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    Aug. 31, 2017

Six Essential HFLR Articles for Emerging Fund Managers

In honor of Labor Day in the United States, this issue of the Hedge Fund Law Report highlights six articles from its historical archives that provide guidance of particular relevance to emerging fund managers. Next week (the week starting September 4, 2017), the HFLR will resume its normal weekly publication schedule.

How Can Hedge Fund Managers Use Founder Share Classes to Raise and Retain Capital?

Early-stage hedge fund managers face significant challenges in raising capital due in large part to the perceived risks related to a short track record, limited resources, inexperience with running a fund management business, lack of institutional-quality operational infrastructure and a shortage of institutional investors. Because of these perceived risks, early-stage managers must be particularly resourceful in offering incentives to attract initial investor capital. One of the most attractive tools that hedge fund managers have at their disposal for this purpose is offering “founder share classes,” which generally give investors preferential investment terms in exchange for assuming some of the risks associated with an early-stage or emerging manager. This article discusses the typical structure of these classes; investment terms commonly offered with founder shares; key advantages and pitfalls of using founder share classes; and practical recommendations for hedge fund managers wishing to offer founder share classes. For additional insight on the tools available to emerging managers to attract capital, see “Lock-Ups and Investor-Level Gates Prevalent in New Hedge Funds” (Mar. 23, 2017); and “AIMA Survey Identifies Key Ways That Managers Align With Investors, Including Alternative Fee Structures, Skin in the Game and Customized Investment Solutions” (Sep. 22, 2016).

How Fund Managers Can Mitigate Prime Broker Risk: Preliminary Considerations, Structural Considerations and Legal Protections

The actions and potential failure of prime brokers pose sizable threats to the well-being of fund managers. In 2008, insolvencies by prominent prime brokers such as Bear Stearns and Lehman Brothers imperiled several hedge funds. See “Hedge Funds Turning to Prime Brokerage Trust Affiliates for Added Protection Against Prime Broker Insolvencies” (Jun. 24, 2009). In addition, as recently as July 2016, Merrill Lynch agreed to pay a $415 million settlement to the SEC in connection with actions that threatened its hedge fund clients. See “Merrill Lynch Settlement Reminds Hedge Fund Managers to Be Aware of How Brokers Are Handling Their Assets” (Jul. 7, 2016). To help our subscribers mitigate the risks posed by their prime brokers, this three-part series outlines steps that fund managers can take when engaging a prime broker. The first article details preliminary considerations when engaging prime brokers, including regulatory protections, several types of arrangements based on fund risk profiles and due diligence efforts managers can undertake. The second article examines structural considerations to mitigate prime broker risk, including the viability of multi-prime and split broker-custodian arrangements. The third article describes legal protections that can be included in prime brokerage agreements to mitigate risk, including with respect to rehypothecation limits and asset transfer restrictions. For more on prime broker selection, see “Factors to Be Considered by a Hedge Fund Manager When Selecting a Prime Broker” (Dec. 4, 2014); “How Should Hedge Fund Managers Select Accountants, Prime Brokers, Independent Directors, Administrators, Legal Counsel, Compliance Consultants, Risk Consultants and Insurance Brokers for Their Funds?” (Jun. 13, 2013); and “Prime Brokerage Arrangements From the Hedge Fund Manager Perspective: Financing Structures; Trends in Services; Counterparty Risk; and Negotiating Agreements” (Jan. 10, 2013).

Marketing and Reporting Considerations for Emerging Hedge Fund Managers

To survive and flourish in a market dominated by large, well-established competitors, emerging hedge fund managers must be well versed in the risks and potential dangers of raising funds and be mindful of regulatory compliance blunders, such as incomplete disclosures, insufficient controls and inadequate policies and procedures. See “$97 Million SEC Settlement Highlights Perils of Inaccurate Disclosures and the Agency’s Continued Focus on Conflicts of Interest and Client Overcharges” (May 25, 2017). Pepper Hamilton hosted a symposium focusing on a number of these risks and offering practical solutions. Moderated by partner Irwin Latner, the panel discussion featured Adil Abdulali, senior managing director of risk management for Protégé Partners; Christopher Edgar, managing director, capital solutions, for Convergex Prime Services; Andrew Goodman, partner at Infusion Global Partners; and Chris Lombardy, managing director at Duff & Phelps. This article highlights the key points raised by the panel. Other articles addressing issues faced by emerging managers include: “Most Small and Emerging Managers Expect Headcount to Increase in Next Three Years: AIMA/GPP Study Explores Viability, Key Business Terms, Outsourcing and Growth Prospects” (Jul. 27, 2017); and “Establishing a Hedge Fund Manager in Seventeen Steps” (Aug. 27, 2015).

