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.

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