Sep. 24, 2009

Primary Legal and Business Considerations in Hedge Fund Seeding Arrangements

Over the last ten years it has become increasingly difficult for an emerging fund manager to start a hedge fund with minimal assets under management, establish a track record and use that record to attract additional capital.  With increased regulation on the horizon and its attendant compliance costs, not to mention investor wariness in the face of current economic conditions, the barrier to entry for hedge fund managers likely will increase even more.  One way for a manager to break through this barrier is to enter into an agreement with a seed investor.  In a typical seeding arrangement, the hedge fund manager or seedee receives start-up capital from a seed investor or seedor, typically a banking or other financial entity or else a fund of funds whose strategy is to invest in promising emerging managers.  In return, the seedor participates (more often than not though a contractual right to a portion of the revenues of the seedee rather than a direct ownership interest).  As a result, the seedor’s and the seedee’s interests appear to be aligned.  Each benefits from an increase in the manager’s assets under management and positive performance.  Yet, the seedor and the seedee have different expectations from a seeding arrangement.  These expectations color how the two parties look at the terms of the seeding arrangement.  In a guest article, Janet R. Murtha, a Partner at Warshaw Burstein Cohen Schlesinger & Kuh, LLP, explores the primary legal and business issues that frequently arise in seeding arrangements from the perspectives of both sides.  In particular, from the perspective of seedees, she examines: objectives; the term of a seed commitment; capacity rights; and other matters.  And from the perspective of seedors, she analyzes: objectives; reputational concerns and related due diligence; and back office concerns and related due diligence.  Finally, she explains the economics of seeding transactions and the use and structuring of put and call provisions.

Boutique Prime Brokers are Emerging to Provide Services to Small and Mid-Size Hedge Funds Marginalized by Larger Prime Brokers

The recent financial crisis witnessed a bifurcation in the prime brokerage business: big hedge fund clients got the same or better terms from big prime brokers, and smaller hedge fund clients got worse terms or got shut out altogether.  In large part, this was the result of frozen credit markets and pervasive risk aversion.  One of the key services provided by prime brokers to hedge funds is lending, see “In Frozen Credit Markets, Enhanced Prime Brokerage Arrangements Offer a Rare Source of Hedge Fund Leverage, But Not Without Legal Risk,” Hedge Fund Law Report, Vol. 2, No. 8 (Feb. 26, 2009), and just as banks ceased making loans to all but their most creditworthy borrowers, so did big prime brokers cease making loans (or providing other services) to all but their most creditworthy hedge fund clients.  Creditworthiness in this context generally was assessed based on assets under management (AUM).  As a rough rule of thumb, from the perspective of the larger prime brokers, AUM of less than $500 million generally presented an unpalatable level of risk.  To compensate for that perceived risk, the big prime brokers charged higher or separate fees to funds below that threshold, and cut back on the range and level of services offered to smaller funds.  In some cases, the big prime brokers “fired” smaller hedge fund clients altogether.  A new crop of boutique prime brokers has arisen to fill the services void left by the retrenchment among the larger prime brokers.  While smaller hedge funds may be perceived as too risky or not sufficiently profitable for the larger prime brokers, smaller hedge funds are precisely the type of client that the new group of boutique prime brokers is structured to serve.  In other words, supply has arisen to meet the market demand.  This article details the services provided by prime brokers (large and small); the terms that are becoming “market” in agreements between hedge funds and boutique prime brokers; terms in prime brokerage agreements that warrant special attention from hedge funds and their counsel when such agreements are being negotiated; the arrangements between boutique prime brokers and larger prime brokers with respect to trade execution and clearing; custody of assets, and in particular, services whereby prime brokers will offer custody of assets with a trust partner or affiliate; the rationale for the rise of smaller prime brokers; and the likely future shape of the small prime brokerage industry.

