The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Side Pockets

  • From Vol. 10 No.2 (Jan. 12, 2017)

    Hedge Fund Platinum Partners and Principals Face Civil and Criminal Proceedings From SEC and DOJ Over Alleged Fraudulent Valuation Practices and Liquidity Misrepresentations

    The SEC has initiated an enforcement proceeding against Platinum Management (NY) LLC, Platinum Credit Management, L.P. and seven individuals, alleging that they improperly inflated the value of illiquid fund assets, made material misrepresentations to investors to hide the liquidity crisis faced by the firm’s flagship fund and orchestrated a scheme to defraud third-party bondholders of one of the fund’s portfolio companies. In a parallel investigation, the DOJ has brought an eight-count indictment against seven individual defendants for securities fraud, investment adviser fraud and conspiracy. The SEC complaint asserts 11 counts of securities and investment adviser fraud against the defendants. This article discusses the alleged fraudulent conduct, along with the specific SEC and DOJ charges. For additional coverage of the SEC’s recent attention to valuation of illiquid assets, see “SEC Continues to Focus on Insider Trading and Fund Valuation” (Jun. 30, 2016); and “SEC Division Heads Enumerate Enforcement Priorities, Including Conflicts of Interest, Valuation, Performance Advertising and CCO Liability (Part Two of Two)” (May 5, 2016). For more on regulatory concerns over liquidity, see “FSOC Report Focuses on Liquidity, Leverage and Other Risks Facing Hedge Fund and Asset Managers” (Apr. 28, 2016).

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  • From Vol. 9 No.20 (May 19, 2016)

    Preparing for Contingent Liabilities: How an Alternative to Hedge Fund Contingency Reserves May Offer More Equitable Investor Treatment (Part Two of Two)

    The power to establish reserves for contingent liabilities and other potential fund obligations may be deployed whenever a fund manager foresees a possible future event that could adversely affect the fund. Depending on the outcome of that possible future event (as well as fund policies on adjusting net asset value), contributing, redeeming or “status quo” investors may bear a higher proportion of such contingency reserve. In this two-part guest series, S. Brian Farmer and Alina A. Grinblat, partner and associate, respectively, at Hirschler Fleischer, explore the drawbacks of hedge fund contingency reserves and suggest an alternative structure. In the first article, they explained how hedge fund contingency reserves operate in practice, illustrating how reserves can affect fund shareholders and the unequal treatment that can result. This second article analyzes hedge fund manager motivations in establishing reserves and proposes an alternative structure that may avoid consequent investor inequality. For additional insight from Farmer, see our series on “The Use of Benchmarks to Measure Hedge Fund Performance by Pension Funds and Institutional Investors”: Part One (Jul. 30, 2015); and Part Two (Aug. 6, 2015).

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  • From Vol. 9 No.19 (May 12, 2016)

    Preparing for Liability: How Hedge Fund Contingency Reserves Can Lead to Inequitable Investor Treatment (Part One of Two)

    Hedge fund governing documents generally give the manager broad discretion to establish reserves for contingent liabilities and other items that may ultimately become fund obligations. However, depending on the hedge fund manager’s practice, establishing and releasing contingency reserves may result in inequitable treatment of investors redeeming, subscribing or simply remaining in the fund. In this two-part guest series, S. Brian Farmer and Alina A. Grinblat, partner and associate, respectively, at Hirschler Fleischer, address hedge fund contingency reserves. In this first article, they explain how the reserves operate in practice, highlighting the effect on shareholders in the fund and the unequal treatment that can result. The second article will analyze hedge fund manager motivations for establishing reserves and propose an alternative structure that may avoid investor inequality resulting from those reserves. For additional insight from Farmer, see our two-part series “‘Best Ideas’ Conference Presentations: Challenges Faced by Hedge Fund Managers Under Federal Securities Law”: Part One (Aug. 7, 2014); and Part Two (Aug. 21, 2014).

