Apr. 16, 2009

Hedge Fund Managers Using Special Purpose Vehicles to Minimize Adverse Effects of Redemptions on Long-Term Investors

When a hedge fund is invested in illiquid assets, redemptions from that fund can adversely affect various constituencies, including non-redeeming investors, redeeming investors, the manager and even those who have day-to-day dealings with the assets.  Managers have various tools available to them for preventing or delaying redemptions, or mitigating the adverse outcomes that can flow from them.  Such tools include fund-level gates, investor-level gates, hard and soft lock-ups, rolling redemption periods, holdbacks, redemption suspensions and side pockets.  In addition, pension funds and other institutional investors are increasingly demanding access to hedge fund strategies via separate accounts, in an effort to minimize the mismatch between the time horizons of different investors in commingled vehicles.  With growing frequency, however, managers are employing a different strategy to effectuate redemptions – at least, redemptions of a sort – while avoiding many of the adverse outcomes normally associated with redemptions.  That strategy involves the use of special purpose vehicles (SPVs) – essentially, separate entities to which a fund can transfer illiquid assets, or economic exposure to illiquid assets, and which can issue interests that are transferred to redeeming investors in lieu of cash or the assets themselves.  In effect, managers formerly had been limited to three options when faced with redemptions: give nothing (i.e., impose a suspension, gate or holdback); give cash; or give in kind.  The use of SPVs introduces a fourth option: give interests in a new entity organized solely to house illiquid assets – if you will, a sort of “bad bank” for illiquid hedge fund assets.  More than anything, SPVs offer managers a way to control the timing of the disposition of currently illiquid assets, and to avoid forced sales into distressed markets.  We provide a comprehensive analysis of the use of SPVs in the redemption context, including a discussion of what SPVs are and how they work, what synthetic SPVs are and the contexts in which they can be used, a comparison with side pockets, recent examples, fee considerations and more.

Hedge Fund Managers Launching Mutual Funds in an Effort to Stay a Step Ahead of Regulatory Convergence

Although the term “hedge fund” has no statutory or common law definition, historically hedge funds have been defined in large part by what they are not: mutual funds.  Unlike mutual funds, hedge funds have been exempt from the definition of “investment company” under the Investment Company Act of 1940, and unlike mutual fund advisers, hedge fund advisers have not been required to register under the Investment Advisers Act of 1940.  Free from many regulatory restrictions that bind registered funds and advisers, the hedge fund format has been understood as a blank canvas on which a creative manager can realize his or her full investment potential; and the historical returns of some managers have borne out that understanding.  However, in a potent sign of the extent to which the challenging economic climate has changed the hedge fund industry, hedge funds managers are now engaging in a move formerly considered unthinkable – they are launching mutual funds.  While there are various reasons for this trend, two macro variables are largely responsible.  First, the negative feedback loop of poor performance and redemptions that has virtually halved the capital base of the industry.  Without capital there are no hedge funds – or mutual funds – and so hedge fund managers are looking for new sources of capital to fill the holes left by redemptions, even if that new capital generates lower fees.  Second, the increasing likelihood, perhaps inevitability, of regulatory convergence between hedge funds and mutual funds, and their respective managers.  Bills presently before Congress would subject hedge funds and their managers to many of the regulations currently applicable to mutual funds and their managers.  If such bills pass – and the consensus view is that they will, though likely with modifications from their current forms – then the regulatory playing field will be leveled and the legal advantages of running a hedge fund over a mutual fund will largely disappear.  In this sense, launching a mutual fund constitutes a recognition by a hedge fund manager of what may well be a legal fait accompli, and an effort to capitalize (from a marketing perspective) on the “aura” of being a hedge fund manager while that still means something in the retail imagination.  We discuss the convergence trend, the benefits and burdens to hedge fund managers of running a mutual fund, which hedge fund strategies lend themselves to mutual fund structures, allocation and marketing considerations and competition issues.

Directors of Cayman Islands Hedge Funds Assume a More Substantive Governance Role in Response to Institutional Investor Demands

As hedge fund investment performance has stumbled, institutional investors have ramped up the rigor of their pre-investment and ongoing due diligence, subjecting heretofore ignored aspects of hedge fund operations to new levels of scrutiny.  One such area of newfound concern among investors is the role of directors of hedge funds organized in the Cayman Islands.  Accurate or not, the general perception in the hedge fund industry has been that Cayman directors have played a less substantive role in the governance of the hedge funds they are supposed to oversee.  Moreover, as a result of a dearth of qualified directors, certain individuals serve on the boards of dozens of hedge funds, which renders it virtually impossible for those directors to actively participate in the governance of any one fund.  We discuss the evolving role of Cayman directors, and the role of institutional investors in that evolution.

