Jun. 19, 2014

Three Pillars of an Effective Hedge Fund Valuation Process

Valuation of assets goes to the heart of a hedge fund’s operations.  It forms the basis for management fees, performance fees and employee compensation.  It is also an area subject to considerable SEC scrutiny, especially with regard to illiquid and other hard-to-value assets.  Consequently, effective, accurate and consistent valuation is critical.  A recent program sponsored by the Regulatory Compliance Association described three “pillars” of an effective valuation program.  This article summarizes that program and details the three pillars.  See also “RCA Enforcement, Compliance and Operations 2014 Symposium Offers Insight from Top SEC Officials on Custody, Conflicts, Broker Registration, Alternative Mutual Funds and the JOBS Act (Part One of Two),” Hedge Fund Law Report, Vol. 7, No. 22 (Jun. 6, 2014) (in particular, subsection entitled “Valuation”).

The Impact of Revenue Ruling 2014-18 on Compensation of Hedge Fund Managers and Employees

The IRS recently issued Revenue Ruling 2014-18, addressing the application of certain anti-deferral provisions of the Internal Revenue Code to nonqualified stock option and stock appreciation right plans (together, Option Plans).  See “Are Compensatory Options on Offshore Hedge Fund Shares Subject to the Anti-Deferral Provisions of Internal Revenue Code Section 457A?,” Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014).  In a guest article, Philip S. Gross and James D. McCann, both Members of Kleinberg, Kaplan, Wolff & Cohen, P.C., discuss some of the potential benefits and detriments of Option Plans from the perspectives of hedge fund managers and investors, and the potential impact of the Revenue Ruling on hedge fund manager taxation, structuring and compensation practices.

K&L Gates and Cordium Detail the Structuring, Investment and Operational Mechanics of Entry by Hedge Fund Managers Into the Alternative Mutual Fund Business (Part One of Two)

As hedge fund and mutual fund managers seek new sources of capital, and retail investors begin to understand the value that alternative investment strategies can add to an investment portfolio, funds registered under the Investment Company Act of 1940 (’40 Act) that pursue “alternative” strategies are growing in popularity.  See “BNY Panels Discuss the Supply Of, and Demand For, Alternative Mutual Funds,” Hedge Fund Law Report, Vol. 7, No. 21 (Jun. 2, 2014).  At a recent panel, K&L Gates partners and executives from Cordium discussed the benefits and limitations of alternative mutual funds, discussed ways to enter the alternative mutual fund market and provided a thorough overview of some of the investment and operational restrictions and requirements imposed on alternative mutual funds.  This article is the first in a two-part series covering the program.  This article addresses: the potential advantages of alternative mutual funds over hedge funds; mutual fund laws and rules that are typically foreign to hedge fund managers; hedge fund strategies that “fit” within the mutual fund model; and the pros and cons of three structures for entry by hedge fund managers into the alternative mutual fund business.  The next article in the series will discuss leverage limits, custody, prime brokers and tri-party agreements, valuation and liquidity, portfolio management, CFTC jurisdiction and applicable compliance rules.

How Can Service Providers to Cayman Islands Hedge Funds Enforce Rights to Contracts to Which They Are Not Parties?

In the hedge fund world, as in all commercial spheres, exclusion and limitation of liability of, and the right of indemnity for, service providers, is a key element in the structure.  See “Indemnification Provisions in Agreements between Hedge Fund Managers and Placement Agents: Reciprocal, But Not Necessarily Symmetrical,” Hedge Fund Law Report, Vol. 3, No. 41 (Oct. 22, 2010).  This structure creates a tension between two competing commercial factors: the need to attract service providers of sufficient quality, and who expect such terms, and commercial acceptability, in particular to prospective investors.  A particular problem has been the enforcement of such terms by service providers or their associates, who are intended to be covered by the protection afforded by such terms, but who are not themselves parties to the contract that creates those terms.  The new Cayman Islands statute, The Contracts (Rights of Third Parties) Law 2014 (the 2014 Law), which came into force on May 21, 2014, directly impacts, and assists, in this area.  In a guest article, Christopher Russell and Jonathan Bernstein, partner and senior associate, respectively, at Appleby, Cayman Islands, provide a thorough analysis of the 2014 Law and its consequences for the allocation of risk among hedge fund service providers, managers and investors.  On hedge fund service providers generally, see “Evolving Operational Due Diligence Trends and Best Practices for Due Diligence on Emerging Hedge Fund Managers,” Hedge Fund Law Report, Vol. 7, No. 15 (Apr. 18, 2014) (section entitled “Due Diligence on Service Providers”).