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  • From Vol. 9 No.14 (Apr. 7, 2016)

    Barbash, Breslow and Rozenblit Discuss Hedge Fund Allocations, Restructurings and Advisory Boards

    Liquidity and performance presentation are only two of the myriad issues facing hedge fund managers. See “Liquidity and Performance Representations Present Potential Pitfalls for Hedge Fund Managers” (Mar. 31, 2016). Hedge fund and private equity managers must also be wary of numerous issues that can trigger conflicts of interest or anti-fraud violations, including expense allocations, restructuring and the use of advisory boards. See “Full Disclosure of Portfolio Company Fee and Payment Arrangements May Reduce Risk of Conflicts and Enforcement Action” (Nov. 12, 2015). During a recent Practising Law Institute program, panelists discussed these and other topics. Barry P. Barbash, a former Director of the SEC Division of Investment Management and now a partner at Willkie Farr & Gallagher, moderated the program, which featured Stephanie R. Breslow, a partner at Schulte Roth & Zabel; and Igor Rozenblit, co-leader of the Private Funds Unit of the SEC Office of Compliance Inspections and Examinations. This article summarizes the panelists’ discussion of these issues. For additional commentary from Breslow, see “Schulte Partner Stephanie Breslow Discusses Tools for Managing Hedge Fund Crises Caused by Liquidity Problems, Poor Performance or Regulatory Issues” (Jan. 9, 2014). For further insight from Rozenblit, see “SEC’s Rozenblit and Law Firm Partners Explain the SEC’s Enforcement Priorities and Offer Tips on How Hedge Fund and Private Equity Managers Can Avoid Enforcement Action (Part Three of Four)” (Jan. 15, 2015).

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  • From Vol. 9 No.13 (Mar. 31, 2016)

    Liquidity and Performance Representations Present Potential Pitfalls for Hedge Fund Managers

    Hedge fund managers must guard against insidious issues that can give rise to conflicts of interest or trigger anti-fraud violations, such as liquidity issues caused by a manager’s operation of multiple funds. See “Operational Conflicts Arising Out of Simultaneous Management of Hedge Funds and Private Equity Funds (Part Two of Three)” (May 14, 2015). Similarly, performance representations present potential issues for hedge fund managers, including possible misrepresentations caused by improper valuation practices and fee deferrals. Both the enforcer and industry perspectives of these and other topics were explored at a recent Practising Law Institute program. Barry P. Barbash, a former Director of the SEC Division of Investment Management and now a partner at Willkie Farr & Gallagher, moderated the program, which featured Stephanie R. Breslow, a partner at Schulte Roth & Zabel; and Igor Rozenblit, co-leader of the Private Funds Unit of the SEC Office of Compliance Inspections and Examinations. This article highlights the panelists’ commentary on these matters. For more from Breslow, see our two-part series on “Gates, Side Pockets, Secondaries, Co-Investments, Redemption Suspensions, Funds of One and Fiduciary Duty”: Part One (Dec. 4, 2014); and Part Two (Dec. 11, 2014). For insight from Rozenblit, see “SEC’s Rozenblit Offers Perspectives From the Private Funds Unit” (Feb. 11, 2016); and “Operations and Priorities of the Private Funds Unit” (Sep. 24, 2015).

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  • From Vol. 8 No.10 (Mar. 12, 2015)

    Structures and Characteristics of Activist Alternative Investment Funds

    Simmons & Simmons and the Alternative Investment Management Association (AIMA) recently undertook joint research to assess the development and state of shareholder activism by alternative investors, investigate the impact of such activism and identify certain trends and implications for future developments.  This article summarizes the findings of that research with respect to the structure and characteristics of activist alternative investment funds.  See also “Practitioners Discuss U.S. and Canadian Shareholder Activism and Activist Tools,” The Hedge Fund Law Report, Vol. 7, No. 45 (Dec. 4, 2014).  For a discussion of the fee and tax provisions of a publicly offered activist investment vehicle, see “Ackman’s Pershing Square Public Offering Features Novel Performance Fee Mechanism,” The Hedge Fund Law Report, Vol. 7, No. 39 (Oct. 17, 2014).

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  • From Vol. 7 No.45 (Dec. 4, 2014)

    Schulte Partner Stephanie Breslow Addresses Gates, Side Pockets, Secondaries, Co-Investments, Redemption Suspensions, Funds of One and Fiduciary Duty

