Author Archives: Hedge Fund Lawyer

Hedge Fund Redemptions and the Gate Provision

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It is no secret that many funds are hurting this year and that many investors are getting ready to, or have, pulled money from many hedge funds.  According to a New York Times article this morning, these redemptions are likely to cause managers to sell securities which may in turn further depress prices.  While the time period for hedge fund-of-funds redemptions has likely passed (FOFs usually require 95 days prior notice for redemption), redemption notices for normal hedge funds are due by tomorrow (assuming a 90-day notice period and end of year or quarter redemptions).

If your fund is feeling the pressure of quite a few redemptions, there are a couple of standard safeguards which are usually built into the hedge fund offering documents.  These provisions include the hedge fund gate provision and a general catch-all provision.  In general, the gate allows redemption requests to be reduced to a certain percentage of the fund’s total assets during any redemption period.  For example, if the fund has a gate of 15% and investors request redemptions which equal 20% of a fund’s NAV, then all redemption requests will be reduced pro rata until only 15% of the redemption requests are met.  The catch all provision allows a hedge fund manager to halt redemptions if certain catastrophic market events take place.  Depending on how the hedge fund offering documents are drafted, the current market situation may or may not apply and you should discuss this with your lawyer.

How to handle invoking a gate provision

In the next few days, managers will be getting a good idea of how much of the fund will be redeemed.  If a decision is made to invoke the gate provision, the manager should discuss this option with his attorney.   The attorney will help the manager decide the best course of action with regard to reducing the redemption amount, which will probably include writing a letter of explanation to the investors.  While each fund’s situation is different, that letter should probably include the expected amount of the reduction as well as a description of the authority (in the offering documents) for the reduction.  Additionally, you should also invite questions directly – it is during times like these when investors get scared and then start talking to their own attorneys.  It is much better to be candid and upfront than to receive a nasty letter from an attorney in the future.

Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

SEC ends CSE program for investment banks

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Last week Goldman and Merril announced that they were going to convert to bank holding companies.  A good article on  the conversion, including questions and answers, can be found here. An interesting consequence of the change is that the SEC’s Consolidated Supervised Entities (CSE) program is no longer necessary.

The CSE was a unique program where the SEC would supervise the very large investment banking firms from the inside. While the program was voluntary, it was designed to identify potential issues in the devolpmental stage.  However, because the SEC really had no authority to recieve certain reports from the investment banks, the program could only do so much and as we’ve seen, the program failed to protect against the meltdown of both Bear and Lehman.

Chairman Cox will definately take some heat for what the CSE program did not accomplish (see this article), however, it is not presently clear whether he deserves the blame.  As his statement below indicates, the SEC had no explicit governmental oversignt of the major investment banks which would allow them to really act as a regulator for these entities.   What is scary about this is that, if congress listens to Cox, there may be a rush toward over-regulation – Cox is already calling for the regulation of the currently unregulated CDS market. If there is more regulation in the future it is unclear what governmental agency will be in charge of such regulation as the SEC is already overburdened and underfunded.

The statement by Cox below can be found here.


Chairman Cox Announces End of Consolidated Supervised Entities Program
FOR IMMEDIATE RELEASE
2008-230

Washington, D.C., Sept. 26, 2008 — Securities and Exchange Commission Chairman Christopher Cox today announced a decision by the Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.

Chairman Cox made the following statement:

The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act, it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.

Because of the lack of explicit statutory authority for the Commission to require these investment bank holding companies to report their capital, maintain liquidity, or submit to leverage requirements, the Commission in 2004 created a voluntary program, the Consolidated Supervised Entities program, in an effort to fill this regulatory gap.

As I have reported to the Congress multiple times in recent months, the CSE program was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.

The Inspector General of the SEC today released a report on the CSE program’s supervision of Bear Stearns, and that report validates and echoes the concerns I have expressed to Congress. The report’s major findings are ultimately derivative of the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.

With each of the major investment banks that had been part of the CSE program being reconstituted within a bank holding company, they will all be subject to statutory supervision by the Federal Reserve. Under the Bank Holding Company Act, the Federal Reserve has robust statutory authority to impose and enforce supervisory requirements on those entities. Thus, there is not currently a regulatory gap in this area.

