Feb. 28, 2014

Co-Investments in the Hedge Fund Context: Structuring Considerations and Material Terms (Part Two of Three)

Co-investments have been a regular feature of private equity investing for decades but historically have played a smaller role in the world of hedge funds.  However, as the range of strategies pursued by hedge funds increases – in particular, as more hedge fund assets are committed to activism, distressed and other illiquid strategies – co-investments are assuming a more prominent place in the hedge fund industry.  In an effort to help hedge fund managers assess the role of co-investments in their investment strategies and operating frameworks, the Hedge Fund Law Report is publishing a three-part series on the structure, terms and risks of hedge fund co-investments.  This article, the second in the series, describes the three general approaches to structuring co-investments; discusses the five factors that most directly affect management fee levels on co-investments; outlines the applicable incentive fee structures; details common liquidity or lockup arrangements; and highlights relevant fiduciary duty and insider trading considerations.  The first article in this series discussed five reasons why hedge fund managers offer co-investments; two reasons why investors may be interested in co-investments; the “market” for how co-investments are handled during the negotiation of initial fund investments; investment strategies that lend themselves to co-investments; and types of investors that are appropriate for co-investments.  See “Co-Investments Enable Hedge Fund Managers to Pursue Illiquid Opportunities While Avoiding Style Drift (Part One of Three),” Hedge Fund Law Report, Vol. 7, No. 7 (Feb. 21, 2014).  The third article will discuss regulatory and other risks in connection with co-investments.

SEC Clarifies Scope of the “Knowledgeable Employee” Exception for Section 3(c)(1) and 3(c)(7) Funds

Hedge funds and other private funds typically rely on the exemptions from registration set forth in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (Act).  Section 3(c)(1) exempts from registration funds that are not planning a public offering and whose securities are owned by fewer than 100 beneficial owners.  Section 3(c)(7) exempts funds that are not planning a public offering and whose securities are owned exclusively by “qualified purchasers” (generally, persons or entities that own more than $5 million in investments).  Rule 3c-5 under the Act provides that “knowledgeable employees” of private funds (Covered Funds) or of affiliated managers of Covered Funds are not counted towards the 100 owner limit under Section 3(c)(1).  In addition, they may invest in Section 3(c)(7) funds even if they are not qualified purchasers.  The knowledgeable employee exemption is important for hedge fund managers who want to use employee participation in their funds for compensation and other purposes.  See “Conflicts and Opportunities Offered by Concurrent Management of Employee-Owned Hedge Funds and Outside-Investor Hedge Funds,” Hedge Fund Law Report, Vol. 2, No. 32 (Aug. 12, 2009).  The Managed Funds Association (MFA) recently asked the SEC for a no-action letter with regard to several of the definitions and concepts used in Rule 3c-5.  In response, the SEC has issued a no-action letter that clarifies the concepts of “principal business unit, division or function”; “policy-making function”; and participation in “investment activities”; and makes clear that the rule may apply to knowledgeable employees of separately managed accounts and of certain related advisers.  In that regard, the SEC has provided valuable guidance on some of the open questions concerning Rule 3c-5.  See “Are the General Counsel and Chief Compliance Officer of a Hedge Fund Manager Considered ‘Knowledgeable Employees’ of the Manager?,” Hedge Fund Law Report, Vol. 5, No. 35 (Sep. 13, 2012).  This article summarizes the SEC’s letter and the relevant portions of the MFA’s request.

Top SEC Officials Discuss Hedge Fund Compliance, Examination and Enforcement Priorities at 2014 Compliance Outreach Program National Seminar (Part Two of Three)

On January 30, the SEC hosted the 2014 version of its annual Compliance Outreach Program National Seminar for senior professionals at hedge fund managers and other investment advisers.  Panelists at the seminar included senior SEC officials and CCOs from hedge and private equity fund managers.  The seminar provided candid insight from regulators and conveyed best practices developed in the private sector.  This is the second article in a three-part series summarizing the more noteworthy points made at the seminar.  This article covers discussions of SEC priorities by theme and by SEC division and relays insights on nine topics of specific interest to private fund advisers: presence examinations, risk assessments, conflicts, co-investments, allocation of expenses, marketing, custody, allocation of investment opportunities and broker-dealer registration.  The first article discussed SEC Chairman Mary Jo White’s opening remarks and detailed the compliance, examination and enforcement priorities outlined by the heads of relevant SEC divisions.  See “Top SEC Officials Discuss Hedge Fund Compliance, Examination and Enforcement Priorities at 2014 Compliance Outreach Program National Seminar (Part One of Three),” Hedge Fund Law Report, Vol. 7, No. 7 (Feb. 21, 2014).  The third article will focus on private equity compliance issues, valuation and CCO liability.

Second Circuit Holds that Portfolio Manager Who Engaged in Insider Trading to Benefit His Fund Is Personally Liable to Disgorge the Fund’s Illicit Profits, Regardless of How Much He Gained Personally

A recent Second Circuit decision clarified the circumstances in which a hedge fund manager who engages in insider trading to benefit the fund can be held liable to disgorge all of the fund’s illicit profits, even if the manager does not personally receive any of those profits.  This article summarizes the court’s decision.  In a substantively related matter, the SEC is presently seeking disgorgement by a Level Global trader of illicit profits made by that fund as a result of insider trading by that trader.  See “SEC’s Insider Trading Suit against Former Level Global Trader Illustrates the Risk of Retaining a Former Public Company Employee as a Consultant,” Hedge Fund Law Report, Vol. 6, No. 47 (Dec. 12, 2013).

Seward & Kissel Study of 2013 Hedge Fund Launches Identifies Trends in Fees, Liquidity, Lockups, Structuring and Seed Investing

Seward & Kissel LLP recently published the 2013 edition of its annual study of new hedge fund launches.  The 2013 study covered hedge funds newly formed during 2013 by new U.S.-based managers that are Seward clients.  The study collected and presented data on trends in investment strategies, incentive fees, management fees, lockups, founder share classes, liquidity, structuring, minimum investments, general solicitation, and founder and seed capital.  This article highlights the main conclusions of the study.  The HFLR previously covered the 2012 and 2011 versions of Seward’s study.

Rothstein Kass Adds Kevin M. Goldstein as Director in Business Advisory Services Practice

On February 27, 2014, Rothstein Kass announced that Kevin M. Goldstein has joined the firm as a director in the Business Advisory Services practice in its New York City office.  For insight from Rothstein Kass, see “Rothstein Kass Provides Roadmap for FATCA Compliance by Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 24 (Jun. 13, 2013); “Rothstein Kass 2013 Hedge Fund Outlook Highlights Managers’ Perspectives on Performance and Economic Trends, Leverage, Capital Raising Strategies, Due Diligence, Staffing, Operational Changes and Regulatory Concerns,” Hedge Fund Law Report, Vol. 6, No. 19 (May 9, 2013).

Richard A. Cagnetta Joins Untracht Early LLC as Tax Director

On February 24, 2013, accounting firm Untracht Early, LLC announced that Richard A. Cagnetta has joined the firm as Tax Director.