The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

Articles By Topic

By Topic: Funds of Funds

  • From Vol. 10 No.50 (Dec. 21, 2017)

    Ernst & Young’s 2017 Global Hedge Fund and Investor Survey Examines Hedge Fund Operations; Talent Acquisition and Retention; and Steps Hedge Funds Can Take to Remain Competitive (Part Two of Two)

    Ernst & Young (EY) recently released the results of its 11th annual Global Hedge Fund and Investor Survey. Among other topics, the survey explored issues affecting operational efficiency, including headcount, fees, expense ratios, expense pass-throughs and passively managed funds; and the challenges of attracting, developing and retaining talent. The survey also explored steps fund managers can take to stay competitive in the evolving market. This article, the second in a two-part series, describes the survey’s key findings in these areas. The first article detailed the survey’s results concerning fund managers’ strategic priorities; investor allocation plans; offerings of non-traditional products by hedge fund managers; evolution of hedge funds’ front-office and investment functions; and key industry risks. For coverage of prior EY surveys, see “Hedge Fund Growth Priorities, Fee and Expense Climate, Prime Brokerage and Operational Matters” (Dec. 3, 2015); “Growth Areas for Hedge Fund Managers, Related Costs and Challenges, Operating Expenses and Cybersecurity” (Jan. 15, 2015); and “Trends in Asset Sourcing, Alternative Mutual Funds, Customized Solutions, Staffing, Administrator Shadowing, Expense Pass-Throughs and Outsourcing” (Dec. 5, 2013).

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  • From Vol. 10 No.49 (Dec. 14, 2017)

    Ernst & Young 2017 Survey Examines Hedge Fund Strategic Priorities; Hedge Fund Offerings and Investor Allocations; Evolution of Front Offices; and Industry Risks (Part One of Two)

    Investors are more confident about the ability of hedge funds to outperform other types of investments than they were five years ago, according to the 11th annual Global Hedge Fund and Investor Survey published by Ernst & Young (EY). Conversely, hedge fund managers face significant barriers to entry and competition from specialty managers. The 2017 survey explores – among other things – fund managers’ strategic priorities; investor allocation plans; offering of non-traditional products; evolution of hedge funds’ front-office and investment functions, including separate accounts, customized fund terms, alternative fee structures and use of big data; and key industry risks. This first article in a two-part series summarizes the survey’s findings in these areas. The second article will detail the survey’s results with respect to issues affecting operational efficiency, along with the challenges of attracting, developing and retaining talent, and will offer key takeaways for fund managers revealed by the survey. For coverage of EY’s 2016 survey, see “Industry Risks; Customized and Non-Traditional Products; Investor Allocation Preferences; Fees; and Hedge Fund Growth Priorities” (Dec. 1, 2016); and “Marketing Strategies, Talent Management, Prime Brokerage and Operational Matters” (Dec. 8, 2016).

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  • From Vol. 10 No.32 (Aug. 10, 2017)

    Fund of Funds Shareholders Lack Standing to Challenge Advisory Fees Paid by Underlying Funds

    Section 36(b) of the Investment Company Act of 1940 permits a registered investment company’s shareholders to sue the fund’s investment adviser for breach of fiduciary duty for charging excessive fees to the company. In a recent decision, the U.S. Court of Appeals for the Eighth Circuit ruled that a shareholder of a fund of funds cannot sue the fund’s adviser for fees paid by an underlying fund to its respective investment adviser. As investors choose to invest through funds of funds, as well as the increasingly popular funds of alternative mutual funds, they need to understand what rights and powers they have – and which they cede – under these approaches. Likewise, managers must remain aware of the extent to which their abilities to charge fees could be challenged by underlying investors in fund of fund complexes. This article summarizes the statutory and factual background of the suit and the Eighth Circuit’s reasoning. For other suits concerning Section 36(b), see “Registered Fund Advisers Delegating to Subadvisers Gain Greater Flexibility From U.S. District Court Ruling to Charge Management Fees” (Mar. 16, 2017); and “In Light of Convergence of Hedge Fund Strategies and Mutual Fund Structures, Mutual Fund Advisory Fee Case Before U.S. Supreme Court May Affect Future Profitability of Hedge Fund Industry” (Sep. 24, 2009).

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  • From Vol. 10 No.14 (Apr. 6, 2017)

    Ten Key Risks Facing Private Fund Managers in 2017

    A recent seminar presented by Proskauer Rose provided valuable insight on emerging risks for hedge fund managers, including the uncertain regulatory landscape, and perennial SEC targets such as conflicts of interest, valuation and performance marketing. The program was moderated by Proskauer partner Timothy W. Mungovan and featured partner Joshua M. Newville; associates Michael R. Hackett and William Dalsen; and special regulatory counsel Anthony Drenzek. This article summarizes their key insights. For additional commentary from Drenzek, see our two-part series on The SEC’s Recent Revisions to Form ADV and the Recordkeeping Rule: “Managed Account Disclosure, Umbrella Registration and Outsourced CCOs” (Nov. 3, 2016); and “Retaining Performance Records and Disclosing Social Media Use, Office Locations and Assets Under Management” (Nov. 17, 2016).

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  • From Vol. 9 No.23 (Jun. 9, 2016)

    Financing Facilities Offer Hedge Funds and Managers Greater Flexibility (Part Two of Three)

    Along with subscription credit facilities, other forms of fund financing are becoming more prevalent in the asset management industry. In the hedge fund space, fund-of-funds managers are employing financing structures, and portfolio acquisition facilities and general partner support facilities are growing in use. However, along with increasing popularity, these structures have also experienced a surge in complexity. In a recent interview with The Hedge Fund Law Report, Zac Barnett and Liz Soutter, partners at Mayer Brown, discussed subscription financing facilities and other debt facilities used by funds. In this second article in a three-part series, Barnett and Soutter discuss financing facilities employed by hedge funds and other private funds, their evolution in the current market and the costs of these facilities. The first article examined subscription facilities, including their prevalence in the asset management industry, investor response to these structures and primary considerations for managers anticipating entering into such a facility. The third article will outline market, structuring and operational considerations for managers when establishing financing facilities. For more on hedge fund financing, see “Barclays Predicts Increased Financing Costs for Hedge Funds Due to Regulatory Changes Affecting Prime Broker Financing” (Oct. 18, 2012).

