What Is the “Market” for Fees and Other Key Terms in Agreements between Hedge Fund Managers and Placement Agents?

Historically, hedge fund managers have retained placement agents and other third-party intermediaries to identify investors, obtain investments and for related purposes.  Hedge fund managers’ use of placement agents is likely to continue and even increase for two simple reasons: because such use is permitted, and because it can add value.  On the first point, the fact that hedge fund managers can use placement agents is only news because between August 2009 and June 2010, the continued viability of that use was in doubt.  In short, in August 2009, the SEC proposed a pay to play rule that would have prohibited hedge fund managers from using placement agents (or “third-party solicitors,” “solicitors,” “finders” or “pension consultants”) to obtain investments from public pension funds.  Given the importance of public pension funds in the hedge fund investor base – according to Preqin, public pension funds comprise approximately 17 percent of all institutional hedge fund investors – many in the hedge fund industry thought that the proposed ban marked the beginning of the end of the use by hedge fund managers of placement agents.  See, e.g., “The Four P’s of Marketing by Hedge Fund Managers to Pension Fund Managers in the Post-Placement Agent Era: Philosophy, Process, People and Performance,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009).  However, the final pay to play rule, adopted by the SEC on June 30, 2010, did not prohibit hedge fund managers from using placement agents to solicit investments from public pension funds, but rather permitted such use so long as the relevant placement agent is a registered investment adviser or registered broker-dealer.  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).  Along similar lines, on September 2, 2010, the SEC adopted a temporary rule (Rule 15Ba2-6T under the Securities Exchange Act of 1934) requiring municipal advisors to register with the SEC by October 1, 2010 (i.e., within three weeks).  This rule does not prohibit the use by hedge fund managers of “finders,” “solicitors” or other previously unregistered entities to obtain investments from public pension funds, but it may require such entities to register with the SEC.  See “Third-Party Marketers that Solicit Public Pension Fund Investments on Behalf of Hedge Funds May Have to Register with the SEC within Three Weeks,” below, in this issue of Hedge Fund Law Report.  In short, while the legal and regulatory environment for placement agents has become more complex, their activities are, in general, still legally permitted.  And on the second point – the idea that placement agents can add value – there are two categories of rationales for this idea: micro rationales and macro rationales.  The micro rationales – the specific categories of services that placement agents are well-positioned to provide to hedge fund managers – are detailed below.  As for the macro rationales, four trends suggest that placement agents will play an increasingly important role in the allocation of capital to hedge funds.  First, a disproportionate volume of recent inflows have gone to larger managers.  Second, according to Preqin, 29 percent of institutional investors plan to invest more capital in hedge funds over the next 12 months than they did during the previous 12 months, and 46 percent of investors plan to increase their hedge fund allocations in the next three to five years.  Third, according to Preqin, 37 percent of institutional investors plan to direct any hedge fund allocations in the short to medium term to a mixture of new and existing managers, and 23 percent of institutional investors plan to invest in new managers only (that is, new to the investor, though not necessarily new to the market, i.e., not necessarily startup managers).  Fourth, according to Preqin, “firm reputation” is tied with “track record” as the second most important factor for institutional investors when making hedge fund allocations.  The point: capital is likely to flow into hedge funds over the next five years, but if you are anything other than a large, established manager, the competition for capital is likely to remain fierce.  And importantly in an industry where performance is easily measured, readily comparable and frequently updated, even “large, established managers” can stumble in terms of size and stature, and find themselves pounding the proverbial fundraising pavement once again.  In light of the anticipated importance of placement agents in steering capital into hedge funds over the next (at least) five years, this article seeks to shed light on a relatively obscure topic: the “market” for fees and other terms in agreements between hedge fund managers and placement agents.  Specifically, this article first identifies seven distinct reasons why a manager may hire a placement agent, then details the most important terms of, and issues in connection with, placement agent agreements, including the following: fee structures and levels; declining fees; duration of engagements and sunset provisions; carve-outs for the manager’s pre-existing relationships; exclusivity; licensing, registration and representations with respect to both; indemnification; insurance; and the pay to play overlay.

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