Author Archives: Hedge Fund Lawyer

More on Congress Talking to Hedge Funds

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Yesterday we wrote about the House Financial Services Committee requesting a hearing with certain hedge fund managers (see Barney Frank to Hedge Funds: See You on November 12).  Other news organizations also picked up on this story.  Below is a story from the website ohmygov.com, the original article can be found here.

BREAKING NEWS: Congress talking tough to hedge fund managers refusing to lower mortgage rates

The New York Times reported yesterday that two hedge funds are fighting proposals to ease the terms of home mortgages put forth by the government in H.R. 3221, a bill passed over the summer that gives flexibilities to some mortgage holders to renegotiate their rates. The hedge fund managers are arguing that such a move would hurt their investments.

Today, the House Financial Services Committee issued a press statement to these institutions expressing their “outrage” over the remarks of these hedge fund managers and their intentions to combat the private sector backlash to government programs aimed at preventing additional home foreclosures.

“For hedge funds, which have been the beneficiary of a lack of regulations and a very permissive attitude, now to put obstacles in the way of this important national policy is intolerable.  Because this is so important, and because this irresponsible, antisocial behavior by these hedge funds has such important implications, we have set a hearing of the Financial Services Committee for November 12, and we are inviting these companies as well as the Managed Funds Association to attend. If we are not able to get voluntary attendance, then we will pursue steps to compel them,” said members of the House Financial Services Committee.

The two funds, Greenwich Financial and Braddock Financial, intend to hold the companies issuing mortgages that they support through their financial instruments to their term rates. That means they’ll use their influence over mortgage companies to prevent the companies from lowering rates for struggling homeowners.

In his statement to the Times, William Frey, the president Greenwich Financial Services said that he was acting to protect the firm’s investments. “Any investor in mortgage-backed securities has the right to insist that their contract be enforced,” he said.

This position is unacceptable to House Financial Services Committee members, who feel the hedge funds are providing road blocks to healing a deeply troubled economy.

“What Congress passed overwhelmingly and President Bush signed last July provides for a reasonable modification of mortgages that clearly never should have been granted in the first place to avoid foreclosure and thus lessen the economic damage that a cascade of foreclosures has been doing to our economy…We believe the law clearly allows for modification where such changes would involve a lesser loss than foreclosure, and the benefits to the whole economy of such an approach are obvious.”

According to the House Financial Services website, H.R. 3221, The American Housing and Foreclosure Act:

  • Provides mortgage refinancing assistance to keep families from losing their homes, protect neighboring home values, and help stabilize the housing market.
  • Expands the FHA program so many borrowers in danger of losing their home can refinance into lower-cost government -insured mortgages they can afford to repay.  This legislation will help troubled borrowers avoid foreclosure while minimizing taxpayer exposure.
  • Only primary residences are eligible: NO speculators, investment properties, second or third homes will be refinanced.
  • Protects taxpayers by requiring lenders and homeowners to take responsibility.  This is not a bailout; in order to participate, lenders and mortgage investors must take significant losses by reducing the loan principal.  In exchange for an FHA guarantee on the mortgage, borrowers must share any profit from the resale of a refinanced home with the government.
  • Contains important protections for taxpayers’ dollars, including higher refinancing fees that establish a new FHA reserve to cover possible losses from defaults on these government-backed mortgages.
  • Provides $230 million for financial counseling to help families stay in their homes.

If other companies join the attitudes of these two hedge funds in fighting government bailout bills, a second wave of panic might overtake the financial markets, which have already factored government interventions into their calculations. Any deviations at this point, and in this tumultuous market, would send stocks spiraling downward even further.

Barney Frank to Hedge Funds: See You on November 12th

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As we’ve previously noted, Congress is chomping at the bit to regulate hedge funds.  An article in the New York Times yesterday regarding hedge fund managers opposing mortgage modifications “outraged” the House Financial Services Committee.  Because of this “irresponsible” and “antisocial” behavior, Congress has summoned the funds mentioned in the NYT article to a hearing on November 12th.  The tone of the Congressional announcement is definately antagonistic, something that the hedge fund industry does not need at this time.  The press release, reprinted below, can also be found here.