The CSE program within the Division of Trading and Markets will now be ending.

Under the Memorandum of Understanding between the SEC and the Federal Reserve that was executed in July of this year, we will continue to work closely with the Fed, but focused even more clearly on our statutory obligation to regulate the broker-dealer subsidiaries of the banking conglomerates. The information from the bank holding company level that the SEC will continue to receive under the MOU will strengthen our ability to protect the customers of the broker-dealers and the integrity of the broker-dealer firms.

The Inspector General’s office also made 26 specific recommendations to improve the CSE program, which are comprehensive and worthy of support. Although the CSE program is ending, we will look closely at the applicability of those recommendations to other areas of the Commission’s work and move to aggressively implement them.

As we learned from the CSE experience, it is critical that Congress ensure there are no similar major gaps in our regulatory framework. Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately $60 trillion credit default swap (CDS) market, which is regulated by no agency of government. Neither the SEC nor any regulator has authority even to require minimum disclosure. I urge Congress to take swift action to address this.

Finally, I would like to commend the extraordinary efforts of the SEC’s diligent staff, who for so many months have been working around the clock in the current market turmoil. Their dedication and commitment in behalf of investors and the American people are unequaled.

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Hedge Fund 13F Filings

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Many people talk about watching hedge funds through their 13F filings. A 13F filing is a quarterly report filed with the SEC by “institutional investment managers.” The reports include the name and number of the securities owned by the hedge fund. The term “institutional investment manager” means those managers who exercise discretion over $100 million or more in Section 13(f) securities. Typically a hedge fund attorney will help the manager file Form 13F.

A summary of Form 13F requirements from the SEC is below and can be found on the SEC’s website here.

Form 13F—Reports Filed by Institutional Investment Managers

Institutional investment managers who exercise investment discretion over $100 million or more in Section 13(f) securities must report their holdings on Form 13F with the SEC.

In general, an institutional investment manager is: (1) an entity that invests in, or buys and sells, securities for its own account; or (2) a person or an entity that exercises investment discretion over the account of any other person or entity. Institutional investment managers can include investment advisers, banks, insurance companies, broker-dealers, pension funds, and corporations. Section 13(f) securities generally include equity securities that trade on an exchange or are quoted on the Nasdaq National Market, some equity options and warrants, shares of closed-end investment companies, and some convertible debt securities. The shares of open-end investment companies (i.e., mutual funds) are not Section 13(f) securities.

Form 13F requires disclosure of the names of institutional investment managers, the names of the securities they manage and the class of securities, the CUSIP number, the number of shares owned, and the total market value of each security.

You can search for and retrieve Form 13F filings using the SEC’s EDGAR database. To find the filings of a particular money manager, use the “Companies & Other Filers” search under “General Purpose Searches” and enter the money manager’s name. To see all recently filed 13Fs, use the “Latest Filings” search function and enter “13F” in the “Form Type” box.

The securities that institutional investment managers must report on Form 13F are found on what is known as the Official List of Section 13(f) Securities. The Official List is published quarterly and is available for free on the SEC’s website. It is not available in paper copy format or on computer disk.

You can learn more about Form 13F filings, as well as obtain a copy of the Form and instructions, and the applicable statutory and regulatory provisions, by reading Frequently Asked Questions About Form 13F prepared by the SEC’s Division of Investment Management.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Citibank to hedge funds – no bank accounts for you…

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A client just informed me that Citibank will not consider opening a bank account for a hedge fund as of today.  Evidently Citibank’s compliance department thinks that being associated with hedge funds, even if it is merely through a simple bank account, is not wise in this climate.  I will be discussing this issue with some of my other banking contacts to see if this is the case at other institutions and will report back on this story.

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CFTC Fines Hedge Funds for Failure to File Annual Report with NFA

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Certain hedge funds which trade futures and/or commodities as part of their investment program are deemed to be commodity pools and the hedge fund management company must register with the NFA as a commodity pool operator (CPO).  Registered CPOs must file annual reports with the NFA and such reports must be sent to investors in the fund.  Generally this will need to be done within either 45 or 90 days after the end of the fund’s fiscal year.  If a CPO needs extra time to file the report, it can request an extension from the CFTC.