    For the last two years, the HFLR has been covering presentations by Stephanie R. Breslow at the Practising Law Institute’s annual hedge fund management program.  Breslow is a partner at Schulte Roth & Zabel LLP, co-head of its Investment Management Group and a member of the firm’s Executive Committee.  Her PLI presentations are invariably thorough, relevant, lucid, informed by a unique level of access and experience and delivered with her trademark wit.  See “Schulte Partner Stephanie Breslow Discusses Tools for Managing Hedge Fund Crises Caused by Liquidity Problems, Poor Performance or Regulatory Issues,” The Hedge Fund Law Report, Vol. 7, No. 1 (Jan. 9, 2014); “Schulte Partner Stephanie Breslow Discusses Hedge Fund Liquidity Management Tools in Practising Law Institute Seminar,” The Hedge Fund Law Report, Vol. 5, No. 43 (Nov. 15, 2012).  Consistent with that tradition, the HFLR is covering Breslow’s presentation at PLI’s 2014 hedge fund management program.  This year’s presentation covered a typically expansive range of topics, including fund-level and investor-level gates, side pockets, synthetic side pockets, in-kind distributions, secondary market trading in hedge fund interests, co-investments, calculating NAV after suspension of redemptions, funds of one and fiduciary duty.  Breslow used the credit crisis as a framing device for her presentation, explaining the applicability and evolution of these concepts before, during and after the crisis.  This article covers the portions of Breslow’s presentation relating to the periods before and during the crisis.

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  • From Vol. 7 No.1 (Jan. 9, 2014)

    Schulte Partner Stephanie Breslow Discusses Tools for Managing Hedge Fund Crises Caused by Liquidity Problems, Poor Performance or Regulatory Issues

    The Practising Law Institute’s (PLI) Hedge Fund Management 2013 program included a session entitled “Managing Hedge Funds in Crisis,” which was presented by Stephanie R. Breslow, a partner at Schulte Roth & Zabel LLP, co-head of the firm’s Investment Management Group and a member of its Executive Committee.  Breslow discussed the various tools that managers have at their disposal to address crises impacting their funds, such as a run on liquidity, and how those tools have changed over time, particularly after the 2008 financial crisis.  This article summarizes the key takeaways from her presentation.  For a general discussion of post-crisis liquidity and crisis management tools, see “Structuring, Valuation, Fee Calculation and Other Legal and Accounting Considerations in Connection with Hedge Fund General Redemption Provisions, Lock-Up Periods, Side Pockets, Gates, Redemption Suspensions and Special Purpose Vehicles,” The Hedge Fund Law Report, Vol. 3, No. 43 (Nov. 5, 2010); “What Are Hybrid Gates, and Should You Consider Them When Launching Your Next Hedge Fund?,” The Hedge Fund Law Report, Vol. 4, No. 6 (Feb. 18, 2011); and “IOSCO Report Discusses Appropriate Use and Disclosure of Hedge Fund Redemption Suspensions, Gates and Side Pockets,” The Hedge Fund Law Report, Vol. 4, No. 10 (Mar. 18, 2011).

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  • From Vol. 5 No.43 (Nov. 15, 2012)

    Schulte Partner Stephanie Breslow Discusses Hedge Fund Liquidity Management Tools in Practising Law Institute Seminar

    “Liquidity” describes the frequency with which investors can get their money back from a hedge fund.  Typically, the governing documents of a hedge fund contain default liquidity provisions and a set of mechanisms the manager can use to vary those default provisions.  For example, the default provisions may say that investors can redeem from the fund quarterly, but the documents may also permit the manager to reduce, delay or recharacterize redemption requests.  Conceptually, liquidity management tools are motivated by investment and equitable considerations: it is difficult to execute an investment program on a fickle capital base, and a manager’s fiduciary duty flows to all investors in a commingled vehicle.  In practice, however, investors are rarely happy to hear that they cannot get their money back.  Prior to the 2008 financial crisis, liquidity management tools in hedge fund governing documents were effectively viewed as boilerplate: present, but rarely used.  Then credit markets seized up, liquidity dried up and everybody needed cash – investors for their own investors or beneficiaries, managers to satisfy redemptions, banks to remain solvent, etc.  Managers blew the dust off long dormant provisions in governing documents and actually imposed gates, suspended redemptions and use other heretofore unthinkable techniques to manage liquidity.  The financial crisis has passed, but liquidity management remains an important topic in the hedge fund industry.  Liquidity issues are often micro rather than macro, and, in any case, post-crisis documents have been drafted with a view to the next macro event.  Recognizing the ongoing importance of liquidity management in hedge fund governance, Stephanie R. Breslow presented a session on the topic at the Practising Law Institute’s September 5, 2012 “Hedge Funds 2012” event.  Breslow is a partner in the New York office of Schulte Roth & Zabel LLP, co-head of Schulte’s Investment Management Group and a member of the firm’s Executive Committee.  Breslow’s session focused on, among other topics: developments in fund liquidity terms since the 2008 financial crisis; tools available to a fund manager for managing liquidity risk, including the right to suspend redemptions, fund-level gates, investor-level gates, side pockets and in-kind distribution of assets; duties owed by a fund manager in the context of a liquidity crisis; the evolution in fund manager attitudes towards secondary market transactions in fund interests and shares; and why fund investors have not pushed for the right to remove fund managers in fund governing documents during liquidity crises.  This article summarizes key points from Breslow’s session.

