Apr. 2, 2010

Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts

CLOs, a species of collateralized debt obligation, are special purpose entities that issue senior rated debt securities and junior unrated equity-like securities which provide different levels of exposure to a pool of loans owned, directly or indirectly, by the entity.  The principal and interest payments on the securities issued by the CLO generally come from the principal and interest payments made by the borrowers of the loans held by the CLO and, in some cases, from purchases and sales of the underlying loans.  The idea behind issuing multiple classes – or “tranches” in CLO parlance – of CLO securities is to reallocate the risk of underpayment or nonpayment on the underlying loans, and thereby diminish the risk assumed by the senior noteholders.  In other words, if a pension fund wanted exposure to a loan used to fund a leveraged buyout in 2006, it might purchase the loan directly, but it would cease receiving principal or interest payments as soon as the borrower stopped making such payments.  However, if the pension fund purchased senior notes issued by a CLO that held that same leveraged loan along with other leverage loans, a default by the borrower on that leveraged loan might not cause the pension fund to cease receiving principal and interest payments on the senior CLO note.  This is because other leveraged loans in the CLO would, in theory, continue paying principal and interest, thus enabling the CLO to continue making principal and interest payments to its senior notes holders.  Also, any underpayment or nonpayment on any of the underlying loans would first be absorbed by holders of the junior or “equity” notes.  What this theory – and the associated AAA ratings of many of the senior notes issued by CLOs – did not take into account prior to 2008 was the possibility that all of the leveraged loans in a CLO could simultaneously stop paying principal and interest.  In other words, the high ratings of senior CLO notes and the associated perception of safety was based on the idea that a diversified portfolio of otherwise risky loans to companies in different industries and geographies was considerably safer and less volatile than the individual loans in the portfolio – especially when the initial losses on that diversified portfolio were contractually allocated to other people.  But credit markets seized up globally starting in 2008, CLO equity tranches were wiped out and CLO senior notes were revealed as significantly riskier than their coupons suggested.  In short, CLOs got a bad name during the credit crisis, and from September 2007 until March 30, 2010 (three days ago), no new CLOs were issued.  However, many CLOs remain in existence and various hedge fund managers currently manage CLOs, have managed CLOs or have the personnel and infrastructure in place to manage CLOs today or with minor adjustments.  For example, the skill sets and infrastructure required to manage distressed debt or credit hedge funds are similar to those required to manage CLOs.  Accordingly, for certain hedge fund managers, purchases of the contracts to manage those existing CLOs may offer a number of attractive features including: (1) an ongoing, reasonably predictable revenue stream; (2) “sticky” investor assets at a time when assets remain difficult to raise and retain; (3) a potential foot in the door with major institutional investors; (4) an asset (the management contract) that may be illiquid, and thus may be obtained at a discount to fair value; (5) forced sellers of management contracts; and (6) an “infrastructure arbitrage” (in the sense that certain larger hedge fund managers may enjoy economies of scale that enable them to manage a CLO at lower cost than smaller managers).  For analysis of another situation in which an albatross for one hedge fund manager may be an opportunity for another, see “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?,” Hedge Fund Law Report, Vol. 3, No. 11 (Mar. 18, 2010).  To assist hedge fund managers in evaluating, entering and negotiating the CLO management market, the remainder of this article discusses: the mechanics of CLOs, including features relating to investments, fees, payment priority, ratings and withdrawals; recent precedent transactions involving sales of CLO management contracts; rationales for selling CLO management contracts; rationales for buying CLO management contracts; and key legal considerations in connection with purchases or sales of CLO management contracts, including consent requirements and how to avoid the assumption of liabilities of the prior manager.

What Is Synthetic Prime Brokerage and How Can Hedge Fund Managers Use It to Obtain Leverage?

One of the services traditionally provided by prime brokers to hedge funds is the provision of leverage, that is, loans extended to hedge funds to pursue their investing activities and enhance returns.  Such leverage takes various forms.  The most common form is a margin loan in which the hedge fund posts a certain amount of equity with the prime broker – for example, 50 percent of the initial purchase price of a security – and the prime broker lends the hedge fund the remainder of the purchase price.  Other methods of providing leverage include repos and stock loans.  Another strategy by which hedge funds obtain leverage is through the use of over-the-counter (OTC) derivatives, notably including total return swaps (TRSs).  Generally in such arrangements, the prime broker pays the hedge fund the “total return” on a reference asset (e.g., in the case of equities, capital gains and dividends) and the hedge fund pays the prime broker fees, capital losses and interest on any embedded leverage.  The prime broker often hedges its position by purchasing the reference asset.  So-called “synthetic prime brokerage” is a means of institutionalizing the TRS-based delivery of leverage to hedge funds from prime brokers.  Generally in a synthetic prime brokerage arrangement, a prime broker establishes an account that is “advised” by a hedge fund manager.  The manager has discretion to trade the assets in the account in accordance with the strategy stated in a management agreement or a PPM incorporated by reference into such an agreement.  However, the prime broker – not the manager – owns the assets in the account.  The account and a hedge fund advised by the manager enter into a global TRS whereby the account pays the hedge fund the total return on the assets in the account and the hedge fund pays the account any losses on those assets, fees and interest on embedded leverage.  Notably, whereas prime brokers that enter TRSs usually must purchase assets to hedge their short TRS positions, in synthetic prime brokerage arrangements, the hedge assets are built into the arrangement: by directing the account to purchase those assets, the hedge fund effectively does the prime broker’s hedging for it.  This article details the mechanics of the typical synthetic prime brokerage arrangement; the level of control retained by a hedge fund manager over the account; how prime brokers ensure reliable hedging; the benefits and pitfalls of synthetic prime brokerage arrangements for hedge fund managers; whether recent U.S. legislative and regulatory action will diminish the utility and availability of synthetic prime brokerage in the U.S.; the global implications of U.S. legislative and regulatory action; and other leverage alternatives beyond synthetic prime brokerage.

