Category Archives: News and Commentary

Hedge Fund Stories and Analysis for the Week of October 5, 2008

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This past week has seen no shortage in the amount of articles on the hedge fund industry and the effect of the market and governmental events.  Below I’ve highlighted a few stories which I found particularly interesting and relevant for hedge fund managers.  Additionally, I think the following are points which hedge fund managers should be particularly aware of in light of recent events.

1. Hedge Fund Offering Documents are important. Most hedge fund offering documents are written very broadly and give the manager wide latitude in managing the fund.  The stories below highlight the important powers given to hedge fund managers.

2. Managers should start thinking of long term business continuity planning. While no one wants to think about and discuss what would happen during if the fund does have negative performance during the year, a well prepared manager will have a plan in place.  The stories below on blocked redemptions and re-negotiation of fees is showing us that managers were not prepared for the possibility of running a fund during lean times.  Managers should potentially think about retaining some performance fees in the management company so that they will be able to keep the doors open while trying to claw back to the high watermark.  Additionally, I believe that hedge fund due diligence will begin to include questions on how a manager would deal with a negative year.

Blocked Hedge Fund Withdrawals

A central concern for many market watchers (and investors) is whether hedge funds will have huge redemptions which would spark a sell off over the next couple of months.  We’ve seen some interesting items.  First, there is a fund which is actually blocking investor withdrawals in order to protect remaining investors from a fire sale of the fund’s assets (see story).

Restructure of Hedge Fund Performance Fees

As hedge fund managers see that the is the likliehood of negative returns this year, and the looming hedge fund high watermark provision, managers are rushing to cut deals with investors so that the funds can stay alive for the foreseeable future. According to a Wall Street Journal story, investors in the UK hedge fund RAB Capital agreed to “a three-year lockup in exchange for a management fee of 1% of assets and performance fee of 15% of returns, instead of 2% and 20%.”  The Stamford advocate reported that Camulos Capital LLC, a Greenwich-based hedge fund, and Ore Hill, a New York-based fund, among others, have restructured their fees to keep investors in their respective funds.

ABL Hedge Funds to step into the role of the banks?

If you listen to the news, and even the presidential candidates, you’ll hear about the “impending doom” in the banking industry – how mom and pop shops will not be able to get any loans to keep their business afloat.  While there have been many anectodes which suggest that this is, and is not, the case, it is likely that the banks will choose to pass on certain types of riskier loans, creating a great opportunity for non-traditional forms of finance.  Asset based lending is a hedge fund strategy in which the manager will make loans to business which will be backed by certain collateral, whether a receivable or some other physical asset.

I believe that we are going to see the launch of several asset based lending funds in the next few months and into the next year.  If the current banking climate remains how it is, asset based lending hedge funds might even become the next neighborhood banking center.  I have also previously written about the popularity of asset based lending hedge funds.

Hedge Fund Due Diligence 2.0

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We hear about the “web 2.0” and today’s San Francisco Chronicle used the term “Wall Street 2.0” which made me wonder what the hedge fund industry will look like after this mess clears itself over the next couple of months.  First, it is obvious that there is going to be government regulation of some sort over the hedge fund industry which I will be detailing over the coming weeks and months.  Additionally, investors are going to need to take proactive steps to protect their investments and hedge fund due diligence will become a greater part of the hedge fund industry – I’m dubbing this “Hedge Fund Due Diligence 2.0”.

Hedge Fund Due Diligence 2.0 is likely to include more questions on the hedge fund manager’s business acumen and operations.  The current crisis has showed us, in numerous circumstances, that hedge fund managers were simply not prepared to handle a complete market crisis.  Hedge fund managers already have to answer in depth questions relating to risk management policies and procedures, but these questions will likely become more in depth.  Specifically, Hedge Fund Due Diligence 2.0 will likely inquire into a manager’s specific cash management policies.  While this might be viewed as digging into the manager’s operational business (as opposed to just the managers performance results), it is necessary to protect an investor’s investment in the event that a high watermark provision is implicated.

More to come on this topic …

Overview of hedge fund short sale rules and likely fallout from recent events

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I received a request today to talk about hedge fund short sales and the likely fallout from the recent market disruptions and the failed bailout bill.

Short Sale Ban

The SEC has banned short sales on 800 individual securities.  These securities are generally within the financial services industry.  The ban on shorting these securities ends at 11:59 p.m. ET on Oct. 2, 2008. The SEC may extend the ban beyond this date if it deems an extension necessary in the public interest and for the protection of investors, but the SEC will not extend the ban for more than 30 calendar days in total duration.  (The SEC press release can be found here.)

