Private fund offering documents are dense. They are loaded with legal terms. We’re kicking off an A to Z guide to the private fund investment process that contains definitions you won’t find in any offering document. In this first installment, we’re covering A through C. Stay tuned for future posts, as we will continue this series — all the way to Z.
A is for Asymmetric Bargaining Power
A private fund is an economic bargain. A manager agrees to provide investment management services and investors agree to pay certain fees and expenses and bind themselves to other investment terms.
In my opinion, practices associated with the private fund investment process now result in a significant disparity in bargaining power that favor managers. These practices include issues with fund expenses and manager indemnification.
B is for Background of Manager Personnel
In a study focused on hedge fund operational risks, a group of researchers reviewed Form ADV for 879 hedge fund managers.* Form ADV is used by managers to register with the SEC. As part of the study, the researchers analyzed how many managers had checked off an Item 11 matter to their Form ADV. Item 11 to Form ADV discloses certain prior “bad acts” conducted by a manager’s personnel (e.g., felony or securities fraud convictions).
Of the 879 managers analyzed, 14.3% checked off an Item 11 matter. Assuming that 879 is a reasonable statistical sample size for the larger pool of SEC registered hedge fund managers, and the 14.3% figure is still accurate, this research implies that one in every seven registered hedge fund manager may have some prior Item 11 “bad act” associated with it.
C is for Creeping Liability Terms
When reviewing a private fund’s offering documents, it pays to focus not only on what the documents say, but also where the terms are placed. A subscription agreement is used for investor suitability and administrative purposes. To the extent an investor lies in a fund’s subscription agreement about its suitability to make the investment, a logical request by a manager is to be indemnified for the harm that may result.
However, there has been a trend to expand this clause to now include manager indemnification for the litigation costs incurred in connection with certain litigation matters brought against it by investors.
Investors should consider two questions related to this indemnification expansion: First, as a procedural matter, why are important investor liability issues emerging in subscription agreement documents, and not in fund agreements where investor indemnification issues are dealt with? Second, what are the merits of a manager imposing a one-way indemnification liability on private fund investors for certain litigation actions pursued?
* “Estimating Operational Risk for Hedge Funds: The w-Score” Stephen Brown, William Goetzmann et al., Yale ICF Working Paper No. 08-08, May, 2008.