In the cases below, each of the CPOs had filed for and were granted extensions.  Even with these extensions, however, they were not able to file their reports.  The NFA evidently takes such an infraction very seriously as the fines were stiff – ranging from $75,000 to $135,000.  Such a potential monetary penalty should make CPOs especially eager to file the appropriate reports on time.

CFTC Rule 4.22 includes the following major provisions.

  • must distribute an Annual Report to each participant in each pool that it operates, and must electronically submit a copy of the Report and key financial balances from the Report to the National Futures Association pursuant to the electronic filing procedures of the National Futures Association
  • Annual Report must be sent to pool participants within 45 calendar days after the end of the fiscal year
  • financial statements in the Annual Report must be presented and computed in accordance with generally accepted accounting principles consistently applied and must be certified by an independent public accountant

If you are a hedge fund manager registered as a CPO you should make sure you understand this and other CFTC rules.  If you have any questions on the rules or other CPO requirements, including possible CPO exemptions, you should have a conversation with your attorney so that you know what needs to be filed and when so that you can avoid harsh fines like the ones below.

The CFTC release below can be found here.

Release: 5555-08
For Release: September 24, 2008

CFTC Sanctions Four Registered Commodity Pool Operators for Failing to File Timely Commodity Pool Reports with the National Futures Association

Mansur Capital Corp., Persistent Edge Management, LLC, Stillwater Capital Partners, Inc., and Stillwater Capital Partners, LLC Ordered to Pay a Total of $330,000 in Civil Monetary Penalties

Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) today simultaneously filed and settled charges against four registered commodity pool operators (CPOs), charging them with failing to distribute to investors and file with the National Futures Association (NFA) one or more of their respective commodity pools’ annual reports in a timely manner. Mansur Capital Corporation of Chicago, Persistent Edge Management, LLC of San Francisco, California, and Stillwater Capital Partners, Inc. and Stillwater Capital Partners, LLC, both of New York, were charged in the CFTC action.

The CFTC orders require the CPOs to pay civil monetary penalties in the following amounts: Mansur, $75,000; Persistent Edge, $120,000; and Stillwater I and Stillwater II to jointly and severally pay $135,000.

Under CFTC regulations, CPOs are required to file annual reports with the NFA and distribute them to each pool participant. This must be done within a prescribed period after the close of their pools’ fiscal years. An annual report is designed to “provide [pool] participants with the information necessary to assess the overall trading performance and financial condition of the pool.” (See Commodity Pool Operators and Commodity Trading Advisors, Final Rules, 44 Fed. Reg. 1918 [CFTC Jan. 8, 1979], re the adoption of Rule 4.22.) According to the CFTC orders, without timely reporting, the CFTC’s goal of providing pool participants with complete and necessary data is hampered.

The CFTC orders find that each of the four CPOs operated one or more commodity pools, including pools that operated as funds-of-funds. While each of the CPOs had obtained extensions of the prescribed deadlines for various pools and reporting years, each failed to timely comply with its obligations, in violation of CFTC regulations.

The following CFTC Division of Enforcement staff are responsible for this case: Camille M. Arnold, Alan I. Edelman, Ava M. Gould, Susan J. Gradman, James H. Holl, III, Diane M. Romaniuk, Scott R. Williamson, Rosemary Hollinger, Gretchen Lowe, and Richard B. Wagner.

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

SEC Wins another Hedge Fund Fraud Case – Provides Insight to Hedge Fund Managers

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Hedge fund fraud cases are important because they give some definition and life to the various investment advisor and hedge fund laws.  Much of the advice that hedge fund lawyers give to their clients is based on reasonableness and best guesses on how the securities laws will be implemented in the hedge fund context.  For many hedge fund issues there are not clear cut cases which give color to the securities laws.  One of my colleagues refers to this as the “square peg – round hole” dilemma by which he means it is hard to apply the archaic securities laws with the current state of the hedge fund and investment management industry.

