Jan. 10, 2013

How Can Hedge Fund Managers Use Reinsurance Businesses to Raise and Retain Assets and Achieve Uncorrelated Returns?  (Part One of Two)

Among the many challenges facing hedge fund managers, two loom particularly large: raising and retaining assets, and achieving uncorrelated returns.  A growing number of brand-name hedge fund managers are addressing these twin challenges through an innovative solution – launching reinsurance businesses, typically in offshore jurisdictions.  If properly managed, the premiums collected by a reinsurance business can offer a stream of income – in effect, a return on investment in the business – that is uncorrelated with returns on other assets; and those premiums provide capital that can be deployed in a manager’s other investment strategies.  But reinsurance businesses are not without challenges, notably including the specialized skill set required to manage such businesses effectively and the possibility of large claims following catastrophes.  This article is the first in a two-part series designed to highlight the primary legal, business and risk considerations for hedge fund managers contemplating the launch of a reinsurance business.  In particular, this article provides background on the reinsurance business; explains how reinsurers generate revenue; discusses how hedge fund managers can participate in the reinsurance business; and describes some principal benefits and drawbacks for hedge fund managers considering launching a reinsurance business.  The second installment will discuss how hedge fund managers generally approach starting a reinsurance business; the best domiciles for reinsurers; a checklist of steps required to launch a reinsurance business; how hedge fund managers invest the “float” generated by such a business; conflicts of interest raised by a hedge fund manager’s side-by-side management of a reinsurance business and an investment management business, and how managers should address such conflicts; and policies and procedures that hedge fund managers should implement to accommodate the operation of a reinsurance business.

How Private Fund Managers Can Manage FCPA Risks When Investing in Emerging Markets

Anti-corruption enforcement efforts have dramatically increased over the last few years.  Every day it seems there is a new headline about an investigation involving alleged violations of the FCPA.  Federal authorities have indicated that their FCPA enforcement efforts are increasingly focused on the financial services industry and, in particular, private fund managers that invest in emerging markets.  Given this heightened level of government scrutiny, it is important that private equity firms, hedge fund managers and other investors that conduct business in foreign markets understand the associated FCPA risks.  Such risks can arise in the context of raising funds overseas, working with joint venture partners and third party agents, and investing in companies that operate in countries known for corruption.  A potential misstep in these areas can result in a fund manager and its employees facing significant civil penalties and possible criminal prosecution or, at a minimum, having to respond to government subpoenas or requests for information in connection with an investigation by federal authorities, thus resulting in the unnecessary expenditure of time and money and the attraction of unwanted attention.  In a guest article, Justin V. Shur and Joel M. Melendez, partner and associate, respectively, at Molo Lamken LLP, consider some of the important and recurring FCPA risks that arise for investors in emerging markets, and offer practical guidance to help private fund managers and their employees avoid or minimize liability in this area.

Prime Brokerage Arrangements from the Hedge Fund Manager Perspective: Financing Structures; Trends in Services; Counterparty Risk; and Negotiating Agreements

As part of its program entitled “Hedge Funds 2012: Strategies and Structures for an Evolving Marketplace,” the Practising Law Institute held a session addressing prime brokerage issues that impact hedge funds.  Specifically, the panel provided an overview of services offered by prime brokers; the impact of the 2008 financial crisis on hedge funds and prime broker operations; critical provisions that hedge funds should consider when negotiating prime brokerage agreements; and other non-legal protections that hedge funds should consider to mitigate the risks that commonly arise when dealing with prime brokers.  This article summarizes key takeaways from that session.

When Does Talking to Corporate Insiders or Advisors Cross the Line into Tipper or Tippee Liability under the Misappropriation Theory of Insider Trading?

As evidenced by the ongoing series of enforcement actions, pleas and settlements of insider trading charges in the hedge fund context, social networks (primarily the old-fashioned kind) play an important role in the movement of corporate information from companies and their advisors to hedge fund managers.  See “Rajaratnam Prosecutor and Dechert Partner Jonathan Streeter Discusses How the Government Builds and Prosecutes an Insider Trading Case against a Hedge Fund Manager,” Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012).  College buddies, club acquaintances and former colleagues often talk investments.  But when one friend works at a company or for one of its advisors, and the other works at a hedge fund manager, such conversations are rife with insider trading risk.  In particular, such conversations create the possibility that the corporate insider or advisor may be considered a “tipper” under the misappropriation theory of insider trading; that the hedge fund manager employee may be considered a “tippee” vis-à-vis the corporate insider or advisor, and a “tipper” vis-à-vis his colleagues; and that everyone in the “chain” of tipping may be liable for insider trading.  In light of the ubiquity of social interactions with an investment component, and the ease with which such interactions can drift from the innocuous to the illegal, a recent federal appeals court decision merits close attention by hedge fund managers.  The decision offers the clearest and most authoritative recent statement of the standard for tipper or tippee liability under the misappropriation theory of insider trading.  In particular, the decision discusses the elements of tipper and tippee liability under the misappropriation theory, with a particular focus on the nature of the personal benefit required to trigger tipper liability; and the application of those elements to a fact pattern common in investment decision-making.  This article provides a comprehensive discussion of the appeals court decision; the trial court decision below; and analysis of what the decision means for the investment analysis process at hedge fund managers.  For a discussion of similar themes and challenges, see “Former Federal Prosecutors Share Perspectives on Insider Trading Hot-Button Issues and Enforcement Trends Relevant to Hedge Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 39 (Oct. 11, 2012).

