Dec. 8, 2011

A Step-By-Step Guide to GIPS Compliance for Hedge Fund Managers

The Hedge Fund Law Report and others have reported on the post-crisis ascendance of non-performance factors in hedge fund due diligence and investment decision-making.  In short, before 2008, hedge fund allocations were driven largely by a manager’s past performance.  After 2008, factors such as transparency, liquidity and robust risk management surpassed performance in the hierarchy of concerns of institutional hedge fund investors.  See “Survey by SEI and Greenwich Associates Identifies the Primary Decision Factors and Concerns of Institutional Investors When Investing in Hedge Funds,” Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 11, 2011).  However, we do not wish to overstate the case or the duration of the trend.  The long-term lesson of the crisis likely will be that robust risk management, appropriate liquidity and transparency and well-developed infrastructure are necessary to justify a hedge fund investment, but not sufficient.  Hedge fund managers without institutional caliber businesses will often be passed over, but as between two managers with good businesses, the deciding factor will often be past performance.  Thus the immediate and important question for hedge fund managers: how can managers present performance information in a manner that maximizes capital raising efforts while complying with relevant law and standards?  An increasingly common answer to this question in the hedge fund community is: by complying with the Global Investment Performance Standards (GIPS), an evolving set of practice standards designed to ensure consistency and uniformity in the presentation of investment performance results.  Compliance with GIPS is ostensibly voluntary, but in practice, more and more institutional hedge fund investors are asking to see GIPS-compliant performance information.  Accordingly, GIPS compliance is becoming a de facto requirement for hedge fund managers, and hedge fund managers are actively seeking to become GIPS compliant.  The main challenge for hedge fund managers is that GIPS were originally designed for a long-only world.  They have been an imperfect fit for managers with complex investment structures, side pockets, illiquid or hard-to-value assets and other typical elements of the hedge fund business.  Sensitive to this, the GIPS Executive Committee recently promulgated guidance specific to alternative investment managers, and service providers have adapted their businesses to help hedge fund managers comply with GIPS and certify such compliance.  However, despite the guidance and available assistance, GIPS compliance remains a challenge for hedge fund managers.  This article aims to assist hedge fund managers in rising to that challenge and surmounting it.  To do so, this article starts by providing a comprehensive overview of GIPS.  The article then identifies five discrete categories of benefits of GIPS compliance and two categories of burdens of compliance.  Next, and most importantly, this article provides a step-by-step process by which hedge fund managers can become GIPS compliant.  In the course of this discussion, this article details the material points from two recent webinars and one recent white paper promulgated by leading GIPS service providers.  Reading this article will enable a hedge fund manager to, among other things: revise its marketing materials to comply with GIPS; organize its front, middle and back offices to collect the data necessary to support a GIPS-compliant presentation; manage service providers with a view to GIPS compliance; ask the right questions of outside counsel; determine whether to engage a specific GIPS compliance service provider; define the scope of any such engagement; and respond effectively to due diligence inquiries on GIPS.

Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part Two of Four)

Many hedge fund managers based in the U.S. or Europe have considered opening an office in Asia, but few are conversant with the benefits and burdens of the various Asian jurisdictions, and fewer still are familiar with the specific steps necessary to open an Asian office.  To address this information gap, Maria Gabriela Bianchini, founder of Optionality Consulting, is publishing a four-part series in the Hedge Fund Law Report.  The first article in this series identified factors that hedge fund managers should consider in determining whether to open an office in Asia and compared the relative merits of Hong Kong and Singapore as locations for an office.  See “Primary Regulatory and Business Considerations When Opening a Hedge Fund Management Company Office in Asia (Part One of Four),” Hedge Fund Law Report, Vol. 4, No. 43 (Dec. 1, 2011).  This article – the second in the series – discusses technical steps and considerations for the actual process of opening an office in either Hong Kong or Singapore.  Many of these steps are applicable to the establishment of any new office outside of a manager’s home jurisdiction, but they are discussed in this article in the context of an Asian office opening.  Part three of this series will discuss the changing regulatory landscape affecting managers in Singapore and part four will conclude with a discussion of Hong Kong.

