The Hedge Fund Law Report

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

Recent Issue Headlines

Vol. 2, No. 20 (May 20, 2009) Print IssuePrint This Issue

  • Why Do Hedge Funds Have So Much Dry Powder, and What Are They Doing to Keep It Safe?

    It is widely understood that investors pay hedge fund managers to invest money.  A less appreciated, but increasingly common, service provided by hedge fund managers is not investing money.  Is that latter service worth a two percent management fee?  Consider a billion dollar equity long-short hedge fund with a two percent management fee that remained in cash for all of 2008.  The fund would have charged investors $20 million for sitting in cash.  Seems unfair: why should investors pay the manager $20 million when they could leave the same money in the bank more or less for free?  The answer is that a bank is not really a viable alternative: most institutional investors in hedge funds have internal allocation policies that require a certain percentage of assets to be invested in hedge funds.  Thus, the appropriate comparison is not between a hedge fund and a bank, but rather between a hedge fund manager who stayed in cash (or largely in cash) and another hedge fund manager who was fully invested.  If that same billion dollar equity long-short hedge fund were fully invested in the S&P 500 during the same period, it would have lost about 38 percent of its investors’ assets.  Even if half of those losses were offset by a short book, the fund still would have lost $190 million.  Most investors would be willing to pay $20 million to avoid a $190 million loss.  As any seasoned investor will tell you, the first rule of investing is not to lose money.  During 2008 and early 2009, the amount of cash – known in the trenches as “dry powder” – held by the more judiciously managed hedge funds has risen dramatically; the cash has come from asset sales and new investments.  The dramatic increase in cash held (as opposed to re-deployed) has been driven largely by three factors: (1) fear of getting back into the market too early; (2) desire to avoid selling assets at depressed prices to satisfy redemption requests; and (3) concern about being prepared to seize new investment opportunities at a time when the opportunity set becomes more compelling but leverage remains unavailable.  We explain why hedge funds are holding so much dry powder, and what the more prudent managers are doing to keep it safe.  We weigh the pros and cons of money market funds and Treasurys, and highlight what is probably the safest strategy for cash management.

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  • For Credit-Focused Hedge Funds, Receivables are the New Zero-Coupon Bonds

    In today’s constrained credit environment, operating companies are still finding it difficult to obtain the credit they need for operations, expansion and working capital.  Risk aversion remains the order of the day among traditional lenders – banks, thrifts, credit unions – and as a result, lines of credit are being reduced, terms loans are harder to come by and fees and interest rates are increasing on various types of credit.  In this environment, companies are turning to alternative financing sources.  One increasingly popular option among such alternatives is receivables financing, in which a company that is owed money sells the right to receive that money to another party in exchange for an amount that is less than the amount owed.  As in other pockets of the credit markets, hedge funds are showing up with growing frequency as buyers of receivables under such arrangements – that is, as lenders.  For the companies selling receivables, such arrangements are the functional equivalent of term loans secured by the receivables, with the interest amount consisting of the difference between the sale price of the receivable and its face value.  For hedge fund investors, buying receivables is the functional equivalent of purchasing a zero-coupon bond, and the investment and legal analysis preceding such an investment is largely the same as in the zero-coupon bond context.  However, receivables financing offers hedge funds exposure to different credits, with a different (often higher) return profile and a different level of correlation with traditional asset classes.  For certain hedge funds, mostly those with a credit orientation, receivables financing offers an interesting alternative (or complement) to investments in more typical assets such as bonds and bank loans.  (However, claims arising out of the purchase of receivables often will rank lower in a bankruptcy of the obligor than bonds or bank loans.)  We detail the mechanics of a typical receivables financing transaction, the function of receivables exchanges, which types of hedge funds are participating in these transactions, expected returns, usury laws, default by the obligor and true sale considerations.

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  • The Hedge Fund Transparency Act and its Unintended Consequences for Cat Bonds

    On January 29, 2009, Senators Carl Levin (D-MI) and Charles Grassley (R-IA) introduced the Hedge Fund Transparency Act (HFTA) for passage in the Senate.  The HFTA is intended to require hedge funds to register with the Securities and Exchange Commission (SEC) and thereby subject them to regulation by that body.  As currently drafted, however, the HFTA proposes amendments to the Investment Company Act of 1940, as amended, which would require any private investment fund with $50 million or more under management to register with the SEC and meet certain disclosure obligations.  Catastrophe or “cat” bond transactions are issued by a special purpose entity which would come within the revised definition of investment companies proposed under the HFTA.  Thus far, introductory remarks on the measure have been made by the sponsors and the HFTA has been read twice and referred to the Committee on Banking, Housing and Urban Affairs.  If enacted, the regulatory obligations of private investment funds with $50 million or more under management, including cat bond issuers, would increase substantially.  In a guest article, Malcolm P. Wattman, a Partner at Cadwalader, Wickersham & Taft LLP, explores the potential consequences of the HFTA for cat bonds.