For Immediate Release: October 24, 2008

Chairmen Frank, Kanjorski, Maloney, Waters, Gutierrez and Watt Demand Hedge Funds Drop Opposition to Foreclosure Prevention

November 12th Financial Services Committee Hearing Announced

Washington, DC – House Financial Services Committee Chairman Barney Frank (D-MA), along with Capital Markets, Insurance and Government Sponsored Enterprises Subcommittee Chairman Paul E. Kanjorski (D-PA), Financial Institutions and Consumer Credit Subcommittee Chairwoman Carolyn Maloney (D-NY), Housing and Community Opportunity Subcommittee Chairwoman Maxine Waters (D-CA), Domestic and International Monetary Policy Trade and Technology Chairman Luis Gutierrez (D-IL), and Oversight and Investigations Subcommittee Chairman Melvin Watt (D-NC), expressed their “outrage” at the report in the New York Times today that at least two hedge funds have warned companies servicing mortgages they should not take advantage of a bill passed by Congress and signed by the President aimed at reducing the rate of foreclosure:

“What Congress passed overwhelmingly and President Bush signed last July provides for a reasonable modification of mortgages that clearly never should have been granted in the first place to avoid foreclosure and thus lessen the economic damage that a cascade of foreclosures has been doing to our economy.  In drafting this legislation, we consulted with a wide range of consumers, industry, and government regulatory groups, and we believe we adopted a reasonable proposal. Indeed, we have been criticized by some in the consumer community for not doing more to pressure institutions to avoid foreclosure while minimizing their losses.  In light of this, we were outraged to read that two hedge funds, Greenwich Financial Services and Braddock Financial Corporation, are instructing the servicers of their mortgages to defy this national program and to insist on further socially and economically damaging foreclosures. We believe the law clearly allows for modification where such changes would involve a lesser loss than foreclosure, and the benefits to the whole economy of such an approach are obvious.”

“For hedge funds, which have been the beneficiary of a lack of regulations and a very permissive attitude, now to put obstacles in the way of this important national policy is intolerable.  We have written to these two hedge funds and to the Managed Funds Association as well, strongly urging them to reverse this policy which will have such negative impacts on the economy.  Because this is so important, and because this irresponsible, antisocial behavior by these hedge funds has such important implications, we have set a hearing of the Financial Services Committee for November 12, and we are inviting these companies as well as the Managed Funds Association to attend.  If we are not able to get voluntary attendance, then we will pursue steps to compel them.

“Many in the financial community have objected to the argument many of us have made that homeowners should be allowed to invoke the protection of the bankruptcy laws on single family residences, as they are on second and third homes.  The argument in the financial community has been not only that this would be damaging, but that it would not be necessary to achieve the economically desirable result of reduced foreclosures.  But the decision of these two companies actively to oppose our efforts to achieve voluntary compliance quickly undercut that argument, and people in the financial community should not be surprised if this sort of blatant refusal to show any cooperation whatsoever with our efforts leads to an increased demand for much tougher legislation.”

Other related HFLB articles include:

Overview of the Investment Company Act of 1940

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The Investment Company Act of 1940 (the “Investment Company Act”) is what gives structure to the hedge fund industry.  The Investment Company Act provides very strict regulations for entities which are “investment companies” such as mutual funds. While hedge funds do fall within the definition of “investment company” they will seek an exemption from the registration provisions because such restrictions are onerous. This article provides an overview of certain aspects of the Investment Company Act including the reason hedge funds seek exemption from the registration provisions and the definition of “investment company”.  In depth discussion of the exemptions for hedge funds under the Investment Company Act can be found elsewhere on this website.