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  • From Vol. 8 No.33 (Aug. 27, 2015)

    Credit Suisse Survey Evaluates Investor Appetite for Alternative Investment Vehicles and Strategy Preferences

    Credit Suisse Capital Services (CS) recently released the results of its 2015 “Mid-Year Survey of Hedge Fund Investor Sentiment” (Survey).  CS considers the Survey to be an extension of its more comprehensive annual survey.  The Survey gathered investor preferences for a variety of alternative investment vehicles in addition to the traditional master-feeder hedge fund structure, comparing investors allocations in the first half of 2014 with their allocation plans for the second half of the year.  It also analyzed investor appetite for various investment strategies.  This article summarizes the key takeaways from the Survey.  For coverage of prior surveys, see “Credit Suisse Hedge Fund Survey Considers Factors in Institutional Investors’ Investment and Redemption Decisions, Appetite for Alternative UCITS and Anticipated 2015 Hedge Fund Investments by Strategy and Region,” The Hedge Fund Law Report, Vol. 8, No. 12 (Mar. 27, 2015); and “Credit Suisse Survey Reveals Allocation Preferences of Hedge Fund Investors, With Particular Attention on Preferences of Pension Funds and Insurance Companies,” The Hedge Fund Law Report, Vol. 6, No. 11 (Mar. 14, 2013).

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  • From Vol. 8 No.22 (Jun. 4, 2015)

    Deutsche Bank Alternative Investment Survey Explores Fee and Liquidity Trends, the Landscape for Investment Intermediaries and Early Stage Investment Terms (Part Two of Two)

    Deutsche Bank Global Prime Finance (DB) has released the results of its 13th annual Alternative Investment Survey.  This article, the second of two-part coverage, summarizes the portions of the survey that address fee and liquidity trends; trends among intermediaries; and early stage investing and seeding.  The first article described the survey methodology and demographics and summarized the portions of the survey that deal with allocations to alternative investments in general, and to hedge funds in particular; allocation plans by strategy and region; and investor preferences regarding hedge fund track record, minimum size, and initial and target investment ticket sizes.  For coverage of DB’s November 2013 survey, see “Deutsche Bank Survey Describes the Contours of the Nontraditional Hedge Fund Product Market: Investor Appetite, Performance, Marketing, Fees and More,” The Hedge Fund Law Report, Vol. 7, No. 3 (Jan. 23, 2014).  For more on fees, liquidity terms and early stage investments, see “Sidley Partners Discuss Evolving Hedge Fund Fee Structures, Seed Deal Terms, Single Investor Hedge Funds, Risk Aggregators, Expense Allocations, Co-Investments and Fund Liquidity (Part One of Two),” The Hedge Fund Law Report, Vol. 7, No. 36 (Sep. 25, 2014).

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  • From Vol. 6 No.25 (Jun. 20, 2013)

    Goldman Prime Brokerage Survey Relays the Views of Institutional Investors on Hedge Fund Fees, Manager Selection, Due Diligence, Return Expectations, Liquidity, Managed Accounts, UCITS and Alternative Mutual Funds

    Goldman Sachs Prime Brokerage (Goldman) recently published a report describing findings from a survey in which Goldman asked respondents about preferences with respect to fees, liquidity, investment strategies, geography, manager track record, sources of investment capital, expectations for capital growth, portfolio composition and turnover, return expectations, hedge fund manager selection criteria and use of managed accounts, UCITS funds and alternative mutual funds.  This article summarizes the key findings of that survey.

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  • From Vol. 6 No.23 (Jun. 6, 2013)

    TheCityUK Report Discusses Trends in Hedge Fund Manager Locations, Fund Domiciles, Performance, Strategies, Investors, Secondary Market Transactions and Service Providers

    TheCityUK (TCUK), an association of representatives from the U.K. financial services sector and other businesses, recently released a report providing an overview of recent trends in the global hedge fund industry, broken down by geography, with a focus on the role of managers and funds based in the U.K.  Specifically, the report provided a geographical breakdown of funds and managers; a snapshot of fund performance and investment strategies; a synopsis of fund manager concerns; recent information on secondary market transactions in hedge fund interests; and perspectives on the use of hedge fund service providers.  This article summarizes the primary insights from the report.

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  • From Vol. 6 No.22 (May 30, 2013)

    Citi Prime Finance Report Describes the Competition among Traditional, Hedge and Private Equity Fund Managers for $1.3 Trillion in Liquid Alternative Assets (Part Two of Two)

    This is the second article in our two-part series summarizing the key insights from a provocative recent report by Citi Prime Finance (Citi).  The report describes a massive opportunity for capital raising in so-called “liquid alternative” investment products, including alternative mutual funds, ETFs and UCITS.  At the same time – and not surprisingly – the report discusses a blurring of the lines between traditional, hedge and private equity (PE) fund managers as all three categories of managers pursue strategies that broadly fall under the rubric of “liquid alternatives.”  It’s a large pie indeed, but with many players looking for a piece.  To help managers increase their odds of obtaining a piece, this article provides a comprehensive summary of the portions of the Citi report covering the “convergence” of services provided by traditional, hedge and PE managers; the “credibility gap” faced by firms that seek to operate in the convergence zone; how traditional asset managers and PE firms are turning to hedge fund managers for talent as they seek to offer liquid alternatives; and the challenges and choices facing hedge fund managers as the market for liquid alternatives develops.  Part one of this series summarized the portions of the Citi report covering the shifting role that hedge funds play in an institutional investor’s portfolio; how regulatory changes have affected the hedge fund market and helped to make liquid alternatives more attractive; the growing “retail” demand for liquid alternatives; and Citi’s predictions for the growth of the retail alternative market.  See “Citi Prime Finance Report on Liquid Alternatives Describes a Massive Capital Raising Opportunity for Hedge Fund Managers Willing to Go Retail (Part One of Two),” The Hedge Fund Law Report, Vol. 6, No. 21 (May 23, 2012).

