19, 2009).  In short, for star traders on broker-dealer prop desks, second chairs, co-managers and trusted lieutenants, the climate for hedge fund entrepreneurship is unusually fertile.  See “As Banks Close Prop Desks and Traders Move to Hedge Funds, Hedge Fund Managers Focus on Permissible Scope of Use of Confidential Information,” Hedge Fund Law Report, Vol. 2, No. 18 (May 7, 2009).  While hedge fund entrepreneurs face all of the usual issues involved in entrepreneurship – employment matters, office leases, professional services fees, etc. – they also face certain issues unique to the hedge fund industry.  See “Stars in Transition: A New Generation of Private Fund Managers,” Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).  Chief among those unique issues are the legal and regulatory limitations on what a hedge fund entrepreneur can communicate to potential investors in the new funds or management entity with respect to prior performance.  Specifically, despite the ubiquity of the disclaimer stating that past performance does not guarantee future results, there remains no more reliable predictor of future results than past performance.  Accordingly, new investors are keenly interested in past performance, and for any hedge fund entrepreneur that seeks to create a viable business, the question is not whether to communicate past performance, but how.  The short answer is: carefully.  Few topics are as central to marketing discussions when launching a new hedge fund management company and new hedge funds, and few topics are as fraught with legal risk.  In an effort to help hedge fund entrepreneurs navigate the thicket of relevant regulation, this article analyzes in depth the laws, rules, regulatory pronouncements (in particular, no-action letters) and market practices governing the permissible and impermissible uses of past performance data when launching new funds or managers.  While the authority is complex and fact-specific, this article extracts and drills down on five broad principles that new managers would be well-advised to keep in mind during (and even after) new fund or manager launches.  Within those five broad principles, this article describes concrete strategies that managers can follow to stay within the rules governing the use of past performance information in marketing efforts.  This article also details the key points from the seminal Clover Capital no-action letter.

Implications of the New U.K. Offshore Funds (Tax) Regulations for U.K. and Global Hedge Fund Managers and Investors

On November 12, 2009, the new Offshore Funds (Tax) Regulations 2009 were enacted in the United Kingdom (U.K.).  At a general level, the new U.K. tax regime may have a profound effect on the tax rate paid by U.K.-based investors in offshore hedge funds.  Specifically, the new regime has the potential to narrow the circumstances in which U.K.-based investors in offshore hedge funds are required to pay tax on most returns at higher income tax rates, as opposed to lower capital gains tax rates.  Next year, the highest marginal income tax rate in the U.K. may rise to 50 percent, while the capital gains rate for individuals is likely to remain at 18 percent.  While the new regulations remain subject to final legal and technical checks, they will be effective for accounting periods beginning on or after December 1, 2009.  For several years, the U.K. government has been working on replacing the “distributing funds” tax regime with a “reporting funds” regime; the new regulations embody a “reporting funds” regime.  Although the general purpose of both regimes is the same – to prevent investors from rolling up income offshore and paying tax at a lower capital gains rate when the relevant investment is sold – the change in regime may affect the type of fund that may generate returns subject to capital gains treatment for U.K. investors.  This article outlines the mechanics of the new regulations and examines their likely effect on U.K. and global hedge fund managers and investors.  In particular, this article details: the definition of “offshore fund” under the new regulations; reporting versus distributing funds; the new rules with respect to investments by offshore funds in other offshore funds; transitional arrangements; cross investments; the white list of qualifying transactions that will be treated for tax purposes as investment activities as opposed to trading activities; and administrative and legal consequences of the new tax regime.

