Mar. 1, 2018

Understanding Subscription Credit Facilities: Their Popularity and Usage Soar Despite Concerns Raised by Certain Members of the Private Funds Industry (Part One of Three)

With estimates that dry powder in private equity now exceeds $1 trillion, there can be no doubt that managers are fiercely competing for the best investment opportunities and that a manager’s inability to close quickly on investment deals may put it at a competitive disadvantage. Although many private funds have sizeable amounts of uncalled capital from their limited partners, that capital may only be accessible following a notice period of 10 business days or more. Subscription credit facility products were created as a form of bridge financing for private funds that employ a capital call structure. Credit lines of this nature have, however, come under intense scrutiny over the past 24 months, with one economist even calling these facilities a “con” used to artificially boost funds’ internal rates of return (IRRs). In this three-part series, the Hedge Fund Law Report examines these lending facilities and the controversies surrounding their use. This first article provides background on the types of funds that frequently use these facilities, recent trends that have emerged regarding this form of financing, basic mechanics of how these facilities are structured and the types of lenders that routinely offer these products. The second article will discuss the primary advantages to funds and their sponsors, as well as investors, of using these facilities and explore the legal documents that govern these facilities. The third article will evaluate some of the concerns raised by members of the private equity industry regarding these facilities, including the debate as to whether these facilities should be used for longer-term financing and how they impact a fund’s IRR. For more on subscription credit facilities, see “Subscription Facilities Provide Funds With Needed Liquidity but Require Advance Planning by Managers (Part One of Three)” (Jun. 2, 2016).

What Fund Managers Investing in Virtual Currency Need to Know About NFA Reporting Requirements and the CFTC’s Proposed Interpretation of “Actual Delivery”

Last December, the NFA adopted new reporting requirements for member commodity pool operators (CPOs) and commodity trading advisors (CTAs) related to virtual currency. Separately, the CFTC published a proposed interpretation of the term “actual delivery” in the context of retail commodity transactions in virtual currency. These actions reflect the enhanced regulatory oversight of virtual currency against the backdrop of spectacular volatility in these products and the recent launch of futures contracts involving virtual currency products. In a guest article, Lawrence B. Patent, of counsel at K&L Gates, reviews the new NFA reporting requirements for CPOs and CTAs; the CFTC’s proposed interpretation of the term “actual delivery”; considerations for hedge fund managers seeking to invest in virtual currency; and the outlook for further regulatory action in this area. See our three-part series on blockchain and the private funds industry: “Basics of the Technology and How the Financial Sector Is Currently Employing It” (Jun. 1, 2017); “Potential Uses by Private Funds and Service Providers” (Jun. 8, 2017); and “Potential Impediments to Its Eventual Adoption” (Jun. 15, 2017). For additional insights from Patent, see our three-part CPO compliance series: “Conducting Business with Non-NFA Members (Bylaw 1101)” (Sep. 6, 2012); “Marketing and Promotional Materials” (Oct. 4, 2012); and “Registration Obligations of Principals and Associated Persons” (Feb. 7, 2013).

What Does the SEC’s Latest Self-Reporting Initiative Portend for the Future of Enforcement?

In an effort to align enforcement with efficiency, many regulators are increasingly turning to self-disclosure and cooperation initiatives to incentivize fund managers to come forward and admit bad behavior in exchange for leniency. The SEC recently announced the newest and most narrow of these: the Share Class Selection Disclosure Initiative (SCSD Initiative). By offering favorable settlement terms, the SCSD Initiative is intended to encourage investment advisers to admit failures to properly disclose their selection of mutual fund share classes that paid a fee pursuant to Rule 12b‑1 of the Investment Company Act of 1940 when lower-cost share classes for the same funds were available to clients. See “Recent SEC Settlement Evidences Agency’s Continued Aggressive Enforcement of Conflicts of Interest” (Sep. 21, 2017); and “$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). This initiative serves as a reminder to all fund advisers of the SEC’s focus on conflicts of interest. In addition, due to its narrow nature – including the short timeframe for taking advantage of its benefits and the potential penalties for non-compliance – some may wonder whether the SCSD Initiative signals a retreat from the “regulatory-lite” approach anticipated under the Trump administration. This article analyzes the SCSD Initiative, including its terms and what it could portend for all private fund managers. For more on self-reporting, see “How Fund Managers Can Maintain Work Product Protection During Investigations After the Herrera Decision” (Feb. 22, 2018); and “Newly Revealed CFTC Self-Reporting and Cooperation Regime Could Offer Benefits to Fund Managers, or Lead to Increased Enforcement” (Oct. 19, 2017).

