The Hedge Fund Law Report

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

Articles By Topic

By Topic: Capacity

  • From Vol. 9 No.39 (Oct. 6, 2016)

    Seward & Kissel Study Finds MFN Clauses and Reduced Fees Most Prevalent Terms in Side Letters 

    Seward & Kissel (S&K) recently completed a study of side letters entered into by its hedge fund manager clients. “The Seward & Kissel 2015/2016 Hedge Fund Side Letter Study” considers the prevalence and features of five common side letter provisions: most favored nation clauses, fee discounts, transparency, preferential liquidity and capacity rights. This article summarizes S&K’s findings. For HFLR coverage of S&K’s annual hedge fund studies, see: 2015 Study (Mar. 31, 2016); 2014 Study (Mar. 5, 2015); 2012 Study (Apr. 11, 2013); and 2011 Study (Feb. 23, 2012). For additional analysis of side letter practices, 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)” (Jun. 13, 2013). Steve Nadel, lead author of the study and a partner in S&K’s investment management practice, will expand on the topics in this article – as well as other issues relating to side letters – in an upcoming webinar co-produced by The Hedge Fund Law Report and S&K. Details of the webinar are forthcoming. 

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  • From Vol. 7 No.18 (May 8, 2014)

    How to Close a Hedge Fund in Eight Steps (Part One of Two)

    In concept, hedge funds are “continuously offered” and, unlike their private equity cousins, have no built-in end date.  In practice, however, hedge funds do not last forever.  For various reasons – this article catalogues nine of them – hedge fund managers may wish to close their funds, or may close their funds without wishing to.  More often than not, a hedge fund manager that closes a fund remains in the investment management business, and continues to interact with the same employees, investors and service providers – even if that interaction occurs under a different structure.  Closing a fund is a complex process involving hard legal and business issues, often with an overlay of meaningful personal dynamics.  This article – the first in a two-part series – aims to add some structure to what can be a fraught and unruly process by presenting an eight-step framework for hedge fund closures.  The second article in this series will highlight a number of challenges that managers typically encounter in the course of those eight steps, and suggest best practices for negotiating the challenges.  It should be emphasized that this series is about winding down the business and investment affairs of a hedge fund.  In industry parlance, “closing” also refers to a situation in which a hedge fund is not accepting new investors or investments.  That latter type of “closing” is not the subject of this series, but was the subject of prior articles in the HFLR.  See “Legal and Investment Considerations in Connection with Closing Hedge Funds to New Investors or Investments,” The Hedge Fund Law Report, Vol. 3, No. 37 (Sep. 24, 2010); “Primary Legal and Business Considerations in Structuring Hedge Fund Capacity Rights,” The Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010).

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  • From Vol. 3 No.37 (Sep. 24, 2010)

    Legal and Investment Considerations in Connection with Closing Hedge Funds to New Investors or Investments

