Jan. 6, 2010

Local Currency Hedge Funds Expand Marketing and Investment Opportunities, but Involve Currency Hedging and Other Challenges

Traditionally, hedge funds have scoured the globe for investments.  To an increasing degree, hedge funds are scouring the globe for investors.  There are various macroeconomic reasons for this trend, including but not limited to: political and economic progress in developing countries generally and the so-called BRIC (Brazil, Russia, India, China) countries specifically; high savings rates, especially in China and Japan; the recent credit crisis, and the resulting loss of wealth in the U.S. and Eurozone countries; record deficit spending in the U.S., and resulting concerns about inflation and interest rates; etc.  At a more practical level, 2008 and 2009 witnessed significant outflows from hedge funds, and managers have been looking for new capital wherever they can find it – even if that new capital comes from places other than the usual suspect jurisdictions.  As more hedge fund capital comes from more places, hedge fund managers have been exploring and, in some cases, launching funds denominated in local currencies.  Local currency hedge funds have two chief advantages over funds denominated in U.S. Dollars or another “reserve” currency: they facilitate marketing to a wider range of institutions and individuals, and they enable investments in assets that otherwise would be inaccessible or difficult to access.  In addition, local currency funds enable managers to avoid, in some cases, certain of the administrative and legal brain damage involved in other approaches to managing currency issues.  At the same time, local currency funds implicate certain unique risks.  This article describes the four primary ways in which hedge fund managers approach multicurrency issues, one of which involves the use of local currency funds, and details the risks and benefits of each.  In particular, this article drills down on the practical and legal challenges involved in hedging currency risk, and discusses the special case of China’s new limited partnership law.

Rolling Lock-Up Periods Enable Hedge Fund Managers to Pursue Less Liquid Strategies While Managing Investors’ Liquidity Expectations

While investors in private equity funds are, with limited exceptions, committed to the fund for the relevant term, investors in hedge funds generally are only locked in the fund for an initial period.  See “Can a Capital On Call Funding Structure Fit the Hedge Fund Business Model?,” Hedge Fund Law Report, Vol. 2, No. 44 (Nov. 5, 2009).  Following the initial period, hedge funds typically offer quarterly or semiannual liquidity.  However, liquidity management – via gates, redemption suspensions, suspensions of the determination of NAV and other measures – remains an imperative among hedge fund managers even as the credit crisis recedes.  See “How Can Hedge Fund Managers Prevent or Mitigate Revocations of Redemption Requests?,” Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009).  Accordingly, hedge fund managers are implementing a new liquidity management tool known as “rolling lock-up periods.”  A fund with a rolling lock-up period requires investors to commit to an initial two- to three-year lock-up, and if the investor does not submit a redemption notice within a set time prior to expiration of the lock-up, the investor is locked-up for another two or three years, and so forth.  See “Investors Demand More Specificity in Hedge Fund Governing Documents Regarding Circumstances in which Liquidity Management Tools May be Used,” Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009).  Notably, a rolling lock-up may be viewed as an ex ante liquidity management measure, versus tools such as gates and redemption suspensions, which can be viewed as ex post measures.  In other words, investors know at the time of investment that they are subject to rolling lock-ups, whereas gates, redemption suspensions and their ilk – regardless of how thoroughly disclosed – invariably remain an unwelcome surprise when imposed.  See “Certain Hedge Funds are Using Enhanced Investor Liquidity as a Marketing Tool,” Hedge Fund Law Report, Vol. 2, No. 22 (Jun. 3, 2009).  On the plus side, rolling lock-ups enable managers to invest in less liquid, more unique opportunities – opportunities that may take years to realize, but that are intended to produce appreciable annualized returns.  For managers, they are an almost unmitigated good, except they may turn away some liquidity-conscious investors, or require the manager to enter into a side letter with respect to such investors, which most managers would prefer to avoid.  On the minus side, investors have to forgo some liquidity.  Ideally, they are compensated for that illiquidity with higher returns, but higher returns are not guaranteed, and even in the best case scenario, investors have to wait for such returns.  This article examines: what hedge fund lock-ups are generally; the mechanics of rolling lock-ups; the benefits to hedge fund managers of rolling lock-ups; how hedge fund managers can use rolling lock-ups as a negotiating tool in discussions with institutional investors; the benefits to hedge fund investors of rolling lock-ups; the downsides of rolling lock-ups; and the use of rolling lock-ups for hedge funds employing private equity-like strategies.