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  • From Vol. 6 No.1 (Jan. 3, 2013)

    Why and How Do Family Offices and Foundations Invest in Hedge Funds?

    Family offices and foundations are an important source of investment capital for hedge funds and funds of funds (together, funds), particularly funds whose managers have a track record, well-developed infrastructure and the ability to demonstrate staying power.  See “Prime Broker Merlin Securities Develops Spectrum of Hedge Fund Investors; Event Hosted by Accounting Firm Marcum LLP Examines Marketing Implications of the Merlin Spectrum,” The Hedge Fund Law Report, Vol. 3, No. 39 (Oct. 8, 2010).  However, family offices and foundations have specific objectives in investing in hedge funds and specific concerns with their hedge fund investments.  Understanding these objectives and concerns is important to hedge fund managers because effective fund marketing should be a refined process rather than a blunt instrument.  Marketing that raises long-term dollars invariably caters to the specific circumstances of an investor rather than generally (or only) touting the achievements of the manager.  This is particularly true in marketing to family offices – entities that often have a range of objectives including but not limited to absolute returns.  See “New Rothstein Kass Study Explains the ‘Consultative’ Approach to Marketing to Single-Family Offices and the Importance of That Approach for Smaller Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 20 (Jun. 17, 2011).  To help hedge fund managers enrich their understanding of the goals and concerns of family offices and foundations, this article describes the pertinent findings from a December 2012 survey of family offices and foundations conducted by Infovest21.  In particular, this article discusses the survey findings on topics including fund fees, allocation criteria, role of assets under management in manager selection, transparency and related topics.

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  • From Vol. 5 No.47 (Dec. 13, 2012)

    SEI Report Highlights Challenges Faced by Fund of Hedge Funds Industry and Recommends Improvements

    In December 2012, SEI, through its subsidiary, SEI Knowledge Partnership, released the results of an online survey of senior managers at 220 institutional investors, investment consultants and fund of hedge fund (FOHF) managers concerning their views of the fund of funds business.  Two-thirds of the investors and consultants and more than half of the managers surveyed agreed that FOHFs “must reinvent their business model in order to survive.”  SEI’s sobering report highlights problems afflicting the FOHF industry and proposes several ways for the industry to adapt.  SEI found a “marked disconnect between investor/consultant and manager responses on some key issues. . . .”  This article summarizes SEI’s report.

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  • From Vol. 5 No.46 (Dec. 6, 2012)

    CFTC Grants Permanent No-Action Relief from CPO Registration for Family Offices and Temporary No-Action Relief for Operators of Funds of Funds

    The February 2012 CFTC rule amendments implementing provisions of the Dodd-Frank Act raised many questions concerning the obligations of fund of fund operators and family offices to register as commodity pool operators (CPOs) with the CFTC, particularly in light of the rescission of the Rule 4.13(a)(4) registration exemption relied upon by many fund of fund operators and family offices.  Recognizing that many fund of fund operators and family offices may need to register as CPOs with the CFTC by December 31, 2012, on November 29, 2012, the Division of Swap Intermediary Oversight (Division) of the CFTC issued two no-action letters, one granting temporary relief from CPO registration for operators of funds of funds and one granting permanent no-action relief for family offices.  However, the relief for fund of fund operators and family offices is not self-executing as potential claimants must make an electronic notice filing with the CFTC and satisfy other conditions to claim the relief.  This article outlines the relief granted by the Division in its no-action letters and the conditions that fund of fund operators and family offices must satisfy to claim such relief.  See also “Practising Law Institute Panel Discusses Sweeping Regulatory Changes for Hedge Fund Managers That Trade Swaps,” The Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012).

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  • From Vol. 5 No.34 (Sep. 6, 2012)

    Report Finds Hedge Fund Assets Continued to Grow in First Half of 2012, Particularly for the Largest Single-Manager Hedge Funds

    In August 2012, PerTrac, Inc. issued a semi-annual update to a full-year analysis of the composition and size of the single-manager hedge fund and fund of hedge funds industry.

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  • From Vol. 5 No.32 (Aug. 16, 2012)

    CFTC Issues Responses to Frequently Asked Questions Concerning Registration Exemption Eligibility and Compliance Obligations for Commodity Pool Operators and Commodity Trading Advisors

    On August 14, 2012, the staff of the Commodity Futures Trading Commission (CFTC) Division of Swap Dealer and Intermediary Oversight issued responses to a number of questions raised by market participants in the aftermath of recent amendments to CFTC rules and regulations, which impacted the registration status and compliance obligations of many commodity pool operators (CPOs) and commodity trading advisors, particularly in light of the elimination of the Rule 4.13(a)(4) CPO registration exemption.  See “Do You Need to Be a Registered Commodity Pool Operator Now and What Does It Mean If You Do? (Part One of Two),” The Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012).  These responses provide answers to registration and compliance questions in a variety of areas.  This article summarizes the guidance that is most pertinent to hedge fund managers.

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  • From Vol. 5 No.26 (Jun. 28, 2012)

    SEC Staff Publishes Answers to Frequently Asked Questions Concerning Form PF

    On June 8, 2012, the SEC’s Division of Investment Management (Staff) published answers to seven frequently asked questions about Form PF, covering topics such as the definition of a “commodity pool”; the definition of a “hedge fund”; the reporting treatment of hedge funds; treatment of parallel managed accounts; and the definition and treatment of “disregarded private funds.”  This article highlights the primary practice points from the Staff answers.

