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    Oct. 1, 2009

Hedge Funds Turning to Life Settlements for Absolute, Uncorrelated Returns

Among other lessons, the recent recession taught that the returns on many assets are more correlated than previously assumed.  From late 2007 through early 2009, it seemed that everything moved in the same direction: down.  Or almost everything.  A few asset classes – or more appropriately, investment categories – remained, during the recession and beyond, resolutely uncorrelated.  Litigation funding is one such investment category, as we discussed in a previous issue of the Hedge Fund Law Report.  See “In Turbulent Markets, Hedge Fund Managers Turn to Litigation Funding for Absolute, Uncorrelated Returns,” Hedge Fund Law Report, Vol. 2, No. 25 (Jun. 24, 2009).  Another such category is life settlements.  In a nutshell, a life settlement is the process by which an investor (often a hedge fund) purchases a life insurance policy from the person who originally purchased the policy – the so-called “insured.”  Specifically, the hedge fund or other investor generally pays the insured an amount greater than the cash surrender value of the policy, but less than the death benefit, in exchange for the right to collect the death benefit and the obligation to continue paying premiums for the life of the policy (and the insured).  For insureds, especially those that need money today, life settlements represent an opportunity to “cash out” of a policy for an amount often greater than what an insurance company will pay.  For hedge funds, life settlements offer an investment, the returns on which are driven largely by the fund manager’s ability to accurately predict the life expectancy of a group of insureds.  In other words, the success of a strategy focused on life settlements has less to do with microeconomic variables (such as corporate earnings) or macroeconomic variables (such as interest rates), and more to do with demographics.  It’s a different ball game, and a different skill set – the quintessential uncorrelated investment category.  Not surprisingly, hedge funds are becoming increasingly interested in life settlements.  Accordingly, this is the first part of a three-part series in which the Hedge Fund Law Report will provide a detailed analysis of the key legal and business considerations for hedge funds investing in life settlements.  In this part, we discuss: state and federal regulation of life settlements; premium financing; pricing of life settlements; advantages to hedge funds of investing in life settlements (including lack of correlation with other assets); concerns of which hedge funds should be cognizant when investing in life settlements (including illiquidity and longevity risk); structuring of hedge funds to invest in life settlements; cash management and adequate capital considerations; specific recommended items for disclosure in the private placement memorandum of a fund organized to invest in life settlements; due diligence considerations; a brief overview of the relevant tax considerations, including the recommended jurisdictions for organizing life settlement hedge funds; the tertiary market and securitization; and opposition from the insurance industry.  Part two in this three part series will focus in more depth on tax considerations relating to life settlement investing, and part three will focus in more depth on securitization of life settlements.

Does Europe Offer a More Hospitable Regulatory Environment for High Frequency Trading Than the United States?

High frequency trading now accounts for the majority of all U.S. equity trades, and by most accounts has dramatically increased liquidity in a variety of markets.  Nonetheless, largely based on a conflation of high frequency trading and flash orders – practices that are related, but different in key ways – high frequency trading has received quite a bit of negative press of late.  On flash orders, see “What Are Flash Orders, and How Might Regulation Curtail the Ability of Hedge Funds Employing High-Frequency Trading Strategies to Profit from Such Orders?,” Hedge Fund Law Report, Vol. 2, No. 32 (Aug. 12, 2009).  One frequently adduced argument is unfairness: high frequency traders are said to have access to potent computers and powerful human resources, while lesser traders do not.  This may be true, but it’s not illegal (at least not yet).  Moreover, it is difficult to identify any reason why this would be less than ethical, or materially different from the informational asymmetries that have characterized trading markets at least since a group of brokers formed the New York Stock Exchange under a buttonwood tree on Wall Street in 1792.  High frequency trading remains a viable investment approach, and securities investing has incontrovertibly become a global business.  Accordingly, this article explores whether Europe offers a more hospitable regulatory environment for high frequency trading and high frequency traders than does the U.S.  It also addresses the practical and technological variations among the two jurisdictions.  The purpose of this article is to help hedge funds with a high frequency trading strategy answer the question: If I’m going to do this, where should I set up shop?  Or if I’ve already set up shop, what are the regulatory considerations of which I should be aware, and how may they change?  Most importantly, how will these regulatory considerations affect my trading profits and opportunities and my investments in technology and other resources?  In particular, this article examines what high frequency trading is, including how it interacts with flash orders, dark pools and multilateral trading facilities; the upsides and downsides of high frequency trading from the perspectives of hedge funds and regulators; regulation of high frequency trading in the U.S. and Europe; and the relative benefits and burdens (practical and regulatory) of the trading environments in both places.

