Which way, the stream of time? The 2010 economic and regulatory outlook for US hedge funds

If you are a hedge fund manager with ties to the United States, you have a full plate. Never mind the basic challenges of generating positive performance on your portfolios and profitably running your business. The global regulatory landscape is shifting under your feet, and pressure from investors on all aspects of your advisory relationships continues.

To be sure, the major breach of trust events in 2008 and 2009 were of a nature and scope not previously seen in the marketplace, and investors are slowly recuperating from the dislocation they caused. But not unlike a relationship with a cheating spouse, the repercussions from these scandals have left an indelible scar that the cosmetic of positive performance cannot mask.
Much more is needed from fund managers. Thankfully, the hedge fund industry remains resilient and still in high demand by institutional and individual investors alike. Yet their increasingly sophisticated demands for better process and risk-management controls means only those fund managers who run an institutional-calibre operation will be able to attract meaningful investor capital.
What predictions can we make as to the impact of the events of 2008 and 2009 on the economic and regulatory aspects of managing private pooled capital for fund managers in 2010? Let’s take a look.
In terms of manager-investor economics, clearly the best news coming into 2010 is that investor sentiment toward hedge funds, and alternative assets broadly, is upbeat following the merciful market rallies of 2009 that helped restore some of 2008’s staggering losses. By most measures, hedge fund performance for 2009 across all strategies was up roughly 20 per cent on average – which, of course, is good news for those managers trying to crawl back above their high water marks. The overriding theme, however, will be alignment of interests between managers and investors, and the mantras for investors in 2010 will continue to be better transparency, shorter lock-ups, and greater liquidity rights.
Expect to see management fees remaining in the 1.25 per cent-2.0 per cent range with lower scales in place for larger funds. But be prepared: the biggest consideration in the management fee discussion will be the manager’s justification of how management fees at any level track approximate the costs of running the business, as opposed to serving as a windfall source of lifestyle capitalisation.

Where management fees are misaligned compared to portfolio performance, expect to see requests for fee givebacks for this same reason. In the fund of funds marketplace, increasing use of staggered fee collection mechanisms is stemming what otherwise has been a mild flight from these diversification vehicles to direct manager selection by some institutional investors and several significant European pension funds.

As pension funds and other institutions move toward internal risk management in conjunction with their revamped programs for making direct investments in single-manager funds, look for increased reliance on a new breed of hard-target investigative due diligence firms, such as 930-GSS, to come calling at the behest of a sophisticated investors – including those who may already be in your fund but who are looking to provide additional assurances to their investment committees and beneficiaries.
The performance fee structures will also remain largely unchanged at a 20 per cent annual average. But managers who offer greater flexibility around the incentive compensation structure will attract the most attention. While some elite managers are continuing to get escalating incentive compensation scales that increase their payout as certain benchmark return levels are reached, for the remainder of the pack investors seem to be willing to trade off fee reductions for shorter lockup periods. Investors are similarly showing a willingness to agree to gating and suspension provisions, if justified by the potential for illiquidity in the underlying assets and so long as the conditions for their invocation by the manager – primarily with regard to preserving asset value in times of fund and/or market stress – are well defined in the governing fund documents.
One area of fund operations that has traditionally received short shrift has been the review of the fund documentation relating to the management and general partner entities themselves, and the rights and responsibilities the principals of the fund share as cohorts in the fund enterprise. Boilerplate operating agreements with a lack of attention to events such as transition amongst the principals and voting deadlocks are as dangerous for investors as fund documents with unrestricted suspension rights.

And of increasing importance to savvy investors are managers who use incentive compensation structures for non-principal employees as a means of retaining and locking in top management talent. Expect to see requests from investors regarding both cash and in kind incentive compensation plans calling for multi-year vesting of equity participations in the general partner as well as mechanisms requiring the reinvesting of meaningful portions of cash bonuses back into the general partner or the fund vehicle, comprehensive employment agreements with robust non-competition and non-solicitation provisions and in cases of both cash and equity compensation, forfeiture on “for cause” termination events and clawbacks based on inadequate performance.