Legal and Practical Issues to Be Addressed When Converting a Hedge Fund Into a Mutual Fund

The volume of assets expected to flow into alternative mutual funds in the coming years is considerable.  See “Citi Prime Finance Report Describes the Competition among Traditional, Hedge and Private Equity Fund Managers for $1.3 Trillion in Liquid Alternative Assets (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 22 (May 30, 2013).  Recognizing this coming wave, some hedge fund managers have converted or explored the possibility of converting their hedge funds into alternative mutual funds.  See “Mechanics of a Counterintuitive Conversion of a Hedge Fund to a Mutual Fund,” Hedge Fund Law Report, Vol. 6, No. 29 (Jul. 25, 2013).  However, doing so involves a range of challenges relating to tax, operations, law, marketing, distribution, personnel, investors and related topics.  In an effort to unravel some of the knots in the process, the Hedge Fund Law Report recently interviewed Dave Carson, Vice President and Director of Client Strategies at Ultimus Fund Solutions.  Carson has two decades of investment management industry experience, including service as chief compliance officer and chief operating officer for mutual fund families.  Our interview covered, among other topics: portability of a track record from a hedge fund to a mutual fund; inclusion of alternative mutual funds in 401(k) and IRA menus; dealing with distributors; the practicability of converting hedge funds that use leverage, hold illiquids or make concentrated investments; conflicts in allocating opportunities between simultaneously managed hedge and mutual funds; tax considerations in reorganizing hedge funds; sub-advisory relationships and series trusts; investor consent issues; expenses; side letters; affiliate transactions; and the mutual fund disclosure regime.

Second Circuit Panel Stays Mum on Whether Trust Indenture Act Applies in All Securitization Deals

In a recent argument before the Second Circuit, a three-judge panel heard oral argument related to class standing in the context of securitization cases.  Apart from the facts of that case, the panel also focused on the potential applicability of the Trust Indenture Act of 1939 (TIA) to all securitizations, not just those governed by an indenture.  This Second Circuit panel is focusing on whether the TIA applies to securitization deals that are governed by Pooling and Servicing Agreements (PSAs).  See “Second Circuit Appeal May Alter the Regulatory Landscape for Hedge Funds and Other Investors in Residential Mortgage-Backed Securities,” Hedge Fund Law Report, Vol. 7, No. 11 (Mar. 21, 2014).  If the Second Circuit decides this issue in the affirmative, corporate trustees in deals governed by PSAs, such as the defendant on this appeal, will be subject to heightened duties.  While the majority of the argument was spent on class standing, there are a few points to highlight on the TIA issue that were addressed at the argument.  This article highlights those points.  The authors of this article are Edmund M. O’Toole, partner-in-charge of the New York office of Venable LLP, and Kaveri B. Arora, an associate at Venable.

Private Fund Litigator Brett Jaffe Joins Alston & Bird

On June 16, 2014, Alston & Bird announced that Brett Jaffe has joined the firm’s New York office as a partner in the Litigation & Trial Practice Group.  Jaffe has particular expertise in the representation of hedge funds, private equity funds (and their portfolio companies), venture capital funds, broker-dealers and investment advisory firms.  For insight from Alston & Bird partner Kristin Hinson on investment consultants, see “Getting to Know the Gatekeepers: How Hedge Fund Managers Can Interface with Investment Consultants to Access Institutional Capital (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 28 (Jul. 18, 2013).