Apr. 30, 2009

As Pension Funds Exceed Hedge Fund Allocation Guidelines as Other Asset Classes Decline More Precipitously, Hedge Fund Managers Ask: Will Pension Funds Redeem or Revise their Allocation Guidelines?

Amid the sound and fury in financial markets in 2008 and early 2009, one of the lesser told tales involved the relative resiliency of hedge funds.  Hedge funds were down by almost 20 percent last year, but the S&P 500 was down by almost double that amount.  Press reports emphasized that the hedge fund industry is likely to shrink “by half” in 2009 from its 2007 peak; but a new report from The Bank of New York Mellon Corporation and Casey, Quirk & Associates LLC found that the industry will almost double, in terms of assets under management, by 2013.  Moreover, the preponderance of the new assets invested in hedge funds is expected to come from pension funds, which remain interested in hedge funds for various reasons, including their uncorrelated returns, absolute return strategies and ability to manage risk in unique ways.  The continued and growing appetite among pension funds for hedge fund investments, combined with the laudable relative performance of hedge funds during the recent downturn, has created something of a conundrum for pension fund allocation guidelines.  Generally, those guidelines provide for the majority of funds to go into bonds (government and corporate) and equities, with a smaller percentage reserved for alternative assets generally or hedge funds specifically.  Oftentimes, those allocations are measured as of the date of investment, so subsequent events can results in actual allocations quite at odds with target allocations.  And that is just what has happened of late.  Hedge funds have declined, but other assets have declined more precipitously.  As a result, pension funds generally are “overweight” hedge funds and “underweight” certain worse-performing assets, such as equities.  The big question facing pension fund and hedge fund managers: will pension funds redeem from hedge funds to bring their actual allocations back into line with their target allocations?  Or will pension funds revise their target allocations to permit a greater proportion of their assets to be invested in hedge funds?  Research conducted by the Hedge Fund Law Report helps answer these important questions.

How Has the New York Pension Fund Kickback Scandal Changed the Landscape for Placement Agents, and for Hedge Fund Managers who Use Them?

Placement agents long have served as a conduit between hedge fund managers and institutional investors.  Placement agents provide managers with a range of marketing services, including introductions to capital sources, honing of marketing materials and presentations and explanations of how managers’ strategies can address investors’ goals.  However, that arrangement has come under pressure, in light of a sweeping indictment filed by the New York State Attorney General Andrew Cuomo and a parallel civil complaint filed by the SEC, both alleging that certain New York State officials conspired to condition access to investments by the state’s pension fund on the payment of kickbacks to state officials or their associates.  In addition, at least one former hedge fund manager has pleaded guilty to paying kickbacks in exchange for state investments in a hedge fund he managed.  The pay-to-play allegations raise a series of potentially game-changing questions for placements agents and hedge fund managers that use them.  At the most extreme, they give rise to the prospect that other state pension funds will follow New York’s lead in banning the use of placement agents, and that other significant private equity and hedge fund managers will cease using placement agents.  This would cause a secular shift in the placement agency business – in effect, would convert it from a business that in large part serves established managers in ongoing fundraising efforts to a business that primarily serves smaller, start-up managers.  A less draconian – and more certain and immediate – effect of the events will be to cause managers to scrutinize their placement agent relationships (current and new) significantly more closely, and to build more robust protections into their agreements with placement agents.  We explore the implications of the pay-to-play allegations for hedge fund managers and investors, and placement agents.

The Hedge Fund Industry in Transition

With the completion of the G20 summit and the continued coverage of economic woes by the media, it leaves the reader to ponder how we arrived at this point in our history.  In a comprehensive guest article, Ernest Edward Badway and Lauren Lezak, Partner and Associate, respectively, at Fox Rothschild LLP, explore the foundation for and the potential changes in store for the hedge fund industry.

Will the States Reassert Control over the Regulation of Private Offerings?

Since passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, regulation of public offerings of securities has largely been the province of federal, as opposed to state, regulators.  Just over 60 years after passage of those laws, Congress confirmed in the National Securities Markets Improvement Act of 1996 (NSMIA) that regulation of private offerings of securities would also fall primarily within the federal jurisdiction.  Specifically, NSMIA provides that the federal regulation of certain private offerings preempts state regulation, although states retain the authority to enforce anti-fraud rules in connection with such offerings.  That is, the federal government has ex ante regulatory authority, and the states have ex post anti-fraud enforcement authority.  To a growing chorus of state securities regulators, that ex post enforcement authority is not sufficient to police and prevent fraud and other wrongdoing in connection with private offerings.  While a reversal of the preemption effected by NSMIA does not appear to be imminent, the agitation by state securities regulators is cause for concern among hedge fund managers that offer interests privately.  This article examines the structure of Regulation D (Reg D), the safe harbor under the Securities Act of 1933 (Securities Act) under which many hedge funds offer interests; the limited anti-fraud enforcement authority retained by the states in connection with Reg D offerings, and the absence of any precedent for the invocation of that authority; recommendations for changes to private offering regulation recently espoused in an audit of the Reg D process conducted by the SEC’s Office of the Inspector General (OIG); and the possibility of greater state involvement in regulation of Reg D offerings.

