The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 4, No. 17 (May 20, 2011) Print IssuePrint This Issue

  • Buying a Majority Interest in a Hedge Fund Manager: An Acquirer’s Primer on Key Structuring and Negotiating Issues

    The hedge fund space has seen significant recent M&A activity.  Deals in late 2010 included Man Group’s purchase of GLG Partners; RBS Wealth Management’s acquisition of BlueBay Asset Management; the acquisition by Japanese financial services group ORIX of a majority stake in U.S. hedge fund platform Mariner; and Carlyle Group’s purchase of a controlling interest in Claren Road Asset Management.  Early indications suggest that 2011 will also be a robust year for hedge fund transactions.  On the surface, hedge fund M&A may be seen simply as bringing the maturing alternative investment industry into line with the broader financial services market, where consolidation has been a fact of life for years.  Deeper reflection, however, suggests that deal activity is being driven by the unique features of the hedge fund sector itself.  Some traditional financial services firms perceive a need to begin offering hedge fund investments to their clients, and buying a fund is a way to plug that product gap.  Or, a financial services firm that already offers some hedge fund products may wish to add a focus on a particular sector, and acquiring an existing fund that fits the bill may be preferable to starting a new fund from scratch.  Acquirers may also consider hedge fund acquisition opportunities particularly appealing in light of recent performance issues and their (perhaps temporary) depressing impact on firm value.  Industry dynamics may be especially compelling to sellers as well.  From the hedge fund manager’s perspective, selling an interest in the firm may spell relief from the volatility and financial stress of recent years.  A transaction also may give principals a welcome chance to diversify personal assets by monetizing a significant stake in their business; this motivation is perhaps coming increasingly to the fore as a generation of hedge fund founders begins to consider retirement.  Finally, a hedge fund manager may be attracted by the prospect of business support from the acquirer, which may take the form of enhanced marketing resources, introductions to prospective investors, assistance with the development of new products, capital for strategic expansion, bolstered compliance and legal functions, or opportunities for cost savings and synergies.  In a guest article, Scott C. Budlong, Eva Marie Carney, Thao H.V. Do, Eric M. O’Meara, William Q. Orbe and Kenneth E. Werner, all Partners at Richards Kibbe & Orbe LLP, examine key transaction structuring points in the acquisition of a majority interest in a hedge fund manager (the “Manager”).  The authors assume a cash deal in which the acquirer (the “Acquirer”) purchases from certain principals of the Manager (the “Selling Principals”) a majority equity interest in the Manager, with the Selling Principals retaining a minority stake.  As discussed in this article, there are at least six major themes at work in such a transaction: regulatory diligence; valuation; incentives and franchise protection; control rights; the parties’ ability to increase or reduce their holdings post-closing; and investor relations.  These themes are inter-related and a successful transaction must find common ground between the Acquirer and the Selling Principals on each one.

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  • Eight Refinements of the Traditional “2 and 20” Hedge Fund Fee Structure That Can Powerfully Impact Manager Compensation and Investor Returns

    In the depths of the credit crisis, investors began to question hedge funds’ traditional claims to fame.  Negative returns undermined the promise of absolute returns across market environments, and a collective downward movement in NAV challenged the notion that hedge funds consistently deliver uncorrelated returns.  Questions about fees followed promptly and inexorably from questions about returns; and a collective expectation developed that the traditional “2 and 20” hedge fund fee structure – a 2% management fee and a 20% performance allocation – would come under pressure and emerge from the crisis slimmed down to something like “1 and 10.”  But a funny thing happened on the road to recovery: the 2 and 20 model remained more or less intact.  Perhaps it was the overall robust returns of hedge funds from late 2009 through late 2010?  Or perhaps it was the argument – difficult to rebut and persuasively made by managers – that reducing fees can lead to a talent exodus and inadequate infrastructure investment, and thus works to the detriment of investors?  Or perhaps it was a combination of these and other factors?  But regardless of the reason, the fact remains: according to a recent survey by SEI and Greenwich Associates (citing data from Hedge Fund Research Inc. (HFRI)), the median management fee for single-manager hedge funds is 1.5% across all major strategies, and 40% of all hedge funds (and 100% of hedge funds following a “macro” strategy) still have a 2% management fee.  The SEI survey also found that performance fees typically remain unchanged at 20% for all major strategies.  However, fee levels are just one part of the picture of manager compensation and investor economics.  The other major determinant of what investors pay and what managers take home is fee structures.  And unlike fee levels, which have remained relatively stable, fee structures have been subject to considerable negotiation.  This article starts by discussing the structure, purpose, taxation and resilience of management fees and performance allocations.  The article then discusses in detail eight ways in which investors and managers have negotiated or renegotiated performance allocation structures.  The article concludes with a discussion of the role of investor size in negotiating for customized fee terms, and how regulation will impact such negotiations.

