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    Jul. 5, 2018

Six Essential 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 9, 2018), the HFLR will resume its normal weekly publication schedule.

Key Considerations for Hedge Fund Managers in Organizing and Operating Valuation Committees

Among the various conflicts of interest that arise in the private fund management business, valuation of portfolio assets may be first among equals. The specific conflict is this: portfolio managers often play a fundamental role in the valuation of portfolio assets, while at the same time, the compensation of portfolio managers is often tied directly to the performance of the fund that owns those assets. In many cases, however, given the intimacy with which the portfolio manager knows the asset, the portfolio manager is in the best position to provide relevant information on how to accurately value it. Therefore, excluding the portfolio manager from the valuation process is not a plausible solution. Against this backdrop, the use of a valuation committee has become a best practice to not only mitigate this conflict of interest but also to ensure that the manager arrives at accurate valuations. This article considers key questions that all private fund managers confront when establishing and operating valuation committees, including: What is the role of a valuation committee? Who should be on it? What functions should it perform? How often should it meet? For more on valuation, see “Investor Suit Against Hedge Fund Manager Illustrates the Perils of Valuing Illiquid Securities” (Oct. 8, 2015); and “DLA Piper Hedge Fund Valuation Webinar Covers Fair Value Methodologies, Valuation Services, Valuing Illiquid Positions and Handling Valuation Inquiries During SEC Examinations” (Aug. 7, 2013).

When and How Should Hedge Fund Managers Shadow Functions Performed by Their Fund Administrators?

In 2007, hedge fund managers administered roughly 75 percent of U.S.-based hedge funds in house. Today – for reasons including the credit crisis, high-profile frauds and the institutionalization of the hedge fund investor base – the majority of the private funds industry outsources certain operational tasks to administrators. Some industries outsource administrative functions primarily for division of labor purposes, as a vendor can perform certain tasks more efficiently and for lower cost than the institution. By contrast, the outsourcing of administrative functions in the private funds industry is not so much a division of labor as a duplication of it, as many private fund managers continue to perform those same functions in house despite that outsourcing. In the private funds industry, this duplication of administrative efforts is known as “shadowing.” To shed light on the practice of shadowing, this article discusses what functions are typically performed by fund administrators; what administrator shadowing entails and reasons why managers shadow their administrators; what functions are most commonly shadowed by fund managers and the methods used to shadow administrators; what the benefits and costs of administrator shadowing are, as well as who bears the costs of shadowing; which circumstances make shadowing an administrator most attractive for managers; and what the challenges of shadowing an administrator are. See “Ernst & Young Survey Juxtaposes the Views of Hedge Fund Managers and Investors on Hedge Fund Succession Planning, Governance, Administration, Expense Pass-Throughs and Due Diligence” (Jan. 5, 2012); and “Primary Legal and Practical Considerations for Hedge Fund Managers Looking to Outsource Their Operational Functions” (Sep. 22, 2011).

How Can Hedge Fund Managers Market Their Funds Using Case Studies Without Violating the Cherry Picking Rule?

Due diligence is a courtship process in which institutional allocators spend considerable time and resources getting to know a manager’s philosophy, people, processes and performance. Investment and operational due diligence focus not only on performance results, but also on how the manager achieved that performance. There is no more comprehensive or persuasive way to convey the “how” of a manager’s investment process than to walk investors through the lifecycle of actual investments – in other words, to present case studies. While managers often have compelling business rationales for telling their stories via case studies, SEC-registered investment advisers must contend with Rule 206(4)-1 under the Investment Advisers Act of 1940 – the so-called “cherry picking” rule – which prohibits an adviser from disseminating, directly or indirectly, advertisements that refer to specific past profitable recommendations. The first article in this two-part series describes the purposes and typical content of case studies; identifies the types of managers and strategies that use and benefit from case studies; and highlights risks associated with the use of case studies in marketing, including a discussion of the cherry picking rule. The second article discusses additional risks of using case studies and provides best practices for managers wishing to use case studies in marketing. See our three-part series on advertising compliance: “Ten Best Practices for a Fund Manager to Streamline Its Compliance Review” (Sep. 14, 2017); “Five High-Risk Areas for a Fund Manager to Focus on When Reviewing Marketing Materials” (Sep. 21, 2017); and “Six Methods for a Fund Manager to Test Its Advertising Review Procedures” (Sep. 28, 2017).

How Can Hedge Fund Managers Prevent Theft of Proprietary Trading Technology and Other Intellectual Property?

Hedge fund managers who have made or are contemplating significant investments in proprietary technology face at least three major issues: (1) whether to develop that technology internally or buy or lease it from a third party; (2) whether to seek to patent it; and (3) how to prevent theft. More often than not, a hedge fund manager is better served by developing its own technology in cases where that technology is central to its trading strategy or operational infrastructures. Internal development confers greater control over the technology, increases the value of the advisory entity and strengthens the case for investors to invest with the manager as opposed to any other licensee of a third-party technology. In general, however, it is ill-advised to seek patent protection for these technologies, given that the process is long and may require disclosure of information that can undermine the proprietary value of the technology, and the protection itself is uncertain. To prevent theft, managers can utilize confidentiality agreements, robust pre-employment (or pre-independent contracting) screening and security measures embedded in the technology itself. Even with carefully thought-out protections, however, intellectual property (IP) remains uniquely susceptible to theft. This article explores the three issues identified above – whether to build or buy, whether to seek to patent and how to prevent theft – and discusses “soft” IP (copyright and trademark) in the hedge fund context. See our two-part series on how hedge funds can protect their brands and IP: “Trademarks and Copyrights” (Feb. 23, 2017); and “Trade Secrets and Patents” (Mar. 9, 2017).

Key Elements of a Hedge Fund Adviser Business Continuity Plan

Although performance remains a critical due diligence point for institutional investors, other aspects of the hedge fund advisory business now play a more prominent role in the investment decision-making process of institutional investors; after all, performance can be subverted by inadequate risk management, compliance and controls. In particular, institutional investors (and regulators) are increasingly focused on adviser business continuity plans (BCPs), which identify the range of events and risks that can interrupt business operations and investment activities, and detail the steps that a manager will take if those events or risks come to fruition. Events that may trigger the procedures in a BCP can be natural (e.g., hurricanes, earthquakes and pandemics), man-made (e.g., terrorism, theft and other crimes) or technological (e.g., power outages, disruption of exchanges and computer viruses). The procedures used to address those risks must be tailored to the manager’s strategy, technology, network of service providers and geographic location. Moreover, the BCP has to be a living document – something that is tested, communicated to employees and other constituents and updated as relevant. This article offers a comprehensive analysis of BCPs in the hedge fund context, including defining a BCP; enumerating key elements of a hedge fund manager BCP; and discussing, among other things, the impact of a hedge fund’s strategy on its manager’s BCP, regulatory requirements, institutional investor expectations, disclosure considerations and the frequency with which a BCP should be reviewed and updated. See also “Can Emerging Hedge Fund Managers Use Technology to Satisfy Business Continuity Requirements and Mitigate Third-Party Risk?” (Sep. 3, 2015); and “What Are the Key Elements of a Comprehensive Hedge Fund Adviser Disaster Recovery Plan, and Why Are Such Plans a Business Imperative?” (Feb. 25, 2010).

Hedge Fund Managers Turn to Hybrid Fund Structures to Reconcile Fund Liquidity Terms and the Duration of Assets

Many managers structure new funds so that the duration and liquidity of each fund matches as closely as possible the duration and liquidity of the assets in the fund’s portfolio. For example, hedge funds that invest in less liquid assets – such as distressed debt, shares of private companies and real estate – may incorporate fund terms more traditionally associated with private equity funds. These “hybrid” funds have several goals: (1) to avoid a disorderly liquidation of assets at inopportune times; (2) to align expectations, allowing investors to assess the fund’s liquidity profile at the time of investment rather than after an investment is made; and (3) to do directly – retain assets and avoid sales at distressed prices – what various managers have been forced to do indirectly, via side pockets, gates, redemption suspensions and similar tools. This article explores the rationale for employing a hybrid structure; the range of hybrid terms and structures (including components derived from traditional private equity and hedge fund models); and the strategies for which hybrids may be particularly well-suited. See “Beyond the Master-Feeder: Managing Liquidity Demands in More Flexible Fund Structures” (May 25, 2017); and “How Can Liquid Hedge Funds Be Structured to Accommodate Investments in Illiquid Assets?” (Feb. 3, 2011).

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