Oct. 26, 2017

Six Essential HFLR Articles for Managers of Private Equity and Hybrid Funds

According to a 2017 survey published by Barclays Capital Solutions Group, hedge funds experienced net outflows of approximately $70 billion in 2016. Capital commitments to private equity funds remain robust however, and hybrid structures – which combine characteristics of both open- and closed-end funds – are growing in popularity. These trends can be explained, in large part, by fund performance. While certain hedge fund strategies continue to underperform stocks and riskier bonds, private equity funds have generally performed well in recent years. This has led some hedge fund managers to pursue less liquid investment opportunities, with the hopes of growing their performance returns. Holding less-liquid or illiquid investments through a vehicle that was originally designed to hold more liquid asset classes presents, however, a number of legal and potential regulatory concerns. To mitigate these risks, many managers have elected to expand their product offerings to include vehicles structured to accommodate investments with longer investment horizons, including private equity and hybrid funds. In recognition of this industry trend, the Hedge Fund Law Report is highlighting six articles from its historical archives that provide guidance of particular relevance to managers of private equity funds and hybrid structures. Next week (the week starting October 30, 2017), the HFLR will resume its normal weekly publication.

How to Mitigate Investment and Operational Conflicts Arising Out of Simultaneous Management of Hedge Funds and Private Equity Funds

As private fund managers seek to diversify their product offerings and lines of business, investment managers are increasingly operating both hedge and private equity funds. Simultaneous management, however, can give rise to potential conflicts of interest, including issues relating to allocation of investment opportunities between the funds, possession of material nonpublic information, valuation and allocation of expenses. The SEC’s Office of Compliance Inspections and Examinations (OCIE) continues to prioritize conflicts of interest during the adviser examination process, with failures in this area frequently leading to referrals by OCIE to the Division of Enforcement. See “SEC Enters Final Judgments in Connection With Allegedly Fraudulent Scheme to Benefit One Fund at the Expense of Another” (Aug. 24, 2017); and “OCIE 2017 Examination Priorities Illustrate Continued Focus on Conflicts of Interest; Branch Offices; Advisers Employing Bad Actors; Oversight of FINRA; Use of Data Analytics; and Cybersecurity” (Jan. 26, 2017). This three-part series assists our readers with identifying and mitigating the conflicts of interest that may arise as a result of the simultaneous management of hedge and private equity funds. The first article explores how the structure of the investment manager, and the investments by its funds, may give rise to potential conflicts, as well as conflicts that may arise from the allocation of investment and disposition opportunities between affiliated hedge and private equity funds. The second article discusses operational conflicts arising out of simultaneous management of hedge and private equity funds, including conflicts involving the possession of material nonpublic information, valuation, allocation of expenses, personal trading and investors. The third article addresses offshore concerns and ways to mitigate conflicts of interest. See also our three-part series “Conflicts Arising Out of Simultaneous Management of Hedge Funds and Alternative Mutual Funds Following the Same Strategy”: Investment Allocation Conflicts (Apr. 2, 2015); Operational Conflicts (Apr. 9, 2015); and How to Mitigate Conflicts (Apr. 16, 2015).

Subscription and Other Financing Facilities Provide Liquidity and Flexibility to Private Funds but Require Advance Planning by Managers

In order to quickly act on investments, instead of waiting for investors to fund capital calls, private equity and other private funds are turning to subscription credit facilities for necessary liquidity. Along with other types of fund financing facilities, subscription credit facilities are becoming more prevalent in the asset management industry. To facilitate the execution of a subscription facility, however, a manager must make certain preparations, particularly at the outset of the fund. In an interview with the Hedge Fund Law Report, Zac Barnett and Liz Soutter, partners at Mayer Brown, discussed subscription and other financing facilities used by funds. In the first article of this three-part series, Barnett and Soutter examine the prevalence of subscription facilities in the asset management industry, investor response to these structures and primary considerations for managers anticipating entering into such a facility. The second article reviews the evolution of other types of financing facilities in the current market, including fund-of-fund facilities, portfolio acquisition facilities and general partner support facilities. The third article focuses on market, structuring and operational considerations for managers when establishing financing facilities. For more on financing options for private funds, see “How Can Private Fund Managers Use Subscription Credit Facilities to Enhance Fund Liquidity?” (Apr. 4, 2013).

