When and How Can Hedge Fund Managers Engage in Transactions with Their Hedge Funds?
Hedge Fund Law Report
Generally, investors hire hedge fund managers to make decisions – hopefully smart ones – with respect to their assets, rather than to serve as trading counterparties. However, circumstances routinely arise in which transactions between a hedge fund manager and its funds can serve investors more effectively than transactions with third parties or the absence of a transaction. The law does not prohibit such transactions, but it looks with suspicion on them based on the inherent conflicts of interest. Hedge fund managers generally act exclusively as agents on behalf of their funds, but in such transactions, hedge fund managers are acting as both principals (with respect to themselves) and agents (with respect to their funds). That is, hedge fund managers are on both sides of so-called “principal transactions,” which raises the question: how can hedge fund managers trade with their own funds without impairing the interests of fund investors? There are practical and legal answers to this question. The practical answer is that most principal transactions are not zero-sum trades. One party does not gain in direct proportion to what the other party loses. Rather, such transactions are more nuanced and involve other dimensions, such as time, fees and opportunity cost. The legal answer is that the investment Advisers Act of 1940 (Advisers Act) and other authority provide disclosure and consent requirements that hedge fund managers must follow to legally effect a principal transaction. The intent of the legal mechanics is investor protection, or in other words, to ensure that hedge fund managers only effect principal transactions where investor benefits are demonstrably present. One of various challenges faced by hedge fund managers in this context is that the required legal process is ill-suited to the reality of most principal transactions. Obtaining consent, for example, is slow and involved, and many investment opportunities are fast and fleeting. Moreover, available legal guidance is limited and general. Accordingly, hedge fund managers typically look to market practice when engaging in transactions with their funds. This article explains market practice in this area in a thoroughgoing way and also details relevant law and regulation to the extent it exists. In particular, this article begins by describing four categories of situations in which hedge fund managers may wish to engage in transactions with their funds (e.g., certain cross trades). The article then discusses: the practical and legal risks of engaging in such transactions and the concomitant conflicts of interest involved; what types of transactions constitute a “principal transaction” as defined in Section 206(3) of the Advisers Act; the statutory disclosure and informed consent requirements applicable to principal transactions; specific methods used by hedge fund managers to streamline the process for obtaining informed consent; and required compliance policies and procedures.