When the SEC does bring cases, as practitioners we get to see how the SEC views the securities rules and how we should be advising clients. While many of the fraud cases represent completely unbelievable actions by unscrupulous people, there are still lessons which well-intentioned managers can learn from.

Specifically this case gives us an opportunity to examine five separate areas which invesment managers should be aware of:

1.    Make sure all statements in the hedge fund offering documents and collateral marketing materials is are accurate.

In this case the hedge fund offering documents contained many material misstatements including materially false and misleading statements in offering materials and newsletters about, among other things, the Funds’ holdings, performances, values and management backgrounds.  For example the complaint alledges:

Specifically, both PPMs represented that most investments made by Partners and Offshore would trade on “listed exchanges.” In truth, a majority of those funds’ investments were and are on unlisted exchanges such as the OTCBB or pink sheets. Furthermore, the Partners’ PPM stated that investors would receive yearly audited financials upon request. Partners has not obtained audited financials since the year ended 2000 and repeatedly refused at least one investor’s requests for audited financials for the year ended 2001.

2.    Make sure all appropriate disclosure relating to personnel are made.

Hedge fund attorneys will usually spend time with the manager discussing the employees of the management company and their backgrounds.  During this time the attorney will ask the manager, among other questions, whether any person who is part of the management company has been involved in any securities related offense.  In this case there were two specific items which the manager should have disclosed in the offering documents and other collateral material:

Failed to disclose that a “consultant” to the management company was enjoined, fined and also barred from serving as an officer or director of a public company for five years for his fraudulent conduct involving, among other things, misallocating to himself securities while serving as CFO and later president of a publicly traded company.

Failed to discloase a member of the fund’s board of directors was barred from associating with any broker or dealer for 9 years.

3.    Take care when going outside stated valuation policies.

Many hedge fund documents have stated valuation policies but then allow the manager to modify the valuation, in the manager’s discretion, to better reflect the true value of the securities.  However, when a manager uses this discretion, the manager should have a basis for the valuation.  Such valuation should not be based on an artificially inflated value of the asset.  To be safe managers should probably have some internal valuation policies which should be in line with generally accepted valuation standards for such assets.  I found the following paragraph from the SEC’s complaint particularly interesting (emphasis added):

II. Bogus Valuations

34. In order to obtain at least year end 2001 audited financials for Offshore, Lancer Management provided Offshore’s auditor with appraisals valuing certain of that fund’s holdings. These appraisals mirrored or closely approximated the values assigned to Offshore’s holdings by Defendants based on the manipulated closing prices at month end. These valuation reports were, however, fatally flawed and did not reflect the true values of Offshore’s holdings under the generally accepted Uniform Standards of Professional Appraisal Practice or American Society of Appraisers Business Valuation Standards. For example, the valuations were improperly based on unreliable market prices of thinly traded securities; unjustified prices of private transactions in thinly traded securities; unfounded, baseless and unrealistic projections; hypotheticals; and/or an averaging of various factors. Indeed, under accepted standards of valuing businesses, certain of the Funds’ holdings were and/or are essentially worthless.

4.    Do not engage in market manipulation.

Many of the securities in which this hedge fund invested were traded on the OTCBB.  The fund engaged in trading in these securities near valuation periods in order to artificially inflate the price of these very thinly traded securities.  Additionally, the complaint alleges many incidents of “marking the close.”  This goes without saying but a hedge fund manager should not engage in market manipulation.

5.    Always produce accurate portfolio statements.  Do not overstate earnings.  Always make sure that statements to investors are accurate.

Enough said.

While many of the examples above are so egregious they probably do not need to be listed on a “do not” list, you should make sure you do not engage in any of these activities. Additionally, if you do make some error or mistake (for example, if a valuation turns out to be incorrect or inaccurate), immediately contact your attorney to create a plan to inform investors about the incorrect or inaccurate statements.  A mistake can generally be cured, all out fraud cannot.

I have posted a full text version of the SEC’s case, SEC v. Lauer.  I have included the statement by the SEC below which can be found here.

