Primary Legal and Business Considerations in Structuring Hedge Fund Capacity Rights

Traditionally, hedge funds and private equity funds have used different funding models.  Private equity funds have used a capital on call model, in which investors agree by contract to contribute a certain amount of capital to the fund, and retain possession of that capital until the manager requests it.  Hedge funds, by contrast, have used an immediate funding model, in which investors actually contribute capital to the fund at the time of investment, and the fund’s custodian retains possession of that capital for the duration of the investment.  (But see “Can a Capital On Call Funding Structure Fit the Hedge Fund Business Model?,” Hedge Fund Law Report, Vol. 2, No. 44 (Nov. 5, 2009).)  However, there is a narrow exception to the immediate funding rule in the hedge fund context.  That exception applies to seed investors and other large, usually early investors in hedge funds (who often simultaneously invest in the hedge fund management entity).  Such investors frequently condition their investments on rights to make additional investments in the fund.  In the hedge fund world, those additional investment rights generally are known as capacity rights.  In effect, investors with capacity rights have the opposite of capital on call.  Instead, they have what might be termed “capital on put.”  Whereas a private equity fund manager has the right to call its investors’ capital, a hedge fund investor with capacity rights has the right to put its capital into the fund.  Capacity rights agreements offer business benefits to managers and investors.  Most notably, they enable start-up managers to bring in anchor investors, and offer anchor investors the opportunity to maximize the value of risky investments with new managers.  But capacity rights agreements also present a variety of legal and practical complications.  The purpose of this article is to highlight some of those complications and, where practicable, offer remedies or solutions.  In particular, this article discusses: the definition of capacity rights; the business rationales for granting (from the manager perspective) or requesting (from the investor perspective) capacity rights; the documents in which such rights are usually memorialized; how such rights are generally structured, including the pros and cons of structuring capacity rights based on dollar amount versus percentage of assets under management (AUM) or total capacity; and various specific concerns raised by capacity rights agreements, including ERISA concerns, concerns relating to most favored nations (MFN) clauses in side letters, the frequently less advantageous economics associated with capital invested pursuant to capacity rights, and fiduciary duty concerns.

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