Reason to seek exemption – Onerous Regulation

While the advantage for a mutual fund is that they can publicly advertise investments in their shares, there are many regulations which the mutual fund must follow.  These include:

  • Mutual funds must register their securities under the Securities Act and Investment Company Act, this is a long and very costly process.
  • Mutual funds must have a Board of Directors and 75% of the Board must be independent.  The Board must approve and vote on various items related to the mutual fund, include 12b-1 fees.
  • Mutual funds have certain investment restrictions.  Form example, mutual funds use of leverage is limited; there are percentage restrictions on investment into other mutual funds and hedge funds
  • Mutual funds have daily net asset value (NAV) calculations and daily redemptions.  Because of the possibility of daily redemption the mutual fund must keep a certain amount of cash available at all times.
  • Mutual funds can only be advised by a registered investment advisor.

Definition of Investment Company

Section 3(a)(1) of the Investment company act as follows:

When used in this title, “investment company” means any issuer which (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Exemption from registration under Section 3(c)(1)

Please see Section 3(c)(1) Hedge Funds

Exemption from registration under Section 3(c)(7)

Please see Section 3(c)(7) Hedge Funds

In addition to the above sections, below is the SEC’s description of the Investment Company Act of 1940 and its important provisions.  This description can also be found here.

Investment Company Act of 1940

This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments. The full text of this Act is available at: http://uscode.house.gov/download/pls/15C2D.txt (Subchapter I). (Please check the Classification Tables maintained by the US House of Representatives Office of the Law Revision Counsel for updates to any of the laws.)

Pooled Investment Vehicles – Non-Traditional Hedge Fund Strategies

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The term “hedge fund” is really a misnomer as most hedge funds are not hedged.  A better term would be pooled investment vehicle.  Traditional types of pooled investment vehicle structures include hedge funds, private equity funds, venture capital funds, real estate funds, and “hybrid” funds (funds which combine components of the above).

This article is going to discuss other types of non-traditional hedge funds, that is hedge funds which do not fall within the typical types of hedge fund securities trading strategies (long/short equity, multi-strategy, global macro, fixed income, equity market neutral, managed futures, etc). As more people become familiar with hedge funds and become interested in investing in them, managers will begin to create funds to fit specific demographics.  The following are interesting projects which can be accomplished through the hedge fund (or pooled investment vehicle) structure:

Green Hedge Funds – in a vein similar to the Vice Fund*, hedge funds can concentrate their investments in any specific hot area. Green companies is currently a hot area and many people are already calling a bubble in “green” companies, at least in the private equity space.  According to this article by Richard Wilson, mandates at institutional level to invest in “green” hedge funds are expected to significantly increase in the coming years.

Horse Racing Hedge Funds – there are two ways that a fund like this would work.  First, the hedge fund can actually pool investor money and then the manager would place bets on various horses through various betting establishments.  With a fund like this the sponsor would need to make sure to disclose the exact nature of the program so that any legal or gambling issues could be vetted before the hedge fund launch.  Second, the hedge fund could buy racing horses and then race them for profit.  There are already these types of pooled vehicles out there and they are usually have a private equity structure with capital calls.

Gambling or Online Gambling Hedge Funds – with the rise in popularity of Texas Hold-em on television and the proliferation of online gambling there has been discussion of hedge funds devoted to making money from this phenomenon.  Basically this would be done through pooling money and then allocating to traders (live or online) who would then play with money.  With a fund like this there are many issues, not the least of which is the illegality of gambling in much of the US and online.  It is likely that a gambling attorney would need to be brought in to opine on the issue of the legality of such a fund.

Sports Betting Hedge Fund – like the gambling hedge fund, sports betting presents a very attractive opportunity for potential hedge fund managers.  A couple of years back Mark Cuban discussed the idea of a sports betting hedge fund on his blog (blog post).  While his fund never got off the ground, I have heard of other potential hedge fund sponsors trying to get a fund like this launched.  I have not yet heard of a successful fund like this, but I think it is just a matter of time.