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SEC Wins Major Hedge Fund Fraud Case Against Michael Lauer, Head of Lancer Management Group

FOR IMMEDIATE RELEASE
2008-225

Washington, D.C., Sept. 24, 2008—The Securities and Exchange Commission announced that a district court judge today granted its motion for summary judgment against the architect of a massive billion-dollar hedge fund fraud.

Michael Lauer of Greenwich, Conn., was found liable for violating the anti-fraud provisions of the federal securities laws. In a 67-page order, The Honorable Kenneth A. Marra, U.S. District Judge for the Southern District of Florida, found that Lauer’s fraud as head of two Connecticut-based companies – Lancer Management Group and Lancer Management Group II – that managed investors’ money and acted as hedge fund advisers was “egregious, pervasive, premeditated and resulted in the loss of hundreds of millions of dollars in investors’ funds.”

Linda Chatman Thomsen, Director of the SEC’s Division of Enforcement, said, “This case highlights the SEC’s ongoing efforts to combat hedge fund fraud and our dedicated work on behalf of investors to ensure that hedge fund managers are held accountable for any unlawful conduct.”
David Nelson, Director of the SEC’s Miami Regional Office, added, “We are particularly gratified at this decision, which resulted from several years of hard work to protect investors, starting when we successfully halted the fraud while it was still ongoing.”

Lauer raised more than $1.1 billion from investors and his fraudulent actions caused investor losses of approximately $500 million. The SEC initially won emergency temporary restraining orders and asset freezes against Lauer and his companies, which were placed under the control of a Court-appointed receiver after the SEC filed its enforcement action in 2003.

During the protracted litigation, the SEC successfully stopped Lauer from diverting or hiding millions of dollars of assets from the Court’s asset freeze.

The summary judgment order found that Lauer:

  • Materially overstated the hedge funds’ valuations for the years 1999 to 2002.
  • Manipulated the prices of seven securities that were a material portion of the funds’ portfolios from November 1999 through at least April 2003.
  • Failed to provide any basis to substantiate or explain the exorbitant valuations of the shell corporations that saturated the funds’ portfolios.
  • Hid or lied to investors about the Funds’ actual holdings by providing them with fake portfolio statements.
  • Falsely represented the funds’ holdings in newsletters.

The judge’s order entered a permanent injunction against Lauer against future violations of Sections 17(a)(1)-(3) of the Securities Act of 1933 (Securities Act), Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (Exchange Act), and Sections 206(1) and (2) of the Investment Advisers Act of 1940 (Advisers Act). The order reserved ruling on the SEC’s claim for disgorgement with prejudgment interest against Lauer, and on the amount of a financial penalty Lauer must pay. The SEC is seeking a financial penalty and disgorgement of the more than $50 million Lauer received in ill-gotten gains from his fraudulent scheme.

SEC brings fraud charges against investment advisor in connection with hedge fund investments

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Investment advisors who recommend hedge fund investments should be very careful to disclose all material agreements between the advisor and the hedge fund and hedge fund manager.  In the case below an investment advisor recommend hedge fund investments to its clients without disclosing to such clients that the advisor was receiving a part of the performance fees that were paid to the hedge fund manager.

Advisors should also take note to the following two issues:

SEC jurisdiction over state registered investment advisors

Even though the advisor was registered with the California Securities Regulation Division and not the SEC, the SEC was able to take action under Section 206 (the anti-fraud provisions) of the Investment Advisers Act.  Additionally the SEC was able to bring charges against the investment advisor under the Securities Act of 1933 and the Securities Exchange Act of 1934 (the “Exchange Act”).  This shows that the SEC’s has quite a few methods to assert jurisdiction over non-SEC registered advisors.

Potential violations of broker registration requirements?

Although I have not yet had a chance to read the unreleased complaint, I am wondering why the SEC did not charge this group with violating the broker registration requirements.  I think there is an argument that the investment advisory firm was acting as a broker.  I checked FINRA’s broker check and the firm did not come up as a registered broker.

Section 15(a)(1) of the Exchange Act generally makes it unlawful for any broker or dealer to use the mails (or any other means of interstate commerce, such as the telephone, facsimiles, or the Internet) to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security” unless that broker or dealer is registered with the Commission in accordance with Section 15(b) of the Exchange Act.