Hedge Fund Managers with Unexplained Aberrational Performance Are More Likely to Become Targets of SEC Enforcement Actions

In a December 1, 2011 press release, the Asset Management Unit of the SEC’s Division of Enforcement (Division) announced the Aberrational Performance Inquiry (Inquiry), a new initiative to identify and combat hedge fund fraud.  Under the Inquiry, the Division is using proprietary risk analytics to screen hedge funds’ performance returns to determine whether the stated returns are consistent with the fund’s investment strategy or appropriate benchmarks.  If the Division identifies a hedge fund whose performance is aberrational – too high, too low or inconsistent with the fund’s strategy – the Division is likely to undertake additional quantitative and qualitative screens to determine the source of the aberration.  Such screens may include contacting the fund’s manager directly, looking more closely at the sources of stated returns and examining factors other than returns.  This article: discusses the Inquiry in greater depth; details the factual and legal allegations in the SEC’s administrative proceeding against unregistered investment adviser LeadDog Capital Markets LLC and its general partners – an action that was brought as part of the Inquiry; and identifies specific practices for hedge fund managers to consider in light of the Inquiry.  For more on the Inquiry based on information that was publicly available as of April of this year, see “SEC’s Hedge Fund Focus to Include Review of Funds That Outperform the Market,” Hedge Fund Law Report, Vol. 4, No. 14 (Apr. 29, 2011).

Five Best Practices for Avoidance of Pay to Play Violations by Hedge Fund Managers or Their Covered Associates

On November 29, 2011, law firm Venable LLP hosted a webinar entitled “Best Practices for Investment Advisers to Avoid Violating Pay-to-Play Regulations (Webinar).”  The purpose of the event, which was hosted by Venable attorneys Ron Jacobs and Scott Gluck, was to help hedge fund managers navigate the various federal, state and municipal restrictions on political contributions by hedge fund managers that solicit government investors.  The Webinar included ideas previously discussed by Gluck in the Hedge Fund Law Report.  See “How Can Hedge Fund Managers Participate in the Political Process without Violating Pay to Play Regulations at the Federal, State, Municipal or Fund Level?,” Hedge Fund Law Report, Vol. 4, No. 35 (Oct. 6, 2011).  This article summarizes the points made during the Webinar with most direct relevance to hedge fund managers, including what the relevant regulations are, how they are applied and how they intersect.  This article also relates five best practices for avoiding violations of relevant regulations, as described by Gluck and Jacobs during the Webinar.

SEC Accuses Former Portfolio Manager of Hedge Fund Millennium Global Emerging Credit Fund and Broker-Dealer Accomplice of Fraud in Conspiring to Inflate the Fund’s NAV

In parallel civil and criminal actions, the SEC and DOJ, respectively, brought charges alleging hedge fund valuation fraud.  Like the LeadDog matter described above, the SEC action was brought as part of the Enforcement Division’s Aberrational Performance Inquiry.  This article describes the factual and legal allegations, and sheds additional light on what the Aberrational Performance Inquiry means for hedge fund managers.

Dismissal of Fortress’ Complaint Against Dechert Illustrates the Limits of a Hedge Fund Manager’s Ability to Rely on a Legal Opinion Issued by a Law Firm of Which It Is Not a Client

On November 29, 2011, the New York State Appellate Division, First Department – the state’s intermediate appellate court (Court) – dismissed a complaint brought in December 2009 by Fortress Credit Corp. and FCOF UL Investments LLC (together, Fortress) against the law firm Dechert LLP (Dechert).  See “Business Issues with Legal Consequences: A Wide-Ranging Interview with Dechert Partner George Mazin about the Most Important Challenges Facing Hedge Fund Managers,” Hedge Fund Law Report, Vol. 4, No. 40 (Nov. 10, 2011).  The Court’s decision helps define the scope of a law firm’s obligations to a non-client in connection with the issuance of a legal opinion.  Accordingly, the decision is relevant to law firms that issue such opinions and hedge fund managers that rely on them.  This article summarizes the allegations in the complaint, the decision below and the Court’s legal analysis.

SEI Report Describes the Growth Opportunity for Hedge Fund Managers in Regulated Alternative Funds

In November 2011, SEI and Strategic Insights released a report highlighting the growth of offerings of alternative investment strategies in regulated products such as Undertakings for Collective Investment in Transferable Securities (UCITS) and mutual funds.  See “The Implications of UCITS IV Requirements for Asset Management Functions,” Hedge Fund Law Report, Vol. 4, No. 36 (Oct. 13, 2011).  This article outlines the main findings in the report and its implications for hedge fund structuring, marketing and investments.

Leading U.K. Private Funds Lawyer Noel Ainsworth to Join Morgan Lewis in London

On December 1, 2011, Morgan Lewis announced that leading U.K. private funds lawyer Noel Ainsworth will join the firm as a partner in its Business & Finance practice in the London office.  He joins Morgan Lewis from the London office of Simmons & Simmons and is scheduled to start at Morgan Lewis in early 2012.

Private Funds Lawyers Jeffrey Blumberg and Paul Patrow Join Fox, Hefter in Chicago

The Chicago law firm Fox, Hefter, Swibel, Levin & Carroll, LLP (FHSLC) has brought on new partners Jeffrey Blumberg (as of September 1, 2011) and Paul D. Patrow (as of February 21, 2011); both have joined the firm’s Corporate and Securities Practice Group.