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  • From Vol. 5 No.12 (Mar. 22, 2012)

    Speakers at Katten Seminar Outline ERISA Concerns for Managers of Plan Asset Hedge Funds

    On January 31, 2012, Katten Muchin Rosenman LLP (Katten) hosted a seminar entitled, “25% Solutions: How to Manage ERISA Plan Assets in a Hedge Fund” in New York City.  Speakers at this event addressed: the implications of the Employee Retirement Income Security Act of 1974 (ERISA) for alternative investment fund managers managing plan asset funds; the plan asset regulations and the exception for comingled investment funds with less than 25% ownership by benefit plan investors; how the 25% calculation should be performed; and special concerns for managers managing hedge funds offering different share classes, fund of funds and funds utilizing a master-feeder structure.  This feature-length article summarizes the key points discussed at the seminar on each of the foregoing topics, and provides a self-contained tutorial on ERISA considerations for hedge fund managers.

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  • From Vol. 5 No.5 (Feb. 2, 2012)

    The Changing Face of Alternative Asset Management in Switzerland

    Switzerland is the third largest global centre of alternative asset management, after North America and the United Kingdom.  Around three times the size of Connecticut, the small, central European country boasts approximately 15% of global assets under management.  In a guest article, Matthew Feargrieve, leader of the Funds and Investment Services practice in the London and Zurich offices of Appleby, examines the composition of the Swiss alternative asset management market, focusing on single managers and managers of funds of hedge funds (FoHFs); reviews the current and prospective regulatory environment in Switzerland for each type of manager; and assesses the country’s future generally as a centre of alternative asset management against the backdrop of economic austerity and regulatory zeal in Europe.

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  • From Vol. 5 No.4 (Jan. 26, 2012)

    Survey by SEI and Greenwich Associates Highlights the Importance to Hedge Fund Investors of a Clearly Articulated, Comprehensible and Credible Value Proposition

    In October 2011, SEI Knowledge Partnership (SEI) and Greenwich Associates conducted their fifth annual survey of institutional hedge fund investors.  On January 25, 2012, they released a report summarizing part one of the results of that survey (Report), including current trends affecting the hedge fund industry, including institutional hedge fund allocations, objectives, performance and preferences in investment strategies and vehicles.  The Report, entitled “The Shifting Hedge Fund Landscape, Part I of II: Institutions Put Fund Managers to the Test,” identifies a deepening commitment to hedge funds on the part of institutional investors, and foreshadows increased institutional allocations.  At the same time, however, the Report finds that institutions keep creating new challenges and requirements for hedge fund managers.  Notably, the Report also details what hedge fund managers must do in order to maintain investor confidence.  Part two of the survey will explore investors’ chief concerns regarding hedge fund investing, as well as the continuing evolution of institutional standards for hedge fund evaluation, selection and monitoring.  This article summarizes the findings of the Report and the key takeaways for hedge fund managers.  See also “SEI Report Describes the Growth Opportunity for Hedge Fund Managers in Regulated Alternative Funds,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).

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  • From Vol. 4 No.38 (Oct. 27, 2011)

    Pension Funds and Sovereign Wealth Funds Shift Towards Direct Allocations with a Distinct “Sweet Spot” for Hedge Fund Managers with Between $1.0 Billion and $5.0 Billion Under Management

    A June 2011 report summarized the results of a survey (Survey) of pension and sovereign wealth fund investors as well as hedge fund managers.  The Survey had two primary goals: (1) tracking the shift of these investors from funds of funds to direct allocation models; and (2) identifying the predominant characteristics of hedge fund managers who received these newfound direct allocations.  Overall, the Survey found that the shift to direct allocation among these investors has been dramatic.  The managers who have benefited most from this transformation are those with assets under management (AUM) of between $1.0 billion and $5.0 billion, a range the Report dubs the “sweet spot.”  This article details the key findings from the Survey and the key conclusions of the Report, focusing in particular on: the factors leading to direct investing; approaches to direct investing; the three primary vehicles used by pension funds and sovereign wealth funds for direct investing; the manager selection process; criteria used by pension funds and sovereign wealth funds to evaluate direct managers; and the pivotal role of consultants.

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  • From Vol. 4 No.27 (Aug. 12, 2011)

    Federal Court Decision Holds That a Fund of Funds Investor May Sue a Fund of Funds Manager That Fails to Perform Specific Due Diligence Actions Promised in Writing and Orally

    A recent federal district court order (Order) described the range of legal claims available to an investor in a hedge fund of funds for alleged inconsistencies between the fund of funds manager’s representations and actions regarding due diligence and monitoring.  Read narrowly, the Order may merely stand for the proposition that a fund of funds manager may not promise to undertake specific actions in the course of due diligence and monitoring, accept investor money based on those representations then fail to take those actions.  Read more broadly, the Order may foreshadow a heightening of the legal standard to which hedge fund of funds managers are held when conducting due diligence and monitoring.  That is, the Order may presage a decision on the merits to the effect that fund of funds managers have a legal duty more or less consonant with industry best practices regarding due diligence.  That would constitute a significant increase in the level of legal obligations applicable to fund of funds managers, but would not enhance the commercial standard of care, which already demands best practices.

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  • From Vol. 4 No.15 (May 6, 2011)

    PerTrac’s Eighth Annual “Sizing the Hedge Fund Universe” Study Identifies Trends Regarding AUM, Domicile, Currency and Performance Information Reporting for Single Manager Hedge Funds, Funds of Funds and Commodity Trading Advisors

    In its recently released study entitled “Sizing the 2010 Hedge Fund Universe” (Study), software and services provider PerTrac analyzed information from ten leading global hedge fund databases to identify trends with respect to assets under management, domicile, currency and performance information reporting by single manager hedge funds, funds of funds and commodity trading advisors.  The Study generally found that the overall number of entities that existed and reported performance information to databases increased during 2010 over 2009, but that the growth was unevenly distributed among the types of entities under analysis.  Moreover, the Study highlighted the significant number of small managers, and thus, from a regulatory perspective, implicitly emphasized the increased importance of state-level hedge fund adviser registration.  See “Connecticut Welcomes You! Federal Financial Regulatory Reform Restores Connecticut’s Authority over Hedge Fund Advisers,” The Hedge Fund Law Report, Vol. 3, No. 30 (Jul. 30, 2010).  This article summarizes the key findings of the Study.  Also, where relevant, this article includes links to other articles in The Hedge Fund Law Report offering concrete guidance to managers on the legal and regulatory implications of the business trends identified by the Study.  See, e.g., “Who Should Newly Registered Hedge Fund Managers Designate as the Chief Compliance Officer and How Much Are Chief Compliance Officers Paid?,” The Hedge Fund Law Report, Vol. 4, No. 7 (Feb. 25, 2011).