Delaware Court Dismisses Hedge Fund Steel Partners Japan Strategic Holdings’ Counterclaims Against Former Consultant Who Started a Competing Japanese Hedge Fund

In 2001, two Japanese investment bankers, Kenzo Kuroda, the plaintiff, and Yusuke Nishi, formed a relationship with the individual defendants, Thomas J. Niedermeyer, Jr. and Warren G. Lichtenstein.  The defendants had created a complex web of corporate entities with the intent to target Japanese publicly traded companies through an aggressive hedge fund investment strategy.  Kuroda and Nishi joined as non-managing members of one entity, defendant Steel Partners Japan Strategic Holdings, LLC (SPJS), the general partner for hedge funds: SPJS Fund, L.P., (Feeder Fund) and SPJS Fund (Offshore), L.P. (Master Fund).  They also co-owned SPJ-KK, a Japanese firm they formed to provide consulting services to SPJ Asset Management (SPJAM), the investment manager for the Funds.  In 2006, Kuroda left SPJS and formed a competing investment fund.  Kuroda demanded full payment for amounts due him as a member of SPJS, and the defendants refused.  Kuroda sued for those sums, and brought claims based on defendants’ purported disparagement of him and of his new business.  On April 15, 2009, the Delaware Chancery Court dismissed all of his claims against the defendants, except for one sounding in breach of contract.  Kuroda v. SPJS Holdings, L.L.C., et al., 971 A.2d 872 (Del.Ch. 2009).  Two weeks later, the defendants brought counterclaims under the SPJS LLC agreement of misappropriation of trade secrets, breach of fiduciary duty, breach of the implied covenant of good faith and fair dealing and breach of contract.  They did not assert counterclaims based on violations of the consulting agreement between SPJ-KK and SPJAM because that contract mandated arbitration in Japan.  On March 16, 2010, the Chancery Court granted the plaintiff’s motion to dismiss the counterclaims.  We summarize the series of events leading up to the instant action and the Chancery Court’s legal analysis.

Texas District Court Rules that Hedge Fund Limited Partners’ Withdrawal Rights Were Not Triggered by Termination of Fund Principal’s Employment with the Fund, where Principal Continued to Exert Influence Over the Fund as 50 Percent Owner of the Fund’s General Partner

Plaintiffs were investors in hedge fund Tuckerbrook/SB Global Special Situations Fund, L.P. (Fund), a fund of funds.  Sumanta Banerjee (Banerjee) was a 50 percent owner of the Fund’s general partner and was employed as its portfolio manager.  The Fund’s limited partnership agreement permitted withdrawal in the event Banerjee ceased to be “directly involved” with the Fund’s general partner or the Fund.  The Fund terminated Banerjee’s employment in March, 2008, and plaintiffs promptly requested redemption of their Fund interests.  The Fund refused and this litigation ensued.  The U.S. District Court for the Southern District of Texas ruled that the Fund and its co-defendants were entitled to summary judgment dismissing plaintiffs’ complaint because the evidence showed clearly that, even though Banerjee was no longer employed by the general partner, he continued to exert substantial influence over the Fund and its operations after the termination of his employment through his ownership interest in the Fund’s general partner.  We describe the facts and circumstances surrounding the lawsuit and explain the rationale for the Court’s decision.

KPMG Webcast Focuses on Implications of Revised Custody Rule for Hedge Fund Managers in the Areas of Operational Independence, Delivery of Financial Statements, Surprise Examinations and Internal Control Reports

As the hedge fund industry continues to work on compliance with the amended custody rule, KPMG LLP hosted a webcast on March 23, 2010 focusing on specific compliance concerns and strategies.  The event was moderated by Sean McKee, Partner and Audit Sector Leader for KPMG LLP’s Investment Management Practice, and included presentations by Michael Barnes and Deborah Hynds, both of KPMG’s Advisory Services group, and John Crowley of Davis, Polk & Wardwell LLP.  The speakers addressed various issues raised by the revised custody rule, including: the changing definition of custody; the definitions of “related party” and “operational independence”; requirements concerning delivery of account statements; the “audited pool exemption”; the exemption from the annual surprise examination requirement; and the proper format for internal control reports.  This article summarizes the key points discussed with respect to each of the foregoing issues, and concludes with a discussion of how the SEC’s recent clarifications of the amended custody rule affect the scope of the audited pool exemption.  Prior issues of the Hedge Fund Law Report have included extensive coverage of the custody rule amendments and their implications for hedge funds and their managers.  See: (1) “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?,” Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010); (2) “How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?,” Hedge Fund Law Report, Vol. 3, No. 4 (Jan. 27, 2010); (3) “How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?,” Hedge Fund Law Report, Vo. 3, No. 5 (Feb. 4, 2010); (4) “Application to Hedge Fund Managers of the Internal Control Report Requirement of the Amended Custody Rule,” Hedge Fund Law Report, Vo. 3, No. 6 (Feb. 11, 2010); and (5) “SEC Adopts Investment Adviser Custody Rule Amendments,” Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010).