Investment products and services exist along a spectrum of customization, and, as a general matter, the bigger the investment ticket, the more customized the investment experience. At the least customized end of the spectrum are mutual funds, effectively adhesion contracts in which investors typically have discretion over price, quantity and timing, but little else. See “PLI Panel Addresses Recent Developments with Respect to Prime Brokerage Arrangements, Alternative Registered Funds and Hedge Fund Manager Mergers and Acquisitions
,” Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013). At the most customized end of the spectrum are family offices
, and, just short of that, individual hedge fund style investment vehicles such as “funds of one” and managed accounts. See “RCA Symposium Clarifies Current Market Practice on Side Letters, Conflicts of Interest, Insider Trading Investigations, Whistleblowers, FATCA and Use of Managed Accounts Versus Funds of One (Part One of Two)
,” Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013). Even within commingled hedge funds, the rights and obligations of investors are typically not uniform. Smaller investors generally get the default terms of the PPM, while larger investors sometimes customize their deal by side letter
or otherwise. Side letters often modify default fund terms relating to liquidity
. Liquidity relates to the right to redeem from a fund, in whole or in part, and transparency relates to the right to know what’s going on in a fund. But sometimes investors will wish to avoid a specific investment while not redeeming from the fund, in whole or even in part. That is, investors sometimes want (or need) investment-specific liquidity rather than fund-level liquidity. In practice, managers can grant investment-specific liquidity by offering investors the right to opt out of designated investments. The concept of investment opt outs originated (at least within the private fund space) in private equity and still looms larger in private equity funds than hedge funds. However, as hedge funds pursue an ever-expanding range of investment strategies – some of which resemble classic private equity – more and more managers are being confronted with requests from investors for investment opt-out rights. Accordingly, the Hedge Fund Law Report is undertaking a three-part series analyzing the rationales for opt-out rights in the hedge fund context, and the legal and operational challenges involved in granting and implementing such rights. This article, the first in the series, explores eight reasons why investors may demand and managers may grant opt-out rights. The second installment will address the structure and exercise of opt-out rights, as well as regulatory risks associated with offering such rights. The third installment will continue the discussion of risks associated with opt-out rights, focusing on regulatory and other risks, and will conclude with a discussion of best practices for implementing such rights.