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  • From Vol. 4 No.4 (Feb. 3, 2011)

    IRS Enhancing Its Scrutiny of Tax Shelter Disclosures by Hedge Funds

    In late 2010, the IRS Office of Chief Counsel issued a memorandum indicating that some common “protective” disclosures that are made by hedge funds and other investment partnerships are inadequate.  This could result in significant penalties for a fund as well as its investors.  In a guest article, Joseph Pacello, a Tax Partner at Rothstein Kass, discusses: the legal and accounting background of the IRS memorandum, including relevant tax disclosure requirements; the IRS Office of Chief Counsel’s analysis in the memorandum; penalties for failure to properly disclose a reportable transaction; and the likely impact of the IRS memorandum for both funds of funds and direct trading funds.

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  • From Vol. 4 No.3 (Jan. 21, 2011)

    Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets

    The SEC recently obtained an emergency asset freeze and temporary restraining order against a hedge fund of funds manager, Stanley J. Kowalewski (Kowalewski), and his management entity, SJK Investment Management LLC (SJK).  The SEC’s complaint, filed in federal district court in Atlanta, generally alleges that Kowalewski and SJK engaged in two categories of conduct in violation of federal securities laws.  First, Kowalewski and SJK allegedly used fund assets to pay management company and personal expenses.  Second, Kowalewski allegedly launched a hedge fund in which his fund of funds invested, but failed to disclose to his fund of funds investors either the existence of the underlying hedge fund or the investment by his fund of funds in it.  Neither the dollar values nor the creativity in this matter are particularly noteworthy.  The alleged fraud itself was trite, brief and straightforward.  However, a close reading of the SEC’s complaint offers a veritable treasure trove of insight into how investors in hedge funds and funds of funds can sharpen their due diligence practices.  We have extracted 13 key lessons from the matter that investors can use to revise their approach to hedge fund due diligence – or, even better, to confirm that their approach reflects current best practices.  This article details the SEC’s factual and legal allegations against Kowalewski and SJK, briefly discusses the procedural posture of the matter, then discusses in detail the 13 key lessons.

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  • From Vol. 3 No.30 (Jul. 30, 2010)

    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?

    On July 1, 2010, the SEC adopted Rule 206(4)-5 (Rule) under the Investment Advisers Act of 1940 (Advisers Act).  See “SEC Adopts Pay to Play Rules for Investment Advisers; Total Placement Agency Ban Avoided,” The Hedge Fund Law Report, Vol. 3, No. 28 (Jul. 15, 2010).  The Rule generally seeks to curtail pay to play practices in the selection by state investment funds, most notably public pension funds, of hedge fund managers and other investment advisers.  Broadly, the Rule does this in three ways: (1) by limiting donations by principals of investment advisers and others with an economic stake in winning public fund business to election campaigns of public officials who may directly or indirectly influence the selection of the adviser to manage a public fund; (2) by prohibiting payments by investment advisers to any person for soliciting government entities for advisory services unless that person is (a) a registered investment adviser subject to the Rule or a registered broker dealer subject to a similar rule to be promulgated by FINRA, or (b) a principal or employee of the adviser; and (3) by revising Advisers Act Rule 204-2 (the recordkeeping rule) to require investment advisers with government clients, or advisers to hedge funds with government entity investors, to maintain records regarding political contributions by the adviser and its covered associates.  According to private fund data provider Preqin, public pension funds represent approximately 17 percent of all institutional hedge fund investors, with an average allocation of six percent of total assets to hedge funds.  The Rule governs the process by which hedge fund managers seek advisory business from this important constituency.  Accordingly, the Rule is of fundamental importance to a wide range of hedge fund managers, for whom the Rule creates a range of new compliance and marketing challenges.  The purpose of this article is to identify and provide guidance with respect to many of those new challenges.  In particular, the descriptive section of this article provides an overview of the mechanics of the Rule.  The analytic section of this article addresses areas in which hedge fund managers should revisit their policies and procedures in light of the Rule, including policies and procedures relating to: political contributions; monitoring contributions; preclearance of contributions; due diligence on placement agents; compliance training with respect to contributions; prescreening of new employees; acquisitions of hedge fund management firms; state, local and fund-specific rules relating to pay to play arrangements; sub-advisers and funds of funds; and mandatory redemptions.  The analytic section also includes a discussion of the implications of the Rule for lobbying by hedge fund managers.  See “Hedge Funds Increasing Lobbying Efforts, Focusing On Shaping Regulations Rather Than Preventing Them,” The Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).  The article concludes with a note on potential constitutional challenges to the Rule.  One of the more important points made by this article is that while the Rule has garnered significant attention, it is just part of a patchwork of federal, state, local and fund-specific rules governing the process by which hedge fund managers solicit investment advisory business from government entities.