Delaware Chancery Court Rules that Rival Bidder’s Lawsuit against Harbinger Capital Partners Hedge Funds Alleging Use of Non-Public Information to Hinder Bidder’s Acquisition Efforts May Proceed

On December 22, 2009, Vice Chancellor J. Travis Laster of the Delaware Chancery Court, refused to dismiss a lawsuit brought by NACCO Industries, Inc., a Delaware holding company that owns the firm which markets Hamilton Beach appliances, against Applica, Inc., a Florida corporation that markets appliances under the Black & Decker label, as well as Harbert Management Corporation, an investment manager, and its affiliated Harbinger Capital Partners hedge funds (collectively, Harbinger).  The suit arises out of NACCO’s failed bid to purchase Applica in 2006 – a bid that began with Applica’s execution of a merger agreement with NACCO, continued with Applica’s termination of that agreement and ended with Harbinger winning Applica in a bidding contest.  NACCO complained that Harbinger’s success purportedly resulted from its advanced receipt of non-public tips through an intermediary from Applica insiders regarding the proposed Hamilton Beach-Applica merger, its resultant quiet and inexpensive accumulation of a controlling shareholder stake in Applica before Applica entered into and then terminated that agreement and its concomitant allegedly fraudulent Schedule 13D and 13G filings which failed to disclose its competing interest in Applica.  As a result, NACCO asserted claims against Applica for breach of contract and breach of the implied covenant of good faith and fair dealing; against Harbinger for tortious interference with contract, fraud, equitable fraud and aiding and abetting a breach of fiduciary duty; and against all defendants for civil conspiracy.  The court, though recognizing that potentially legitimate reasons existed for Harbinger’s conduct, nonetheless allowed the tortious interference and fraud counts to proceed against it.  In contrast, the court had “no difficulty” finding evidence inferring that Applica breached its contract with NACCO.  This article details the background of the action and the most salient portions of the court’s legal analysis.

SEC Adopts Investment Adviser Custody Rule Amendments

At an open meeting held on December 16, 2009, the Securities and Exchange Commission (SEC) adopted amendments to the custody requirements under the Investment Advisers Act of 1940 (Advisers Act).  These amendments aim to strengthen controls over client assets held by registered investment advisers (RIAs) or their affiliates.  On December 30, 2009, the SEC published the adopting release for these amendments.  These amendments significantly modify the amendments previously proposed in May 2009 in response to about 1,300 comment letters.  For a more detailed analysis of the prior proposal, see “SEC Proposes Stricter Custody Rules for Investment Advisers,” Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009).  For an analysis of the impact of the proposed custody rule on hedge fund managers, see “The SEC’s Proposed Custody Rule Changes: An Analysis of the Impact on Hedge Fund Managers,” Hedge Fund Law Report, Vol. 2, No. 21 (May 27, 2009).  Rule 206(4)-2 under the Advisers Act, commonly referred to as the “custody rule,” protects assets managed by RIAs.  The rule requires RIAs to maintain client funds and securities with a “qualified custodian” in accounts that contain only client funds, and to segregate and identify client securities and hold them in a reasonably safe place.  Few RIAs maintain physical custody of client assets, however; the SEC deems many RIAs to have custody because an RIA affiliate – e.g., an affiliated prime broker – maintains the client assets or the RIA retains access to the accounts via fee arrangements, general partner relationships or powers of attorney, among others.  The amendments to Rule 206(4)-2 impose significant additional requirements on RIAs with “custody” of client assets, including an annual surprise examination by an independent public accountant, registered with the Public Company Accounting Oversight Board to verify client assets, as well as a report by the accountant of internal controls relating to the custody of those assets.  With the amendment, the SEC also published an interpretive release providing guidance to auditors regarding the surprise examination and internal controls report requirements.  This article summarizes the amendments and their implications for the investment adviser community generally, and hedge fund managers specifically.

UBS Appoints New Co-Heads of Prime Brokerage Sales to U.S. Hedge Funds

In response to UBS AG’s evolving strategic goals for its U.S. Prime Brokerage unit, the bank has appointed Jon Yalmokas and Charlotte Burkeman to assume responsibility for managing U.S. Prime Brokerage Sales.

Carlo di Florio Named Director of SEC’s Office of Compliance Inspections and Examinations

On January 4, 2010, the Securities and Exchange Commission announced that Carlo V. di Florio has been named Director of the agency’s Office of Compliance Inspections and Examinations.

Schulte Roth Elects New Partner and Special Counsel to Investment Management Group

Effective January 1, 2010, Schulte Roth & Zabel LLP has elected Daniel F. Hunter as Partner and has appointed Michael G. Brown as Special Counsel.  Each will work in Schulte’s New York investment management group.