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  • From Vol. 5 No.1 (Jan. 5, 2012)

    Legal and Operational Due Diligence Best Practices for Hedge Fund Investors

    In the wake of the financial crisis in late 2008, many investors were left trapped in suspended, gated or otherwise illiquid hedge funds.  Unfortunately, for many investors who had historically taken a passive role with respect to their hedge fund investments, it took a painful lesson to learn that control over fundamental fund decisions was in the hands of hedge fund managers.  Decisions such as the power to suspend or side pocket holdings were vested in managers either directly or through their influence over the board of directors of the fund.  In these situations, which were not uncommon, leaving control in the hands of the manager rather than a more independent board gave rise to a conflict of interest.  Managers were in some cases perceived to be acting in their own self-interest at the expense, literally and figuratively, of the fund and, consequently, the investors.  The lessons from the financial crisis of 2008 reinforced the view that successful hedge fund investing requires investors to approach the manager selection process with a number of considerations in mind, including investment, risk, operational and legal considerations.  Ideally, a hedge fund investment opportunity will be structured to sufficiently protect the investor’s rights (i.e., appropriate controls and safeguards) while providing an operating environment designed to maximize investment returns.  Striking such a balance can be challenging, but as many investors learned during the financial crisis, it is a critical element of any successful hedge fund program.  The focus on hedge fund governance issues has intensified in the wake of the financial crisis, with buzz words such as “managed accounts,” “independent directors,” “tri-party custody solutions” and “transparency” now dominating the discourse.  Indeed, investor efforts to improve corporate governance and control have resulted in an altering of the old “take it or leave it” type of hedge fund documents, which have become more accommodative towards investors.  In short, in recent years investors have become more likely to negotiate with managers, and such negotiations have been more successful on average.  In a guest article, Charles Nightingale, a Legal and Regulatory Counsel for Pacific Alternative Asset Management Company, LLC (PAAMCO), and Marc Towers, a Director in PAAMCO’s Investment Operations Group, identify nine areas on which institutional investors should focus in the course of due diligence.  Within each area, Nightingale and Towers drill down on specific issues that hedge fund investors should address, questions that investors should ask and red flags of which investors should be aware.  The article is based not in theory, but in the authors’ on-the-ground experience conducting legal and operational due diligence on a wide range of hedge fund managers – across strategies, geographies and AUM sizes.  From this deep experience, the authors have extracted a series of best practices, and those practices are conveyed in this article.  One of the main themes of the article is that due diligence in the hedge fund arena is an interdisciplinary undertaking, incorporating law, regulation, operations, tax, accounting, structuring, finance and other disciplines, as well as – less tangibly – experience, judgment and a good sense of what motivates people.  Another of the themes of the article is that due diligence is a continuous process – it starts well before an investment and often lasts beyond a redemption.  This article, in short, highlights the due diligence considerations that matter to decision-makers at one of the most sophisticated allocators of capital to hedge funds.  For managers looking to raise capital or investors looking to deploy capital intelligently, the analysis in this article merits serious consideration.

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  • From Vol. 4 No.36 (Oct. 13, 2011)

    Hedge Fund Healey Alternative Investment Partnership’s Complaint Against Royal Bank of Canada for Failure to Pay Full Cash Settlement Value of Equity Barrier Call Option Agreement Survives Bank’s Motion to Dismiss

    Plaintiff Hedge Fund Healey Alternative Investment Partnership (Fund) purchased a cash-settled equity barrier call option from defendants Royal Bank of Canada and RBC Dominion Securities Corporation (together, Bank).  The option agreement referenced a basket of financial assets, including interests in hedge funds.  However, the Bank was not obligated to own those assets.  In September 2008, the Bank’s monthly report on the option agreement showed its value to be almost $22 million.  The Fund formally terminated the option agreement as of June 30, 2009.  The Bank paid about $9.16 million to the Fund, but refused to pay any further amounts, claiming that it was unable to value certain hedge fund interests, particularly hedge fund investments held in side pockets.  The Fund sued the bank, claiming breach of contract, breach of fiduciary duty and breach of the covenant of good faith and fair dealing.  The Bank moved to dismiss for failure to state a cause of action.  This article provides a comprehensive summary of the factual background and the District Court’s legal analysis.

