How Will the SEC’s New Pay to Play Rule Impact Mergers and Acquisitions of Hedge Fund Management Companies?

Three trends are likely to increase the volume of mergers and acquisitions of hedge fund management companies – especially sales of smaller firms to larger firms and sales by banking entities of advisers to “sponsored” hedge funds.  First, various provisions of the Dodd-Frank Act (most notably, the registration provisions) are likely to increase ongoing compliance costs for hedge fund managers.  Many such costs will be fixed, and thus will adversely impact smaller hedge fund managers to a greater degree than larger ones.  Some of those smaller managers will determine that selling the advisory business is preferable to continuing to operate independently.  See “For Managers Facing Strong Headwinds, Sales of the Advisory Business Offer a Means of Preserving the Franchise While Avoiding Fund Liquidations,” Hedge Fund Law Report, Vol. 2, No. 11 (Mar. 18, 2009).  Increased compliance costs also are likely to deter, at the margin, entry into the hedge fund management business by potential startups.  Second, the version of the Volcker Rule included in the Dodd-Frank Act is likely to cause some investment and commercial banks to divest certain internal hedge fund management businesses.  See “Implications of the Volcker Rule – Managing Hedge Fund Affiliations with Banks,” Hedge Fund Law Report, Vol. 3, No. 10 (Mar. 11, 2010).  In cases where banks purchased going hedge fund management concerns rather than developing them internally, management buyouts may be a common deal structure.  Also, various hedge fund industry participants expect the Volcker Rule to displace traders and portfolio managers currently working at investment banks on proprietary trading desks or at in-house hedge funds.  Certain of those traders and managers will start new hedge fund management firms: some of those new firms will fail, some will continue independently and some will be sold to established players.  See “Stars in Transition: A New Generation of Private Fund Managers,” Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).  Third, the fundraising environment may remain difficult, causing smaller managers to sell to larger managers with more developed marketing and distribution infrastructures.  Indeed, distribution is a key consideration even in deals involving larger hedge fund managers: the proxy statement relating to Man Group’s acquisition of GLG Partners cited Man’s distribution capabilities as one of the strategic benefits of the transaction.  See "Transaction Analysis: Hedge Fund Managers Man Group and GLG Partners Announce Plans to Merge,” Hedge Fund Law Report, Vol. 3, No. 21 (May 28, 2010).  (That acquisition is expected to close in the third quarter of 2010.)  The SEC’s recently approved pay to play rule (Rule) introduces a new category of legal risk into mergers and acquisitions of hedge fund management companies.  See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures and Marketing Practices in Light of the SEC’s New ‘Pay to Play’ Rule?,” Hedge Fund Law Report, Vol. 3, No. 30 (Jul. 30, 2010).  At best, the Rule will add new categories of due diligence, new integration tasks and new post-closing training requirements to such transactions.  At worst, the Rule will delay or even derail such transactions.  This article identifies concerns raised by the Rule in the hedge fund manager M&A context, and offers strategies to address them.  Specifically, this article outlines fact patterns in which the Rule can adversely affect the outcome in the purchase or sale of a hedge fund management business; identifies notable recent investment management merger and acquisition transactions and transaction trend statistics; lists the four primary options available to hedge fund managers or others to prevent or remedy violations of the Rule in connection with acquisitions of hedge fund management businesses; discusses the pros and cons of each of the primary options; and outlines five alternative options, and the benefits and burdens of each.

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