Jan. 5, 2012

Legal and Operational Due Diligence Best Practices for Hedge Fund Investors

In the wake of the financial crisis in late 2008, many investors were left trapped in suspended, gated or otherwise illiquid hedge funds.  Unfortunately, for many investors who had historically taken a passive role with respect to their hedge fund investments, it took a painful lesson to learn that control over fundamental fund decisions was in the hands of hedge fund managers.  Decisions such as the power to suspend or side pocket holdings were vested in managers either directly or through their influence over the board of directors of the fund.  In these situations, which were not uncommon, leaving control in the hands of the manager rather than a more independent board gave rise to a conflict of interest.  Managers were in some cases perceived to be acting in their own self-interest at the expense, literally and figuratively, of the fund and, consequently, the investors.  The lessons from the financial crisis of 2008 reinforced the view that successful hedge fund investing requires investors to approach the manager selection process with a number of considerations in mind, including investment, risk, operational and legal considerations.  Ideally, a hedge fund investment opportunity will be structured to sufficiently protect the investor’s rights (i.e., appropriate controls and safeguards) while providing an operating environment designed to maximize investment returns.  Striking such a balance can be challenging, but as many investors learned during the financial crisis, it is a critical element of any successful hedge fund program.  The focus on hedge fund governance issues has intensified in the wake of the financial crisis, with buzz words such as “managed accounts,” “independent directors,” “tri-party custody solutions” and “transparency” now dominating the discourse.  Indeed, investor efforts to improve corporate governance and control have resulted in an altering of the old “take it or leave it” type of hedge fund documents, which have become more accommodative towards investors.  In short, in recent years investors have become more likely to negotiate with managers, and such negotiations have been more successful on average.  In a guest article, Charles Nightingale, a Legal and Regulatory Counsel for Pacific Alternative Asset Management Company, LLC (PAAMCO), and Marc Towers, a Director in PAAMCO’s Investment Operations Group, identify nine areas on which institutional investors should focus in the course of due diligence.  Within each area, Nightingale and Towers drill down on specific issues that hedge fund investors should address, questions that investors should ask and red flags of which investors should be aware.  The article is based not in theory, but in the authors’ on-the-ground experience conducting legal and operational due diligence on a wide range of hedge fund managers – across strategies, geographies and AUM sizes.  From this deep experience, the authors have extracted a series of best practices, and those practices are conveyed in this article.  One of the main themes of the article is that due diligence in the hedge fund arena is an interdisciplinary undertaking, incorporating law, regulation, operations, tax, accounting, structuring, finance and other disciplines, as well as – less tangibly – experience, judgment and a good sense of what motivates people.  Another of the themes of the article is that due diligence is a continuous process – it starts well before an investment and often lasts beyond a redemption.  This article, in short, highlights the due diligence considerations that matter to decision-makers at one of the most sophisticated allocators of capital to hedge funds.  For managers looking to raise capital or investors looking to deploy capital intelligently, the analysis in this article merits serious consideration.

How Can Hedge Fund Managers Rebut the Presumption of Materiality of Certain Disciplinary Events in Form ADV, Part 2?

Part 2 of Form ADV (specifically Item 9 of Part 2A) requires a registered hedge fund manager to disclose all “material facts about any legal or disciplinary event that is material to a client’s (or prospective client’s) evaluation of the integrity of the adviser or its management personnel.”  In contrast to the check-the-box disclosures regarding disciplinary history required by Part 1 of Form ADV, the disciplinary disclosures required by Item 9 of Part 2A must be made in narrative form and in plain English.  Item 9 requires a registered hedge fund manager to disclose all material facts about a disciplinary event involving the firm or any of its “management persons” if that event is material to a client’s evaluation of the firm or its management persons.  Items 9A, B and C provide a list of disciplinary events that are presumed to be material and must be disclosed unless, among other things, the hedge fund manager can rebut the presumption of materiality.  Rebutting the presumption is important for hedge fund managers because disclosing disciplinary events can undermine capital raising, obscure other achievements (even a good track record), monopolize due diligence conversations and give risk-averse institutions a reason not to invest or to redeem.  Therefore, this article discusses how registered hedge fund managers can rebut the presumption of materiality in determining what disciplinary events must be disclosed in Item 9.  This article begins with a discussion of Item 9, including a listing of disciplinary events presumed to be material as well as an explanation of key definitions that inform the required disclosures.  The article then explains the four factors that registered hedge fund managers should use in evaluating whether they can rebut the presumption of materiality and applies the factors to specific scenarios.  Next, the article discusses best practices for documenting determinations rebutting the presumption of materiality.  In addition, the article examines: other disciplinary events to be disclosed in Item 9 (even though not specifically listed); the materiality standard; other areas where a hedge fund manager must make disciplinary disclosures; consequences for omitting disciplinary information required by Part 2; and best practices for gathering disciplinary information about a firm’s advisory personnel.