For Hedge Funds, Ownership of Commercial Mortgage-Backed Securities Servicers Offers a Growing, Uncorrelated Stream of Fee Income and Advantageous Access to Distressed Mortgages, But Not Without Legal and Business Risk

Servicers of commercial mortgage-backed securities (CMBS) collect mortgage payments, remit distributions to investors and facilitate interactions among borrowers, lenders, investors and rating agencies.  Just as certain hedge funds have acquired residential mortgage servicers, see “Hedge Funds are Purchasing or Launching Mortgage Servicers to Take Advantage of Increased Opportunities in Distressed Residential Mortgages,” Hedge Fund Law Report, Vol. 2, No. 35 (Sep. 2, 2009), some hedge funds are evaluating the purchase of CMBS servicers, but for different reasons.  In the residential context, a primary reason for a hedge fund manager to own a servicer is the ability to modify residential mortgages owned by its hedge funds.  In the commercial context, by contrast, the primary reasons for owning a servicer include a steady, likely growing (in the short and medium term) and uncorrelated revenue stream and advantageous access to defaulted loans in the CMBS serviced by the owned servicer.  However, modification of loans in a CMBS by a servicer is significantly more difficult (for various regulatory and practical reasons, explained more fully below) than modification of whole residential loans by a residential servicer.  In other words, the purchase of a CMBS servicer is more of an investment in itself, as opposed to an adjunct to a separate investment.  This article defines CMBS and describes the securitization process; defines the master servicer and the special servicer and the different roles played by each; the rights and obligations of CMBS servicers; pooling and servicing agreements; Real Estate Mortgage Investment Conduit rules; the legal and contractual standards to which CMBS servicers are held; commercial real estate market dynamics; the benefits to hedge funds of owning CMBS servicers; the concerns raised by CMBS servicer ownership; the reasons why the interests of holders of junior and senior tranches of CMBS bonds often diverge, and how servicers can perform in light of such divergent interests.

Interview with Tullett Prebon’s Neil Campbell on the Launch of an Enhanced Security Transaction Settlement and Escrow Service for the Secondary Hedge Fund Market

Tullett Prebon, a leading interdealer broker, announced on September 14, 2009 that it had launched “the first enhanced security transaction settlement and escrow service for the secondary hedge fund market.”  The initiative was launched by Tullett Prebon’s Alternative Investments desk in response to a perceived market need for a more secure, streamlined transaction settlement process for institutional investors.  Tullett Prebon will jointly offer the service through an exclusive agreement with KAS BANK, who will act as an independent administrator for Tullett Prebon’s institutional client transactions.  The Hedge Fund Law Report recently spoke with Neil Campbell, Tullett Prebon’s Head of Alternative Investments in London, about the mechanics of the new initiative, and the dynamics and challenges of the hedge fund secondary market.  The full transcript of that interview is available in this issue of the Hedge Fund Law Report.

SEC Recommends More Hedge Fund Oversight in Audit on Its Failure to Uncover Madoff Fraud; House Oversight and Government Reform Committee Chairman Questions SEC Competence

On September 4, 2009, the Securities and Exchange Commission (SEC) published the report of its Office of the Inspector General (OIG) chronicling the failure of its enforcement and examinations staff to uncover Bernard Madoff’s fraud despite numerous red flags dating as far back as 1992.  In an accompanying statement, SEC Chairwoman Mary Schapiro pledged her agency’s continuing and careful review of the report to “learn every lesson we can to help build upon the many reforms we have already put into place.”  Meanwhile, in a letter dated September 3, 2009 to Chairwoman Schapiro, House Oversight and Government Reform Committee Chairman Edolphus Towns (D-N.Y.), asked whether the level of experience of the SEC’s employees has improved since Congress authorized the SEC to increase compensation in 2002.  He also pledged to hold a hearing on the subject.  Then, on September 10, 2009, SEC Inspector General H. David Kotz testified before the Senate Banking Committee regarding the audit of the agency’s failed oversight of Bernard Madoff.  He told the committee to expect more reports, more revelations of missteps, and more recommendations aimed at improving nearly every aspect of operations within the Office of Compliance Inspections and Examinations (OCIE), and of procedures within the Division of Enforcement (DoE).  This article summarizes the major findings of the OIG report, the concerns expressed in Chairman Towns’ letter, and the pertinent details of Inspector General Kotz’ testimony before the Senate Banking Committee.

