Jul. 16, 2009

Secondary Buyers of Private Equity Fund Interests are Looking at Assets in Hedge Fund Side Pockets

The past two years have witnessed two related but opposing trends in the hedge fund world: an increasing proportion of assets placed in side pocket accounts, and an unprecedented volume of redemption requests.  The trends are related in that as the volume of redemption requests or anticipated requests increased, side pockets were one of the tools employed by managers to stem the outflow of capital.  See “Hedge Fund Managers Using Special Purpose Vehicles to Minimize Adverse Effects of Redemptions on Long-Term Investors,” Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009).  The trends are opposing in that as more assets were placed in side pockets, fewer assets were available to pay redemptions in cash.  See “Can a Hedge Fund Make Redemption Payments ‘In Kind’ by way of the Issue of ‘Participation Interests’ in its own Illiquid Assets, and What is the Status of a Redeeming Investor who has not Received any Payment at All?,” Hedge Fund Law Report, Vol. 2, No. 13 (Apr. 2, 2009).  Moreover, to the extent redemptions were paid in cash, the remaining portfolio became less liquid – to the dismay of many investors who invested with certain liquidity assumptions.  In an effort to reconcile these opposing trends – to increase the overall liquidity of a portfolio, which in turn would enhance the ability (if not the desire) to pay redemptions in cash, which in turn (presumably) could help slow the rate of redemption requests – hedge fund managers have been looking for ways to liquidate assets in side pockets.  But as credit markets have remained more or less frozen, buyers of such assets have been few and far between.  Some investors and managers have turned to secondary markets to transfer exposure to side pocketed assets to investors with more “patient capital.”  However, secondary markets can be an imperfect remedy for various reasons, including the substantial discount at which hedge fund interests often trade in secondary transactions, as well as valuation and confidentiality concerns.  See “Valuation and Confidentiality Concerns in Secondary Market Trading of Hedge Fund Interests,” Hedge Fund Law Report, Vol. 1, No. 27 (Dec. 9, 2008); “Hedge Fund Managers and Investors Turning to Dutch Auctions as an Alternative to Secondary Markets for Hedge Fund Interests,” Hedge Fund Law Report, Vol. 2, No. 10 (Mar. 11, 2009).  However, there may be another option for hedge fund managers looking to liquidate side pocketed assets.  In at least a few recent deals, firms that have historically specialized in purchasing secondary interests in private equity funds have purchased assets in hedge fund side pockets.  Such investors are structured for longer-term investments – they generally have capital locked up for at least three years, often longer – and thus are better situated to realize long term value in currently illiquid assets than are many of the hedge fund investors with side pocket exposure.  Our analysis of this trend includes discussions relating to: illiquid assets; the mechanics of side pockets; the operations of and participants in the secondary market for purchasing side pocketed assets; the opportunity identified by buyers of such assets; and the ongoing relevance and practicability of side pockets.

Hedge Fund Replication is Gaining in Popularity, but is it a Viable Alternative to Hedge Fund Investing?

The turbulence of 2008 refocused the attention of hedge fund investors on three principal areas (in addition, of course, to performance): liquidity, transparency and fees.  In general, investors are demanding, as a condition of new or continued investment, greater liquidity, enhanced transparency and lower fees.  See “Hedge Fund Managers Grapple with Legal and Practical Consequences of Demands from CalPERS, URS and Other Pension Funds for Better Investment Terms and Separate Accounts,” Hedge Fund Law Report, Vol. 2, No. 14 (Apr. 9, 2009).  However, to the extent managers give ground in any of these areas, their performance and operations can be complicated: enhanced liquidity can undermine the viability of longer-term investments; increased transparency can threaten the confidentiality of investment strategies; and lower fees can make it harder to attract and retain the best talent.  Investors still want access to hedge fund strategies – hedge funds as a group outperformed the broad equity indices in 2008 by a significant margin – but many have become skittish about traditional hedge fund structures.  Hence the growing popularity of so-called hedge fund “replication” strategies and funds.  Such hedge fund replication funds generally are registered investment companies that invest in liquid securities with the goal of tracking the performance of a group of hedge funds.  On the plus side, such funds generally offer daily liquidity, daily or frequent transparency and low fees (relative to traditional hedge fund fees).  On the negative side, they offer – or purport to offer – beta as opposed to alpha.  That is, they offer the returns of the hedge fund herd, as opposed to the returns of a star manager.  (By the same token, they generally avoid, or at least mitigate, the fallout from investment in a poor-performing or even fraudulent manager.)  In addition, the jury is still out on the ability of certain replication funds to faithfully track hedge fund indices by investing exclusively in liquid securities.  Nonetheless, interest among hedge fund investors and others in hedge fund replication is robust and growing.  We offer a comprehensive analysis of the pros and cons of hedge fund replication, including discussions of: what hedge fund replication is and how it works; the main providers of indices used for replication products; advantages and drawbacks of investing in replication strategies; and how institutional investors such as pension funds characterize investments in replication strategies for allocation purposes.

