Placement agents, in-house marketers, data providers and others interviewed by the Hedge Fund Law Report have identified two salient trends in the current hedge fund capital raising environment: the “race to the top” and the growing importance of ERISA money. As discussed below, both trends highlight the importance to the hedge fund industry of a provision in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank or the Act), enacted on July 21, 2010, relating to swaps with “special entities.” On the first trend: The race to the top refers to the fact – good for larger managers, not so good for smaller and start-up managers – that the lion’s share of recent inflows have gone to the largest hedge funds. According to data provider Hedge Fund Research, Inc., 93 percent of the $9.5 billion of net inflows into hedge funds in the second quarter of 2010 went to funds managed by managers with more than $5 billion in assets under management (AUM). And that capital raising advantage is only enhancing the current distribution of assets in favor of larger managers. According to HFR, as of June 30, 2010, managers with $5 billion or more in AUM managed approximately 60 percent of total industry assets of $1.6 trillion. Moreover, HFR data as of June 30 showed that while 342 hedge funds with $1 billion or more in AUM comprised just 4.9 percent of the total number of hedge funds globally, they accounted for 76.1 percent of total industry AUM. While a full analysis of the reasons for this race to the top is beyond the scope of this article, a few of the reasons are discussed herein. However, investors racing to the top may miss many of the more interesting hedge fund investment opportunities. According to research published by PerTrac Financial Solutions in February 2007 and updated to incorporate 2009 data, smaller, younger hedge funds appear to perform better, over longer periods, than larger, older funds. And on the second trend: the Hedge Fund Law Report has and continues to analyze the growing importance of ERISA investors in hedge funds. See, for example, the Hedge Fund Law Report’s three-part series
on ERISA considerations for hedge fund managers and investors. The story here is essentially as follows: private sector pension funds are the most important category of ERISA investor. According to data provider Preqin, as of late 2009, private sector pension funds represented 14 percent of institutional investors in hedge funds and constituted the largest group of investors actively considering their first investment in hedge funds in 2010. Moreover, survey data released by Preqin on August 10, 2010 indicates that 29 percent of institutional investors plan to allocate more capital to hedge funds in the next 12 months while just 15 percent are looking to redeem, meaning the balance of inflows into hedge funds over the next year is expected to be positive. Preqin also found that 37 percent of institutional investors are planning to invest in new hedge funds in the next 12 months. Many of those new investments, often with new managers, will come from private sector pension funds and other ERISA investors. Accordingly, more hedge fund managers (by number and AUM) will become subject to ERISA in the near term. In anticipation of that trend, we have provided managers with a roadmap for accepting ERISA money without materially undermining their investment and operational discretion. See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Three of Three)
,” Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010). In light of the importance of the race to the top and ERISA money to hedge fund capital raising, any legal provision that directly impacts larger hedge funds and hedge funds subject to ERISA (Plan Asset Hedge Funds) is of central importance to the industry. Dodd-Frank contains precisely such a provision. Specifically, Dodd-Frank will require a “swap dealer” or “major swap participant” that enters into a swap with a “special entity” to: (1) have a reasonable basis to believe that the special entity has an independent representative that, among other things, has sufficient knowledge to evaluate the transaction and risks; and (2) comply with certain business conduct standards. As explained more fully below, the definition of “major swap participant” in Dodd-Frank may include large hedge funds, and the definition of “special entity” in Dodd-Frank may include Plan Asset Hedge Funds. See “Hedge Fund Industry Practice for Defining ‘Class of Equity Interests’ for Purposes of the 25 Percent Test under ERISA
,” Hedge Fund Law Report, Vol. 3, No. 29 (Jul. 23, 2010). To help explain the application of this “swaps and special entities” provision of Dodd-Frank to hedge fund managers, swap dealers and others, this article: defines the relevant terms, including a discussion of the extent to which those definitions may include hedge funds and hedge fund managers; offers examples of applications of the special entities provision in the hedge fund context; explains the mechanics of the “reasonable basis test” included in the statute; describes the business conduct standards; then analyzes the elements of the statutory reasonable basis test, including a potential “de facto best execution” standard included in the test.