Your agreements at the management company level should ensure the continuity and alignment of the management team as a means of demonstrating the strength of your fund to investors.
In the post-Madoff/Stanford environment, expect a thorough evaluation of your risk management processes. Counterparties are increasingly viewed as a source of independent verification of information and events beyond just their contractual obligations to a fund and the managers and will be extensively queried as part of the due diligence process. A manager who resists providing access to its counterparties or who provides access but with conditions and limitations will be skeptically viewed by investors. Further, the new operating paradigm for even smaller private investment funds is to have multiple prime brokers and custodians as means to mitigate counterparty risk. In this vein, the increasing attraction of separately managed accounts is a trend that will continue throughout 2010 and beyond. The ability to coordinate these structures with other private capital pools with the same investment strategy advised by a fund manager can become increasingly challenging in this complex regulatory environment, and information pertaining to the integration of controls between the fund vehicles and managed accounts will be extensively probed.
In terms of regulation and enforcement, hedge funds and other forms of private pooled capital will continue in 2010 to come under substantial scrutiny from securities officials – a process which appears to have no clear end in sight. Looking back to calendar year 2009, we saw 22 pieces of major proposed legislation from the United States Congress impacting private investment funds, their advisers and certain kinds of investors such as pension funds. Eight of these Bills were announced in January 2009 alone. In addition to expected proposals in the area of Investment Adviser registration for hedge fund managers and disclosure of various management and portfolio information, we saw Bills presented in the areas of swaps/derivatives trading and market regulation, private fund registration and reporting, enhanced regulation of US financial markets (with an emphasis on identifying and singling out “systemically significant” market participants, including larger hedge funds), increased coordination of regulatory efforts between international regulatory bodies, enhanced protections and obligations for pension plans when investing plan assets of beneficiaries in private funds, curtailing various types of commodities speculation, taxation and reporting of offshore accounts and holdings, and of course, the dreaded initiative to change the favourable tax treatment of carried interest payments.

In July 2009, the White House and Treasury Department entered the fray with the release of the draft “Private Fund Investment Advisers Registration Act of 2009”. We saw definitive Bills from powerful committee chairmen Barney Frank and Christopher Dodd announced and/or voted on in the fourth quarter of 2009. We also saw the passage of major proposals from the US Securities and Exchange Commission regarding important operational areas such as custody of client assets, and the recently adopted “Hedge Fund Fraud Rule” (set forth in Advisers Act Rule 206(4) 8), that is applicable to investment advisers to “pooled investment vehicles”.
The flurry of 2009 legislative activity reached a crescendo in March 2010 with President Obama’s “Volcker Plan”, which in many ways attempts to roll back the separation of commercial and investment banking activities to the days prior to the 1999 enactment of the controversial Gramm-Leach-Bliley Act, which toppled the walls between these functional activities that had been established, ironically, after the Great Depression through the Glass-Steagall Act of 1933. With its Volcker Rule, the Treasury Department is proposing to limit the size and scope of US depository banking institutions (and their bank holding companies) by prohibiting them from owning, investing in, or sponsoring hedge funds, private equity funds, or proprietary trading operations. The proposal would require these bank holding companies to divest their existing hedge fund investments, and would impose requirements on fund managers to carefully monitor their affiliations with these US depository entities. While it is still early in the process and the Treasury proposal would need to be reconciled with existing legislative proposals from Chairmen Frank and Dodd, the move signals a deepening sense that some form of structural overhaul of the US financial markets is inevitable – and that hedge funds and other private pooled capital arrangements will not escape this reformation movement.
What specific areas of change should we expect in the regulatory landscape in 2010?
First and foremost, registration as investment advisers under the US Investment Advisers Act of 1940 for managers of most forms of private pooled capital (with the possible exception of managers to venture capital funds) is a virtual certainty. The days of the private advisers relying on “fewer than 15 clients” as an exemption to investment adviser registration will likely come to an end in 2010 with the elimination of rules allowing funds themselves to be counted as a single client – even if they have hundreds of underlying investors. Even if Congress passes legislation on this aspect of fund management, it will likely have a delayed effective date well into 2011 and possibly 2012, as well as a “grand-fathering” clause with respect to existing investors not having to meet heightened “qualified clients” standards applicable to registered investment advisers who are entitled to performance fees from their clients.
While we can debate the efficacy of increased regulation as a means of fulfilling the mission of protecting investors, from the vantage point of both federal and state regulators, in the absence of statutes mandating the registration of managers of private pooled capital, they have no means of obtaining even basic demographic data and information on these entities, their principals, the size and scope of the funds they manage and the impact of their activities on their counterparty relationships. Of course, the bottom line for fund managers is that registration and all its trappings will mean increased operating costs due to such things as hiring your own compliance personnel or paying an outsourced compliance company, properly maintaining your books and records, filing and updating your Form ADV and making sure you comply with its ongoing disclosure and delivery obligations, developing and following extensive policies and procedures regarding the valuation process and pricing methodology for you assets, as well as criteria for the use of ‘side-pocket’ accounts for hard-to-value and illiquid assets, using outside consultants to verify your performance claims and having multiple counterparties involved in handling your client assets. If you are a manager with custody over client accounts, you will have to deal with the heightened scrutiny, independent auditing and surprise examination requirements that come with the newly adopted SEC “Custody Rule”. In short, if you are a manager presently contemplating a new fund and are not accounting for the likelihood of needing a registered investment adviser as part of the fund structure, you are not getting the message.