New York State Supreme Court Upholds Former Portfolio Managers’ Claims Against Hedge Fund Manager Touradji Capital for Breach of Contract and Intentional Infliction of Emotional Distress; Dismisses Remaining Causes of Action

In January 2009, two portfolio managers formerly employed by Touradji Capital Management, LP, a hedge fund manager with approximately $3.5 billion under management (Touradji Capital or the Fund), sued the Fund and its principal and founder, Paul Touradji (Touradji), alleging several causes of action based on the defendants’ alleged failure to pay tens of millions of dollars of compensation to them over their tenure at Touradji Capital.  The defendants moved to dismiss the complaint for failure to state a cause of action.  The New York State Supreme Court allowed plaintiffs’ claims for breach of contract and intentional infliction of emotional distress to proceed, but dismissed all other claims.  We describe the factual background and the court’s legal analysis.

Why Does Capital Raising for Distressed Debt Hedge Funds Remain Particularly Challenging Despite the Recent and Anticipated Positive Performance of the Strategy?

For hedge funds with distressed debt strategies, 2009 has been a good year.  As of August 2009, the HFRI distressed/restructuring index was up 15.3 percent for the year, and the HFN Research distressed index was up 18.4 percent, with August gains of 4.3 percent.  Corporate default rates have been at historical highs, and the prices of distressed bank debt have been at historical lows.  In short, 2009 appears to have been a golden era for distressed investing, and according to some sources interviewed by the Hedge Fund Law Report, the medium- and long-term prospects for the strategy are attractive.  One would expect investor money to be piling into the strategy.  And indeed, for a handful of the bigger players, that appears to be the case, as evidenced by reports of a recent commitment by China Investment Corp. to place approximately $1 billion with funds managed by Oaktree Capital Management LP.  However, for other distressed debt managers, and especially for new managers seeking to launch funds with such a strategy, anecdotal evidence suggests that money-raising has been a challenge.  Numerous explanations have been proffered for this phenomenon (if indeed it is a phenomenon and not just a series of isolated instances).  The illiquidity of distressed debt is the most often cited explanation.  But private equity funds – funds that invest in shares of private companies and thus are at least as illiquid as distressed debt funds – have raised money of late, so illiquidity cannot be the full story.  Perhaps it the perception that distressed debt is a counter-cyclical strategy, and the worst is behind us?  But the historical evidence suggests that distressed debt strategies do best in the years immediately following a crisis, so now would appear to be an ideal time for allocations to the strategy.  Perhaps it’s a perception that the strategy entails more risk than other strategies?  But that’s also insufficient as an explanation.  The risk in distressed debt, like in other strategies, can be mitigated via prudent risk management; and in any case, much of the debt in which distressed funds invest is secured by real assets.  So what accounts for the money raising challenges faced by existing and new distressed debt hedge fund managers?  This article seeks to answer that question, and in doing so describes: what a distressed debt strategy involves; the opportunity set over the short-, medium- and long-term; lock up terms; examples of the difficulty raising money for the strategy and potential reasons for the difficulty; and what managers can do (and what they should avoid doing) in an effort to address the difficulty.

Structuring Managed Accounts Key Focus of GlobeOp’s “Managed Accounts Insights for Investors” Event

With the events of 2008 and early 2009 – faltering hedge fund performance, high profile frauds and prime broker and counterparty failures – hedge fund investors are showing increased interest in managed accounts.  Managed accounts generally are investment portfolios owned by the investor and managed by the hedge fund manager side by side with a primary hedge fund.  They can offer an efficient vehicle for investors looking to segregate their assets from the assets of a primary fund and to avoid the various problems (many having to do with the timing of redemptions) that can affect investors in a commingled vehicle.  See, e.g., “Investors in Hedge Fund Strategies Increasingly Demanding Separate Accounts to Avoid Gates and Other Consequences of Commingled Investment Vehicles,” Hedge Fund Law Report, Vol. 2, No. 8 (Feb. 26, 2009); “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); “How Can Hedge Fund Managers Prevent or Mitigate Revocations of Redemption Requests?,” Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009).  As a potentially attractive option for investors, managed accounts offer managers a method for attracting investor assets.  But the various investor and marketing benefits of managed accounts have to be balanced against the significant administrative burdens posed by managing separate accounts – including but not limited to accounting and allocation issues.  On September 17, 2009, GlobeOp Financial Services hosted the Managed Accounts Insights for Investors event in New York City.  During the one-day event, industry participants discussed such topics as structuring and negotiating managed account agreements, potential conflicts of interest and proper due diligence.  This article highlights and discusses the key points discussed at the conference.

