Feb. 16, 2012

Key Considerations for Hedge Fund Managers in Developing a Succession Plan (Part One of Two)

Many hedge fund managers may be surprised to learn that they are mortal.  But managers are being reminded of this unpleasant fact with increasing frequency by institutional investors requesting robust succession plans.  In one view, succession planning is part and parcel of the frequently cited “institutionalization” of the hedge fund industry.  By definition, institutions are not about any one person.  They may have a charismatic founder – a Sam Walton or a Ross Perot – but they can survive the death, disability or departure of that founder, and even thrive following such an event.  But more fundamentally, succession planning is about going from good to great.  A good hedge fund manager can generate consistent returns over an extended period.  A great hedge fund manager can create an institution that generates consistent returns over an extended period.  In other words, a good hedge fund manager is a good investor, but a great hedge fund manager is a good investor and a good businessperson.  Paradoxically, greatness in the hedge fund business – as in any business – requires the ability to render yourself somewhat irrelevant.  Service partnerships like hedge fund managers are inherently fragile because their primary asset is their talent and talent can be fickle, fleeting and, absent contractual restrictions, mobile.  See “Schulte Roth & Zabel Partners Discuss Non-Competition and Non-Solicitation Provisions and Other Restrictive Covenants in Hedge Fund Manager Employment Agreements,” Hedge Fund Law Report, Vol. 4, No. 42 (Nov. 23, 2011).  Moreover, talent at the top that is insufficiently diffused throughout the organization can result in a top heavy hedge fund manager, and one that is therefore easily toppled.  Accordingly, investors in hedge funds and acquirers of hedge fund management businesses want concrete evidence that a manager has mitigated the business risk.  A considered, workable and realistic succession plan is the best evidence that a manager has thought ahead.  Reasoning backwards, a succession plan is more than just a defensive document: it offers franchise value to acquirers, predictability to investors and long-term value to the founder and his or her heirs.  See also “Key Person Provisions in Hedge Fund Documents: Structure, Consequences and Demand from Institutional Investors,” Hedge Fund Law Report, Vol. 2, No. 37 (Sep. 17, 2009).  This is the first article in a two-part series that will outline key considerations for hedge fund managers seeking to develop and implement a succession plan.  This feature-length article discusses: why succession planning is an imperative for hedge fund managers looking to raise institutional capital and create long-term enterprise value; applicable regulatory requirements; the imperative of commencing succession planning today rather than deferring difficult decisions; examples of prominent hedge fund managers that have implemented succession plans; what types of succession events a succession plan should cover; people decisions, including how to identify roles to be filled and how to identify, incentivize and train successors; and the role of management committees in succession planning.  The second article in this series will discuss potential changes in a firm’s ownership and compensation structure designed to incentivize prospective successors to stay with the firm and to address the economics of departing founders or key employees; buyout and sunset provisions and the role of insurance; how to document and test the succession plan; how to communicate information about a manager’s succession plan with investors; and considerations with respect to redemption rights.

How Should Hedge Fund Managers Determine Which of Their Advisory Affiliates Should Register with the SEC?

On January 18, 2012, the SEC’s Division of Investment Management (Staff) issued a no-action letter in response to a request for guidance from the ABA Subcommittee on Hedge Funds seeking confirmation as to whether certain affiliates of an investment adviser must separately register with the SEC.  This article discusses the Staff guidance in detail and outlines the implications of the guidance for hedge fund managers.

Enforcement Session at SEC’s Compliance Outreach Program National Seminar Highlights Regulatory Focus on Valuation, Conflicts of Interest and Compliance Shortcomings at Hedge Fund Managers

On January 31, 2012, the SEC hosted its annual “Compliance Outreach Program National Seminar” (Seminar).  (The program was previously called “CCOutreach,” but it has been “rebranded,” as the SEC explained in a press release, to be more inclusive of all senior personnel at firms.)  The Seminar included five sessions.  One of those sessions – and the focus of this article – was entitled “Enforcement-Related Matters” (Session).  The purpose of the Session was to inform fund industry participants about the SEC’s recent risk analytic initiatives and to provide insight into the SEC’s areas of focus and enforcement priorities.  The Session was conducted by: Rosalind Tyson, Regional Director of the SEC’s Los Angeles Regional Office; Barbara Chretien-Dar, Assistant Director of the SEC’s Division of Investment Management; and Bruce Karpati and Robert Kaplan, Co-Chiefs of the Asset Management Unit of the SEC’s Division of Enforcement.  The Session provided valuable insight into the SEC’s current regulatory priorities, which are or are likely to become areas of focus for investors.  This insight, in turn, can help hedge funds managers deploy limited compliance resources to address the areas of greatest concern for both regulators and investors.  Specifically, the Session: (1) explained how and when risk-based examinations are initiated and their potential progression to investigations; (2) identified the main current focus areas for enforcement staff; and (3) discussed enforcement actions based on these main focus areas.  This article discusses each of the foregoing topics in detail.