Lottery Hedge Fund – about a year and a half ago I had the idea of starting a lottery hedge fund which would pool money to buy a large amount (or all possible number combinations) of number combinations at one of the very large lottery drawings.  While it is feasible to create a fund to do this, there are many technical issues which would need to be resolved if a fund like this was to launch.

Charitable Hedge Funds – while not necessarily having a different strategy from traditional hedge funds, these charitable hedge funds would take a portion of their profits and devote them to charitable causes.  Presumably the sponsor of a charitable hedge fund would create such a fund for his network of friends and family, all of whom would have similar views on the nature of the charitable donation.

Shariah Compliant Hedge Funds – such funds have become more over the past couple of years and are expected to continue such growth in the future.

Other Issues – in general, establishing a non-traditional hedge fund or pooled investment vehicle will involve the same basic steps as forming a hedge fund (see Start Up Hedge Fund Timeline).  The key issue is what type of assets the fund will buy and sell.  The nature of the assets will necessarily drive the structure.  These are they types of issues you would discuss with your attorney, include whether the manager will need to be registered as an investment advisor. Other articles of interest may include:

* The Vice Fund is a mutal fund which invests in domestic and foreign companies engaged in the aerospace and defense industries, owners and operators, gaming facilities as well as manufacturers of gaming equipment, manufactures of tobacco products and producers of alcoholic beverages.  The website can be found here.

The Beginning of Hedge Fund Regulation…

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As much as it is despised by all in the industry, it is likely that hedge fund regulation will be coming to the U.S.  Today the House Oversight Committee interviewed three very important regulations as part of an examination into the role of federal regulators in the current financial crisis.  Congress will interview Former Federal Reserve Chairman Alan Greenspan, Former Treasury Secretary John Snow and SEC Chairman Christopher Cox.  Hopefully these three will be able to stem the rising tide of hedge fund regulation rhetoric and help congress to realize that hedge funds are not the problem.

From the House website:

Committee Holds Hearing on the the Role of Federal Regulators in the Financial Crisis
Table of Contents

The Committee is holding a hearing titled, “The Financial Crisis and the Role of Federal Regulators” at 10:00 a.m. on Thursday, October 23, 2008, in 2154 Rayburn House Office Building. The hearing will examine the roles and responsibilities of federal regulators in the current financial crisis.

From the SEC website:

Chairman Christopher Cox to Testify

Chairman Cox will testify before the House Committee on Oversight and Government Reform on Thursday, October 23, 2008, at 10:00 a.m. at the Rayburn House Office Building, Room 2154, concerning “The Role of Federal Regulators”.

Distressed Debt Fund of Hedge Funds to be Launched Soon

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As many hedge funds scramble to keep investor’s from redeeming and/or proposing to restructure the terms of the fund, other funds are getting ready for the next wave of hot investments: distressed assets.

As evidence that money will be moving into these areas is a story by Reuters about a new launch of a distressed debt fund of funds.  According to the article, the fund of funds will invest in other distressed asset hedge funds and will have a two year lock up person.  GAM chief executive David M. Solo told Reuters that “We are completing a thorough review of a range of the best managers in the U.S. and Europe so as to create a diversified vehicle to benefit from this unique opportunity.”

While this is the first article I have seen announcing a fund of funds focusing on this asset strategy, there are likely to be more of these fund of funds launching in the future.  The New York Times also ran a story this morning about “vulture investors” sitting on the sidelines for now.  While the NYT article discusses players biding their time, it also notes that the “volume of loan portfolios sold in the first three weeks of October has already beaten the previous monthly record.”  This indicates that the area is heating up and is likely to be a popular strategy near the end of this year and the beginning of next.  Additionally, other types of credit based funds, like asset based lending funds, are likely to be popular in the next year as the credit markets continue to be locked.