Recent SEC Enforcement Action Demonstrates the SEC’s Focus on the Accuracy and Consistency of Disclosures by Hedge Fund Managers in Form ADV

The SEC initiated a record number of enforcement actions in fiscal year 2011.  Among other things, the SEC has focused more attention on ferreting out false and misleading statements made by investment advisers in communications with investors and regulators.  As recently as November 2011, Robert Khuzami, Director of the SEC’s Division of Enforcement, explained that the SEC is specifically targeting investment advisers that it suspects may have filed Forms ADV containing false or misleading statements.  This article describes a recent SEC action indicating that the agency will bring enforcement actions based on allegations of inaccuracies in Form ADV.  This article also makes recommendations that hedge fund managers can implement to avoid Form ADV-related violations.  For a discussion of another current SEC enforcement initiative, see “Hedge Fund Managers with Unexplained Aberrational Performance Are More Likely to Become Targets of SEC Enforcement Actions,” Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).

Ernst & Young Survey Juxtaposes the Views of Hedge Fund Managers and Investors on Hedge Fund Succession Planning, Governance, Administration, Expense Pass-Throughs and Due Diligence

Ernst & Young (E&Y) recently released the 2011 edition of its annual hedge fund survey entitled, “Coming of Age: Global Hedge Fund Survey 2011” (Report).  The Report conveys and compares the views of hedge fund managers and investors on topics including succession, independent board oversight, use of administrators, expense pass-throughs and due diligence.  This article summarizes the more salient findings from the Report.  One of the Report’s many interesting insights is that managers frequently receive little in the way of feedback when a potential investor declines an investment.  The Report partially fills this “feedback gap” by offering generalized insight on what matters most to investors.  For example, managers may be surprised to learn that the absence of a robust and reliable succession plan may have played as much or more of a role in a lost investment as performance or even operational issues.  (The HFLR will be covering succession planning for hedge fund managers in an upcoming issue.)  More generally, the depth of the disparity in perception between managers and investors on a range of topics, as found by the Report, is at times startling.  The Report therefore offers a sobering reality check for both managers and investors.  Both sides need one another, albeit for different reasons, and the lifecycle of an investment can be significantly more productive if expectations and assumptions are better aligned.

Recent SEC Settlement Cautions Hedge Fund Managers Not to Turn a Blind Eye to Potential Impropriety in Evaluating Transactions with Counterparties

A recent SEC settlement demonstrates that financial institutions, including hedge fund managers, can be held liable for turning a blind eye to potential counterparty impropriety in choosing to enter into transactions with such counterparties.  This article describes the settlement and discusses its implications for hedge fund managers.

Implications for Hedge Fund Managers of the Rule Amendments Recently Adopted by the SEC to Raise Accredited Investor Standards

On December 21, 2011, the SEC issued a final rule release (Release) in which it adopted rule amendments designed to implement the revisions to the accredited investor standards outlined in the rules under the Securities Act of 1933 (Securities Act) made by Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).  The accredited investor standards are important to hedge fund managers because hedge funds typically rely on the safe harbor from securities registration provided by Rule 506 under the Securities Act, which generally requires that most investors qualify as “accredited investors” to qualify for the safe harbor.  This article provides a detailed analysis of the final rule amendments and catalogues the various ways in which the amendments will impact the day-to-day businesses of hedge fund managers.

Madoff Feeder Fund Kingate Sues Deutsche Bank to Enforce Commitment to Purchase Madoff Bankruptcy Claims

Plaintiffs Kingate Global Fund Ltd. and Kingate Euro Fund Ltd. (Funds) were two feeder funds that invested substantially all of the money they raised with Bernard L. Madoff Investment Securities (Madoff).  In August 2011, the Funds and defendant Deutsche Bank Securities Inc. (Deutsche Bank) signed a “confirmation letter” that contemplated the purchase of $1.6 billion of the Funds’ claims against Madoff for 66 cents on the dollar.  The parties negotiated through the fall, but never signed a formal purchase agreement.  In December 2011, the Funds commenced this action against Deutsche Bank seeking to enforce the confirmation letter.  This article summarizes the Funds’ allegations, which are relevant to hedge funds that trade Madoff exposure or other bankruptcy claims.  See also “Two Key Levels of Risk Facing Hedge Funds That Buy or Sell Bankruptcy Claims,” Hedge Fund Law Report, Vol. 4, No. 27 (Aug. 12, 2011).