Short Sale Disclosure Requirements

For hedge fund managers who are subject to 13F filings (i.e. those managers who manage $100mm or more), such managers will need to disclose their short positions by filing Form SH with the SEC.  More information on this can be found at 13F questions and answers or at the SEC’s website here. Please click here to view form-sh

Likely Fallout

There is so much uncertainty in the air right now.  Congress is having trouble trying to find some way to unfreeze the credit markets and money managers are just trying to find a way to stay afloat.  Additionally, as I mentioned this morning, investors are getting worried and are pulling cash out of hedge funds.  They way I see it, there are many scenarios which are likely to play out in the next couple of weeks and months:

1. Hedge fund redemptions – many investors are scared and are looking for safety right now.  While some managers are doing phenomenal in this wildly votile market, most are not and have not been doing well for much of the year.  I think that we’ll see in the coming days stories of large amounts of redemptions.

2. Hedge fund closures – as I discussed previously, because of the problems with the hedge fund high watermark, you are going to see money managers face the difficult decision of whether or not to keep their fund running.  Undoubtedly many managers will choose to close down their funds because of lack of capital (from redemptions and/or losses) or because they are too far under to make any money in the coming year.

3. Hedge fund regulation – while hedge funds have not faced the front page criticisms that the large investment banks and other financial institutions have seen over the past few weeks, the lawmakers have already began calling for investigations into the cause of this mess.  These investigations are likely to focus on systemic risks and how hedge funds may have contributed to the current market crisis.  As these reports begin spilling out over the next few weeks and months, I believe hedge funds will be a prime target and you are likely hear lawmakers facing re-election calling for more regulation.  [Please also note, Congress has indicated that it is more than willing to require more regulation of the financial markets as evidenced by its willingness to allow the CFTC to begin regulating the retail spot forex market.  For more information, please see this note from the CFTC. ]

4. Hedge fund start ups – over the next couple of months as funds begin to close down, successful traders will decide to go and start up their own hedge funds.  For these traders the transition to hedge fund manager will be difficult, but they will be able to be successful if they can find investors willing to invest in a start up hedge fund manager.  These traders will need to talk with a hedge fund attorney in order to get started with the hedge fund formation process.

5. Hedge fund due diligence will increase – hedge fund due diligence is one of the areas that is set to grow quickly.  I expect that investors, especially smaller institutional investors, will require greater risk management disclosure from hedge funds.  A simple manager back ground check is no longer going to be sufficient.

6. Hedge fund consolidations – while every now and again I will hear something about hedge fund consolidation, it never really seems to happen in any sort of large scale way.  This year may be different as smaller firms with decent track record decide to merge with more established funds with greater risk management procedures.

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

NFA sends request for financials to Commodity Hedge Funds

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Hedge fund managers which are licensed as commodity pool operators (CPOs) should have received an email from the NFA which requests certain financial information. While not disclosed on their website, the NFA sent a request on Friday to all of the CPO Members. Each member will need to make a filing which represents (i) the commodity pool has not suffered a drawdown of 25% or more since December 31, 2007 or (ii) the commodity pool’s actual drawdown numbers. CPOs will have until October 8 to make the filing. If you are a CPO and have not received this email request, you should contact the NFA immediately. If you did receive the request and have any questions, you should contact the NFA and/or your attorney immediately.

The NFA contact persons are:

Mary McHenry, Senior Manager, Compliance, ([email protected], or (312) 781-1420)

Tracey Hunt, Senior Manager, Compliance, ([email protected] or (312) 781-1284)

The request for information does not apply to pools which are exempt under CFTC Rule 4.13. For the whole email, please see below.

September 26, 2008

Important Request for CPOs

Due to current events in the global financial markets, NFA is requesting CPO Members to provide information by October 8, 2008 regarding the financial status of their pools. However, this request does not apply to any CFTC 4.13 exempt pools.

To see a list of the active pools NFA has on file for your firm, click on the following link and access the EasyFile system: https://www.nfa.futures.org/AppEntry/Redirect.aspx?app=EasyFilePool. (However, if you currently operate a pool that may be subject to this request, but it is not included in the EasyFile listing, you must notify one of the individuals listed at the end of this message.)

NFA is requesting certain financial information as of 9/30/2008 for each pool listed that has experienced a drawdown of 25% or more since December 31, 2007. For further instructions on completing the filing, see the information below regarding How to File.