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  • From Vol. 2 No.52 (Dec. 30, 2009)

    Why Are Most Hedge Fund Investors Reluctant to Sue Hedge Fund Managers, and What Are the Goals of Investors that Do Sue Managers? An Interview with Jason Papastavrou, Founder and Chief Investment Officer of Aris Capital Management, and Apostolos Peristeris, COO, CCO and GC of Aris

    An article in last week’s issue of The Hedge Fund Law Report detailed a ruling by the New York State Supreme Court permitting a lawsuit by funds managed by Aris Capital Management (Aris) to proceed against hedge funds in which the Aris funds had invested and the managers of those investee funds.  See “New York Supreme Court Rules that Aris Multi-Strategy Funds’ Suit against Hedge Funds for Fraud May Proceed, but Negligence Claims are Preempted under Martin Act,” The Hedge Fund Law Report, Vol. 2, No. 51 (Dec. 23, 2009).  That lawsuit is one of various suits brought by Aris and its managed funds against hedge funds or managers in which the Aris funds have invested.  The Aris suits allege a variety of claims in a variety of circumstances, but collectively are noteworthy for their mere existence.  In the hedge fund world, there has been a conspicuous absence during the past two years of legal actions by hedge fund investors against hedge fund managers, despite the coming-to-fruition of circumstances that industry participants thought, pre-credit crisis, would augur an uptick in litigation: the imposition of gates, suspensions of redemptions, mispricing of securities, large losses, etc.  Jason Papastavrou, Founder and Chief Investment Officer of Aris, appears to have broken ranks with what seems like an unspoken agreement in the hedge fund world to avoid the courthouse steps, and he has done so with a considerable degree of thoughtfulness, for specific reasons and with particularized goals.  In an interview with The Hedge Fund Law Report, Papastavrou and Apostolos Peristeris, COO, CCO and GC of Aris, discuss certain of their lawsuits, why they brought them, what they seek to gain from them and what the relevant managers might have done differently to have avoided the suits.  They also discuss: seven explanations for the reluctance on the part of most hedge fund investors to sue managers; the fund of funds redemption process; how their lawsuits have affected their due diligence process; in-house administration; background checks; the importance of face-to-face meetings; side letters; how Aris investors have reacted to the lawsuits; and Aris’ transition to a managed accounts model from a fund of funds model.

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  • From Vol. 2 No.49 (Dec. 10, 2009)

    Morgan Stanley Finds Hedge Fund Assets May Rise to $1.75 Trillion by the End of 2010

    According to a new report from Morgan Stanley, entitled “Hedge funds: where next (II)?,” 2010 appears likely to be a pivotal and beneficial year for hedge funds due to a rise in demand for better risk adjusted returns, the migration of talent from investment banks and the trading off of a successful 2009.  The report addresses five issues: (1) the growth outlook for the hedge fund industry; (2) the hedge fund strategies that will prosper in the foreseeable market environment; (3) the viability of the hedge fund of funds model; (4) the reality of fee compression; and (5) the risk to hedge funds from regulatory change.  Most notably, the report suggests that hedge funds provided as much as 40 percent of the money raised this year by United States and European banks as they sought to offset losses and meet government capital requirements.  Of equal note, it also suggests that hedge fund assets may rise to $1.75 trillion by the end of 2010.  This article details the report’s most salient findings and its implications for the hedge fund industry.

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  • From Vol. 2 No.47 (Nov. 25, 2009)

    New CFTC Rules Significantly Amend Reporting Requirements Applicable to Commodities-Focused Hedge Fund Managers

    On November 9, 2009, the Commodity Futures Trading Commission (CFTC) adopted several amendments to its regulations applicable to commodity pool operators (CPOs).  These Final Rules specify detailed information that must be included in periodic account statements and annual reports for commodity pools with more than one series or class of ownership interest; clarify that periodic account statements must disclose either the net asset value (NAV) per outstanding participation unit in the pool, or the total value of a participant’s interest in the pool; extend the time period for filing and distributing annual reports of commodity pools that invest in other funds; codify existing CFTC staff interpretations regarding proper accounting and financial statement presentation of certain income and expense items in financial reports; streamline annual reporting requirements for pools ceasing operation; establish conditions for use of International Financial Reporting Standards in lieu of U.S. Generally Accepted Accounting Principles and clarify and update several other requirements for periodic and annual reports to be prepared and distributed by CPOs.  The Final Rules become effective on December 9, 2009 and apply to commodity pool annual reports for fiscal years ending December 31, 2009 or later.  The amended rules will have a significant effect on the regulatory environment in which commodities-focused hedge fund managers operate.  Accordingly, this article offers a detailed explanation of the amendments and the resulting new reporting obligations applicable to CPOs.

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  • From Vol. 2 No.45 (Nov. 11, 2009)

    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

    As a result of the recent “pay to play” scandals in New York, California and other states, the SEC, New York Attorney General Andrew Cuomo and certain state pension fund managers have restricted or prohibited hedge fund managers from using placement agents when marketing to state pension fund managers.  See “What Do the Regulatory and Industry Responses to the New York Pension Fund ‘Pay to Play’ Scandal Mean for the Future of Hedge Fund Marketing?,” The Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009).  Prior to the pay to play scandals, placement agents often served an important intermediary role between investment managers and the trustees of state retiree money: they understood the investment goals of pension funds and the investment competencies of particular managers, and they added value by connecting goals with appropriate competencies.  However, the regulatory and industry responses to the pay to play scandals – still perceived in various quarters as unduly draconian – have all but eliminated placement agents from hedge fund manager marketing efforts, at least to the extent those efforts are directed at state pension funds, and at least for now.  At the same time, pension funds are expected to contribute a growing proportion of the assets under management by hedge funds in the next few years.  So who or what is going to fill the hedge fund marketing void that has opened up in the post-placement agent era?  In an effort to answer that question, this article revisits the New York State pension kickback case then discusses: the reduction in the use of placement agents by state pension funds in New York and California; the SEC’s recently proposed rule regarding placement agents; the move by pension funds away from allocations to funds of funds in favor of direct investments in hedge funds; specific examples of pension funds that have moved to single manager allocations; what precisely pension funds are looking for in allocating capital to single managers; specific steps that hedge fund managers can take to market to pension fund managers without relying on placement agents; considerations with respect to in-house marketing teams and prime broker capital introduction services; due diligence by pension funds; and background checks.

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  • From Vol. 2 No.40 (Oct. 7, 2009)

    How Can Hedge Fund of Funds Managers Manage a “Liquidity Mismatch” Between Their Funds and Underlying Hedge Funds?