Hedge Funds Increasing Lobbying Efforts, Focusing On Shaping Regulations Rather Than Preventing Them

The nature and volume of lobbying by hedge funds and groups representing them has changed dramatically in the past year.  Formerly, hedge funds and their representatives engaged in only a limited amount of lobbying, relative to various other industries, and such lobbying as they engaged in was generally focused on preventing legislation or regulation that would require registration of hedge fund managers with the SEC.  Largely as a result of the credit crisis and the flurry of bills and proposals it has engendered, many of which would impact hedge funds and their managers directly or indirectly, hedge fund lobbying has shifted focus.  The new goal of such lobbying is to shape law and regulation, rather than to prevent it.  Specifically, the new lobbying efforts aim to ensure that any law or regulation applicable to hedge funds that makes its way onto the books be more procedural than substantive.  In this view, registration by itself would not be such a bad outcome, but dramatic limits on leverage, frequent public disclosure of positions and restrictions on the industries in which hedge funds can invest (all of which have been suggested in one form or another) might, together with similar substantive limitations, materially undermine hedge fund performance and operations.  We detail the reasons for the changed nature and volume of hedge fund lobbying; the role of the Managed Funds Association; the benefits and detriments of lobbying efforts by individual fund managers; the specific legislative and regulatory areas on which hedge fund lobbying is focusing; and international coordination of lobbying efforts.

Investors Allege that Hedge Fund Manager Deliberately Concealed High Number of Redemptions

On July 8, 2009, a group of investors, including a feeder fund and several charities, accused two hedge funds, Highland Credit Strategies Fund, LP and Highland Credit Strategies Fund, Ltd. (the Funds), their manager, Highland Capital Management (Highland) and affiliated parties of purposefully concealing the high level of redemption requests submitted to the Funds that led to the Funds’ collapse.  This article describes the events that led to the suit and summarizes the legal theories advanced by the investors.

Citadel Investment Group Sues Former Employees Alleging Violations of Non-Disclosure, Non-Solicitation and Non-Compete Agreements

On July 9, 2009, Citadel Investment Group (Citadel) filed a lawsuit in the Circuit Court of Cook County, Illinois against three of its former employees – Mikhail Malyshev, Jace Kohlmeier and Matthew Hinerfeld – and Teza Technologies LLC, a corporation founded by those three former employees.  Citadel’s complaint alleges that the individual defendants violated non-disclosure, non-solicitation and non-complete covenants in their employment agreements with Citadel, as well as the Illinois Trade Secrets Act, by misappropriating trade secrets and other confidential data relating to Citadel’s high frequency trading technology.  We describe the factual and legal allegations in the complaint.

State Street Vision Report on Hedge Funds Predicts a Migration to Third-Party Administration, Custody and Specialized Services, and a Comprehensive Reconsideration of Financial Regulation

On July 1, 2009, State Street Corporation released two papers on alternative investments as part of its Vision series of thought-leadership reports.  The papers examine two components of alternative investments, hedge funds and private equity, and their future prospects amid the global economic downturn.  According to State Street, both industries will likely adapt to the changed investment environment caused by the financial crisis and continue to provide significant long-term opportunities for institutional investors.  Our article examines the report on the hedge fund industry, entitled “Alternatives: New Views of the Hedge Fund Industry.”  In particular, our article addresses the potential ramifications of two trends identified by the report: (1) a migration to third-party administration, custody and specialized services; and (2) a comprehensive reconsideration of financial regulation.

In FINRA’s First Action Involving Credit Default Swaps, FINRA Fines ICAP $2.8 Million to Settle Price Fixing Claims

ICAP Corporates LLC (ICAP), a unit of ICAP Plc, one of the largest brokers of inter-bank transactions, has settled with the Financial Industry Regulatory Authority (FINRA) over allegations that a former broker improperly influenced fees on credit-default swaps (CDS).  Specifically, FINRA accused a former broker and manager of the ICAP CDS desk, Jennifer Joan James, of “improper communications” with competing firms about customers’ proposed brokerage rate reductions in the wholesale credit default swap market.  We detail FINRA’s allegations and the specifics of the settlement.

One William Street Capital Management Brings On Kathleen Riorda as Managing Director and Head of Business Development

On July 13, 2009, One William Street Capital Management, L.P. announced that Kathleen Riorda joined the firm as a managing director and head of business development.  Riorda, who has over 20 years of alternative investment experience, will expand the firm’s coverage of larger institutional clients and further develop the firm’s client service and investor communications capabilities.