Do Hedge Funds Really Pose a Money Laundering Threat?  A Decade of Regulatory False Starts Raises Questions

If terrorists and drug runners need to launder illicit gains, are hedge funds the perfect vehicle?  Since 2001, regulators and legislators have debated subjecting hedge funds to anti-money laundering rules like those in place for banks, broker-dealers and other financial institutions.  Despite the promulgation of specific rules and significant legislative pressure, hedge funds remain largely outside the purview of anti-money laundering regulations.  Now, new moves from U.S. financial regulators suggest that, after a decade of false starts, hedge funds may be brought into the fold.  The history of these proposed regulations sheds light on the question of whether hedge funds even pose the kind of threat the rules were designed to ameliorate.  In a guest article, Michael B. Himmel and Matthew M. Oliver, both Members of Lowenstein Sandler PC, provide a comprehensive overview of U.S. anti-money laundering legislation and regulation over the past decade, and conclude with a discussion of recent anti-money laundering developments that have direct bearing on hedge funds, hedge fund managers and investors.

CFTC Adopts Final Rules That Are Likely to Require Many Hedge Fund Managers to Register as Commodity Pool Operators

On February 9, 2012, the Commodity Futures Trading Commission (CFTC) adopted final rules (Final Rules) amending Part 4 of its regulations promulgated under the Commodity Exchange Act governing commodity pool operators (CPOs) and commodity trading advisers (CTAs).  Notably for hedge funds, the Final Rules, among other things, rescind the exemption from CPO registration contained in Rule 4.13(a)(4), which is relied on substantially in the hedge fund industry.  Notably for hedge funds, the Final Rules differ from the rule amendments proposed by the CFTC (Proposed Rules) on January 26, 2011, in that the Final Rules do not rescind the exemption from CPO registration under Rule 4.13(a)(3) for hedge funds that conduct a de minimis amount of trading in futures, commodity options and other commodity interests.  For an in-depth discussion of the Proposed Rules, see “CFTC Proposes New Reporting and Compliance Obligations for Commodity Pool Operators and Commodity Trading Advisers and Jointly Proposes with the SEC Reporting Requirements for Dually-Registered CPO and CTA Investment Advisers to Private Funds,” Hedge Fund Law Report, Vol. 4, No. 5 (Feb. 10, 2011).  As a result, unless an exemption is otherwise available, the Final Rules will require a CPO to register with the National Futures Association if the managed commodity pool (i.e., hedge fund) conducts more than a de minimis amount of speculative trading in futures, commodity options and other commodity interests; and CPO registration imposes significant obligations on registrants.  This article provides a detailed summary of the CFTC’s Final Rules and highlights relevant changes from the Proposed Rules.  The article focuses on the provisions of the Final Rules with most direct application to hedge fund managers following commodities-focused investment strategies.

A New Year in Old World Distressed Debt: Distressed Investment Opportunities for Hedge Fund Managers in the UK/Europe for 2012

The UK and Europe appear poised to provide unprecedented opportunities in distressed debt in 2012.  A variety of factors are expected to force banks in the UK/Europe to delever their balance sheets by a colossal sum of €1.5 to €2.5 trillion over the next 18 to 24 months.  Analysts anticipate, as a result, a spate of distressed bank loans coming to market.  In order to capitalize on this unique opportunity – which some have characterized as “the next great trade” – hedge fund managers will need to be well-versed in local law, particularly local insolvency law.  In a guest article, Solomon J. Noh discusses legal considerations that can impact the outcome of investments by hedge funds in UK and European distressed debt.  Noh is a Partner in the Bankruptcy & Reorganization Group at Shearman & Sterling LLP, currently resident in Shearman’s London office.  For related analysis by Noh, see “Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act,” Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011).

Recent Delaware Chancery Court Opinion Clarifies Default Fiduciary Duties Owed By Managers of Limited Liability Companies

Much confusion has arisen surrounding the scope of fiduciary duties owed by managers of Delaware limited liability companies (LLCs) to other members of the LLC.  Hedge fund managers must understand the scope of such fiduciary duties because they frequently organize LLCs both as hedge funds that they manage as well as the management entities which provide advisory and administrative services to their hedge funds.  As a result, hedge fund managers may owe fiduciary duties not only to hedge fund investors, but also to the other members of their management entities organized as LLCs.  This article describes a recent Delaware Chancery Court opinion that clarifies the default fiduciary duties owed by managers of Delaware LLCs, as well as the scope of the ability of managers to limit or eliminate such duties by contract.

Bingham Expands Private Equity and Insurance Capabilities with Addition of Jeffrey MacDonald

On February 6, 2012, Bingham McCutchen LLP announced that it has expanded its private equity and insurance capabilities at its New York and Hartford offices with the addition of partner Jeffrey MacDonald, who joined the firm from Dewey & LeBoeuf LLP.