In Light of Convergence of Hedge Fund Strategies and Mutual Fund Structures, Mutual Fund Advisory Fee Case before U.S. Supreme Court May Affect Future Profitability of Hedge Fund Industry

Recent decisions regarding mutual funds, particularly with regard to advisory fee disputes, have taken on heightened importance for the hedge fund community.  This is because of the growing convergence between hedge fund strategies and mutual fund structures.  As previously reported in the Hedge Fund Law Report, investment managers who manage both hedge and mutual funds may have, for somewhat counterintuitive reasons (i.e., reasons other than short term fee considerations), an incentive to favor mutual funds.  See “New Study Offers Surprising Findings on the Incentives Created by Concurrent Management of Hedge and Mutual Funds,” Hedge Fund Law Report, Vol. 2, No. 23 (Jun. 10, 2009).  Such managers may use the mutual funds to “advertise” their investing prowess to the public and potential hedge fund investors because, with respect to the mutual fund, they have less onerous restrictions with respect to communications with the public, investor solicitations and performance advertising.  Successful mutual fund managers sometimes capitalize on their success by launching hedge funds following similar strategies, but with higher total fees.  Also, an increasing number of mutual funds are employing hedge fund strategies.  As a consequence of this convergence trend, a case now before the U.S. Supreme Court dealing with advisory fees in the mutual fund context has significance for the hedge fund community.  We detail the substantive and procedural history of that case, including the most recent decision from the Seventh Circuit and a dissent from the redoubtable Judge Posner (that could foreshadow the outcome in the U.S. Supreme Court).  We also summarize the arguments advanced by SIFMA, the Independent Directors Council and the Investment Company Institute in amicus briefs.

When “Socially Conscious” Hedge Funds Are Not

In a guest Op-Ed, Philip McBride Johnson, the former Chairman of the CFTC, now Of Counsel at Skadden, Arps, Slate, Meagher & Flom LLP, takes university endowments to task for not making a greater contribution to student tuition when they can afford to do so without any material imposition on other spending priorities.  He also criticizes hedge funds for the losses of endowment funds that, had priorities been different, could have been spent on student aid.

Holtz Rubenstein Reminick Hosts Conference on “Uncovering Foreign Income: The Implications and Consequences of Foreign Bank Account Reporting”

On September 16, 2009, the accounting firm Holtz Rubenstein Reminick (HRR) hosted a seminar on reporting of foreign bank accounts, for both income tax and anti-money laundering purposes.  Reporting on foreign income has become headline news of late.  Notably, in February 2009, UBS, the largest Swiss bank by assets, reached a settlement with the U.S. Internal Revenue Service (IRS) in which UBS agreed to give the IRS hundreds of names of Americans suspected of using UBS accounts to evade U.S. income taxes.  Several UBS clients have been prosecuted. The HRR seminar was chiefly designed to address the issue of whether people who have accounts with UBS or other foreign banks should make voluntary disclosure to the IRS of the existence of such accounts and other data with respect to such accounts.  Panelists also briefly discussed the still-undecided issue of whether an interest in an offshore hedge fund must, under the Bank Secrecy Act, be reported in a Report of Foreign Bank and Financial Accounts (FBAR).  See “IRS Indicates that U.S. Persons May be Required to Report Interests in Offshore Hedge Funds in Reports of Foreign Bank and Financial Accounts,” Hedge Fund Law Report, Vol. 2, No. 26 (Jul. 2, 2009).  We detail the relevant points from the conference.

Ellen Schubert and Ray Iler Join Deloitte Hedge Fund Practice

On September 16, 2009, Deloitte announced that hedge fund pioneers Ellen C. Schubert and Ray J. Iler have joined the hedge fund team of its Asset Management Services practice, marking the latest in a series of strategic growth initiatives executed over the last 18 months by Cary Stier, Deloitte’s U.S. Head of Asset Management Services.  The addition of Schubert and Iler complements the simultaneous dedication of ten current Deloitte partners with capital markets experience to the hedge fund team.

3rd Annual Hedge Fund General Counsel Summit, October 1, 2009, Greenwich, CT; Special Offer for Hedge Fund Law Report Subscribers

The troubled economy, recent industry scandals and a new administration calling for increased accountability and regulation is driving the hedge fund industry into a perfect storm.  Hedge fund executives must monitor the winds of change to protect their funds, their reputations and their investors.  The 3rd Annual Hedge Fund General Counsel Summit, taking place on October 1, 2009, in Greenwich, CT, will address these and other concerns by delivering cutting-edge information and facts essential to success in today’s climate.  Subscribers and trial subscribers to the Hedge Fund Law Report are eligible for a special discount offer.  Click on the “Read full article” link to access details of the special discount offer.