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  • From Vol. 4 No.21 (Jun. 23, 2011)

    SEC’s Fraud Suit Against Principals of Palisades Master Fund for Overvaluation of “Side Pocket,” Misappropriation of Assets and Improper Short-Selling Survives Motion to Dismiss

    In October 2010, the Securities and Exchange Commission (SEC) brought civil securities fraud charges against defendants Paul T. Mannion, Jr., and Andrew S. Reckles, and the investment advisers they controlled, claiming that they defrauded investors in hedge fund Palisades Master Fund, L.P. (Fund) by lying to investors about the value of the Fund’s stake in World Health Alternatives, Inc. (WHA), stealing and exercising WHA warrants owned by the Fund, failing to disclose their private sales of WHA stock and concealing a short position in Radyne Corporation at the time that the Fund invested in that corporation’s PIPE offering.  For a detailed summary of the SEC’s complaint, see “SEC Brings Civil Securities Fraud Action Against Principals of Hedge Fund Palisades Master Fund, Alleging Fraud, Self-Dealing, Misuse of Fund Assets and Use of a ‘Side Pocket’ to Misrepresent the Fund’s Value to its Investors,” The Hedge Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010).  The Defendants moved to dismiss the entire complaint on the ground that it failed to state any cause of action against the Defendants.  The District Court generally permitted all counts of the complaint to proceed.  We summarize the factual background and the Court’s legal analysis.

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  • From Vol. 4 No.10 (Mar. 18, 2011)

    IOSCO Report Discusses Appropriate Use and Disclosure of Hedge Fund Redemption Suspensions, Gates and Side Pockets

    On March 8, 2011, the International Organization of Securities Commissions (IOSCO) Technical Committee issued a draft Consultation Report entitled “Principles on Suspensions of Redemptions in Collective Investment Schemes.”  The report focuses on all open-ended collective investment schemes (CIS), including hedge funds, which offer a continuous redemption right, without regard to the type of investor to which the CIS is offered (i.e., institutional or retail).  The report proposes general principles to inform regulatory regimes in their oversight of CIS, and to guide fund managers in deciding if, when and how to suspend investor redemptions.  The report addresses basic management of liquidity risk, permissible reasons for suspension and the actions a CIS should take following a decision to suspend.  It emphasizes three basic principles, and offers guidance relating to alternative liquidity tools available in certain jurisdictions.  This article discusses the most important points of the consultation report, focusing in particular on the points most relevant to hedge fund managers.

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  • From Vol. 4 No.8 (Mar. 4, 2011)

    Six Important Lessons for Hedge Fund Managers, Investors, Administrators and Others in Structuring Side Pockets and Monitoring Their Use

    The SEC recently charged hedge fund manager Baystar Capital Management, LLC (BCM) and its principal, Lawrence Goldfarb, with fraud in connection with the use of side pockets in a hedge fund.  The alleged fraud in this case was unorthodox: rather than stashing a poor-performing investment in a side pocket in order to slow redemptions, BCM and Goldfarb allegedly placed a good-performing asset in a side pocket, but diverted the cash flows from the asset to improper uses and misrepresented to fund investors various facts relating to the side pocket.  See generally “SEC Brings Civil Securities Fraud Action Against Principals of Hedge Fund Palisades Master Fund, Alleging Fraud, Self-Dealing, Misuse of Fund Assets and Use of a ‘Side Pocket’ to Misrepresent the Fund’s Value to Its Investors,” The Hedge Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010).  Despite these somewhat atypical facts, and despite the diminishing relevance of side pockets in hedge fund structuring (discussed in more detail below), the SEC’s complaint in the matter yields at least six important lessons for hedge fund managers, investors, administrators and others – lessons on topics including structuring, drafting, valuation, transparency and the appropriate role of administrators.  This article details the relevant factual and legal allegations in the matter, then discusses those six important lessons.

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  • From Vol. 4 No.4 (Feb. 3, 2011)

    How Can Liquid Hedge Funds Be Structured to Accommodate Investments in Illiquid Assets?

