Aug. 6, 2010

How Will the SEC’s New Pay to Play Rule Impact Mergers and Acquisitions of Hedge Fund Management Companies?

Three trends are likely to increase the volume of mergers and acquisitions of hedge fund management companies – especially sales of smaller firms to larger firms and sales by banking entities of advisers to “sponsored” hedge funds.  First, various provisions of the Dodd-Frank Act (most notably, the registration provisions) are likely to increase ongoing compliance costs for hedge fund managers.  Many such costs will be fixed, and thus will adversely impact smaller hedge fund managers to a greater degree than larger ones.  Some of those smaller managers will determine that selling the advisory business is preferable to continuing to operate independently.  See “For Managers Facing Strong Headwinds, Sales of the Advisory Business Offer a Means of Preserving the Franchise While Avoiding Fund Liquidations,” Hedge Fund Law Report, Vol. 2, No. 11 (Mar. 18, 2009).  Increased compliance costs also are likely to deter, at the margin, entry into the hedge fund management business by potential startups.  Second, the version of the Volcker Rule included in the Dodd-Frank Act is likely to cause some investment and commercial banks to divest certain internal hedge fund management businesses.  See “Implications of the Volcker Rule – Managing Hedge Fund Affiliations with Banks,” Hedge Fund Law Report, Vol. 3, No. 10 (Mar. 11, 2010).  In cases where banks purchased going hedge fund management concerns rather than developing them internally, management buyouts may be a common deal structure.  Also, various hedge fund industry participants expect the Volcker Rule to displace traders and portfolio managers currently working at investment banks on proprietary trading desks or at in-house hedge funds.  Certain of those traders and managers will start new hedge fund management firms: some of those new firms will fail, some will continue independently and some will be sold to established players.  See “Stars in Transition: A New Generation of Private Fund Managers,” Hedge Fund Law Report, Vol. 2, No. 49 (Dec. 10, 2009).  Third, the fundraising environment may remain difficult, causing smaller managers to sell to larger managers with more developed marketing and distribution infrastructures.  Indeed, distribution is a key consideration even in deals involving larger hedge fund managers: the proxy statement relating to Man Group’s acquisition of GLG Partners cited Man’s distribution capabilities as one of the strategic benefits of the transaction.  See "Transaction Analysis: Hedge Fund Managers Man Group and GLG Partners Announce Plans to Merge,” Hedge Fund Law Report, Vol. 3, No. 21 (May 28, 2010).  (That acquisition is expected to close in the third quarter of 2010.)  The SEC’s recently approved pay to play rule (Rule) introduces a new category of legal risk into mergers and acquisitions of hedge fund management companies.  See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures and Marketing Practices in Light of the SEC’s New ‘Pay to Play’ Rule?,” Hedge Fund Law Report, Vol. 3, No. 30 (Jul. 30, 2010).  At best, the Rule will add new categories of due diligence, new integration tasks and new post-closing training requirements to such transactions.  At worst, the Rule will delay or even derail such transactions.  This article identifies concerns raised by the Rule in the hedge fund manager M&A context, and offers strategies to address them.  Specifically, this article outlines fact patterns in which the Rule can adversely affect the outcome in the purchase or sale of a hedge fund management business; identifies notable recent investment management merger and acquisition transactions and transaction trend statistics; lists the four primary options available to hedge fund managers or others to prevent or remedy violations of the Rule in connection with acquisitions of hedge fund management businesses; discusses the pros and cons of each of the primary options; and outlines five alternative options, and the benefits and burdens of each.

Modification of Definition of Accredited Investor Requires Hedge Funds to Revise Their Subscription Agreements

To invest in domestic hedge funds, a natural person must be an “accredited investor.”  The term “accredited investor” is defined Rule 501 of Regulation D, the private placement safe harbor promulgated under Section 4(2) of the Securities Act of 1933, as amended.  If a natural person satisfies either of two tests in Rule 501, that person is an “accredited investor.”  Those tests are the income test and the net worth test.  Under the income test, a natural person is an accredited investor if he or she had individual income in excess of $200,000 in each of the two most recent years or joint income with his or her spouse in excess of $300,000 in each of the those years, with a reasonable expectation of reaching the same income level in the current year.  Under the net worth test, a natural person is an accredited investor if he or she has a net worth of at least $1 million.  Dodd-Frank did not modify the income test, but did modify the net worth test.  Specifically, Dodd-Frank modified the net worth test by providing that a natural person may no longer include the value of his or her primary residence in determining whether he or she has a net worth of at least $1 million.  (Prior to enactment of Dodd-Frank, natural persons were allowed to include the value of the primary residence in making the net worth calculation.)  On July 23, 2010, the SEC issued guidance providing that in calculating net worth, a natural person may exclude the amount of any indebtedness secured by his or her primary residence up to the fair market value of the primary residence, but must include (that is, subtract from) net worth any indebtedness secured by his or her primary residence in excess of the fair market value of the primary residence.  We analyze the modified accredited investor definition, and explain why its impact on hedge funds may be muted.

Delaware Chancery Court Rules that Countersuit for Indemnification by Manager of Fund Administration Holdings, LLC, May Proceed against those Members of the Fund who Sued Him for Intentional Withholding of Distributions

On June 30, 2010, the Delaware Chancery Court denied a motion to dismiss counterclaims brought by James P. Kelly, the managing member of Fund Administration Holdings, LLC (FAH), as against members of FAH who had sued him.  Kelly had intentionally withheld payments from the sale of fund assets to those members after they had assisted another firm, State Street Bank and Trust Company (State Street), in unrelated litigation against him.  After the members sued Kelly, he counterclaimed for indemnification, breach of a non-disparagement clause, and release under FAH’s operating agreement.  The court, though “skeptical” of Kelly’s position in seeking indemnification, felt “constrained” to permit his claims to go forward due to ambiguities in the operating agreement.  We detail the background of the action and the court’s legal analysis.

IRS Private Letter Ruling Offers Guidance to Hedge Funds Investing in Auction Rate Preferred Shares

The classification of interests issued by closed-end funds as debt or equity for tax purposes has significant ramifications for hedge funds that invest in such funds.  Interests that are classified as debt generally allow holders to treat payments received from the fund as interest income and nontaxable principal repayments.  By contrast, interests that are classified as equity generally allow investors to receive dividends, capital gains or a mixture of the two.  A recent private letter ruling (PLR) issued by the Internal Revenue Service (IRS or Service) addressed the classification of preferred stock issued by a closed-end fund as debt or equity.  The IRS determined that the preferred stock should be classified as equity for federal tax purposes.  The PLR is significant for a variety of reasons.  First, the fact that the PLR was issued at all represents a change in procedure for the IRS, which previously declined to issue rulings on the classification of financial instruments as debt or equity because of the fact-specific nature of such classifications.  Second, the PLR has implications for hedge funds interested in the auction rate preferred shares market.  This article examines the PLR, its background and its potential significance for hedge funds invested or considered an investment in auction rate preferred shares.

M. Holland West Joins Dechert as a Partner in the Financial Services Practice Group

On August 2, 2010, Dechert LLP announced that M. Holland West, a leading private funds and derivatives lawyer, joined the firm as a partner in the financial services practice group in the New York office.