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    Jun. 20, 2013

How Can Hedge Fund Managers Structure, Negotiate and Implement Expense Caps to Amplify Capital Raising Efforts?  (Part One of Two)

The evolving view appears to be that an investment in a hedge fund is less like the purchase of a product, and more like the negotiation of a customized contract; and this view applies whether the investment is in a commingled vehicle (with the terms abridged by a side letter) or a bespoke product like a “fund of one.”  Under this “contractual” view of hedge fund investing, one of the more vigorously negotiated points relates to the allocation of organizational, operating and other expenses.  Expenses are a big deal for investors because they are high, going up and can reduce investor returns, often dollar for dollar.  See “Citi Prime Finance Report Dissects the Expenses of Running a Hedge Fund Management Business, Identifying Components, Levels, Trends and Benchmarks,” Hedge Fund Law Report, Vol. 6, No. 1 (Jan. 3, 2013).  The concern is especially pronounced for “anchor” or early investors in a hedge fund, who typically bear a large proportion of expenses until the burden can be spread among later investors.  See “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).  From the manager perspective, the analysis is less zero-sum.  Assuming fixed revenue, internalizing fund expenses would reduce the management company’s profit.  But revenue is not fixed, and internalizing the right types and amounts of expenses can increase management company revenue by more than the internalized amount.  This is because internalizing expenses can materially assist in capital raising, which in turn grows assets and increases fee revenue.  In other words, given the intense focus on expenses on the part of many investors, conceding on expenses can sometimes be the “but for” cause of an investment that generates fees well in excess of the relevant expenses.  This is not necessarily rational or logical on the part of investors, but investment decision-making in the hedge fund world (as in other investment settings) is often governed more by investor psychology than detached rationality.  For managers confronting this reality, the question is how much to concede on the expense issue, and how to concede with dignity – that is, how to structure an expense allocation mechanism that is fair, workable and predictable.  Increasingly, managers are answering this question with a simple but effective tool: a contractual cap on organizational and operating expenses to be borne by the investor.  This article is the first in a two-part series weighing the opportunities and drawbacks of expense caps.  Specifically, this article addresses what expense caps are; whether expense caps can be offered only to select investors; expenses typically covered by caps; structuring of expense caps; and the levels at which expense caps are set.  The second installment will address topics including whether expense caps should apply for only a limited period; benefits and drawbacks of offering expense caps; and recommendations for managers in negotiating and implementing expense caps.

CLO 2.0: How Can Hedge Fund Managers Navigate the Practical and Legal Challenges of Establishing and Managing Collateralized Loan Obligations? (Part One of Two)

While its much-maligned counterparts, collateralized debt obligations (CDOs) and structured investment vehicles, have languished, the cash-flow collateralized loan obligation (CLO) has emerged from the financial crisis relatively unscathed.  The issuance of post-crisis CLO paper has experienced a sustained resurgence, surpassing $53 billion in 2012 and catapulting past $27 billion in the first quarter of 2013 alone.  For many fund managers, managing a CLO may present a very attractive opportunity.  Unlike the standard hedge fund platform, a CLO can generate lucrative and stable management fees with minimal redemption risk during the non-call period while remaining largely insulated from market value declines.  Although the characteristics of the post-crisis “CLO 2.0” hardly represent a sea-change from the pre-crisis version, there have been a number of important structural developments.  The CLO 2.0 era has also ushered in changes to the underlying transaction documentation aimed at addressing various lessons learned from the failings of CDOs and other structured products during the market meltdown.  Despite the recent fanfare, there remain several practical and legal obstacles that a CLO manager can expect to encounter in the current market environment.  This article is the first in a two-part series discussing the practical challenges of establishing a CLO in the current market environment, and how CLO managers can address the challenges.  Specifically, this article addresses a number of common documentation requests by anchor investors in the most senior and subordinated (or equity) classes of the CLO capital structure and explores certain inherent difficulties in obtaining warehouse financing in connection with the ramp up of the CLO portfolio prior to the initial issuance of CLO notes.  The second installment in this series will present a brief overview of various legal developments that have or may alter the CLO management landscape, including (1) risk retention rules, the Volcker Rule and various Commodity Futures Trading Commission requirements under the Dodd-Frank Act, (2) enhanced registration requirements under the Investment Advisers Act of 1940, (3) the implementation of the Foreign Account Tax Compliance Act provisions of the Internal Revenue Code, and (4) Sections 409A and 457A of the Internal Revenue Code.  The authors of this series are Greg B. Cioffi and Jeff Berman, both partners in Seward & Kissel’s Structured Finance and Asset Securitization Group, and David Sagalyn, an associate in the group.  See also “Key Legal and Business Considerations for Hedge Fund Managers When Purchasing Collateralized Loan Obligation Management Contracts,” Hedge Fund Law Report, Vol. 3, No. 13 (Apr. 2, 2010).

