One of the categories of questions most frequently posed by hedge fund managers to outside counsel is: Who should bear the cost of this or that expense – the manager or one or more of its funds? Generally, the answer is governed by the organizational documents of the manager and its funds, which in turn are drafted in the shadow of legal principles that provide, at best, indirect guidance on allocating expenses. That is, the SEC and other regulators have not provided specific guidance to hedge fund managers on how to allocate expenses. This is partly because such guidance would not be practicable – expense types are more various than routine rulemaking can accommodate – and partly so that agencies can reserve enforcement and examination discretion. At the same time, the stakes of such questions have increased because the costs of operating a hedge fund management business have increased, thanks to Dodd-Frank, the presence examinations initiative
and an evolving set of investor expectations
more focused on infrastructure, compliance and risk management
. See “Citi Prime Finance Report Dissects the Expenses of Running a Hedge Fund Management Business, Identifying Components, Levels, Trends and Benchmarks
,” Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013). In short, hedge fund managers have a growing number and volume of expenses and little in the way of reliable guidance on allocating them. Hence the frequency of calls to outside counsel on this topic. In an effort to short-circuit, or at least shorten, some of those calls – to make our in-house counsel subscribers more informed purchasers of legal services; to enable our law firm partner subscribers to deliver lower-margin services more efficiently, the better to focus on higher-margin services; and to refine the due diligence practices of our institutional investor subscribers – the Hedge Fund Law Report is publishing a two-part series on allocation of expenses among hedge fund managers and their funds. This article, the first in the series, provides an overview of the key issues and challenges inherent in allocation decisions, and outlines various regulatory and other concerns posed by allocation practices. The second article in the series will provide an overview of approaches used by hedge fund managers in allocating expenses; describe challenges associated with disclosure of expense allocation practices; highlight approaches for addressing the allocation of expenses when disclosures are silent with respect to specific expenses; and discuss key controls designed to ensure that expenses are being allocated in accordance with the manager’s policies and procedures.