Hedge Fund Hotels

Office Space, IT, Trading For Start up Hedge Funds

The term hedge fund hotel generally describes the offering of office space, IT and consulting services (including, potentially, capital introduction) for start up hedge fund managers.  Most of these relationships are established as turn-key solutions for managers which provide them the back-office infrastructure to run a hedge fund without the headaches of managing the development and maintenance of such infrastructure.  Many times the rent is discounted and the managers are encouraged to utilize the services of the group that is providing the hedge fund hotel.  Groups which typically provide these hedge fund hotel relationships include prime brokers, banks, and other hedge fund service providers or consultants.  These relationships are not without controversy and

Issues with Hedge Fund Hotels

One of the major issues with hedge fund hotels is that they will pay below market rate for office space and IT which implicates issues is similar to soft dollar issues.  Managers who use soft dollars need to be very cognizant of the conflicts of interest which may arise in soft-dollar contexts, especially if the manager has any ERISA fiduciary duties.  Likewise, managers who have hotel relationships need to be cognizant of issues related to conflicts of interests with regard to brokerage and execution.  Because managers will normally choose (and periodically review) their brokers based on a variety of criteria (such as pricing/speads/commissions, execution of orders, financial strength of the broker, available research, etc.), the fact that they receive (in certain cases) reduced rent should not influence the manner in which they decide upon brokerage.  In theory it is easy to say, but in practice it is hard to do.  As such, there have been a few recent controversy’s which have acknowledge the potential conflict of interest issues with these relationships.

Hedge Fund Hotel Controversy

In 2007 the Massachusetts Securities Division filed an action against UBS for its activities related to it running a hedge fund hotel.  Below are a couple of excerpts from the UBS Hedge Fund Hotel Administrative Complaint:

Other than hedge fund adviser, prime brokers are the primary third party service providers to hedge funds.  Prime brokers provide a suite of services essential to the successful implementation of hedge funds’ individual objectives.  Prime Brokers generate substantial revenue from those hedge fund clients in exchange for these services.  UBS competes for prime brokerage revenue in part by providing a range of benefits to the advisers of those hedge fund clients to induce the advisers to bring and keep the hedge fund business with UBS.  Among the methods UBS used to influence or reward hedge fund advisers and their principals are: Provision of office space to hedge fund advisers at rates that are substantially below market rate; Free access to information technology personnel and other office personnel; Introductions to potential new clients (that would increase management fees for the adviser); Low interest personal loans; and Tickets to sporting events and other forms of entertainment.

Unbeknownst to the pension funds, university endowments, charitable foundations, institutional investors and individuals who invest in hedge funds, the rewards for the hedge fund advisers come implicit and sometimes explicit quid pro quos.  UBS requires the hedge fund advisers to cause the hedge funds they manage to meet certain benchmarks of profitability for UBS or ensure they do not use other prime brokers.

Page 2-3 of the complaint

Later on in the complaint, the Enforcement Section of the Massachusetts Securities Division provides the following definition of prime brokerage and the fees generated by prime brokers.

“Prime Brokerage is a service provided by certain broker-dealers to facilitate the clearance of securities trades and other services to substantial retail and institutional customers, including hedge funds.  The services offered by Prime Brokers may include: trading, securities lending, margin lending, customized reporting; research; valuation; technology; operations services; and other services needed by hedge funds or other large clients.

Prime Brokers generate revenue on hedge fund business from commissions, spreads, administrative fees, ticket charges, stock loans and credit interest earned from providing position financing and arranging securities loans (“Prime Fees”).

In the Prime Brokerage relationship, the client who pays the Prime Fees is the hedge fund.  The Hedge Fund Adviser is an agent of the hedge fund, acts on behalf of the hedge fund and has fiduciary duties to the hedge fund.

Page 9 of the complaint

Conclusion

Hedge fund hotels actually can provide valuable services to start up hedge funds during a very important part of the hedge fund life cycle.  However, there are a number of disclosure issues which must be addressed and which should be discussed in detail in the hedge fund offering documents.  The managers should discuss their brokerage/hotel relationship with their hedge fund attorney who will help them to identify and properly disclose the various compliance and conflicts issues which may be present.  Additionally, when a hedge fund and manager reaches a certain place in the fund growth/lifecycle, they may want to explore paying market rates for their space and/or moving to another location.  These issues should be contemplated by management in consultation with the hedge fund attorney.

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

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