How Fund Managers Can Prepare for Investor Due Diligence Queries About Cybersecurity Programs

Cybersecurity remains a top-of-mind issue for regulators, investors and advisers. As part of operational due diligence, investors often evaluate whether an adviser has robust cybersecurity defenses. Similarly, advisers must ensure that their administrators, brokers and other third parties have appropriate defenses. A program presented by the Investment Management Due Diligence Association (IMDDA) explored the fundamentals of cyber due diligence, the role of insurance in cybersecurity preparedness, recommendations for evaluating cyber insurance coverage and the evolving cyber-risk landscape. The program was moderated by Richard M. Morris, partner at Herrick Feinstein, and featured Herrick partner Alan R. Lyons; Herrick associate Erica L. Markowitz; and Michael Stiglianese, managing director of BDO USA. This article details the panelists’ insights, which provide valuable guidance to investors when conducting cyber due diligence on fund managers and to fund managers about the necessary elements of a cybersecurity program. For insights into the SEC’s expectations with respect to an adviser’s cyber policies and procedures, see “SEC Review of Cybersecurity Finds Gains Since 2014, but Cites Gaps in Training and Compliance” (Aug. 24, 2017); and “Investment Adviser Penalized for Weak Cyber Policies; OCIE Issues Investor Alert” (Oct. 1, 2015). For coverage of other IMDDA events, see “How Due Diligence Professionals Approach the Private Fund Review Process” (Jun. 15, 2017); and “How Studying SEC Examinations Can Enhance Investor Due Diligence” (Oct. 6, 2016).

Trending Issues in Employment Law for Private Fund Managers: Non-Compete Agreements, Intellectual Property, Whistleblowers and Cybersecurity

Attracting, compensating and retaining talented employees is a critical part of a fund manager’s business. Managers routinely use non-compete agreements and other measures to ensure that departing employees do not harm the managers’ businesses. A program presented by EisnerAmper offered an overview of the law of non-compete agreements and insight into other common employment issues that private fund managers face, including portability of track records, status of employees, protection of intellectual property and cybersecurity. Moderated by EisnerAmper director Frank L. Napolitani, the program featured Cole-Frieman & Mallon partner John Araneo. This article highlights the key takeaways from the presentation. For additional commentary on employment law issues, see “Four Steps NYC-Based Fund Managers Should Take in Light of Newly Enacted Law Prohibiting Compensation History Queries When Interviewing Prospective Employees” (May 11, 2017); “Best Practices for Fund Managers to Mitigate Litigation and Regulatory Risk Before Terminating Employees” (Feb. 9, 2017); and “Lessons on Separation Agreements That Fund Managers Can Glean From Recent SEC Action” (Feb. 2, 2017).

Structuring Private Funds to Avoid ERISA While Accommodating Benefit Plan Investors

Private fund managers need to understand what ERISA is, why ERISA matters and what exceptions are available to managers who do not want to be subject to ERISA as a manager of “plan assets.” At an event sponsored by the New York City Bar, ERISA practitioners from Simpson Thacher, Proskauer, Skadden and Wachtell Lipton discussed these issues and other ERISA-related developments applicable to organizing and operating private equity and hedge funds. The first article in this two-part series summarizes insights from the panelists on identifying benefit plan investors and exemptions available to fund managers under ERISA. The second article addresses drafting fund documents, ERISA-related liability and circumstances under which a private equity fund may be liable for unfunded pension liabilities of a portfolio company. See also “Steps Hedge Fund Managers May Take Today to Avoid Being Deemed a Fiduciary Under the DOL’s New Fiduciary Rule” (Jun. 29, 2017); “Happily Ever After? – Investment Funds That Live With ERISA, for Better and for Worse (Part Five of Five)” (Oct. 2, 2014); and “What Should Hedge Fund Managers Expect When ERISA Plans Conduct Due Diligence on and Negotiate for Investments in Their Funds?” (Jun. 20, 2013).

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