Would the Expanded Disclosures Required by Proposed Amendments to Federal Rule of Bankruptcy Procedure 2019 Deter Hedge Funds from Investing in Distressed Debt? (Part Three of Three)

On August 12, 2009, the Advisory Committee on the Federal Rules of Bankruptcy Procedure (Advisory Committee) proposed a significant revision of Federal Rule of Bankruptcy Procedure 2019 (Rule 2019), the rule that in its current form requires disclosure by an “entity or committee representing more than one creditor” of the identity of each creditor involved, the nature and amount of its interest, the times when the entity’s interests were acquired and the amounts paid for them.  The proposed amendment would clarify that every entity that plays an active part in a bankruptcy proceeding is at least potentially subject to a requirement to disclose a wide range of information of the sort that distressed debt hedge funds and other bankruptcy investors have long sought to keep proprietary.  Comments on the proposed revision are due by February 16, 2010.  The proposed rule revision would change the bankruptcy investing game in three principal ways: (1) it would widen the scope of who must disclose under Rule 2019; (2) it would widen the scope of what must be disclosed; and (3) it would give bankruptcy courts wider discretion to relieve or abridge disclosure obligations, especially disclosure regarding the prices of assets purchased in secondary market trading.  This article discusses the proposed revision in depth, focusing on the potential consequences for hedge funds that invest in and around bankruptcies.  This article is the third in a three-part series on Rule 2019, and its impact on hedge fund strategies.  For the two previous installments in the series, see “How Can Hedge Funds that Invest in Distressed Debt Keep their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)? (Part One of Three),” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009); and “How Can Hedge Funds that Invest in Distressed Debt Keep Their Strategies and Positions Confidential in Light of the Disclosures Required by Federal Rule of Bankruptcy Procedure 2019(a)? (Part Two of Three),” Hedge Fund Law Report, Vol. 2, No. 36 (Sep. 9, 2009).

Open Europe Survey Finds that Proposed AIFM Directive Would Impose Substantial Compliance Costs on Hedge Fund Industry

During August 2009, the independent think tank Open Europe conducted two surveys of hedge fund and private equity fund managers to assess the potential impact of the European Union’s (EU) proposed Alternative Investment Fund Manager (AIFM) Directive on their industries.  (For a more detailed analysis of the AIFM Directive, see “Andrew Baker, CEO of the Alternative Investment Management Association, Discusses the AIFM Directive, UK Tax, Short Selling and Other Topics with the Hedge Fund Law Report,” Hedge Fund Law Report, Vol. 2, No. 29 (Jul. 23, 2009); “AIFM Directive: Loosening the Regulatory Noose,” Hedge Fund Law Report, Vol. 2, No. 24 (Jun. 17, 2009); “Directive on Alternative Investment Fund Managers Likely to Occasion Substantial Ongoing Debate Over the Appropriate Scope of Regulation of European Hedge Fund Managers,” Hedge Fund Law Report, Vol. 2, No. 19 (May 13, 2009).)  The respondents, primarily based in the United Kingdom (U.K.), included 121 hedge fund managers and fund of funds managers representing $342 billion in assets under management and 41 private equity fund managers, representing funds under management of over $204 billion.  In September 2009, Open Europe released its survey findings and recommendations in a report, entitled “The EU’s AIFM Directive: Likely impact and best way forward.”  Among other things, Open Europe found that the Directive would impose ongoing compliance costs of between €689 million and €985 million on the hedge fund industry, as firms act to comply with the new rules.  This article examines the most salient findings from the report, including its analysis of the benefits and costs of the AIFM Directive and its criticisms of the current proposal.

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