Mar. 18, 2010

Will Reported Purchases by D.E. Shaw Hedge Funds of Assets in Other Hedge Funds’ Side Pockets Set a Precedent, or Highlight the Fiduciary Duty, Valuation and Other Challenges in Such Transactions?

While it is not unusual for a hedge fund to be organized for the purpose of purchasing distressed debt, the D.E. Shaw group (D.E. Shaw) is putting an interesting twist on this concept.  It has been widely reported in the press that D.E. Shaw organized an in-house team in 2009, the D.E. Shaw Portfolio Acquisitions Unit, to evaluate purchases of illiquid assets from other hedge funds.  In particular, the D.E. Shaw unit is looking at assets in other hedge funds’ side pockets.  Generally, a side pocket is an account established by a hedge fund to hold assets that are less liquid than the remainder of the portfolio.  See “Secondary Buyers of Private Equity Fund Interests are Looking at Assets in Hedge Fund Side Pockets,” Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).  Such purchases can be a boon to both sides.  Selling hedge funds can refocus on their more liquid portfolio, and purchasing hedge funds – especially those with longer lock-ups – can realize the long-term value in currently illiquid assets.  However, such purchases also involve challenges.  For example, investors in the selling hedge fund may allege that the side pocketed asset was undervalued for purposes of the sale, and based on such alleged undervaluation may bring claims against the selling manager for breach of fiduciary duty or material misrepresentations or omissions.  For the purchasing hedge fund, such a purchase will involve considerable due diligence, including obtaining sufficient information to make an informed investment decision in light of what is often a matrix of confidentiality agreements.  Similarly, only certain hedge funds are set up to hold side pocketed assets for long enough to realize value – and to avoid the same liquidity pressures that cause the selling hedge fund to sell.  Depending on the characteristics of the purchased asset, the purchasing hedge fund would need a lock-up that in most cases could not be less than two years.  This article highlights the potential and challenges involved in purchases by hedge funds of assets in the side pockets of other hedge funds.  In particular, this article discusses: the mechanics of side pockets (including their implications for calculation of net asset value (NAV) and management and performance fees); fiduciary duty and securities law concerns inherent in purchases by hedge funds of illiquid assets from other hedge funds; the recent increase in distressed debt trading activity, both by hedge funds with a traditional competency in the area and newer entrants; valuation issues facing the selling hedge fund; valuation issues for the buyer; lock-up and liquidity prerequisites for the buyer; and the effect of such purchases on redeeming and non-redeeming investors in the selling fund.

How Should Hedge Fund Managers Adjust Their Marketing to Pension Funds in Light of Potential Downward Revisions to Pension Funds’ Projected Rates of Return?

Recent market chatter suggested that public pension funds – as a group, one of the largest allocators of capital to hedge funds – were considering reducing their target rates of return.  For example, recent news reports suggested that the California Public Employees’ Retirement System (CalPERS), the largest public pension fund in the U.S., was considering reducing its target annual rate of return from 7.75 percent to 6 percent.  One of the headline responses to the rumored reduction in pension fund investment targets was that such reductions would decrease the capital allocated to hedge funds by pension funds.  The assumption behind this idea was that pension funds invest in hedge funds for alpha, or above-market returns, and because the reduced investment targets would be more in line with beta, or market returns, pension funds no longer needed the market-beating services of hedge funds.  However, while alpha may be one reason why pension funds invest in certain hedge funds, it is by no means the only reason.  In fact, in the wake of the credit crisis, alpha has fallen in the ranking of rationales for pension fund investments in hedge funds, and other rationales are ascendant.  As explained more fully below, those other rationales include, but are not limited to: uncorrelated returns; absolute returns; reduced volatility; sophisticated risk management; access to standout managers; and access to unique assets.  In short, even if pension funds reduce their investment targets – and whether or not they will remains uncertain – pension funds are likely to continue allocating capital to hedge funds, likely at a hastening clip.  See “The Four P’s of Marketing by Hedge Fund Managers to Pension Fund Managers in the Post-Placement Agent Era: Philosophy, Process, People and Performance,” Hedge Fund Law Report, Vol. 2, No. 45 (Nov. 11, 2009).  But as they do, the specific factors on which pension funds base their hedge fund investment decisions are likely to evolve in subtle but important ways.  In other words, while the potentially reduced investment targets likely will not materially diminish the volume of pension fund allocations to hedge funds, they do reflect a shift in the focus of pension funds’ concerns.  For hedge fund managers seeking to raise and retain institutional capital, it is critical to understand pension fund decision-making and to translate that understanding into informed marketing strategies.  Accordingly, this article examines how hedge fund managers may adjust their marketing to pension funds in light of the potentially reduced investment targets.  Or more precisely, this article examines how hedge fund managers may refocus their investment strategies and operations in light of pension fund concerns – because marketing in the hedge fund context should not be a matter of puffery or salesmanship, but rather should be a matter of clearly, candidly and comprehensively conveying a manager’s strategy and operations.  In particular, this article discusses: the potential reduction in target returns; the rationale for pension fund investments in hedge funds; trends and data with respect to such investments; specific marketing strategies that hedge fund managers can employ when targeting pension funds (including discussions of strategy drift, pension fund consultants, liquidity and other relevant matters); and the evolving role of placement agents in connecting pension funds and hedge funds.

