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    Jul. 6, 2017

Six Essential HFLR Articles for Fund Managers to Revisit

In honor of Independence Day in the United States, this issue of the Hedge Fund Law Report is highlighting the depth of its historical archives by featuring six articles that remain just as relevant and vital to fund managers today as they did when originally published. Next week (the week starting July 10, 2017), the HFLR will resume its normal weekly publication schedule.

How Can Hedge Fund Managers Distinguish Between Market Color and Inside Information?

Hedge fund managers are in the business of collecting, analyzing and acting on a significant volume of complex information, which requires navigating various federal securities laws to determine whether that information can be traded upon. The spectrum of information received by managers ranges from public information gleaned from sources such as filed annual or quarterly reports (permitted for trading), to material nonpublic information (MNPI) obtained from someone with a duty to the securities’ issuer (impermissible for trading). Somewhere in the middle is “market color” – information that is more specific to a company, industry or market than public information, but that does not rise to the level of MNPI. Distinguishing between market color and inside information is, however, infamously difficult and fraught with peril considering the SEC’s recent attempts to crack down on insider trading. See “SEC Insider Trading Action Highlights Red Flags Hedge Fund Managers Must Heed When Employing Political Intelligence Consultants” (Jun. 8, 2017). This article addresses this issue by identifying sources of market color and the channels via which it is provided; distinguishing between these information types in various contexts; detailing the relationship between soft dollars and market color; and identifying regulatory precedents that may provide insight into how the SEC may treat market color. For coverage of recent developments in insider trading laws, see “Supreme Court’s Ruling in Salman v. U.S. Affirms the Importance of a Tipper’s ‘Personal Benefit’ for Insider Trading, but Also Creates Uncertainty” (Feb. 9, 2017); and “General Insider Trading Policies and Procedures May Be Insufficient for Hedge Fund Managers to Avert SEC Enforcement Action” (Nov. 3, 2016).

Co-Investments Enable Hedge Fund Managers to Pursue Illiquid Opportunities While Avoiding Style Drift

Co-investment rights offer investors opportunities to participate in certain investments to the extent that the manager elects not to pursue those investments entirely in its commingled fund. Historically, co-investments have been the province of private equity funds, managers and investors. As the range of hedge fund investment strategies has grown to incorporate less-liquid assets, however, the relevance and use of co-investments has grown as well. In the first article in this three-part series, we discuss key reasons why hedge fund managers offer co-investments; identify the categories of investors that typically pursue co-investment opportunities and the reasons for their interest; and discuss the investment strategies that lend themselves to co-investments. The second article describes how co-investments are commonly structured and discusses their key terms, such as management fee rates, incentive compensation and liquidity considerations. The third article analyzes fiduciary duty considerations that may arise when allocating investment opportunities between the main fund and co-investors, and identifies five common conflicts of interest associated with co-investments. For more on co-investments, see “Private Equity in 2017: How to Seize Upon Rising Opportunity While Minimizing Compliance and Market Risk” (Jun. 8, 2017); and “Sadis & Goldberg Seminar Highlights the Ample Fundraising and Co-Investment Opportunities in the Private Equity Industry, Along With Attendant Deal Flow and Fee Structure Issues” (Dec. 8, 2016).

Eight Recommendations for Hedge Fund Managers That Utilize Most Favored Nation Provisions in Side Letters

The challenging capital-raising environment has generally tilted the balance of power in favor of institutional investors. This has led to an uptick in investor requests for managers and their funds to enter into side letter agreements that grant the investor preferential rights such as reduced fees, greater transparency, enhanced liquidity rights and access to fund investment capacity. In addition to preferential terms, side letter requests now regularly include “Most Favored Nation” (MFN) provisions, which ensure that rights granted to current or future investors are also offered to the investor protected by the MFN. While managers may acquiesce to these demands, dismissing them as “standard” requests, MFN provisions can present numerous pitfalls for fund managers if they are not properly evaluated, prudently negotiated and effectively monitored to ensure compliance. This article, in addition to describing the anatomy of an MFN provision, sets forth eight recommendations for drafting and administering MFN provisions gleaned from conversations with industry experts. For additional commentary on side letter negotiations, see “HFLR and Seward & Kissel Webinar Explores Common Issues in Negotiating and Monitoring Side Letters” (Nov. 10, 2016).

What Are the Key Elements of a Comprehensive Hedge Fund Adviser Disaster Recovery Plan, and Why Are Such Plans a Business Imperative?