    The growing trend toward retailization of hedge funds of funds (FOFs) faces a considerable practical hurdle: retail investors demand frequent liquidity, while many of the more interesting opportunities for underlying hedge funds remain in less liquid investments.  See, e.g., “Why Does Capital Raising for Distressed Debt Hedge Funds Remain Particularly Challenging Despite the Recent and Anticipated Positive Performance of the Strategy?,” The Hedge Fund Law Report, Vol. 2, No. 39 (Oct. 1, 2009).  For example, Alexandre Poisson, managing director of FOF HDF Switzerland recently stated that a well-structured FOF portfolio can give investors “monthly access to their money rather than quarterly, without any mismatch.”  But he added an important caveat: to accomplish this, the FOF must avoid illiquid strategies among its underlying funds.  At best, such avoidance restricts investment decision making.  At worst, it renders FOFs ineligible for some of the best opportunities, and thereby constrains alpha.  Are there better ways to reconcile liquidity and investment discretion?  To address this question – and hopefully to expand the range of options available to FOF managers looking to maintain their strategic approach while accessing a broader retail market – this article discusses the practical and legal bases for the obligation on the part of FOF managers to conduct thorough due diligence, especially with respect to the match between the liquidity of the FOF and the hedge funds in which it invests; the so-called “FOF regulatory loophole”; structural changes in the FOF market; the benefits and burdens of investments by FOFs in only liquid underlying funds; the early notification approach; FOF disclosure matters; side letters; and fee deferrals.  In addition, in mid-September 2009, the International Association of Securities Commissions (IOSCO) published a report titled “Elements of International Regulatory Standards of Funds of Hedge Funds Related Issues Based on Best Market Practices.”  The report broadly focuses on liquidity management and due diligence, and is both descriptive and prescriptive.  That is, it purports to describe how the market is, and how it should be.  We detail the salient points from the IOSCO report, and relay insights from industry participants on the extent to which the report reflects current market practice, and the extent to which the prescriptive sections may change market practice (to the extent they differ from it).

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  • From Vol. 2 No.40 (Oct. 7, 2009)

    What Can Hedge Fund Managers Learn From the SEC’s Failure to Catch Madoff? An Interview with Charles Lundelius, Senior Managing Director at FTI Consulting, Inc.

    FTI Consulting Inc. (FTI), a global business advisory firm, substantially assisted the Securities and Exchange Commission’s (SEC) Office of Inspector General (OIG) in preparation of its report on the agency’s responses – or failures to respond – to a series of “red flags” regarding Bernard Madoff and Bernard Madoff Investment Securities LLC (BMIS).  For more on that report, see “SEC Recommends More Hedge Fund Oversight in Audit on Its Failure to Uncover Madoff Fraud; House Oversight and Government Reform Committee Chairman Questions SEC Competence,” The Hedge Fund Law Report, Vol. 2, No. 38 (Sep. 24, 2009).  Charles Lundelius, a Senior Managing Director in the FTI Forensic and Litigation Consulting Practice, led the FTI engagement team, and thus has a uniquely clear perspective on the OIG’s review, the omissions in the SEC’s approach as determined by the OIG, structural flaws at the SEC as identified by the OIG and the OIG’s suggestions for remedying those flaws.  The Hedge Fund Law Report recently interviewed Lundelius, focusing on his experience assisting the OIG in preparation of its report.  The full transcript of that interview is included in this issue of The Hedge Fund Law Report, and touches on topics including: what FTI is and what they do; the most salient red flags that were missed by the SEC in the Madoff context; structural problems that may exist at the SEC and OCIE; the tendency of investigators to view new evidence in light of old experience; how the SEC – and for that matter, hedge funds and funds of funds – can use news and information services to discover information that may lead to red flags and ultimately to decisions against investments or in favor of redemptions; how the OIG’s report can offer tips to hedge funds of funds on how to conduct effective due diligence and how to detect fraud; and the role of hedge fund manager Renaissance Technologies in the Madoff investigation.

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  • From Vol. 2 No.30 (Jul. 29, 2009)

    Investors Demand More Specificity in Hedge Fund Governing Documents Regarding Circumstances in which Liquidity Management Tools May Be Used

    The credit crisis witnessed unprecedented deployment of liquidity management tools that, prior to the crisis, lay dormant in fund documents – tools such as fund-level gates, investor-level gates, hard and soft lock-ups, rolling redemption periods, holdbacks, redemption suspensions and side pockets.  The stigma previously attached to use of such tools faded as survival became the paramount imperative.  See “Stigma Fades as Use of Gates Becomes More Common,” The Hedge Fund Law Report, Vol. 1, No. 29 (Dec. 24, 2008).  In addition, managers sought to stem the tide of outflows to ensure that remaining investors were not left with the least liquid assets, and to facilitate the execution of longer-term investment strategies.  See “Investors in Hedge Fund Strategies Increasingly Demanding Separate Accounts to Avoid Gates and Other Consequences of Commingled Investment Vehicles,” The Hedge Fund Law Report, Vol. 2, No. 9 (Feb. 26, 2009).  The constituent documents of funds being launched today reflect the experience of the past year and a half.  At least for the time being, investors still have the upper hand in many cases in negotiating capacity with hedge fund managers, and many of those investors are demanding more specific liquidity provisions in fund documents.  In particular, investors are asking for – and in many cases getting – more specificity with respect to the circumstances in which liquidity management techniques may be employed, and the particular techniques that may be employed in specific circumstances.  The old approach was to vest essentially plenary discretion in the manager to lower a gate, suspend redemptions, etc. in a wide variety of circumstances.  The new drafting reflects an effort to enumerate the circumstances in which liquidity may be curtailed.  At the same time, investors and managers continue to recognize the impracticability of describing every circumstance in which liquidity restrictions may be prudent.  So while the drafting of liquidity management provisions is getting more precise, it still leaves room – albeit less room – for manager discretion.  We discuss relevant standards promulgated by the Hedge Fund Standards Board, and changes to those standards to reflect the trend toward more specific liquidity management disclosure, offer practitioner insight on the rationale for the trend and – importantly – provide actual language from the PPMs of two recently-launched hedge funds that reflect the new, more specific drafting.