Does Regulatory Certainty Decrease Profits from Merger Arbitrage?

On March 5, 2009, Xinyu Ji and Gaurav Jetley completed a study titled “The Shrinking Merger Arbitrage Spread: Reasons and Implications.”  The study defines merger arbitrage as “an investment strategy that involves buying shares of a firm that is being acquired . . . and in the case of a merger that involves payment in shares, also shorting the shares of the acquiring firm.”  Gaurav Jetley is a Vice President at Analysis Group, Inc., and Xinyu Ji is an Associate there.  (However, the study reflects the analyses and findings of Mr. Jetley and Mr. Ji, and does not necessarily reflect the perspectives or conclusions of Analysis Group.)  Ji and Jetley compiled data indicating that there has been a long-term reduction in profits from merger arbitrage.  However, market participants interviewed by the Hedge Fund Law Report suggested the regulatory uncertainty with respect to merger approval may be on the upswing, which may increase the returns to merger arbitrage strategies.  We discuss these competing views, and highlight an underappreciated niche in which the prospect for returns to a merger arbitrage strategy may be brightest.

Massachusetts Trial Court Rules that Integration Clause in Subscription Agreement does not Protect Hedge Fund Manager from Fraudulent Misrepresentation Claims

On January 30, 2009, the Massachusetts Superior Court ruled that Edward Marram, as trustee for Geo-Centers, Inc. Profit Sharing Plan & Trust (the Plan), which had invested $2 million of its assets with the defendant hedge fund, Kobrick Offshore Fund (Kobrick or the Fund), could proceed with the various securities fraud claims it had originally brought against Kobrick.  The court also granted sanctions to Kobrick with respect to the plaintiff’s discovery failure; permitted the Plan to amend its complaint; dismissed all of Kobrick’s counterclaims; and dismissed all claims against third party defendants who allegedly provided negligent advice to the Plan.  The parties were ordered to attempt to resolve the action through mediation.  The court’s key substantive holding was that an integration clause in a subscription agreement does not protect a hedge fund manager defendant from suit based on separate oral or written misrepresentations.  We provide a detailed discussion of the court’s analysis.

Registered Investment Adviser Fined For Fraud and Failure to Perform Adequate Due Diligence

On April 22, 2009, the Securities and Exchange Commission issued an order charging investment adviser Hennessee Group LLC and its principal, Charles J. Gradante, with violations of various federal securities laws for failing to perform due diligence before advising their clients to invest in the Bayou hedge funds, a fraudulent fund that later imploded.  Pursuant to the order, the Hennessee Group and Gradante settled the SEC’s accusations by agreeing to pay more than $814,000 in fines without being required to confirm or deny their guilt.  We explain the background and practical implications of the order.

IndexIQ Launches “Hedged” Exchange-Traded Funds

An exchange-traded fund (or ETF) is essentially an investment vehicle with mutual fund features which trades on stock exchanges like a stock.  An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value (NAV) of its underlying assets over the course of the trading day.  As a result, an ETF investment provides the flexibility of a stock and the diversification of an index fund.  Recently, IndexIQ, a New York based investment firm, expanded the ETF universe when it launched the first ever U.S. hedge fund index-linked ETF in March, which offers the benefits of hedge fund investments to the public via ETFs, and then filed a registration statement for fifteen additional hedge fund replication ETFs in April 2009.  We review the filing, including a discussion of the advantages of hedge fund ETFs over actual hedge funds, and the relevant risk factors.

Selectica, Inc. v. Versata Enterprises, Inc.: Lessons from the First Triggering of a Modern Poison Pill and Video of Trial Testimony

In a March 2009 M&A Commentary titled “Lessons from the First Triggering of a Modern Poison Pill: Selectica, Inc. v. Versata Enterprises, Inc.,” Latham & Watkins LLP provided an insightful discussion of the important case pending in the Delaware Court of Chancery.  The case is particularly important for activist hedge funds whose investments in Delaware companies may, in certain circumstances, trigger poison pills.  We provide key parts of Latham’s discussion, and include video clips of testimony in the trial from the Delaware Court of Chancery, as provided by Courtroom View Network.

Christopher P. Harvey Joins Dechert LLP as a Partner in the Financial Services Group

On April 27, 2009, Dechert LLP announced that Christopher P. Harvey joined the firm as a partner in the financial services group.  Harvey, who will be resident in the firm’s Boston office, was previously a partner and co-chair of the investment management practice group at WilmerHale.