What Should Hedge Fund Managers Expect When ERISA Plans Conduct Due Diligence On and Negotiate For Investments in Their Funds?

Pension and other plans subject to the Employee Retirement Income Security Act of 1974 (ERISA) have sought out hedge fund investments as a way of achieving more attractive risk-adjusted returns.  However, ERISA plan trustees must be careful to fulfill their fiduciary duties and comply with other ERISA requirements when investing plan assets in hedge funds.  Because such regulations can be daunting, a recent program provided a roadmap for ERISA plans considering making investments in alternative investment funds.  Specifically, the program provided both general insights into key criteria that ERISA plans consider when evaluating hedge fund managers as well as specific insights concerning the types of provisions that ERISA plans negotiate for in hedge fund subscription documents and side letters.  The program was instructive not only for ERISA plan investors, but also for managers who seek to raise assets from ERISA plan investors.  This article summarizes the key takeaways from the program.  See also “Application of the QPAM and INHAM ERISA Class Exemptions to Hedge Fund Managers,” Hedge Fund Law Report, Vol. 5, No. 46 (Dec. 6, 2012).

RCA Symposium Clarifies Current Market Practice on Side Letters, Conflicts of Interest, Insider Trading Investigations, Whistleblowers, FATCA and Use of Managed Accounts Versus Funds of One (Part Two of Two)

On April 18, 2013, the Regulatory Compliance Association held its Regulation, Operations & Compliance 2013 Symposium (Symposium), at which industry leaders and regulators offered perspectives on hot-button issues facing hedge fund managers and investors.  This article, the second installment in our series covering the Symposium, addresses how managers should address high-priority conflicts of interest; techniques and strategies regulators and prosecutors are using to investigate insider trading; the SEC’s whistleblower program; and Foreign Account Tax Compliance Act compliance.  The first article addressed challenges raised by side letters; evaluating requests for most favored nation provisions; and how hedge fund managers are using funds of one and managed accounts.  See “RCA Symposium Clarifies Current Market Practice on Side Letters, Conflicts of Interest, Insider Trading Investigations, Whistleblowers, FATCA and Use of Managed Accounts Versus Funds of One (Part One of Two),” Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013).

Goldman Prime Brokerage Survey Relays the Views of Institutional Investors on Hedge Fund Fees, Manager Selection, Due Diligence, Return Expectations, Liquidity, Managed Accounts, UCITS and Alternative Mutual Funds

Goldman Sachs Prime Brokerage (Goldman) recently published a report describing findings from a survey in which Goldman asked respondents about preferences with respect to fees, liquidity, investment strategies, geography, manager track record, sources of investment capital, expectations for capital growth, portfolio composition and turnover, return expectations, hedge fund manager selection criteria and use of managed accounts, UCITS funds and alternative mutual funds.  This article summarizes the key findings of that survey.

PLI Panel Provides Regulator and Industry Perspectives on Ethical and Compliance Challenges Associated with Hedge Fund Investor Relations

The Practising Law Institute recently sponsored a program entitled “Hedge Fund Compliance and Regulation 2013,” which included a segment entitled “Investor Relations: Ethical Considerations and Compliance Challenges.”  During that session, the expert panel of regulators and industry professionals offered detailed insights on topics related to hedge fund investor relations, including compliance violations unearthed during recent presence examinations of hedge fund managers; strategies for building and maintaining an effective compliance program; views on navigating specific compliance challenges including valuation, conflicts, fees, disclosures and preferential treatment; and potential changes that could arise as a result of the Jumpstart Our Business Startups Act.  This article summarizes key insights from the session.  For our coverage of another session from the program, see “PLI Panel Provides Regulator and Industry Perspectives on SEC and NFA Examinations, Allocation of Form PF Expenses, Annual Compliance Review Reporting and NFA Bylaw 1101 Compliance,” Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013).

SS&C Appoints Timothy Reilly Senior Vice President, Institutional Outsourcing

On June 17, 2013, SS&C Technologies Holdings, Inc., a global provider of financial services software and software-enabled services, announced it has appointed Timothy Reilly as senior vice president of institutional outsourcing for its Institutional Services division.  See “Report Maps Outsourcing Landscape for Hedge Fund Managers, Including Outsourced Services Offered, Trends, Goals, Drawbacks and Provider Profiles,” Hedge Fund Law Report, Vol. 5, No. 43 (Nov. 15, 2012).  For a summary of SS&C GlobeOp’s early experience with the Form PF process, see “Ten Key Lessons Learned From Test Filings of Form PF,” Hedge Fund Law Report, Vol. 5, No. 33 (Aug. 23, 2012).

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