The release below can be found here.

U.S. SECURITIES AND EXCHANGE COMMISSION
Litigation Release No. 20737 / September 24, 2008

Securities and Exchange Commission v. WealthWise, LLC and Jeffrey A. Forrest, United States District Court for the Central District of California, Civil Action No. CV 08-06278 GAF (SSx)

SEC Charges California Investment Adviser With Committing Fraud While Recommending Hedge Fund to Clients

The Securities and Exchange Commission today charged a San Luis Obispo, Calif.-based investment adviser and its owner with fraud for failing to disclose a material conflict of interest when recommending that their clients invest in a hedge fund that made undisclosed subprime and other high-risk investments.

The SEC alleges that WealthWise LLC and its principal Jeffrey A. Forrest recommended that more than 60 of their clients invest approximately $40 million in Apex Equity Options Fund, a hedge fund managed by Salt Lake City-based Thompson Consulting, Inc. (TCI). According to the SEC’s complaint, WealthWise and Forrest failed to disclose a side agreement in which WealthWise received a portion of the performance fee that Apex paid TCI for all WealthWise assets invested in the hedge fund. From April 2005 to September 2007, WealthWise received more than $350,000 in performance fees from TCI. Apex collapsed in August 2007, and WealthWise clients lost nearly all of the money they invested.

The SEC’s complaint, filed in federal district court in Los Angeles, charges WealthWise and Forrest with violating Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1) and 206(2) of the Investment Advisers Act of 1940. The SEC seeks an injunction, an accounting of the total amount of performance fees WealthWise received from TCI, disgorgement of those fees, and financial penalties.

On March 4, 2008, the SEC filed a civil action in federal district court in Salt Lake City against TCI and three of its principals in connection with the collapse of Apex and another hedge fund.

What happens if a hedge fund doesn’t do proper diligence to ascertain that a client meets the qualified purchaser standards?

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This question came to us yesterday:

Question: What happens if a hedge fund doesn’t do proper diligence to ascertain that a client meets the qualified purchaser standards? Does the hedge fund have to register or notify the SEC?

Answer: In practice I don’t know how this would happen unless someone at the hedge fund management company was completely asleep at the wheel.

The job of the hedge fund attorney is to provide the hedge fund offering documents to the manager and to inform the manager of how the offering documents should be completed.  The hedge fund’s subscription documents usually include some sort of investor questionnaire where the investor will need to make certain representations to the hedge fund manager.  One of these representations will be whether the investor is an accredited investor and, if the fund is a 3(c)(7) fund, whether the investor is a qualified purchaser.  When the investor returns the subscription documents (and before the investor has sent a wire to the fund), the manager should make sure that the offering documents have been completed in their entirety and correctly.  If a manager has a question about whether the investor has completed the subscription documents correctly, the manager should bring up such questions or concerns with the hedge fund attorney.  In the event that the manager does not receive properly completed subscription documents, the manager should discuss this issue immediately with the attorney.

I cannot think of any reason why a hedge fund manager would have to register as an investment advisor because of incomplete (or improperly completed) subscription documents.

Hedge fund performance fees – is it time to rethink the high watermark?

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There are many news stories out covering what may be a worst case scenario for many hedge funds – the distinct possibility of no performance fees this year.  This seems to be a major topic of conversation for many people within the industry and just yesterday I received the following comment with a link to a Wall Street Journal article discussing this issue.

The comment:

Regarding performance fees: the underlying hedge funds naturally also have high performance fees. But in the current climate, they aren’t making them. “Just one in 10 hedge funds is currently receiving performance fees from their funds.” See: http://blogs.wsj.com/deals/2008/09/22/fee-slump-hits-hedge-funds/

Unfortunately, with the current market conditions, many funds are going to be feeling the pressure of little to no performance fees at the end of the year.  For many hedge fund managers, the problem is compounded by the fact that their asset management fee is simply not enough to keep the business going.  Many managers cannot keep operations going with only the management fee.  Without performance fees, hedge fund managers may have their operations disrupted for a number of reasons, including the fact that for some, the traders will be expecting bonuses no matter the performance of the fund as a whole.  If these traders don’t receive bonuses, then some hedge funds could see talent drain, to the extent that such traders thought they could receive greater compensation at other firms or by starting their own fund.