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  • From Vol. 2 No.29 (Jul. 23, 2009)

    Luxembourg Authorities Create Fast-Track Procedure for Approval of Transfers of Illiquid Assets to Hedge Fund Side Pockets

    The financial regulatory authority in the Grand Duchy of Luxembourg, the Commission de Surveillance du Secteur Financier (CSSF), has approved a new fast-track authorization procedure for the use of side pockets by hedge funds in two specific situations: the spin-off from an existing share/unit class to a new share/unit class and the spin-off from an existing subfund to a new subfund.  The fast track procedure is not to be used if the assets to be side pocketed represent more than 20 percent of the total assets of the relevant fund or subfund.  Also, the procedure requires that the board of directors of the management company of the affected fund confirm that the proposed side pocketing complies with the fund’s articles of incorporation or rules; that the administrator is technically capable of servicing the contemplated side pocket; and that it not be implemented to solve “temporary valuation problems” or to address a merely “potential or presumed illiquidity.”  Managers must also undertake to “promptly realize the asset as soon as the asset is once again liquid.”  We offer additional details on the specifics of the fast-track procedure, and shed light on some of the more complicated definitional questions raised by the terms used in the procedure.  For example, we address how the CSSF is likely to construe, in this context, concepts such as “temporary valuation problems” and “promptly realize the asset as soon as the asset is once again liquid.”

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  • From Vol. 2 No.25 (Jun. 24, 2009)

    The SEC’s Proposed Custody Rule Changes: An Analysis of the Impact on Hedge Fund Managers

    The SEC recently voted to propose changes to the Advisers Act custody rule.  The SEC initiated this action with the intention of providing additional safeguards when an adviser has custody of client assets.  The proposed changes follow a series of recent enforcement actions involving alleged misappropriation or other misuse of client assets.  The proposed changes would primarily impose two new requirements on registered advisers with custody of client assets.  First, those advisers would need to undergo an annual surprise examination by an independent public accountant to verify client assets.  Second, those advisers who are qualified custodians and self custody client assets or use a related person who is a qualified custodian (rather than an “independent” qualified custodian) would need to obtain a written report from an independent public accountant.  The report would include an opinion as to the qualified custodian’s controls regarding the custody of client assets.  While the proposed changes would impact all registered advisers with custody of client assets, the changes would also have unique application to hedge fund managers.  In a guest article, Terrance J. O’Malley and Jessica Forbes, both Partners at Fried, Frank, Harris, Shriver & Jacobson LLP, examine the proposed changes to the custody rule from the perspective of a hedge fund manager.  Their article begins with a brief review of the rule’s history, then examines the current requirements under the rule and finally describes the proposed changes, including those most relevant to hedge fund managers.

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  • From Vol. 2 No.22 (Jun. 3, 2009)

    Northern Trust Announces New Feature to Enable Funds of Funds to Assess the Impact of Gates on Their Liquidity In Real Time

    On May 21, 2009, Northern Trust announced that it had enhanced its offering to funds of hedge funds (FoHF) clients with a new feature that enables FoHF managers to assess the impact of gates on their liquidity in real time.

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  • From Vol. 2 No.19 (May 13, 2009)

    The Fund of Hedge Funds Regulatory Loophole

    From a regulatory perspective, both in the United States and abroad, a hedge fund is essentially the same type of legal entity as a fund of hedge funds (FOHF).  As such all of the current and proposed hedge fund regulations apply virtually the same legal and compliance standards to both hedge funds and fund of hedge funds.  While such a distinction may have been too fine a regulatory point to make during the early stages of the modern hedge fund resurgence, this distinction can no longer be ignored.  Fund of hedge funds aggregate capital and allocate it to hedge funds.  They are supposed to be performing a certain minimum amount of due diligence (both investment and operational).  Unfortunately, as Madoff and the current Ponzimonium have demonstrated, FOHF were not performing such due diligence adequately.  All of the proposed hedge fund regulations dangerously ignore the opportunity to protect investors and institutions which place their capital within this lax due diligence framework.  In a guest article, Jason Scharfman, Managing Partner of Corgentum Consulting, LLC, critiques what he calls the “fund of hedge funds regulatory loophole.”

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  • From Vol. 1 No.29 (Dec. 24, 2008)

    Involvement of Funds of Funds in Alleged Madoff Fraud Reemphasizes Importance of Due Diligence

    As Warren Buffett famously said in his 2001 Chairman’s Letter, “you only find out who is swimming naked when the tide goes out.”  According to a criminal complaint and press reports, the tide has clearly gone out on Bernard L. Madoff Investment Securities LLC and its founder Bernard Madoff, and a number of prominent funds of hedge funds have been caught swimming sans bathing trunks.  Specifically, a significant part of the value proposition of funds of funds is the ostensibly rigorous due diligence they perform on underlying managers.  Yet some of the biggest names in the fund of funds world appear to have invested in Madoff investment vehicles without performing adequate due diligence.  The anticipated losses of such names from the Madoff scandal emphasize the central importance of due diligence, especially for funds of funds, and the inadequacy of exclusive or near-exclusive reliance on personal relationships in making investment decisions.  We explore the implications of the Madoff scandal on the rigor and content of due diligence that should be performed by funds of funds prior to and after investing in underlying funds.

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  • From Vol. 1 No.16 (Jul. 22, 2008)

    An IRS Trifecta: Three Public Releases Affecting Hedge Funds and Funds of Funds Issued on One Day

    A triumvirate of IRS releases all issued on July 3, 2008 clarify the deductibility of hedge fund investment interest expenses by hedge fund investors, and the tax treatment of fund of funds management fees. Guest contributor Mark H. Leeds, a Shareholder of Greenberg Traurig LLP, explains the releases in a lucid, insightful and timely article.

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