A key element of any hedge fund manager’s business continuity plan (BCP) is the disaster recovery plan (DRP), which contains procedures for getting back to business as quickly as possible following a business interruption via natural (e.g., hurricanes and pandemics), man-made (e.g., terrorism and theft) or technological (e.g., power outages and computer viruses) events. Institutional investors are focusing with renewed vigor on DRPs (as they are on BCPs) in the course of their due diligence, particularly as a recent spate of cyberattacks have affected various sectors around the globe. See “Steps Hedge Fund Managers Should Take to Defend Against the Rising Threat of Ransomware in the Wake of WannaCry” (Jun. 15, 2017). The SEC also issued a 2013 risk alert directed at deficiencies in fund manager BCPs and DRPs, as well as best practices that should be adopted. See “SEC Risk Alert Describes Deficiencies Found During Reviews of Investment Advisers’ Business Continuity and Disaster Recovery Plans and Recommends Best Practices for Such Plans” (Sep. 26, 2013). The Commission followed that alert up in 2016 by issuing a rule proposal that would require investment advisers to adopt and implement written BCPs and transition plans. To assist fund managers in preparing for this scrutiny, this article outlines key elements of a DRP; analyzes the impact a fund’s strategy has on a manager’s DRP; describes the role DRPs play in institutional investor due diligence; identifies specific technology issues (e.g., cloud-computing and smart phones); and outlines measures managers can undertake to test and maintain their DRPs. For more on BCPs and DRPs, see “Can Emerging Hedge Fund Managers Use Technology to Satisfy Business Continuity Requirements and Mitigate Third-Party Risk?” (Sep. 3, 2015).

Key Legal and Operational Considerations for Hedge Fund Managers in Establishing, Maintaining and Enforcing Effective Personal Trading Policies and Procedures

Rule 204A-1 of the Investment Advisers Act of 1940 provides minimum standards for SEC-registered investment advisers in crafting personal trading policies. The rule is sparse with respect to detail, however, giving advisers relatively wide latitude in designing those policies and procedures. Moreover, once personal trading policies and procedures are in place, the adviser must, in the language of Rule 204A-1, “maintain” and “enforce” them, yet the rule offers little in the way of guidance with respect to that maintenance and enforcement. Accordingly, market practice looms large in the design and implementation of personal trading policies and procedures. This three-part series discusses common elements of personal trading policies and procedures of hedge fund managers. The first article presents the overarching considerations in establishing a personal trading program; the scope of persons who should be covered by the personal trading program; and the reporting obligations that apply to covered persons. The second article provides examples of personal trading restrictions commonly included in these policies, including discussions on restricting the number of brokerage firms where covered persons can hold covered securities, the requirement to pre-clear certain transactions, holding periods for investments and blackout periods during which trades cannot be executed. The third article surveys technology a manager can use to monitor compliance with its personal trading policies and procedures. For current trends in personal trading policies and procedures, see “ACA 2016 Compliance Survey Addresses Custody; Fee Policies and Arrangements; Safeguarding of Assets; and Personal Trading (Part Two of Two)” (Feb. 2, 2017).

Key Person Provisions in Hedge Fund Documents: Structure, Consequences and Demand From Institutional Investors

Traditionally, the success of a hedge fund manager and its funds depends on the vision, expertise and acumen of a small group of people, including its founding partners and other key employees. Given the roles of those key people in generating revenue and ensuring a fund manager’s success, investors are rightfully concerned about what may happen if they were to die, become disabled or cease to actively participate in the management of the underlying funds for any reason. To address and mitigate those concerns, key person provisions are often drafted into side letters or into various fund or manager documents. Investors have been particularly insistent on including key person provisions when wielding their considerable leverage in negotiations amidst the poor recent performance of hedge funds. For more on navigating increased investor demands for favorable terms, see “How Hedge Fund Managers Can Accommodate Heightened Investor Demands for Bespoke Negative Consent, Liquidity, MFN and Other Provisions in Side Letters” (Oct. 13, 2016). This article explores how key person provisions are drafted and the mechanics they establish; the consequences of including the provisions in different documents; the ramifications of triggering those provisions; the demand by institutional investors for those provisions; and the relationship between key person provisions and succession planning. See also “Succession Planning Series: A Blueprint for Hedge Fund Founders Seeking to Pass Along the Firm to the Next Generation of Leaders (Part One of Two)” (Nov. 21, 2013).

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