Investing in distressed assets has always been one of the central hedge fund strategies.  These investments might include investing in distressed debt and other types of distressed assets.  One of the bigger issues for investors in distressed asset hedge funds is going to be lock-up period.  Because the asset class is not as liquid, the lock-up for investors is going to be longer, as it will generally be in the hedge fund industry going forward.

Other relevant articles include:

Schedule 13D

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Below is information from the SEC’s website on Schedule 13D which can be found here.  Generally, hedge fund managers who must file Schedule 13D will have their hedge fund attorney submit this filing for them on their behalf.  Additionally, there may be other legal issues which arise and so it is advisable for the manager to discuss all aspects of an investment subject to the filing requirements of Section 13(d) of the Securities Exchange Act.

Schedule 13D

Schedule 13D is commonly referred to as a “beneficial ownership report.” The term “beneficial owner” is defined under SEC rules. It includes any person who directly or indirectly shares voting power or investment power (the power to sell the security).

When a person or group of persons acquires beneficial ownership of more than 5% of a voting class of a company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D with the SEC. (Depending upon the facts and circumstances, the person or group of persons may be eligible to file the more abbreviated Schedule 13G in lieu of Schedule 13D.)

Schedule 13D reports the acquisition and other information within ten days after the purchase. The schedule is filed with the SEC and is provided to the company that issued the securities and each exchange where the security is traded. Any material changes in the facts contained in the schedule require a prompt amendment. The schedule is often filed in connection with a tender offer.

You can find the Schedules 13D for most publicly traded companies in the SEC’s EDGAR database. You can learn how to use EDGAR to find information about companies. You can find an HTML version of the Schedule and download a PDF version for easier printing.

For more information, please contact us.  Additional information can be found:

Hedge Fund Capital – How to Raise Assets for a Hedge Fund

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The biggest issue for start up hedge funds (and also established hedge fund managers) is how to grow assets under management.  Growing a hedge fund’s capital base is very important because increased AUM mean both increased management fees and performance fees (assuming the fund has positive performance returns).   This article focuses on traditional avenues of raising capital for a hedge fund.

Raising Hedge Fund Capital – Friends and Family

Most hedge funds raise capital to start up through their friends and families.  Often this can be a significant sum, other times it can be relatively small.  I have seen some hedge funds start with as little as $500,000 and sometimes less.  Often, after a hedge fund has a few months of performance (assuming again positive performance) these friends and family members will invest more money.  Other friends and family members, who did not originally invest, may also decided to invest.  Family members of investors may also be persuaded to invest in the hedge fund.

Generally investments from friends and family are completed fairly quickly and through less formal conversations than from other types of investors.  However, the hedge fund manager must always make sure that the friends and family have the fund’s offering documents and have made the appropriate representations in the subscription documents.

After an initial investment from friends and family, it is important for a start up manager to focus on the trading as it is most important to have a good 6-12 month track record that you will be able to market to other potential investors.

Raising Hedge Fund Capital – High Net Worth Individual Investors

High net worth investors (generally qualified purchasers as well as some qualified clients and accredited investors) often invest in hedge funds.  High net worth investors will usually have legal and investing teams which will vet the managers and the strategy.  Usually there will at least be a minimum amount of due diligence requests on the manager and the fund.  Managers can be introduced to high net worth investors through their own networks or through other channels such as hedge fund conferences, hedge fund databases or through other means.

Raising Hedge Fund Capital – Institutional Investors

Institutional investors will occasionally invest in hedge funds with a track record shorter than one year.  Generally in these cases the hedge fund sticks out to them for various reasons.  Such reasons might be that the hedge fund performance was just spectacular, or the institutional investor likes the way the particular investment strategy fits within the institution’s allocation design, or the hedge fund manager may have a strong pedigree which appeals to the institutional investor.