FCA Outlines U.K. and MiFID II Requirements for the Development, Testing and Operation of Algorithmic Trading Systems

The U.K. Financial Conduct Authority (FCA) has laid out relevant regulatory requirements and best practices for algorithmic trading in a recent report that highlights five key areas: the definition of algorithmic trading; the development and testing process; risk controls; governance and oversight; and market conduct. The report draws on reviews that the FCA conducted in anticipation of the implementation of the recast Markets in Financial Instruments Directive. “This report is relevant for all firms developing and using algorithmic trading strategies in wholesale markets. Firms should consider and act on its content in the context of good practice for their business,” said Megan Butler, FCA Director of Supervision – Investment, Wholesale and Specialist, in the FCA press release announcing the report. This article summarizes the report’s key takeaways. See our two-part series on managing automated trading strategies: “Examining and Documenting Strategies” (Jan. 7, 2016); and “Monitoring and Reviewing Strategies” (Jan. 14, 2016).

How Alternative Investment Managers Can Avoid Becoming Digital Dinosaurs: KPMG and CREATE-Research Survey Examines How Digitization May Transform the Industry (Part One of Two)

Blockchain, big data, machine learning and artificial intelligence have been on the radar of private fund managers for some time. KPMG International and CREATE-Research (together, the Authors) recently conducted a study in which they explored how alternative investment managers are approaching the digital age. This two-part series summarizes the key findings from the study and includes insights from Professor Amin Rajan, chief executive of CREATE-Research and one of the authors of the study. This first article examines digitization as a disrupter in the alternative investment industry and its anticipated effects; seven drivers of digitization; and key factors that are likely to affect the pace of digitization. The second article will discuss how both hedge and private equity fund managers are currently implementing digital innovations into their businesses, including the types of digital technologies they have adopted, and how alternative investment managers can move toward a more digital environment. For recent insights from KPMG on how technology is transforming the alternative investment industry, see “Private Fund Advisers and Service Providers Must Evolve Their Businesses to Keep Pace With Innovations in Technology, or Risk Becoming Obsolete” (Jan. 18, 2018).

Securities Docket Webinar Analyzes SEC Focus on Cybersecurity and Cryptocurrencies, Along With Implications of Court Decisions on the ALJ Regime and Attorney-Client Privilege (Part Two of Two)

The SEC, which increasingly uses technology to leverage its oversight and enforcement powers, recently reaffirmed its commitment to combatting cybercrime and misconduct in cryptocurrencies through the creation of a Cyber Unit. See “Co-Director of SEC Enforcement Division Champions New Retail Strategy Task Force and Cyber Unit” (Nov. 16, 2017). In addition, the Commission is continuing its trend of holding individuals accountable to deter misconduct. Finally, recent judicial decisions continue to shape insider trading law; the extraterritorial application of securities laws; the legitimacy of the SEC’s administrative law judge (ALJ) regime; and the risks and benefits of providing privileged material to government agencies. These issues, among others, were discussed in a recent Securities Docket webinar featuring William R. McLucas, partner at WilmerHale; Doug Davison, partner at Linklaters; and Martin Wilczynski and Steven E. Richards, senior managing directors at Ankura Consulting Group. This article, the second in a two-part series, analyzes developments in the areas of cybersecurity and cryptocurrencies; individual accountability; insider trading; extraterritorial application of securities laws; the ALJ regime; and attorney-client privilege. The first article summarized 2017 enforcement actions and other developments in the areas of accounting and audit cases, disgorgement and whistleblowers. For further commentary from WilmerHale attorneys, see “Financial CHOICE Act of 2017 Proposes Sweeping Reforms, but May Allow Regulators to Maintain Status Quo in Some Areas” (Jun. 1, 2017).

Karl Egbert Joins Baker McKenzie in New York

Baker McKenzie has expanded its corporate and securities practice with the hiring of Karl Egbert as a partner in New York. Egbert provides counsel to hedge fund managers on fund formation, investor issues and the intricacies of conducting deals under more than one regulatory framework. See “HFA Briefing Covers U.S. and Global Regulatory Climate Relating to Liquidity, Enforcement, Examinations and Cybersecurity” (Jan. 4, 2018). For commentary from another Baker McKenzie attorney, see “ALM General Counsel Summit Highlights Key Elements of a Robust Cybersecurity Compliance Program” (Dec. 17, 2015).