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  • Treasury, SEC and CFTC Jointly Propose Mandatory Central Clearing of Standardized Over-The-Counter Derivatives

    On May 13, 2009, the Secretary of the Treasury, Timothy Geithner, along with the chairman of the Securities and Exchange Commission (SEC), Mary Schapiro, and the acting chairman of the Commodity Futures Trading Commission (CFTC), Michael Dunn, jointly announced a plan for reforming the regulation of over-the-counter (OTC) derivatives.  Secretary Geithner elaborated on the plan in a letter dated the same day to House and Senate leaders.  At the heart of the proposed reform is legislation that would require centralized clearing – through “central counterparties” or CCPs – of all standardized OTC derivatives.  To prevent circumvention of the legislation, Geithner has cautioned that the customization of derivatives must not be “used solely as a means to avoid using a CCP.”  Such practices might be headed off, Geithner suggested, by the creation of a legal presumption: the acceptance for clearing by one or more regulated CCPs of an OTC derivative would create a presumption that the accepted contract is standard, and thus within the mandatory clearing requirement.  We provide a detailed discussion of the proposed reforms as well as the Authorizing the Regulation of Swaps Act, proposed by Senators Carl Levin (D-MI) and Susan Collins (R-ME) on May 4, 2009.

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  • Interview With Drinker Biddle Partner David Matteson on Citadel’s Entry Into the Investment Banking Business

    Earlier this month, hedge fund manager Citadel Investment Group L.L.C. announced that it is entering the investment banking business, hiring three former Merrill Lynch executives to lead the effort.  Todd Kaplan, who joined Citadel in March, will run the unit, reporting to Citadel Securities CEO Rohit D’Souza.  Reporting to Mr. Kaplan will be Brian Maier, head of industry groups, and Carl Mayer, head of leveraged finance.  In the past, Citadel has entered non-hedge fund businesses, including the successful launch of an options market-making unit, but this marks its first major foray into a non-trading business.  The Hedge Fund Law Report discussed Citadel’s move in an interview with David Matteson, a Partner at Drinker Biddle & Reath LLP.  We provide excerpts from the interview.

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  • Connecticut District Court Dismisses Complaint Against Hedge Fund Manager and Investment Adviser for Lack of Venue

    On April 22, 2009, the United States District Court for the District of Connecticut dismissed a complaint by BNY AIS Nominees Limited (BNY AIS) on behalf of the shareholders of the hedge fund Stewardship Credit Arbitrage Fund, Ltd. (the Hedge Fund) against Marlon Quan (Quan), the Hedge Fund’s managing director and Stewardship Investment Advisors, LLC (SIA), the Hedge Fund’s investment adviser, for improper venue.  The Hedge Fund’s subscription agreement required disputes under the agreement to be resolved in the Bermuda.  The District Court dismissed the complaint, holding that even though the defendants were not parties to the subscription agreement, they were so closely related to the Hedge Fund as to be entitled to the benefits of the forum selection clause.  We detail the facts, analysis and holding of the case.

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  • Federal District Court Halts California Hedge Funds’ Alleged Fraudulent Scheme

    On April 29, 2009, the U.S. District Court for the Central District of California granted a motion filed by the Securities and Exchange Commission (SEC) to halt an allegedly fraudulent scheme in which Bradley L. Ruderman (Ruderman) conned approximately twenty investors into investing at least $38 million in his two hedge funds, Ruderman Capital Partners, LLC and Ruderman Capital Partners A, LLC (RCP-A) (together, the Funds), by misrepresenting the Funds’ stature and investment returns.  Specifically, Ruderman claimed that the Funds held more than $800 million in assets, when it fact the Funds had significantly less than $650,000 in assets.  Based on these accusations, the SEC requested and obtained a temporary restraining order and a preliminary injunction against Ruderman and the Funds he managed.  We describe the allegations in the SEC’s complaint and the district court’s action.

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  • Akin Gump Adds Former UBS Lawyer to London Funds Practice

    On May 14, 2009, international law firm Akin Gump Strauss Hauer & Feld LLP announced the hiring of investment funds lawyer Ash Gulati as senior counsel in its London office.

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