Whatever the reason, getting an investment from an institutional investors is usually a longer and more in depth process than receiving money from friends and family or from a high net worth investor.  The hedge fund manager will need to first establish a meeting with the institutional investor.  Generally the meeting will be at the office of the institution and the manager will have a certain amount of time to give his pitch, usually through a pitchbook presentation.  Some managers of the institution will look carefully at these presentations; others will not even open the cover.  However, the hedge fund manager should be ready to answer any number of different questions from the institution regarding the program.  Such questions will likely cover the following topics: risk management procedures, expected performance in down markets, performance analytics, etc.  The hedge fund manager should act composed and answer each question directly and completely – this is the time for the manager to show his knowledge of the investment strategy and sell the strategy to others.

Either before or after the meeting with the institution, the hedge fund manager will likely be asked to complete some basic due diligence.  I’ve outlined a sample request in this article: Institutional Hedge Fund Due Diligence.  After the institution has interviewed and vetted a manager it may take some time before the institution actually invests in the fund.  This happens for a variety of reasons and the hedge fund manager is urged to stay patient during the process.

Non-tradtional forms of raising hedge fund capital

I will be discussing other ways to raise capital in subsequent articles.  Such non-traditional ways include: utilizing the services of a third party marketer, capital introduction services, hedge fund conferences, and hedge fund databases.

Legal Implications of Raising Capital for a Hedge Fund

As most hedge fund managers know, under the Regulation D offering rules managers cannot raise capital through any type of general advertising or solicitation.  This means that they cannot: buy advertising in any financial publications, advertise generally on the internet (but please see article on Hedge Fund Websites), cold call potential investors and or engage in other similar activities.  Additionally, hedge fund managers, and others raising money for hedge funds, must be aware of and abide by all broker-dealer regulations.  This is a very important issue, so please discuss it with your hedge fund attorney (please see Guide to Broker-Dealer Registration).

Please contact us if you have a story on raising capital for you hedge fund – we would like to hear your story and potentially profile your fund on our blog.  Other articles which are related to items in this article include:

Hedge Fund Manager – Information on Hedge Fund Managers

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I have seen many hedge fund managers and, like the investment strategies they pursue, each one is different.  This article will attempt to discuss hedge fund managers in general, if you have any specific questions, please feel free to contact us.

Who are hedge fund managers?

In general hedge fund managers are people who have a strong conviction about their certain investment program and who are willing to put their money where their mouth is so to speak.  At any given time there are any number of different ways to make money and because of this we have a chance to see all types of hedge fund managers, even those who go against conventional wisdom.

What types of backgrounds do hedge fund managers have?

I have seen all types of hedge fund managers.  Many were traders at other investment advisory firms or were brokers at a broker or investment bank.  Many managers were previously employed outside of the financial industry and traded for themselves on the side – managers like this have often found a program that works and want to allow their friends, family and other investors participate in the investment program and potential gains.  Some hedge fund managers were involved in real estate and choose to run a real estate hedge fund or some sort of hybrid hedge fund.  Some managers have relatively less experience in managing money and will act as a kind of sponsor of the hedge fund – participating in the business aspects of the hedge fund like raising assets.

Most all hedge fund managers will have at least a college degree.  Many hedge fund managers, and analysts, will also have a Masters in Business Administration (MBA).  Some hedge fund managers will be former professionals such as doctors or lawyers.  It is also common to see a manager with a third party designation like a Chartered Financial Analyst (CFA) which is bestowed by the CFA Institute.

Are there any exam or qualification requirements to be a hedge fund manager?

There are no specific requirements to be a hedge fund manager, but depending on the domicile of the manager he may need to be registered as an investment advisor with the state securities commission or the SEC.  If a manager was required to be registered as an investment advisor, he would likely need to have the Series 65 exam license or the Series 7 and Series 66.  Depending on the nature of the hedge fund and the extent of the hedge fund’s activities, the manager may need to have the Series 7 and the fund, or a related company, would need to be registered as a broker-dealer.