Best Practices for Expense Allocation and Fee Practices: High-Risk Allocation Practices, Inadequate Disclosures and Remedying Improper Allocations

There were no specific regulations – and minimal SEC guidance – for fund managers to reference prior to 2015 when allocating expenses between themselves and their funds. To fill this void and protect investors, the SEC announced in 2015, and again in 2016, that private fund fee and expense practices would be a priority of its Office of Compliance Inspections and Examinations. A flurry of enforcement actions followed, targeting practices often viewed as “market” by advisers to private equity funds at the time. Fund managers must study those actions to ensure they do not commit the same violations highlighted by the SEC. This three-part series illuminates best practices for fund managers to avoid expense allocation violations. The first article outlines trends in the types of expense allocations most aggressively scrutinized by the SEC. The second article examines the flaws in disclosures to investors and the gaps in policies and procedures of managers that frequently result in expense allocation violations. The third article describes best practices fund managers should adopt to prevent violations, as well as remedial actions to take upon discovering the improper allocation of an expense. See “ACA 2017 Fund Manager Compliance Survey Details Variety in Expense Allocation Practices and Business Continuity Measures (Part Two of Two)” (Jun. 8, 2017); and “SEC Enforcement Director Highlights Increased Focus on Undisclosed Private Equity Fees and Expenses” (May 19, 2016).

How Can Liquid Hedge Funds Be Structured to Accommodate Investments in Illiquid Assets?

Since the early 2000s, hedge funds have focused heavily on traditional liquid strategies. As a result, market inefficiencies have narrowed or vanished, and opportunities for arbitrage have grown fewer and farther between. In response, some hedge fund managers that traditionally focused on liquid strategies started investing at least part of their funds’ capital in private equity and other illiquid securities and assets. Using liquid fund vehicles to invest in illiquid assets, however, has presented a variety of problems, including those relating to taxation, liquidity, valuation, manager compensation, strategy drift, due diligence, expectations regarding returns and regulatory scrutiny. Convergence at the fund level is problematic because illiquid assets do not fit naturally into a liquid fund. Convergence at the manager level is more palatable, but institutional investors have typically demonstrated a preference for managers that specialize in managing either private equity funds or hedge funds. This article explains traditional liquid fund structuring and taxation; characteristics and taxation of marketable securities versus private equity; structures employed by liquid funds to accommodate illiquid assets (including side pockets, lock-ups, gates and redemption suspensions); and some of the reasons why illiquid assets present problems when housed in liquid funds. The article concludes with thoughts on structuring for managers that traditionally have focused on liquid strategies but are exploring illiquid opportunities. For more on hedge funds and illiquid assets, see “Co-Investments Enable Hedge Fund Managers to Pursue Illiquid Opportunities While Avoiding Style Drift” (Jul. 6, 2017); “Credit Suisse Investor Survey Finds Steady Demand for Hedge Funds and Growing Demand for Less-Liquid Products” (Apr. 13, 2017); and “Lock-Ups and Investor-Level Gates Prevalent in New Hedge Funds” (Mar. 23, 2017).

SEC Settlement Order Reignites Concerns Over Whether Private Fund Managers Must Register As Brokers

One hallmark of being a “broker” is the receipt of transaction-based compensation. In 2013, the SEC’s David W. Blass suggested that a private equity fund manager that receives transaction-based fees in connection with a fund’s acquisition of portfolio companies should register as a broker under the Securities Exchange Act of 1934. The SEC, however, did not provide additional guidance until a 2016 settlement with a private equity fund manager and its principal. The adviser allegedly received transaction-based compensation and engaged in traditional brokerage activities. Although the SEC also charged the adviser with a number of other violations, the press release announcing the settlement emphasizes that issue and quotes Andrew J. Ceresney, then Director of the SEC Division of Enforcement, who said, “The rules are clear: before a firm provides brokerage services and receives compensation in return, it must be properly registered within the regulatory framework that protects investors and informs our markets. . . . [The adviser] clearly acted as a broker without fulfilling its registration obligations.” This article summarizes the facts that led up to the SEC’s action, the alleged violations and terms of the settlement. For more on the relationship between transaction-based compensation and broker registration, see “Perspectives From In-House and Private Practice: Cadwalader Special Counsel Garret Filler Discusses Family Offices, Broker-Dealer Registration Issues and Impact of Capital, Liquidity and Margin Requirements (Part Two of Two)” (Aug. 25, 2016); “SEC No Action Letter Suggests That There May Be Circumstances in Which Recipients of Transaction-Based Compensation Do Not Have to Register As Brokers” (Feb. 21, 2014); and “Do In-House Marketing Activities and Investment Banking Services Performed by Private Fund Managers Require Broker Registration?” (Apr. 18, 2013).

Use by Private Fund Managers of the British Virgin Islands for Private Equity Fund Formation and Private Equity Investments

The British Virgin Islands (BVI) has a reputation for being Asia’s favored offshore jurisdiction for companies. While the use of BVI companies as holding companies, sole-director entities and listing vehicles for Hong Kong initial public offerings is well known, the advantages of the BVI as a domicile of choice in the context of private equity transactions is not as widely recognized. Many features which make the BVI an attractive domicile for listing vehicles also make it an attractive jurisdiction for private equity investments and for the formation of private equity funds. This article describes certain of these benefits. See also “Advantages and Drawbacks of Four Main Fund Structures for Offshore Launches in the BVI” (Apr. 27, 2017).