Apr. 23, 2010

Single Investor Hedge Funds Offer the Benefits of Managed Accounts and Additional Tax and Other Advantages for Hedge Fund Managers and Investors

Managed accounts started 2010 as the ostensible antidote to many of the more egregious evils experienced by hedge fund investors over the last two years.  Managed accounts offer transparency, liquidity, control and risk management, whereas during the credit crisis, many hedge funds and other investment vehicles offered opacity, gates, lack of control and increased risk.  While the case for managed accounts is not without valid objections – including administrative cost, allocation issues and other issues discussed more fully below – managed accounts are an increasingly popular method of accessing hedge fund strategies and managers while avoiding the downsides of commingled funds.  According to a February 2010 survey conducted by Preqin, the alternative investment data provider, 16 percent of institutional investors have a current allocation to managed accounts and a further 23 percent of institutional investors are considering an initial allocation to a managed account during 2010.  Similarly, 65 percent of fund of funds managers surveyed by Preqin either operate a managed account currently or are considering doing so during 2010.  Preqin also found that larger investors are more likely to demand, and larger managers are more likely to offer, managed accounts, and that the proportion of fund of funds managers operating managed accounts is greatest in North America (60 percent), followed by Asia and rest of world (including Hong Kong, Singapore, Japan and Israel, at 44 percent) then Europe (40 percent).  Recently, various hedge fund managers have been exploring an alternative structure that effectuates many of the goals of managed accounts, while offering a number of additional benefits and avoiding at least one of the chief downsides.  That alternative structure is the single investor hedge fund – as the name implies, a hedge fund with one outside investor (in addition to the manager’s investment).  To assist hedge fund managers and investors in evaluating whether a single investor hedge fund may be an appropriate alternative to a traditional hedge fund, on the one hand, or a managed account, on the other hand, this article discusses: the definition of a managed account; the six chief benefits and eight primary burdens of managed accounts versus hedge funds; the definition of a single investor hedge fund; the six chief benefits of single investor hedge funds over managed accounts; and the two primary downsides of single investor hedge funds versus managed accounts.

Implications for Hedge Funds of a Potential Paradigm Shift in Pension Fund Allocation Strategies

Public pension funds are the largest institutional allocator of capital to hedge funds by dollar value.  Accordingly, how public pension fund managers approach asset allocation matters profoundly to the size, strategies and revenues of the hedge fund industry.  Recently, managers of some prominent public pension funds have been rethinking their approach to asset allocation in light of the lessons of the credit crisis.  Three of the more important lesson from the crisis relate to liquidity, risk and correlation.  The liquidity story is well-known: it dried up, and many hedge fund investors who needed liquidity were not able to get it.  With respect to risk, the crisis highlighted the inadequacy of existing risk management tools employed by hedge fund investors.  And regarding correlation, the crisis witnessed assets heretofore considered uncorrelated moving – generally downward – in lockstep.  Some public pension fund managers have revised, or are considering revising, their asset allocation strategies to incorporate these three lessons.  Under the old paradigm, pension funds allocated their considerable assets based on asset class or type.  That is, they invested designated percentages of their assets in bonds, stocks, real estate, private funds (hedge funds, private equity funds, venture capital funds, infrastructure funds, etc.) and cash.  Under the new approach, pension funds are allocating their assets to categories defined by three key considerations: drivers of return, liquidity and risk.  For example, as explained more fully below, under the old approach, Treasury Inflation Protected Securities (TIPS) generally were grouped with bonds for allocation purposes.  However, the Alaska Permanent Fund Corporation (Alaska PFC) now groups TIPS with other assets intended to protect against inflation, including real estate and infrastructure investments.  (The Alaska PFC is the state-owned corporation in charge of administering the Alaska Permanent Fund.  Under the Alaska state constitution, 25 percent of the state’s mineral revenues are placed in the Alaska Permanent Fund, which is invested in a diversified portfolio and pays income dividends to qualifying Alaska residents.)  Similarly, Denmark’s ATP Fund, the largest Danish pension fund, reportedly has combined public and private equity for allocation purposes because the returns of both asset classes are affected to a significant degree by corporate earnings.  Previously, the ATP Fund had separated public and private equity for allocation purposes.  This article examines the potential paradigm shift in pension fund allocation strategy in more depth.  In particular, it discusses the evolving views of pension fund managers on liquidity and risk.  In addition, based on an interview conducted by the Hedge Fund Law Report with Michael Burns, CEO of the Alaska PFC, the article provides a detailed description of Alaska’s revised allocation approach.  Since CalPERS is also considering a shift to an allocation strategy based on drivers of returns, Alaska’s revised approach may serve as a persuasive precedent.  Finally, the article discusses the potential impact on hedge funds of pension funds’ changed allocation strategy, and briefly describes the related trend toward “liability-driven” investing.