Second, as part of the registration mandate, we may see an increase in the asset threshold for when a manager becomes eligible for SEC investment adviser registration. Under current US law, a manager with less than $25 million in client assets must register with its state regulator as an investment adviser if required under the laws of its home state and may not register with the SEC unless it exceeds this amount. This rule, enacted in 1997 as part of the “National Securities Markets Improvements Act” (which also amended the Investment Company Act to add the now-popular 3(c)(7) exclusion from the definition of investment company), was vehemently fought by state securities regulators, who felt the SEC was taking more turf than it could handle – a prediction which, in hindsight, was quite prescient. The association representing the interests of state securities regulators is making substantial headway in influencing the drafting of the regulatory proposals in Congress by having this “NSMIA threshold” raised from $25 million to somewhere in the range of $100 million or more. This would mean that significantly more early stage funds will become subject to state investment adviser statutes and rules. While state securities regulators are often erroneously viewed by many in the securities industry as children of a lesser god in comparison to their federal counterparts, many of these authorities, like those in the State of Connecticut, are highly activist when it comes to their inspection and enforcement authority and frequently have been the first responders on investor tips and complaints that could not get the attention of federal regulators.

Third, look for developments that may curtail access to sources of investment capital. These initiatives may take a variety of forms. For example, in response to kick-back scandals involving the New York Common Investment Fund, third party marketing firms may be allowed to call on public pension funds only if they are registered with the US Financial Industry Regulatory Authority (“FINRA”), and if FINRA agrees to establish procedures to prevent pay for play practices. We may also see a possible revival of the long-pending SEC proposal to raise the accredited investor standard, which has not been changed (even to adjust for inflation), since its adoption in 1982. The SEC’s proposal, first announced in December 2006, would amend the accredited investor definition to require that any natural person own at least $2.5 million in investments (in addition to meeting the current requirements of annual income in excess of $200,000 in each of the two most recent years for individuals or $300,000 if jointly with a spouse, plus have a reasonable expectation of achieving those levels in the current year) to be eligible to invest in private pooled capital arrangements. Also, we may see draft legislation requiring different treatment of public and private pension plan investors in private funds with respect to their redemption, liquidity and information rights or imposing heightened standards under the US Employee Retirement Income Security Act (“ERISA”) on pension fiduciaries themselves when investing in private pooled capital funds. A heightened threat of liability may prompt these investment officers to steer clear of private pooled capital vehicles.