    During the past decade, an increasing volume of hedge fund dollars has poured into traditional liquid strategies.  As a result, market inefficiencies have narrowed or vanished, and opportunities for arbitrage – and the alpha it can generate – have grown fewer and farther between.  In response, some hedge fund managers that traditionally focused on liquid strategies started investing at least part of their funds’ capital in private equity and other illiquid securities and assets.  However, using liquid fund vehicles to invest in illiquid assets has presented a variety of problems, including those relating to: taxation, liquidity, valuation, manager compensation, strategy drift, due diligence, expectations regarding returns and regulatory scrutiny.  While there has been considerable discussion regarding the convergence of hedge funds and private equity funds, the experience and aftermath of the credit crisis indicate that the convergence discussion should be more refined.  Convergence at the fund level is problematic because illiquids do not fit naturally into a liquid fund.  Convergence at the manager level – for example, the same manager managing both private equity funds and hedge funds – is marginally more palatable, but by and large, institutional investors have demonstrated a preference for managers who stick to their knitting.  In a guest article, Philippe Simoens, Senior Manager in Tax and Strategic Business Services for Weaver, an independent certified public accounting firm, addresses some of the reasons why illiquid assets present problems when housed in liquid funds – even liquid funds purportedly structured to accommodate illiquid investments via mechanisms such as side pockets.  In the course of doing so, this article explains traditional liquid fund structuring and taxation; characteristics and taxation of marketable securities versus private equity; and structures employed by liquid funds to accommodate illiquid assets (including side pockets, lock-ups, gates and redemption suspensions).  The article concludes with thoughts on structuring for managers who traditionally have focused on liquid strategies, but who are exploring illiquid opportunities.

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  • From Vol. 3 No.43 (Nov. 5, 2010)

    Structuring, Valuation, Fee Calculation and Other Legal and Accounting Considerations in Connection with Hedge Fund General Redemption Provisions, Lock-Up Periods, Side Pockets, Gates, Redemption Suspensions and Special Purpose Vehicles

    Due to the recent financial crisis, the hedge fund industry has experienced significant investor redemptions along with reduced availability of credit and leverage from prime brokers and other financial institutions.  As a result, certain shortcomings have been revealed in the way hedge funds have been managed, including liquidity mismatches identified between investment portfolio assets and liabilities and redemption restriction provisions contained in fund offering documents.  The liquidity mismatch dilemma was quite a shock for many hedge fund investors who were unable to withdraw capital according to required redemption terms upon the freezing of the credit markets.  Redemption restriction provisions such as lock-ups and gates have become commonplace as hedge funds have evolved from traditional strategies which primarily invested in liquid securities.  Hedge fund offering documents generally contain multiple liquidity provisions that enable fund managers to manage the liquidity needs of investors without selling assets at distressed prices or disposing of liquid assets while leaving the most illiquid investments to remaining investors.  Financial statements of hedge funds prepared in accordance with accounting principles generally accepted in the United States (“US GAAP”) usually contain disclosures of liquidity provisions specified in the fund offering documents.  In a guest article, Fredric S. Burak and Cindy Shen, both partners at EisnerAmper LLP, generally discuss the various liquidity provisions contained in hedge fund offering documents as well as the relevant accounting and financial statement reporting requirements and practices related to such provisions.  Specifically, Burak and Shen describe market practice regarding structuring of redemption provisions, including discussions of Accounting Standards Codification Topic 480 (formerly FAS 150), frequency of permitted redemptions, holdback provisions and in-kind distributions; lock-up periods, including discussions of “hard” and “soft” lock-ups and the use of sub-accounts within capital accounts; investor-level and fund-level gates and related disclosure considerations; suspensions of redemptions; side pockets and designated investments (i.e., investments placed in side pockets); the interplay between valuation of designated investments, US GAAP and the Custody Rule; calculation of management and performance fees with respect to designated investments; reporting performance of designated investments; structuring, fees and books and records considerations in connection with special purpose vehicles; and market color with respect to: typical length of lock-up periods, the relationship between strategy and length of lock-up; investor receptivity to various lock-up period lengths, percentage of assets typically subject to a gate on any redemption date, the “market” for the number of successive redemption dates to which excess redemptions may be carried over, opt-out rights with respect to side-pockets and renewed SEC attention on disclosure relating to side pockets.