For any pool that did not sustain such a drawdown, you must attest to this fact by deleting the filing request from the listing. For further instructions on deleting the request, see the information below under How to Delete a Request.

How to File: For each pool that has experienced a drawdown of 25% or more since December 31, 2007, you must use the EasyFile system to submit the pool’s key financial balances and Schedule of Investments, as well as a written representation on disclosure and withdrawal restrictions.

The key financial balances consist of the same summary categories you enter for year-end statements. The Schedule of Investments is an itemized listing of all investments that individually exceed 5% of NAV. NFA has created a standardized spreadsheet for this filing, which is available at https://www.nfa.futures.org/EASYFILE/Static/CPOSchedule.xls. Use this link to access the spreadsheet and then perform a “save as” to save the blank spreadsheet to your local computer. Once you complete the spreadsheet, upload it to NFA via the EasyFile system. Additionally, you must submit any written documentation your firm has provided to participants relating to any additional disclosure, including whether the firm has placed any restrictions on redemptions and, if so, a description of these restrictions. You should save this written documentation as a PDF file and then upload it to the EasyFile system as well.

How to Delete a Request: For any pool that does not meet the 25% threshold, you must delete the filing request in the EasyFile system. Detailed instructions on how to delete a filing request are included in the guide entitled “Help for Special 9/30/2008 Filing” on the initial Pool Index screen in the EasyFile system.
BY DELETING THE REQUEST, YOU ARE ATTESTING THAT THIS POOL DID NOT EXPERIENCE A DRAWDOWN OF 25% OR MORE SINCE DECEMBER 31, 2007. In addition, NFA will maintain a record of the deletion, as well as the user who performed it.

Thank you in advance for your cooperation. If you have any questions regarding this request, please contact one of the following individuals:

Mary McHenry, Senior Manager, Compliance, ([email protected], or (312) 781-1420) Tracey Hunt, Senior Manager, Compliance, ([email protected] or (312) 781-1284)

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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 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 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.

—————–

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.

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

SEC to hedge funds – show us your shorts

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In a time of unprecedented moves by the federal government, the SEC is halting short sales in certain financial stocks.  The SEC is also requiring large institutional investors, such as hedge funds, to show the world their short positions.  The press release can be found here.  The list of financial stocks which cannot be shorted by hedge funds can be found here.

SEC Halts Short Selling of Financial Stocks to Protect Investors and Markets
FOR IMMEDIATE RELEASE
2008-211
Commission Also Takes Steps to Increase Market Transparency and Liquidity

Washington, D.C., Sept. 19, 2008 — The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, today took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence. The U.K. FSA took similar action yesterday.

The Commission’s action will apply to the securities of 799 financial companies. The action is immediately effective.

SEC Chairman Christopher Cox said, “The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets. The emergency order temporarily banning short selling of financial stocks will restore equilibrium to markets. This action, which would not be necessary in a well-functioning market, is temporary in nature and part of the comprehensive set of steps being taken by the Federal Reserve, the Treasury, and the Congress.”

Today’s decisive SEC action calls a time-out to aggressive short selling in financial institution stocks, because of the essential link between their stock price and confidence in the institution. The Commission will continue to consider measures to address short selling concerns in other publicly traded companies.

Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets. At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation. Financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.

Given the importance of confidence in financial markets, today’s action halts short selling in 799 financial institutions. The SEC’s emergency order, pursuant to its authority in Section 12(k)(2) of the Securities Exchange Act of 1934, will be immediately effective and will terminate at 11:59 p.m. ET on Oct. 2, 2008. The Commission may extend the order beyond 10 business days if it deems an extension necessary in the public interest and for the protection of investors, but will not extend the order for more than 30 calendar days in total duration.

The Commission notes today’s similar announcement by the U.K. FSA. The SEC and FSA are consulting on an ongoing basis with regard to short selling matters and will continue to cooperate in carrying out regulatory actions.

The Commission also has taken the following steps to address the recent market conditions:

  • Temporarily requiring that institutional money managers report their new short sales of certain publicly traded securities. These money managers are already required to report their long positions in these securities.
  • Temporarily easing restrictions on the ability of securities issuers to re-purchase their securities. This change will give issuers more flexibility to buy back their securities, and help restore liquidity during this period of unusual and extraordinary market volatility.

The Commission may consider additional steps as necessary to protect the integrity and quality of the securities markets and strengthen investor confidence.