Still worse, managers who have negative performance numbers at the end of the year will have another issue to deal with – the high watermark.  The high watermark is a concept designed as an investor-friendly provision that essentially prevents a manager from taking a performance fee on the same gains more than once.  The high watermark is a similar concept to the clawback provision in a private equity fund.

When a fund suffers a significant drawdown during a performance fee period, the high watermark will actually create a perverse incentive for the investment manager – either take extra risk to generate higher returns so that there will be a performance fee in the next performance fee period or close down the fund and start again.  Both of these potential actions would be taken to the detriment of the investor, and the investor may only have the choice of making a redemption or letting the investment ride. 

If the manager does shut his doors, the investor is going to have his assets at risk as the hedge fund wind-down takes place.  Depending on the hedge fund’s strategy, the wind-down could subject the fund to a fire sale of its assets which will reduce the value of the investment even further.  If such investor was to move into another hedge fund, he would step into the new fund with a high watermark equal to his investment and would be subject to performance fees on those assets anyway. Because such a turn of events is detrimental to such an investor, it might make sense for such investors to allow for some sort of modification of the high watermark.

Some potential alternatives to the standard hedge fund highwatermark might include the following:

No high watermark – this is probably not a viable solution as it would afford investors absolutely no protection from paying two sets of performance fees on the “same” gains.  Additionally, without the threat of the high watermark, there would be little deterrent for a manager to improperly manage risk.  Additionally, because the highwatermark provision is one of the most uniform provisions in the hedge fund industry, it is unlikely to simply disappear.  (Although I have seen a couple of funds which actually did not have the provision.)

Modified high watermark – I have seen all types of variations within the performance fee structure and the withdrawal structure, but the high watermark is one provision which is generally resistant to modification. The high watermark could potentially be modified in many ways including the following:

Reset to zero – under certain circumstances, that if stated in the offering documents prior to investment, the investment manager can be given the ability to reset the high-watermark to zero.

Amortization – one potential way could be to “amortize” the losses over a 2- or 3-year period so that some performance fees can be earned on a going forward basis.  Additionally, if the investor chose to withdraw before the end of the high watermark amortization period, there could be some sort of clawback.

Rolling – the high watermark can be taken under certain circumstances over a rolling period.  The concept is that the high watermark will be determined for a certain window so a drawdown would in essence be erased after a certain amount of time has elapsed.  This might work better for those funds that have a monthly or quarterly performance fee period.

Resetting to zero and an amortization reduction method could be both potentially valuable to investors as it will keep a manager in the game and it will reduce the incentive for a manager to abandon risk management procedures. Also, management companies may be willing to decrease fees if investors agree to keep their investment in the fund for a certain amount of time after the reset or amortization.

[HFLB note: any new investors coming into a fund during a performance fee period will have an initial high watermark that is equal to the initial investment value; depending on the time of the contribution and when the fund made its losses, there may be some performance fees paid even during a down year for such incoming investors.]

Further Resources

Another good article and some good comments on the article can be found here.

For an interesting academic paper on this subject, please click here. The paper is by William N. Goetzmann, Yale School of Management.  The abstract for the paper states:

Incentive or performance fees for money managers are frequently accompanied by high-water mark provisions which condition the payment of the performance fee upon exceeding the maximum achieved share value. In this paper, we show that hedge fund performance fees are valuable to money managers, and conversely represent a claim on a significant proportion of investor wealth. The high-water mark provisions in these contracts limit the value of the performance fees. We provide a closed-form solution to the high-water mark contract under certain conditions. This solution shows that managers have an incentive to take risks. Our results provide a framework for valuation of a hedge fund management company.

We conjecture that the existence of high-water mark compensation is due to decreasing returns to scale in the industry. Empirical evidence on the relationship between fund return and net money flows into and out of funds suggest that successful managers, and large fund managers are less willing to take new money than small fund managers.