British Appeals Court Authorizes FSA To Compel Production of U.K. Accounting Firm’s Documents In Cooperation With S.E.C. Investigation Into Illegal Short-Selling Scheme In U.S. Involving Hedge Fund Amro International SA

On February 24, 2010, the U.K. Financial Services Authority (FSA) won an appeal in the U.K. Court of Appeal, Civil Division, concerning the scope of its authority to assist the U.S. Securities and Exchange Commission (SEC) in its investigations by compelling document production from U.K. firms.  As part of an investigation into an illegal short-selling scheme by Rhino Advisors Inc., an unregistered investment adviser, the SEC had requested that the FSA obtain a decade worth of documents from a London-based accounting firm relating to its service of Rhino and Rhino clients Amro International SA and Creon Management SA.  In August 2009, a U.K. Administrative Court quashed the FSA’s order because it found the SEC’s request “exceedingly wide” and beyond the scope of issues presented in the underlying U.S. litigation.  The Court of Appeal reversed.  Emphasizing the increasingly international nature of financial enterprises and transactions, it declared, “It is . . . of the greatest importance that national financial regulators cooperate, particularly where there are suspicions or allegations of financial fraud or other misconduct.”  It then rejected the Administrative Court’s concerns, explaining, “It is not for the courts of this country to determine whether the SEC’s request will result in documents being obtained that will be useful for it,” or not.  We summarize the background of the action, the relevant legal framework and the Court of Appeal’s legal analysis.

Employee Misappropriation of Trade Secrets Litigation Stresses Dangers of Willful Spoliation of Evidence; Texas Federal Court Orders Trial, Adverse Inference Instruction and Monetary Sanctions for Willful Destruction of Electronically Stored Information

The subject of spoliation of electronically stored information raises grave concerns for litigation generally, and in the hedge fund community in particular.  As we discussed in our February 11, 2010 issue, in Pension Committee of the University of Montreal Pension Plan v. Banc of Am. Sec., LLC, No. 05 Civ. 9016, 2010 WL 184312 (S.D.N.Y. Jan.15, 2010), Judge Shira Scheindlin of the U.S. District Court for the Southern District of New York addressed the duties of hedge fund managers and investors to preserve electronically stored information in anticipation of litigation involving failed hedge funds, and the sanctions for negligent spoliation of such evidence.  See “Pension Committee Case Highlights Obligations of Hedge Fund Managers to Preserve Documents and Information in Anticipation of Litigation,” Hedge Fund Law Report, Vol. 3, No. 6 (Feb. 11, 2010).  The instant case, an employment dispute in the U.S. District Court for the Southern District of Texas, presents the next step in understanding this issue: what happens when the conduct complained of involves intentional spoliation?  On February 19, 2010, Judge Lee H. Rosenthal of the U.S. District Court answered that question.  He severely sanctioned defendants Nickie G. Cammarata and Gary Bell for their intentional spoliation of e-mails relevant to litigation with their former employer, plaintiff Rimkus Consulting Group, Inc.  The lawsuit arose over defendants purported use of trade secrets and proprietary information in forming a competing firm, U.S. Forensic, L.L.C., after resigning from Rimkus, and their alleged violation of non-compete and non-solicitation clauses in their employment contracts.  Rimkus moved for sanctions after discovering that defendants had destroyed e-mails relevant to the dispute.  Relying heavily on Pension Committee, Judge Rosenthal conducted an extensive analysis of spoliation law.  He found that defendants had a legal duty to preserve the e-mails in question; that they had committed a culpable breach of that duty; that the e-mails appeared to be relevant to the dispute; and that Rimkus suffered prejudice as a result of their destruction.  As a result, he imposed harsh sanctions: permitting the jury to hear detailed evidence of the defendants’ misconduct; providing the jury with an adverse inference instruction against them; and awarding Rimkus attorneys fees and costs resulting from the spoliation.  Notably, the court also cited the defendants’ spoliation and withholding of evidence as the basis to partially dismiss their motion for summary judgment.  We provide extensive detail the background of the action and the court’s legal analysis.

Simple Goals in a Complex World: Estate Planning for Hedge Fund Interests

In a guest article, Steven D. Leipzig and Lori I. Wolf, both Members of law firm Cole, Schotz, Meisel, Forman & Leonard, P.A., and Steven M. Saraisky, an Associate at Cole Schotz, provide an introduction to estate planning considerations for hedge fund managers and hedge fund interests.  The authors first describe some fundamental concepts of sophisticated estate planning, and the typical structure of a hedge fund investment.  They then discuss certain approaches to estate planning with both a new hedge fund investment and an existing hedge fund investment.  The authors’ goal is to provide subscribers to the Hedge Fund Law Report with an understanding of the family planning and tax savings results that can be achieved with this kind of estate planning.

Foley & Lardner Expands Public Pension Plan, Hedge Fund and Alternative Investment Capabilities with Addition of Thomas Hickey in Boston

On March 4, 2010, Foley & Lardner LLP announced that Thomas A. Hickey III has joined the firm as a partner in the Boston office, working with the Private Equity & Venture Capital Practice Group.  Prior to joining Foley, Hickey was a partner at K&L Gates LLP.  For a number of years Tom has represented the San Bernardino County Employees’ Retirement Association.  The organization has invested in funds of hedge funds such as those managed by Gottex Fund Management and Mesirow Financial, and has made single strategy investments with multiple managers.

Dilworth Paxson Adds Securities and Hedge Fund Lawyer Robert V. Cornish to its Washington, D.C. Office

On March 15, 2010, Dilworth Paxson announced that securities and hedge fund lawyer Robert V. Cornish, Jr. had joined its Washington D.C. office as Of Counsel.