The growing trend toward retailization of hedge funds of funds (FOFs) faces a considerable practical hurdle: retail investors demand frequent liquidity, while many of the more interesting opportunities for underlying hedge funds remain in less liquid investments. See, e.g., “Why Does Capital Raising for Distressed Debt Hedge Funds Remain Particularly Challenging Despite the Recent and Anticipated Positive Performance of the Strategy?
,” Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009). For example, Alexandre Poisson, managing director of FOF HDF Switzerland recently stated
that a well-structured FOF portfolio can give investors “monthly access to their money rather than quarterly, without any mismatch.” But he added an important caveat: to accomplish this, the FOF must avoid illiquid strategies among its underlying funds. At best, such avoidance restricts investment decision making. At worst, it renders FOFs ineligible for some of the best opportunities, and thereby constrains alpha. Are there better ways to reconcile liquidity and investment discretion? To address this question – and hopefully to expand the range of options available to FOF managers looking to maintain their strategic approach while accessing a broader retail market – this article discusses the practical and legal bases for the obligation on the part of FOF managers to conduct thorough due diligence, especially with respect to the match between the liquidity of the FOF and the hedge funds in which it invests; the so-called “FOF regulatory loophole”; structural changes in the FOF market; the benefits and burdens of investments by FOFs in only liquid underlying funds; the early notification approach; FOF disclosure matters; side letters; and fee deferrals. In addition, in mid-September 2009, the International Association of Securities Commissions (IOSCO) published a report
titled “Elements of International Regulatory Standards of Funds of Hedge Funds Related Issues Based on Best Market Practices.” The report broadly focuses on liquidity management and due diligence, and is both descriptive and prescriptive. That is, it purports to describe how the market is, and how it should be. We detail the salient points from the IOSCO report, and relay insights from industry participants on the extent to which the report reflects current market practice, and the extent to which the prescriptive sections may change market practice (to the extent they differ from it).