SEC Accuses Goldman, Sachs & Co. and a Goldman V.P. of Securities Fraud

On April 16, 2010, the U.S. Securities & Exchange Commission charged Goldman, Sachs & Co. and Fabrice Tourre, a vice president on leave from Goldman, with committing fraud in the structuring and marketing of a synthetic collateralized debt obligation (CDO) linked to subprime mortgages.  See “SEC Charges Goldman, Sachs & Co. and a Goldman V.P. with Securities Fraud; Hedge Fund Manager Paulson & Co. Named in Complaint, But Not Charged with Any Violation of Law or Regulation,” Hedge Fund Law Report, Vol. 3, No. 15 (Apr. 16, 2010).  The SEC alleges that one of the world’s largest hedge fund managers, Paulson & Co., paid Goldman to create the CDO, participated in the process of selecting subprime residential mortgage-backed securities (RMBS) to be referenced by the instruments in the CDO and then entered into a credit default swap transaction with Goldman to buy protection from credit events on specific layers of the CDO.  According to the SEC, Paulson did not violate federal securities law in its actions, but Goldman did when it thereafter failed to disclose to investors that Paulson had played a key role in developing the financial product when Paulson also had an investment that would increase in value if the CDO decreased in value.  The case represents the latest in a series of SEC enforcement actions seeking to hold firms accountable for their alleged roles in the financial crisis.  As the SEC alleged in its complaint filed in U.S. District Court for the Southern District of New York, Goldman’s actions “contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.”  This article provides a detailed recitation of the key factual and legal allegations in the SEC’s complaint, and outlines Goldman’s preliminary response.

Impact of Regulatory Reforms on Hedge Funds is Key Focus of PLI’s Hedge Fund Registration and Compliance 2010 Seminar

As the government and the Securities and Exchange Commission (SEC) push for a number of reforms in the financial markets, the impact on hedge funds is expected to be significant, particularly with the Private Fund Investment Advisers Registration Act of 2009 (House bill) and the Wall Street Reform and Consumer Protection Act of 2009 (Dodd bill) both calling for the mandatory registration of hedge fund managers who meet certain assets under management (AUM) thresholds.  On April 9, 2010, the Practising Law Institute hosted the Hedge Fund Registration and Compliance 2010 seminar in New York City.  Among the key topics discussed during the conference were: fund manager registration; likely changes to the definition of accredited investor; proposed resolution authority; the Volcker Rule; key issues regarding hedge fund marketing; side letters; strategy drift; and soft dollars.  This article offers a comprehensive summary of the key points raised and discussed at the conference.

Hedge Fund Management Conglomerate S.A.C. Capital Advisors Strikes Back, Countersues Biovail Corp. for Filing Vexatious Lawsuit

On February 22, 2006, Biovail Corporation, a publicly-traded Canadian pharmaceutical company, sued S.A.C. Capital Advisors LP (SAC), the $12 billion hedge fund manager led by Steven A. Cohen, in New Jersey Superior Court.  Biovail accused SAC and numerous others of engaging in a market manipulation scheme to devalue its shares by allegedly fabricating reports about Biovail misconduct and purportedly engaging in a short selling conspiracy of its stock.  Then, on March 24, 2006, Biovail allegedly directed the filing of a proposed class action lawsuit by Biovail shareholders against SAC in the U.S. District Court for the District of New Jersey, one which “parroted [Biovail’s] complaint almost verbatim, adding a federal securities fraud claim.”  As previously reported in the Hedge Fund Law Report, in 2009, the respective courts dismissed these causes of action on the pleadings.  See “New Jersey Court Dismisses Biovail Suit Against Hedge Fund Manager S.A.C. Capital Advisors,” Vol. 2, No. 35 (Sep. 2, 2009).  On February 17, 2010, SAC struck back against Biovail by filing a lawsuit in the U.S. District Court for the District of Connecticut.  Describing Biovail’s conduct as “false, scandalous and outrageous,” SAC asserted causes of action for vexatious suit and abuse of process.  SAC alleged that Biovail manufactured its lawsuit against it to direct attention away from the well-founded class action litigation pending against it by its own shareholders and from developing criminal and regulatory inquiries by the U.S. and Canadian governments, actions which eventually resulted in a class action settlement as well as serious criminal and regulatory sanctions and fines.  We detail the background of the allegations.

Banking and Finance Litigator Jonathan Kelly Joins Cleary Gottlieb as Partner in London Office

On April 19, 2010, international law firm Cleary Gottlieb Steen & Hamilton LLP welcomed Jonathan Kelly, a leading English banking and finance litigation lawyer, as a partner in its London office.  Kelly joins the firm from Simmons & Simmons, where he was head of the finance litigation group.