Lawsuits and Letters: TPG-Axon’s Playbook for Unseating a Recalcitrant and Underperforming Board of Directors

The shareholder consent solicitation process often affords company shareholders, such as hedge funds, an opportunity to effect portfolio company changes, such as the amendment of the company’s bylaws or the ouster of the company’s board, without calling a formal shareholder meeting.  Nonetheless, in a recent row between hedge fund TPG-Axon Partners, LP (Axon Partners) and affiliated hedge funds (together with Axon Partners, Axon or the Funds) and SandRidge Energy, Inc. (SandRidge), Axon sued, claiming that SandRidge inappropriately interfered with the consent solicitation process, thus making it more difficult for Axon to obtain in a timely fashion the required consents necessary to effect its desired changes to the company’s bylaws and board.  Axon’s suit requested, among other things, that SandRidge be enjoined from interfering with the consent solicitation process.  The outcome of this suit could have a significant impact on the ability of hedge funds that owns shares in public companies organized in Delaware to effect changes through the consent solicitation process.  This article describes the disputes between Axon and SandRidge in the courts and in the press; outlines the allegations contained in Axon’s complaint and in letters from Axon to the SandRidge Board; and discusses Axon’s proposed consent request to SandRidge shareholders.

SEC Continues Its Crackdown on Misleading Representations of “Skin in the Game” by Hedge Fund Managers

In many situations, the interests of hedge fund managers and investors diverge.  See generally “Ernst & Young’s Sixth Annual Global Hedge Fund Survey Highlights Continued Divergence of Expectations between Managers and Investors,” Hedge Fund Law Report, Vol. 5, No. 44 (Nov. 21, 2012).  Recognizing this – and recognizing the insufficiency of the law to effectively mitigate the divergence – managers and investors have developed tools to align interests.  One such tool is the pay-for-performance concept embodied in the performance fee or allocation common to hedge fund structures.  See “SEC Adopts Final Rules Governing the Payment of Performance Fees to Registered Hedge Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 9 (Mar. 1, 2012).  Another tool is manager co-investment or “skin in the game.”  The idea here is for the manager to put his money where his mouth is by making the same investments as investors.  Indeed, many hedge fund PPMs contain language to the effect that the principals of the management company have invested a “substantial portion of their net worth” in the funds.  See “Investments by Hedge Fund Managers in Their Own Funds: Rationale, Amounts, Terms, Disclosure, Duty to Update and Verification,” Hedge Fund Law Report, Vol. 3, No. 21 (May 28, 2010).  However, from time to time, a manager’s claims with respect to skin in the game are at odds with the facts.  The SEC is attuned to the potential dissonance between representations and reality, particularly in hedge fund marketing materials.  In June of last year, the SEC settled administrative proceedings against a hedge fund manager alleging, among other things, misleading statements regarding skin in the game.  See “SEC Sanctions Quantek Asset Management and its Portfolio Manager for Misleading Investors About ‘Skin in the Game’ and Related-Party Transactions,” Hedge Fund Law Report, Vol. 5, No. 23 (Jun. 8, 2012).  The SEC recently settled another administrative action based on similar allegations, this time in connection with investments in collateralized debt obligations (CDOs).  This article describes relevant factual and legal points from the more recent settlement.  For a discussion of another matter involving overlapping facts, see “Implications of the Second Circuit’s Decision to Reinstate Breach of Contract and Gross Negligence Claims Brought against a CDO Manager,” Hedge Fund Law Report, Vol. 5, No. 33 (Aug. 23, 2012).

Former Blackstone Counsel Joshua B. Rovine Rejoins Sidley Austin in New York

On January 8, 2013, Sidley Austin LLP announced that Joshua B. Rovine, former General Counsel of Advisory Services at The Blackstone Group and Chief Compliance Officer of Blackstone Capital Partners, has rejoined the firm’s Pooled Investment Entities (PIE) Group as a partner in New York.

Former AIMA Chairman Todd Groome Joins Highwater

Todd Groome, former Chairman of the Alternative Investment Management Association (AIMA) and hedge fund industry veteran, has joined Hightwater Group’s specialist corporate governance team.  See “Survey by AIMA and KPMG Identifies the Key Drivers of the Bifurcation of the Hedge Fund Industry Between Larger and Smaller Managers,” Hedge Fund Law Report, Vol. 5, No. 21 (May 24, 2012).