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    Mar. 7, 2014

Co-Investments in the Hedge Fund Context: Fiduciary Duty Concerns, Conflicts and Regulatory Risks (Part Three of Three)

This is the third article in our series on co-investments in the hedge fund industry.  This article starts by citing evidence of interest among regulators in co-investments, then focuses on the challenging fiduciary duty concerns raised by co-investments, as well as conflicts and regulatory risks that typically arise when structuring or managing co-investments.  The first article in this series discussed the rationales for co-investments from the perspectives of hedge fund managers and investors; negotiating dynamics; and investment strategies in which co-investment are relevant.  The second article in this series described structuring of co-investments, fees, liquidity and relevant insider trading issues.

Options Under the Volcker Rule for Bank Investment in Unaffiliated Private Equity and Hedge Funds

On December 10, 2013, the federal banking agencies, the SEC and the CFTC adopted final regulations to implement Section 13 of the Bank Holding Company Act (commonly known as the “Volcker Rule”).  A key question for sponsors of private equity and hedge funds not affiliated with “banking entities” is the extent to which banking entities will be permitted to invest in those unaffiliated private funds.  Because one purpose of the Volcker Rule was to limit investment by banking entities of their own capital in private funds, not surprisingly, such investment is severely limited.  Nonetheless, a “U.S. Banking Entity” may invest in third-party sponsored private funds under limited circumstances.  A Non-U.S. Banking Entity with a U.S. banking presence has somewhat greater flexibility.  And a Non-U.S. Banking Entity with no U.S. banking presence is not affected by the Volcker Rule.  In a guest article, Satish M. Kini and Michael P. Harrell, both partners at Debevoise & Plimpton LLP, and Gregory T. Larkin, an associate at Debevoise, outline the available options.

SEC Provides Guidance on When the Bad Actor Rule Disqualifies Hedge Fund Managers from Generally Soliciting or Advertising

In July 2013, the SEC adopted final rules under the JOBS Act that permit hedge fund managers to generally solicit and advertise so long as (1) the manager reasonably believes that relevant investors are accredited, and (2) the principals of the management company and certain other persons are not “bad actors” as generally defined in the rules.  See “Schulte, Cleary and MoFo Partners Discuss How the Final and Proposed JOBS Act Rules Will Impact Hedge Fund Managers and Their Funds,” Hedge Fund Law Report, Vol. 6, No. 29 (Jul. 25, 2013).  Contrary to expectations in some quarters, the volume of hedge fund advertising following the relaxation of the ban on general solicitation and advertising has been modest.  See, e.g., “Seward & Kissel Study of 2013 Hedge Fund Launches Identifies Trends in Fees, Liquidity, Lockups, Structuring and Seed Investing,” Hedge Fund Law Report, Vol. 7, No. 8 (Feb. 28, 2014).  The emerging industry consensus appears to be that the JOBS Act will make accomplished managers less reluctant to speak at conferences and otherwise present in public, but will not result in a material amount of retail advertising by managers.  If anything, traditional advertising by a manager may indicate that the manager is on the wrong side of the adverse selection divide, and, in that sense, may backfire.  In any case, even for managers contemplating the “middle road” of less guarded public pronouncements, the bad actor disqualification provisions are complex in application because of the expansiveness with which the SEC structured the provisions.  Recognizing the complexity – and endeavoring to mitigate it – the SEC has issued, starting in December 2013, a series of bad actor disqualification Compliance and Disclosure Interpretations (CDIs).  This article synthesizes the guidance from the CDIs with the most direct application to hedge fund managers.  See also “A Compilation of Important Insights from Leading Law Firm Memoranda on the Implications of the JOBS Act Rulemaking for Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 30 (Aug. 1, 2013).

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

On January 30, the SEC hosted the 2014 edition 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 third article in a three-part series summarizing the more noteworthy points made at the seminar.  This article covers: compliance considerations specific to the private equity industry; best practices in fair value pricing; due diligence on pricing services; CCO liability; and outsourcing of compliance functions.  The first article in this series 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.  And the second article detailed SEC priorities by theme and by SEC division and relayed 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.

SEC Order Suggests That Private Fund Operating Expenses Should Be Allocated Based on Line-by-Line Determinations Rather Than an Across-the-Board Percentage Split

On February 25, 2014, the SEC issued an administrative order (Order) against a private equity fund manager and one of its founders and principals accusing the respondents of securities fraud in misappropriating more that $3 million from the funds they managed through improper allocations of operating expenses.  See “How Should Hedge Fund Managers Approach the Allocation of Expenses Among Their Firms and Their Funds? (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 19 (May 9, 2013).  The SEC also claims that the respondents violated provisions of the Investment Advisers Act of 1940 that require securities to be held by a “qualified custodian,” prohibit principal transactions, require effective compliance policies and procedures and prohibit false filings with the SEC.  See “ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part Two of Two),” Hedge Fund Law Report, Vol. 6, No. 39 (Oct. 11, 2013) (in particular, discussion under subheading Allocations by Private Equity Fund Managers).  This article describes the factual and legal allegations in the Order.

K&L Gates Strengthens Investment Management Practice in Sydney

On March 3, 2014, the Sydney office of K&L Gates announced that Liz Gray has joined the firm as a partner in its investment management practice.  For recent insight from the firm, see “K&L Gates Investment Management Seminar Addresses Compliance Obligations for Registered CPOs and CTAs, OTC Derivatives Trading, SEC Examinations of Private Fund Managers and the JOBS Act (Part Two of Two),” Hedge Fund Law Report, Vol. 7, No. 5 (Feb. 6, 2014).

Herbert Smith Freehills Hires Financial Services Regulatory Expert Andrew Procter

On March 5, 2014, Herbert Smith Freehills announced the recruitment of financial services regulatory expert Andrew Procter.  Procter is expected to join the firm’s global financial services regulatory practice as a partner in June 2014.  An Australian lawyer, Procter most recently served as Deutsche Bank’s Global Head of Compliance, Government and Regulatory Affairs.  See “Deutsche Bank Survey Describes the Contours of the Nontraditional Hedge Fund Product Market: Investor Appetite, Performance, Marketing, Fees and More,” Hedge Fund Law Report, Vol. 7, No. 3 (Jan. 23, 2014).

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