    What a difference two years make.  In late September 2008, Lehman Brothers Holdings Inc. had just filed a bankruptcy petition, and hedge fund redemptions were growing in size and speed.  Some even thought, at the time, that the viability of the hedge fund industry itself was in doubt.  But two years later, the industry is not only viable, but vibrant, and facing a very different set of challenges.  Whereas the problem in late 2008 was, generally, too little money, the problem today, at least for some managers, is too much money.  That is, a growing number of hedge funds are reaching a level of assets under management (AUM) above which it will be difficult for their managers to deliver performance consistent with target returns or expectations.  As a result, managers are closing such funds to new investors or new investments.  See “Primary Legal and Business Considerations in Structuring Hedge Fund Capacity Rights,” The Hedge Fund Law Report, Vol. 3, No. 22 (Jun. 3, 2010).  There are at least four reasons for this trend.  First, gross assets under management by hedge funds are growing.  See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part One of Three),” The Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010).  Second, institutional investors are, with some notable exceptions, shifting away from funds of funds in favor of direct investments in hedge funds, for two primary reasons: increasing familiarity and comfort on the part of institutional investors with direct hedge fund investing, and skepticism regarding whether the due diligence and monitoring services performed by funds of funds justify the extra layer of fees.  This shift to direct hedge fund investing can strain capacity in various ways.  For example, in times past, a pension fund might have invested $10 million in a fund of funds that in turn invested $8 million in an underlying hedge fund and kept $2 million in cash.  Today, that same pension fund might invest the same $10 million directly in the underlying hedge fund, resulting in $2 million less capacity in the hedge fund.  See “Three Significant Legal Pitfalls for Hedge Fund Marketers, and How to Avoid Them,” The Hedge Fund Law Report, Vol. 3, No. 36 (Sep. 17, 2010).  Third, a disproportionate share of the capital recently invested in hedge funds and expected to be invested in the coming quarters has flowed into larger funds.  See “Dodd-Frank May Impose New Obligations on Managers of Large Hedge Funds and Plan Asset Hedge Funds that Enter into Swaps,” The Hedge Fund Law Report, Vol. 3, No. 32 (Aug. 13, 2010).  And fourth, some institutional investors are changing their approach to allocations in ways that, on balance, may result in larger percentages of their portfolios being allocated to hedge funds.  See “Implications for Hedge Funds of a Potential Paradigm Shift in Pension Fund Allocation Strategies,” The Hedge Fund Law Report, Vol. 3, No. 16 (Apr. 23, 2010); “Lessons for Hedge Fund Managers on Liquidity, Allocations, Marketing and More from Yale’s 2009 Endowment Report,” The Hedge Fund Law Report, Vol. 3, No. 14 (Apr. 9, 2010); “As Pension Funds Exceed Hedge Fund Allocation Guidelines as Other Asset Classes Decline More Precipitously, Hedge Fund Managers Ask: Will Pension Funds Redeem or Revise their Allocation Guidelines?,” The Hedge Fund Law Report, Vol. 2, No. 17 (Apr. 30, 2009).  The net effect of these four factors is that, in certain strategies, the demand for hedge fund capacity is starting to outstrip the perceived supply, or as Simon Ruddick, CEO of alternative investment consultant Albourne Partners, Ltd., put it in recent comments to Pensions & Investments, “Contingent institutional interest massively exceeds credible alpha supply.  This means capacity is bound to be an issue sooner or later.”  In order to help hedge fund managers think through whether, when and how to close their funds to new investors or investments, this article discusses: recent example of closings; the benefits of hedge fund size; the drawbacks of size, or in other words, the rationales for closing; hard versus soft closes; the overlay of capacity rights granted in side letters; using hedge fund closings to manage the composition of an investor base; disclosure with respect to closings and reopening in hedge fund governing documents; communicating with investors; side letters; managed accounts; and fiduciary duty.  Before proceeding, a caveat is in order.  We recognize that for every hedge fund manager running up against capacity constraints, there are one or probably many managers knocking themselves out to raise funds.  At the industry level, there may well be sufficient capacity to meet the investment demand.  However, implicit in our phrase “perceived supply” and Ruddick’s phrase “credible alpha supply” – and in the “race to the top” phenomenon discussed above – is a note of risk aversion: for many institutional investors, the issue is not hedge fund capacity overall, but capacity with the largest, most established managers.  Such risk aversion may be rational for the managers of many institutional investors in light of restrictive investment policies, considerable personal downside for investment losses and limited personal upside for returns in excess of modest targets.  However, the opportunity cost of that risk aversion includes the strong returns that, according to studies, can be generated over long periods from a portfolio of smaller hedge funds.  See “The Space between Alpha and Beta (and Why Hedge Fund Investors Should Care),” The Hedge Fund Law Report, Vol. 3, No. 24 (Jun. 18, 2010).  Also, industry participants expect Dodd-Frank in the U.S. and the AIFM Directive in Europe to increase the costs of launching and operating a hedge fund management company, and thus to diminish entry into the hedge fund business by potential new managers, increase exits by closure or sale and decrease the total capacity in smaller hedge funds.

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  • From Vol. 3 No.22 (Jun. 3, 2010)

    Primary Legal and Business Considerations in Structuring Hedge Fund Capacity Rights

    Traditionally, hedge funds and private equity funds have used different funding models.  Private equity funds have used a capital on call model, in which investors agree by contract to contribute a certain amount of capital to the fund, and retain possession of that capital until the manager requests it.  Hedge funds, by contrast, have used an immediate funding model, in which investors actually contribute capital to the fund at the time of investment, and the fund’s custodian retains possession of that capital for the duration of the investment.  (But see “Can a Capital On Call Funding Structure Fit the Hedge Fund Business Model?,” The Hedge Fund Law Report, Vol. 2, No. 44 (Nov. 5, 2009).)  However, there is a narrow exception to the immediate funding rule in the hedge fund context.  That exception applies to seed investors and other large, usually early investors in hedge funds (who often simultaneously invest in the hedge fund management entity).  Such investors frequently condition their investments on rights to make additional investments in the fund.  In the hedge fund world, those additional investment rights generally are known as capacity rights.  In effect, investors with capacity rights have the opposite of capital on call.  Instead, they have what might be termed “capital on put.”  Whereas a private equity fund manager has the right to call its investors’ capital, a hedge fund investor with capacity rights has the right to put its capital into the fund.  Capacity rights agreements offer business benefits to managers and investors.  Most notably, they enable start-up managers to bring in anchor investors, and offer anchor investors the opportunity to maximize the value of risky investments with new managers.  But capacity rights agreements also present a variety of legal and practical complications.  The purpose of this article is to highlight some of those complications and, where practicable, offer remedies or solutions.  In particular, this article discusses: the definition of capacity rights; the business rationales for granting (from the manager perspective) or requesting (from the investor perspective) capacity rights; the documents in which such rights are usually memorialized; how such rights are generally structured, including the pros and cons of structuring capacity rights based on dollar amount versus percentage of assets under management (AUM) or total capacity; and various specific concerns raised by capacity rights agreements, including ERISA concerns, concerns relating to most favored nations (MFN) clauses in side letters, the frequently less advantageous economics associated with capital invested pursuant to capacity rights, and fiduciary duty concerns.

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