District Court Preserves PIPE Insider Trading Claims Against Gryphon Hedge Fund

On March 23, 2009, the United States District Court for the Southern District of New York  decided that a lawsuit brought by the Securities and Exchange Commission against hedge fund manager Edwin “Bucky” Buchanan Lyon, IV, and the Gryphon family of hedge funds (Gryphon Funds) he managed (collectively, the defendants), may advance to trial.  The SEC accused the defendants of securities fraud and insider trading for allegedly short selling shares in four companies after obtaining confidential non-public solicitations to participate in those companies’ upcoming private investments in public equities (PIPE) transactions.  The trial court declined to enter summary judgment on behalf of either party, holding “issues of material fact remain in dispute – namely, whether defendants accepted a duty of confidentiality with regard to each of the four PIPE offerings” which they subsequently breached.  We explain how a PIPE transaction works, and detail the facts of the case and the court’s holding and analysis.

Hedge Fund Managers Contemplate Alternative Fee Structures in Anticipation of Passage of Federal and State Bills to Tax Carried Interest as Ordinary Income

For years now, bills introduced at the federal and state levels have sought to tax carried interest earned by hedge fund managers – traditionally, 20% of any gains made by the fund – as ordinary income.  To date, none of those bills has gained sufficient traction to become law.  However, the appearance of a line in President Obama’s budget relating to carried interest; a bill recently proposed by Rep. Sander Levin (D-Michigan) addressing and remedying some of the shortcomings that prevented past bills from becoming law; and various New York State and City efforts on the topic all have increased both the momentum and viability of increased tax on carried interest.  In anticipation of such tax changes, hedge fund managers and academic tax experts are thinking about how to revise fee structures to mitigate the adverse impact of such new taxes on net income, returns and incentives.  We detail the relevant provisions in the Obama budget, Rep. Levin’s bill, ideas from various academic experts on how fees might evolve in response to tax law changes and relevant New York State and City proposals.

State Street Hedge Fund Survey Shows that Institutional Investors Remain Committed to Increasing Hedge Fund Allocations in 2009

According to a recent study by institutional money manager State Street Corporation, although overall allocations to hedge funds have been in moderate decline, the majority of institutional investors intend to increase or maintain current hedge fund allocations over the next 12 months.  The study, conducted in conjunction with the 2008 Global Absolute Return Congress, indicates that the turbulent financial markets of 2008 have not significantly affected institutional investors’ asset allocations.  Indeed, three quarters of the investors surveyed, which included global public and government pensions, corporate pensions, endowments, foundations and insurance companies, reported that they do not plan to modify portfolio allocations.  We provide a detailed overview of the study.

Ray Wearmouth Joins Ogier as Group Partner in BVI

On April 15, 2009, offshore lawfirm Ogier announced the appointment of Ray Wearmouth as Ogier Group Partner in the firm’s British Virgin Islands office.  Among other roles, Ray will be acting in a legal advisory role for hedge fund clients as well as serving as director for certain funds in a fiduciary capacity.  Historically, he has provided legal advice on leverage and credit for hedge fund clients and expects to continue this role at Ogier.

Latham & Watkins Adds Brynn Peltz as an Investment Management Partner in its New York Office

On April 15, 2009, Latham & Watkins LLP announced that Brynn Peltz joined the firm’s New York office as a partner in the Corporate Department.  Peltz has a broad base of expertise advising financial institutions, private equity, real estate and hedge fund sponsors, alternative asset managers and registered investment companies with respect to all aspects of the Investment Advisers Act of 1940 and the Investment Company Act of 1940.

Lori Murphy Barton, CA CFA, Joins Castle Hall Alternatives As Managing Director

On April 14, 2009, Castle Hall Alternatives, a provider of independent operational due diligence for the hedge fund industry, announced that Lori Murphy Barton, CA CFA, has joined the firm as Managing Director.

Joyce E. Heinzerling Appointed as President of Meridian Fund Advisers LLC

On April 13, 2009, Meridian Global Fund Services Group announced that it had appointed Joyce E. Heinzerling to head a newly formed hedge fund consulting affiliate, Meridian Fund Advisers LLC.  At its core, Meridian Fund Advisers will provide hedge fund regulatory and corporate governance best practices advice to hedge funds both within and outside of the Meridian Global client base.  In this capacity, Ms. Heinzerling will work side by side with her extensive network of leaders in the hedge fund legal and accounting fields.