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  • From Vol. 3 No.42 (Oct. 29, 2010)

    SEC Brings Civil Securities Fraud Action Against Principals of Hedge Fund Palisades Master Fund, Alleging Fraud, Self-Dealing, Misuse of Fund Assets and Use of a “Side Pocket” to Misrepresent the Fund’s Value to Its Investors

    According to a complaint filed by the Securities and Exchange Commission (SEC) in the U.S. District Court for the Northern District of Georgia, Defendants Paul T. Mannion, Jr. (Mannion), and Andrew S. Reckles (Reckles), through the investment advisers they controlled, defrauded investors in hedge fund Palisades Master Fund, L.P. (Fund), by misstating the value of certain Fund assets, stealing from the Fund and failing to disclose material information about Fund assets.  In reports to Fund investors, Mannion and Reckles reported that the Fund’s investment in World Health Alternatives, Inc. (WHA), a medical staffing company, was worth over $19 million, even though they knew that the investment was worth millions less than the reported value.  The Defendants also allegedly stole and exercised WHA warrants owned by the Fund and failed to disclose their private sales of WHA stock.  Finally, in a transaction unrelated to WHA, Mannion and Reckles are alleged to have concealed their short position in Radyne Corporation at the time that they invested in that corporation’s PIPE offering.  The SEC seeks an injunction barring future securities law violations, disgorgement of unlawful profits and civil penalties.  This article summarizes the SEC’s Complaint.

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  • From Vol. 3 No.11 (Mar. 18, 2010)

    Will Reported Purchases by D.E. Shaw Hedge Funds of Assets in Other Hedge Funds’ Side Pockets Set a Precedent, or Highlight the Fiduciary Duty, Valuation and Other Challenges in Such Transactions?

    While it is not unusual for a hedge fund to be organized for the purpose of purchasing distressed debt, the D.E. Shaw group (D.E. Shaw) is putting an interesting twist on this concept.  It has been widely reported in the press that D.E. Shaw organized an in-house team in 2009, the D.E. Shaw Portfolio Acquisitions Unit, to evaluate purchases of illiquid assets from other hedge funds.  In particular, the D.E. Shaw unit is looking at assets in other hedge funds’ side pockets.  Generally, a side pocket is an account established by a hedge fund to hold assets that are less liquid than the remainder of the portfolio.  See “Secondary Buyers of Private Equity Fund Interests are Looking at Assets in Hedge Fund Side Pockets,” The Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).  Such purchases can be a boon to both sides.  Selling hedge funds can refocus on their more liquid portfolio, and purchasing hedge funds – especially those with longer lock-ups – can realize the long-term value in currently illiquid assets.  However, such purchases also involve challenges.  For example, investors in the selling hedge fund may allege that the side pocketed asset was undervalued for purposes of the sale, and based on such alleged undervaluation may bring claims against the selling manager for breach of fiduciary duty or material misrepresentations or omissions.  For the purchasing hedge fund, such a purchase will involve considerable due diligence, including obtaining sufficient information to make an informed investment decision in light of what is often a matrix of confidentiality agreements.  Similarly, only certain hedge funds are set up to hold side pocketed assets for long enough to realize value – and to avoid the same liquidity pressures that cause the selling hedge fund to sell.  Depending on the characteristics of the purchased asset, the purchasing hedge fund would need a lock-up that in most cases could not be less than two years.  This article highlights the potential and challenges involved in purchases by hedge funds of assets in the side pockets of other hedge funds.  In particular, this article discusses: the mechanics of side pockets (including their implications for calculation of net asset value (NAV) and management and performance fees); fiduciary duty and securities law concerns inherent in purchases by hedge funds of illiquid assets from other hedge funds; the recent increase in distressed debt trading activity, both by hedge funds with a traditional competency in the area and newer entrants; valuation issues facing the selling hedge fund; valuation issues for the buyer; lock-up and liquidity prerequisites for the buyer; and the effect of such purchases on redeeming and non-redeeming investors in the selling fund.