Regulatory Compliance Association Hosts Program on Increased Risk for Hedge Fund Directors and Officers in the New Era of Heightened Regulation and Enforcement

On December 9, 2009, The Regulatory Compliance Association (RCA) hosted a teleconference titled “Director and Officer Liability Escalate in the New Era of Heightened Regulation,” as part of its CCO University Outreach Series.  Walter Zebrowski, CIO and COO for Hedgemony Partners and Chairman of the RCA, explained in his introductory remarks that the “aftermath of the financial collapse coupled with the new era of heightened regulation shall significantly intensify the scrutiny and liability for directors and officers.”  The event was moderated by Richard Maloy, CIC, CRM, Chairman and CEO of Maloy Risk Services.  The panelists included Peter Welsh, a Partner at Ropes & Gray LLP; Ingrid Pierce, a Partner at Walkers Global; and Michael Pereira, Publisher of the Hedge Fund Law Report.  The panelists discussed issues including: the increased effectiveness on the part of regulators, especially the SEC; pending legislation relating to registration of hedge fund managers, and the practical burdens that registration would (and would not) entail; liquidity and regulation of the insurance industry; demands from institutional investors and insurance underwriters for transparency from hedge funds and managers; the role of independent directors; claims trends, including insider trading (and 12 specific strategies that may be used to avoid insider trading allegations); the institutionalization of the hedge fund industry; and the changing directors and officers (D&O) insurance landscape.  This article summarizes the speakers’ insights on the foregoing issues, and highlights the salient points raised by the speakers on related topics.

Infovest21’s Annual Hedge Fund Manager Compensation Survey Reveals Top Paid Manager Positions and Top Factors Affecting Performance

Infovest21, LLC, an information services company for the hedge fund industry, conducted its eighth annual executive compensation survey of hedge fund managers in the fall of 2009.  The survey aimed to: (1) analyze the compensation structures of hedge fund managers during the current year; and (2) examine major trends as perceived by fund managers.  It analyzed results separately for those managers with assets over $1 billion and those with assets under $1 billion.  This article focuses on the salient findings from the former category, addresses the survey’s approach and methodology and describes the profile of the respondents surveyed (including an analysis of recent cost cutting efforts).  Importantly, this article also details compensation trends for employees at various levels at hedge fund managers, factors affecting compensation and the impact of asset size on the survey findings.

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.

Prospectus for Suspended Ellington Financial IPO Details Mechanics of a Hedge Fund Permanent Capital Vehicle

Only days after Ellington Financial LLC (Ellington), run by Michael Vranos’ hedge-fund firm, Ellington Management Group, LLC (Manager), filed a prospectus with the SEC announcing a planned initial public offering (IPO) to raise cash in order to purchase mortgage-backed bonds, Ellington suspended the IPO due to “market conditions.”  The IPO was premised on the idea that investors would be willing to purchase Ellington shares at a premium, an average of $26 per share, 6.1 percent more than the value of its net assets, or 1.06 times Ellington’s shareholder equity, so that Ellington could invest in potentially underrated home loans in the recovering United States housing market.  While the IPO has ceased, its mechanics and the risk factors discussed in the Ellington prospectus remain particularly interesting for hedge fund managers contemplating a similar issuance of shares to obtain so-called “permanent capital” for the purpose of investing in designated assets.  This article summarizes the material terms and provisions of the Ellington prospectus and the suspended IPO.

Gregory Fleming Joins Morgan Stanley as President of Morgan Stanley Investment Management

On December 13, 2009, Morgan Stanley announced that Gregory J. Fleming will join the firm as President of Morgan Stanley Investment Management, including Merchant Banking.  Fleming will also be responsible for Global Research.

Morgan Stanley Appoints Edward Keller to Oversee North American Prime-Brokerage

Morgan Stanley recently appointed Edward Keller to oversee its North American prime-brokerage business.  Keller will oversee securities and cash lending and other prime-brokerage services catering to hedge fund clients in the U.S.

Hogan & Hartson and Lovells Vote to Combine Effective May 1, 2010

On December 15, 2009, international law firms Hogan & Hartson LLP (founded in Washington, D.C.) and Lovells LLP (with a principal place of business in London) jointly announced that their respective partnerships approved the merger of their firms.  The combined firm will be known as Hogan Lovells, effective May 1, 2010.

Offshore Law Firm Mourant Welcomes James Wauchope as Equity Partner in the Cayman Islands

James Wauchope recently joined Mourant du Feu & Jeune as an equity partner.  He specializes in establishing, maintaining and restructuring Cayman Islands hedge, hybrid and private equity funds.

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