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  • Is a Threatening Letter from a Hedge Fund Manager to a Seed Investor Admissible in Litigation between the Manager and the Investor as Evidence of the Manager’s Breach of Fiduciary Duty?

    Hedge fund manager Paige Capital Management, LLC (Fund), had a dispute with seed investor Lerner Master Fund, LLC (Lerner), over Lerner’s demand to withdraw its entire investment.  The Fund’s attorney wrote a letter to Lerner “reminding” Lerner of the potential costs of litigation over Lerner’s withdrawal rights and advising Lerner that, if it did not drop its withdrawal demand, the Fund would invest Lerner’s funds in “high risk, long-term, illiquid, activist securities” and spare no expense in defending the Fund.  This litigation ensued and the Fund sought to block Lerner from introducing the letter as evidence of breach of fiduciary duty by the Fund, claiming that the letter was protected both as a settlement communication and by the privilege for allegedly defamatory statements made in the course of litigation.  We summarize the decision.

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  • When Does the SEC Acquire the Right to Freeze the Assets of a Hedge Fund or Appoint a Receiver over a Hedge Fund?

    As previously reported in The Hedge Fund Law Report, on March 24, 2011, the SEC brought a civil enforcement action against Marlon Quan, and the firms he managed, Acorn Capital Group, LLC (ACORN) and Stewardship Investment Advisors, LLC (SIA), in the U.S. District Court for the District of Minnesota.  The SEC accused Quan of using his hedge funds to facilitate a Ponzi scheme orchestrated by Thomas J. Petters by funneling hundreds of millions of dollars of investor money to Petters, while falsely assuring investors of actions taken to protect their investments.  See “SEC’s Hedge Fund Focus to Include Review of Funds That Outperform the Market,” The Hedge Fund Law Report, Vol. 4, No. 14 (Apr. 29, 2011).  The SEC filed the action on that date in order to stop the imminent distribution of approximately $14 million in settlement funds – obtained from the Petters’ bankruptcy and receivership estates – to certain of Quan’s offshore hedge funds, and to prevent Quan from allegedly dispersing more assets to individuals associated with him.  The SEC did so, it said, to protect the interests of investors in Quan’s onshore hedge funds.  Thus, the SEC also named as “relief defendants” (defined as persons or entities who received ill-gotten funds or assets as a result of the illegal acts of the defendants) the company that held the settlement funds on behalf of Quan’s associated entities, Asset Based Resource Group (ABRG), and Florene Quan, Quan’s wife who allegedly received certain properties from Quan for nominal value.  See, by way of background, “Connecticut District Court Dismisses Complaint Against Hedge Fund Manager and Investment Adviser for Lack of Venue,” The Hedge Fund Law Report, Vol. 2, No. 20 (May 20, 2009).  After filing the complaint, the SEC immediately filed a motion to obtain an order freezing the assets of all named defendants, appointing a receiver over certain of Quan’s onshore entities and ABRG, and enjoining Quan, Acorn and SIA from further violations of securities laws.  A Bermuda court-appointed liquidator, who took over Quan’s offshore hedge funds, successfully moved to intervene for the limited purpose of being heard regarding the disbursement of settlement proceeds and to object to the appointment of a receiver over ABRG.  We detail the background of the action and the Court’s legal analysis.  For more on receivers in the hedge fund context, see “Seventh Circuit Approves Federal Receiver’s Hedge Fund Liquidation Plan Subordinating Priority Rights of Redeeming Investors; Agrees That Equity Mandates That All Investors, Redeeming and Not, Be Treated Equally Where Fund Lacks Sufficient Assets to Make Them Whole,” The Hedge Fund Law Report, Vol. 3, No. 50 (Dec. 29, 2010).

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  • New York State Governor Cuomo Nominates Benjamin Lawsky to Head New York State Department of Financial Services

    On May 16, 2011, New York State Governor Andrew Cuomo announced the nomination of Benjamin M. Lawsky for Superintendent of New York’s Department of Financial Services (DFS).  The newly formed department was created by the Financial Services Law (FSL), which was enacted in April 2011.  The new entity consolidates New York’s banking and insurance regulators into a unified financial regulator with the goal of creating a “more efficient, modern, and comprehensive regulator of the financial sector,” according to a release from the Governor’s office.  The DFS is tasked with preventing fraud, regulating financial products and services and preventing state level regulatory arbitrage.  See “First Department Decision May Give Aggrieved Hedge Fund Investors an Unexpected and Powerful Avenue of Redress,” The Hedge Fund Law Report, Vol. 4, No. 9, (Mar. 11, 2011).

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