In the examination and enforcement arena, look for continued SEC scrutiny of abusive short-selling, insider trading and other forms of market manipulations, side-pockets and valuation practices and disparate treatment of investors. Short-selling continues to be a hot-button for the SEC, as is seen in its recent adoption of the “Alternative Uptick Rule” restricting short sales in exchange-listed equity securities that experience a price decline of more than 10 per cent on any trading day from the prior trading day’s closing price. The SEC continues to pressure exchanges to require publication of “sort-sale related information”, which would include daily short-sale volumes of individual equity securities. Expect this area to continue to receive significant attention, with a special focus on managers who, directly or indirectly through employees or intermediaries, spread “false rumours” to drive down the stock price of a company shorted by the fund advised by the manager. Insider trading in all its forms continues to be a “top priority” for the SEC, and the sweeping indictments and guilty pleas in connection with the Galleon Fund case have bolstered the SEC’s resolve in this area. Expect to see continued emphasis at the examination level on internal controls governing the handling of material non-public information in proprietary, client and employee accounts, as well as with respect to “PIPEs” transactions which, due to their dilutive impact on existing stockholders and tendency to cause a drop in stock price when announced, create opportunities for manipulative short-selling.
Valuation practices and the mechanisms around side-pockets remain an area of high interest for the SEC following the liquidity paralysis of late 2008 and early 2009, and managers must be prepared to demonstrate the fairness of their process, pricing, and asset dispositions. Communications with investors around these events and the manager’s decisions is taking on an increasingly important role, as the SEC scrutinises more carefully the extent to which decision-making by managers with regard to their illiquid assets comports with investor expectations from the governing fund documents. In a similar vein, whether certain investors received preferential treatment with respect to events surrounding the imposition of gates or the suspension of redemptions and whether such actions were taken in a manner consistent with the governing fund documents is viewed as an area of continuing concern by SEC examiners. Expect SEC examiners also to review the governing documents against the historic and current portfolio composition for the purpose of assessing adherence to, or drift from, the fund investment program and strategy. Under the newly adopted Hedge Fund Fraud Rule, a proper motive (including that the drifted style was ultimately profitable) is not a defence to a claim of fraud based on making material misrepresentations (or omissions) to both investors and potential investors – meaning that adherence to the statements and expectations as set forth in the governing fund documents is a critical element of every manager’s operational controls. In all of these areas, the existence of ‘side letters’ and the extent to which they deviate from the governing fund documents will continue to be fertile ground for examination deficiencies, or more serious action.
To summarise then, the current ‘state of the industry’ for private pooled capital arrangements in the United States is not only one of repair and growth, but 2010 also seems the harbinger of an “era of realignment” in both the economic interests and operational expectations of fund managers and investors. Managers need to continually evaluate investor expectations as to fund governance and important investor rights such as transparency, liquidity, and communication. Opportunities will continue to abound for flexible, solid performing managers with a well-documented, institutionalised process, making the management of a hedge fund or private equity fund an attractive and highly rewarding profession for managers who can respond to this new world order.


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John A. Brunjes

John Brunjes is a partner in the Private Investment Funds Group of Bracewell & Giuliani LLP, resident in the Connecticut and New York offices, and heads the firm’s Fund Formation and Advisor Compliance practice. He handles a wide variety of investment-related securities law and transactional matters, and his clients include domestic US and international institutional and individual investors, leading and emerging hedge funds, private equity, venture capital and real estate funds and their managers, and other participants in the private investment funds industry.

John A. Brunjes
Partner, Private Investment Funds
Bracewell & Giuliani LLP
Goodwin Square, Suite 2600
225 Asylum Street
Hartford, Connecticut 06103
T. +1 (860) 256 8539
[email protected]