Is there anything hedge fund managers cannot do?

Generally a hedge fund manager can mold his investment program as he sees fit.  However there are two specific items to note.  First, the manager should be careful when trading that he stays within the description of the trading program.  Especially in these very volatile times, investors are very aware of style drift and managers should be very cognizant of this.

Second, the hedge fund manager cannot violate any laws while trading.  The federal securities laws apply to hedge fund managers who are not registered as investment advisers in certain instances.  In addition to out and out fraud, the manager should not engage in any activities which he is not sure is legal.  If there are any questions, the hedge fund manager should consult a hedge fund attorney.

What are the common qualities of hedge fund managers?

The number one commonality between hedge fund managers is a desire to see their program and ideas come to fruition.  Another trait which is common to hedge fund managers is a very strong work ethic.

What about pedigree?

You will often hear advisors and consultants talk about pedigree, especially hedge fund marketers.  To these groups the term “pedigree” essentially means the strength of the manager’s bio.  A manager who went to Harvard undergrad, Harvard MBA and then worked for Goldman Sachs will have a strong pedigree.  It is generally going to be easier for a manager with a strong pedigree to get his foot in the door with regard to institutions and high net worth investors.

However, having a strong pedigree does not guarantee a hedge fund manager will be able to sell his hedge fund to investors.  Indeed, I have seen firsthand instances where a manager with a strong pedigree did very poorly in front of institutional investors.  Likewise, I have seen where a manager with a less strong pedigree shot the lights out during an institutional investor presentation.  All this is to say that while pedigree is important in the eyes of some, it will not necessarily help a hedge fund manager to raise assets and of course, once a manager has assets, the manager must perform.

Start up hedge fund managers

If you are a start up hedge fund manager, you will first need to discuss the hedge fund formation process with a hedge fund attorney.  Some other articles which provide background on many of the subjects covered in this article include:

Hedge Fund Side Pocket Investments

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Overview of Side Pockets

In general hedge fund side pocket investments are illiquid investments which the hedge fund manager places into a side pocket account.  Mechanically the side pocket account is simply an entry on the hedge fund’s books which is tracked separate from the liquid, non side pocket investments.  The structure is flexible so that an asset can be deemed a side pocket asset at any time – either at the time of purchase or at a later date.  Typically a follow-on investment to an investment in a side pocket account will also be placed in the side pocket.  Hedge fund managers will usually place an outside limit on the amount of assets which can be placed in the side pocket investments, usually calculated as a percentage of the fund’s assets and based on the purchase price of the side pocket investment. There are potentially additional issues for side pocket accounts in a master-feeder structure which should be discussed by the hedge fund attorney.

The actual mechanics of the side pocket account will be discussed in the hedge fund offering documents.  It is advisable that the manager discuss the side pocket provision with the administrator and the auditor as well to make sure that all of the service providers are comfortable with the mechanics of the account.

The following asset types are usually good candidates for side pocket accounts:

  • Real Estate
  • PIPEs
  • Thinly traded securities
  • Private Equity investments
  • Any follow-on investment related to the above

Reasons for the side pocket account

The main reason to have a side pocket investment is so that the manager does not get under or overpaid from a valuation before an investment is sold.  For instance, if the manager held a piece of property in a non-side pocket account it would be difficult to find a valuation for the property at the end of a performance fee period.  Because managers are paid a performance fee (or allocated gains) on unrealized as well as realized investments, there is the potential for the manager to overstate the hedge funds unrealized gains by overvaluing the piece of property.

Another characteristic of the side pocket account is that a withdrawing investor cannot receive any part of his investment which is in the side pocket account.  This allows the manager the flexibility to sell an illiquid asset on the manager’s terms and not merely to satisfy an investor’s redemption request.  Once the side pocket investment is liquidated, appropriate distributions are made to the investor which has made a previous redemption.

Please feel free to contact us with any questions.  Other articles which relate to this subject include: