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    Dec. 1, 2011

Legal Mechanics of Converting a Hedge Fund Manager to a Family Office

Over the past two years, a number of prominent hedge fund managers have decided to return capital to outside investors and to restructure their businesses as family offices.  In August 2010, Stanley Druckenmiller announced he was winding down Duquesne Capital Management LLC to create a family office to oversee some of his $2.8 billion fortune.  In February 2011, Chris Shumway announced that he would return outside money invested in Shumway Capital Partners because of increased fund liquidity risks, and would focus on managing internal capital.  In March 2011, Carl Icahn announced he would return money to outside investors and convert Icahn Associates into a family office, citing a desire not to disappoint investors should another financial crisis erupt.  In July 2011, George Soros noted in an investor letter that he intended to return nearly $1 billion to outside investors and to convert Soros Fund Management into a family office, citing regulatory uncertainty as a key reason for his decision.  In August 2011, Edward Perlman announced that he planned to return nearly $470 million to investors and to convert Scottwood Capital Management into a family office, citing increased risks in the credit markets and regulatory uncertainty.  Many hedge fund managers cite the burdens associated with the heightened regulatory scrutiny facing hedge fund managers for their decision to restructure their businesses as family offices.  As a result of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), many large fund managers that have historically been exempt from registration as investment advisers pursuant to the Investment Advisers Act of 1940 (Advisers Act) will need to register by March 30, 2012 unless an exemption or exclusion is available.  While the Dodd-Frank Act mandated adviser registration for many advisers, it also provided several narrowly-tailored exemptions and exclusions, including an exclusion for family offices whereby family offices are not only exempt from registration as investment advisers, but also are excluded from the definition of an investment adviser altogether, which means that they are not subject to the Advisers Act.  For a thorough description of the definition of a “family office” and related definitions, see “Developments in Family Office Regulation: Part Three,” Hedge Fund Law Report, Vol. 4, No. 23 (Jul. 8, 2011).  This article starts by providing a detailed catalog of the primary benefits of converting a hedge fund manager to a family office and the primary downsides of such a conversion.  For managers who determine that the benefits outweigh the burdens, this article then provides a roadmap of the primary legal and practical mechanics involved in such a conversion.  Moving to a family office structure implicates considerations well beyond law and business – considerations relating to legacy, family, time and life goals.  Such considerations are beyond the purview of this or any other practical publication; rather, they are the province of deep thought, reflection, conversation and exploration.  But for managers who have undertaken the hard analysis and determined that the family office structure fits their goals, this article provides a useful starting place for identifying the relevant issues and taking the first steps.

Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part One of Four)

Over the past 24 months, many articles have been written about global hedge fund managers expanding into Asia.  Indeed, with global markets continuing to experience volatility and Western governments facing significant challenges, many are looking East.  In the current environment, there are many reasons why a U.S.- or European-based manager may choose to open an office or offices in Asia, including, among other things, access to an abundance of Asian investment opportunities and favorable regulatory treatment in certain Asian jurisdictions.  See “AsiaHedge Study Finds That a Growing Proportion of Hedge Funds with Asia-Focused Strategies are Managed from Asia,” Hedge Fund Law Report, Vol. 4, No. 36 (Oct. 13, 2011).  Establishing an office in Asia can also facilitate tax-efficient deployment of certain Asia-focused investment strategies.  For these and other reasons, many international hedge fund managers have established satellite offices in Asia.  Before embarking on this venture, however, a manager should carefully evaluate the host of considerations critical to determining whether and how to accomplish this task.  Hong Kong and Singapore remain the two most common destinations for offices in Asia; Mumbai, Beijing and Sydney are also home to fund managers, but generally host country-specific strategies.  In this guest article, Maria Gabriela Bianchini, founder of Optionality Consulting, a Singapore-based consulting firm specializing in assisting hedge funds with regulatory and operational issues, provides a roadmap for opening up a subsidiary office in Hong Kong or Singapore.  In particular, Bianchini discusses the impact of the following factors, among others, in determining whether to open an office in Hong Kong or Singapore: composition of the manager’s portfolio; tax treaty status in light of the manager’s investment strategies; whether the purpose of the office is investment or marketing; licensing and regulatory issues; number of people in the office; whether the manager focuses on fixed income, equities, illiquid assets or other strategies; access to deal and information flow; access to talent; and personal decisions (such as housing, schools for children and related considerations).  This article is the first in a four-part series by Bianchini to be published in the Hedge Fund Law Report.  Part two will discuss practical considerations and guidance with respect to opening an office in Singapore and Hong Kong, Part three will discuss the changing regulatory landscape affecting managers in Singapore and Part four will conclude with a discussion of Hong Kong.

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.

Recent FSA Settlement Helps Define the Scope of Potential Liability of the Chief Compliance Officer of a U.K. Hedge Fund Manager

In the heightened global regulatory climate, chief compliance officers of hedge fund managers are rightfully concerned about being held liable for their own acts or omissions, or for those of other employees of the management company.  See “Can the Chief Compliance Officer of a Hedge Fund Manager be Terminated for Investigating a Potential Compliance Violation by the Manager’s Principal, CEO or CIO?,” Hedge Fund Law Report, Vol. 4, No. 2 (Jan. 14, 2011).  A recent investigation and settlement by the U.K. FSA helps to define the scope of potential CCO liability and the standard of care applicable to CCOs presented with “red flags.”  See also “To Whom Should the Chief Compliance Officer of a Hedge Fund Manager Report?,” Hedge Fund Law Report, Vol. 4, No. 22 (Jul. 1, 2011).

Motion for Appointment of an Examiner in Dynegy Bankruptcy Illustrates the Divergence of Interests of Investors in Equity and Debt of the Same Issuer Group

In the latest round of sparring between holders of bonds guaranteed by bankrupt defendant Dynegy Holdings LLC (Dynegy Holdings) and Dynegy’s equity holders, the indenture trustee for those bonds has moved that the Bankruptcy Court appoint an examiner to review the circumstances under which Dynegy sold its profitable coal-fired power plants to its parent company, Dynegy Inc., shortly before Dynegy Holdings filed for Chapter 11 protection.  Dynegy Inc. is not in bankruptcy and its shareholders stand to benefit from the deal at the expense of Dynegy Holdings’ bondholders.  The indenture trustee alleges, among other things, that the sale of assets was for less than fair value, involved self-dealing by Dynegy directors and was structured to frustrate the bondholders’ efforts to challenge the deal.  This article summarizes the bondholders’ allegations and legal arguments.  More generally, the motion illustrates one of the many fact patterns in which interests of holders of equity and debt of the same issuer group may diverge in a bankruptcy.  Hedge funds often get involved in distressed situations at different levels of the capital structure, and this article helps clarify the relative strengths and weaknesses of equity versus debt.  More generally, this article demonstrates that court decisions can affect investment outcomes in distressed investing as or more powerfully than economic fundamentals.  Given the unpredictability of legal outcomes, distressed investing – whether via debt, equity or something else – may offer a genuinely uncorrelated investment opportunity, which is increasingly rare in this era when debt, equity and even some commodity markets are moving in unison, all with an eye on Europe.  See “The Impact of Asymmetric Information, Trade Documentation, Form of Transfer and Additional Terms of Trade on Hedge Funds’ Trade Risk in European Secondary Loans (Part Two of Two),” Hedge Fund Law Report, Vol. 4, No. 38 (Oct. 27, 2011).

Recent SEC Enforcement Action Provides a Dramatic Example of Style Drift in the Hedge Fund Context

Style drift generally refers to a situation in which a hedge fund manager tells investors he will do X and instead he does Y.  At its worst, style drift constitutes a classic “bait and switch.”  A manager promises a safe and sober investment strategy and does something wild and risky.  In its more innocuous forms, style drift is a matter of degree.  A recent SEC enforcement action illustrates style drift of the former, more egregious, type.  While bad facts make bad law, this enforcement action nonetheless illustrates rather starkly one of the ways in which a hedge fund manager may depart from its representations, and the importance of identifying a manager’s outside business activities.  Our article on the matter, accordingly, will help investors ask questions in ongoing due diligence to ascertain the consistency of a manager’s actual investments with its represented investment strategy.

Kristin Snyder Named Head of Examinations Program in SEC’s San Francisco Regional Office

On November 29, 2011, the Securities and Exchange Commission (SEC) announced the appointment of Kristin Snyder to lead the examinations program in the agency’s San Francisco Regional Office.  See “SEC Exams of Hedge Fund Advisers: Focus Areas and Common Deficiencies in Compliance Policies and Procedures,” Hedge Fund Law Report, Vol. 4, No. 38 (Oct. 27, 2011).  To prepare for a visit from Snyder, see “Legal and Practical Considerations in Connection with Mock Examinations of Hedge Fund Managers,” Hedge Fund Law Report, Vol. 4, No. 26 (Aug. 4, 2011).  And, more generally, please refer to the “Examinations” section of our Archive.

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