Chairman Cox talks to the Senate regarding hedge funds and the markets

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There has been so much news and volitility over the past couple of weeks that it is hard to get a feeling of where things are headed.  It seems pretty clear, however, that this in this brave new world of government sponsored capitalism there is likely to be more hedge fund regulation in the picture.  Look forward to some interesting articles that we have coming up and this article on Chairman Cox’s statements to Congress.

This morning the Securities and Exchange Comission’s Chairm Christopher Cox testified to the Sentate Committee on Banking, Housing, and Urban Affairs regarding the current market events. Pertinent excepts from the speech follow:

On the new short sale rules

Last week, by unanimous decision of the Commission and with the support of the Secretary of the Treasury and the Federal Reserve, the SEC took temporary emergency action to ban short selling in financial securities. We took this action in close coordination with regulators around the world. At the same time, the Commission unanimously approved two additional measures to ease the crisis of confidence in the markets that threatened the viability of all financial firms, and which potentially threatened the ability of our markets to function in a fair and orderly manner. The first makes it easier for issuers to repurchase their own shares on the open market, which provides an important source of liquidity in times of market volatility. The second requires weekly reporting to the SEC by hedge funds and other large investment managers of their daily short positions — just as long positions are currently reported quarterly on Form 13F.
All of these actions relying upon the Commission’s Emergency Authority under Section 12(k) of the Securities Exchange Act remain in effect until October 2, and are intended to stabilize the markets until the legislation you are crafting becomes law and takes effect.t

The Commission’s recent actions followed on the heels of new market-wide SEC rules that more strictly enforce the ban on abusive naked short selling contained in Regulation SHO. These new rules require a hard T+3 close-out; they eliminate the options market maker exception in Regulation SHO; and they have put in place a new anti-fraud rule expressly targeting fraudulent activity in short-selling transactions.

On Bear Stearns

Recently the Commission brought enforcement actions against two portfolio managers of Bear Stearns Asset Management, whose hedge funds collapsed in June of last year. We allege that they deceived their investors and institutional counterparties about the financial state of the hedge funds, and in particular the hedge funds’ over-exposure to subprime mortgage-backed securities. The collapse of the funds caused investor losses of over $1.8 billion.

On monitoring the large investment banks

The SEC’s own program of voluntary supervision for investment bank holding companies, the Consolidated Supervised Entity program, was put in place by the Commission in 2004. It borrowed capital and liquidity measurement approaches from the commercial banking world — with unfortunate results similar to those experienced in the commercial bank sector. Within this framework, prior to the spring of 2008, neither commercial bank nor investment bank risk models contemplated the scenario of total mortgage market meltdown that gave rise to, for example, the failure of Fannie Mae and Freddie Mac, as well as IndyMac and 11 other banks and thrifts this year.

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But beyond highlighting the inadequacy of the pre-Bear Stearns CSE program capital and liquidity requirements, the last six months — during which the SEC and the Federal Reserve have worked collaboratively with each of the CSE firms pursuant to our Memorandum of Understanding — have made abundantly clear that voluntary regulation doesn’t work. There is simply no provision in the law that authorizes the CSE program, or requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to SEC requirements regarding leverage. This is a fundamental flaw in the statutory scheme that must be addressed, as I have reported to the Congress on prior occasions.

Because the SEC’s direct statutory authority did not extend beyond the registered broker dealer to the rest of the enterprise, the CSE program was purely voluntary — something an investment banking conglomerate could choose to do, or not, as it saw fit. With each of the remaining major investment banks now constituted within a bank holding company, it remains for the Congres.s to codify or amend as you see fit the Memorandum of Understanding between the SEC and the Federal Reserve, so that functional regulation can work.

On the CDS Markets

The failure of the Gramm-Leach-Bliley Act to give regulatory authority over investment bank holding companies to any agency of government was, based on the experience of the last several months, a costly mistake. There is another similar regulatory hole that must be immediately addressed to avoid similar consequences. The $58 trillion notional market in credit default swaps — double the amount outstanding in 2006 — is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market. This is an area that our Enforcement Division is focused on using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer outsized incentives to market participants to see an issuer referenced in a CDS default or experience another credit event.

Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based.   Certainly we