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  • From Vol. 2 No.29 (Jul. 23, 2009)

    Luxembourg Authorities Create Fast-Track Procedure for Approval of Transfers of Illiquid Assets to Hedge Fund Side Pockets

    The financial regulatory authority in the Grand Duchy of Luxembourg, the Commission de Surveillance du Secteur Financier (CSSF), has approved a new fast-track authorization procedure for the use of side pockets by hedge funds in two specific situations: the spin-off from an existing share/unit class to a new share/unit class and the spin-off from an existing subfund to a new subfund.  The fast track procedure is not to be used if the assets to be side pocketed represent more than 20 percent of the total assets of the relevant fund or subfund.  Also, the procedure requires that the board of directors of the management company of the affected fund confirm that the proposed side pocketing complies with the fund’s articles of incorporation or rules; that the administrator is technically capable of servicing the contemplated side pocket; and that it not be implemented to solve “temporary valuation problems” or to address a merely “potential or presumed illiquidity.”  Managers must also undertake to “promptly realize the asset as soon as the asset is once again liquid.”  We offer additional details on the specifics of the fast-track procedure, and shed light on some of the more complicated definitional questions raised by the terms used in the procedure.  For example, we address how the CSSF is likely to construe, in this context, concepts such as “temporary valuation problems” and “promptly realize the asset as soon as the asset is once again liquid.”

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  • From Vol. 2 No.28 (Jul. 16, 2009)

    Secondary Buyers of Private Equity Fund Interests are Looking at Assets in Hedge Fund Side Pockets

    The past two years have witnessed two related but opposing trends in the hedge fund world: an increasing proportion of assets placed in side pocket accounts, and an unprecedented volume of redemption requests.  The trends are related in that as the volume of redemption requests or anticipated requests increased, side pockets were one of the tools employed by managers to stem the outflow of capital.  See “Hedge Fund Managers Using Special Purpose Vehicles to Minimize Adverse Effects of Redemptions on Long-Term Investors,” The Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009).  The trends are opposing in that as more assets were placed in side pockets, fewer assets were available to pay redemptions in cash.  See “Can a Hedge Fund Make Redemption Payments ‘In Kind’ by way of the Issue of ‘Participation Interests’ in its own Illiquid Assets, and What is the Status of a Redeeming Investor who has not Received any Payment at All?,” The Hedge Fund Law Report, Vol. 2, No. 13 (Apr. 2, 2009).  Moreover, to the extent redemptions were paid in cash, the remaining portfolio became less liquid – to the dismay of many investors who invested with certain liquidity assumptions.  In an effort to reconcile these opposing trends – to increase the overall liquidity of a portfolio, which in turn would enhance the ability (if not the desire) to pay redemptions in cash, which in turn (presumably) could help slow the rate of redemption requests – hedge fund managers have been looking for ways to liquidate assets in side pockets.  But as credit markets have remained more or less frozen, buyers of such assets have been few and far between.  Some investors and managers have turned to secondary markets to transfer exposure to side pocketed assets to investors with more “patient capital.”  However, secondary markets can be an imperfect remedy for various reasons, including the substantial discount at which hedge fund interests often trade in secondary transactions, as well as valuation and confidentiality concerns.  See “Valuation and Confidentiality Concerns in Secondary Market Trading of Hedge Fund Interests,” The Hedge Fund Law Report, Vol. 1, No. 27 (Dec. 9, 2008); “Hedge Fund Managers and Investors Turning to Dutch Auctions as an Alternative to Secondary Markets for Hedge Fund Interests,” The Hedge Fund Law Report, Vol. 2, No. 10 (Mar. 11, 2009).  However, there may be another option for hedge fund managers looking to liquidate side pocketed assets.  In at least a few recent deals, firms that have historically specialized in purchasing secondary interests in private equity funds have purchased assets in hedge fund side pockets.  Such investors are structured for longer-term investments – they generally have capital locked up for at least three years, often longer – and thus are better situated to realize long term value in currently illiquid assets than are many of the hedge fund investors with side pocket exposure.  Our analysis of this trend includes discussions relating to: illiquid assets; the mechanics of side pockets; the operations of and participants in the secondary market for purchasing side pocketed assets; the opportunity identified by buyers of such assets; and the ongoing relevance and practicability of side pockets.

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  • From Vol. 2 No.1 (Jan. 8, 2009)

    Side Pockets: Operation, Valuation, Practical Considerations

    A side pocket is a segregated account created by a hedge fund manager in accordance with provisions in the fund’s governing documents to hold portfolio assets that the manager deems illiquid or less liquid.  Generally, the values of side pocketed assets are excluded from the periodic calculation of net asset value of the liquid portfolio, the theory being that including valuation of such illiquid or less liquid assets in NAV calculations could distort NAV in a way that does not accurately reflect the current realizable value of all portfolio assets, which could unfairly help or hurt new or redeeming investors.  We explore the mechanics of side pockets, their utility in an environment of heavy redemptions, valuation and ERISA considerations and the interaction of side pockets and fees.

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