We kick off a new video series: “The Process of Hedge Fund Investing.” In Part I, Yarden Law Founder Nir Yarden describes his background, along with the importance of filling a critical legal void for investors.
All posts by Nir Yarden
Director Independence: The Critical Issue
A study on hedge fund operational due diligence reports that the lack of independent directors on a fund’s board is a major reason why investors will veto a hedge fund investment.* Seems simple enough, but what does director independence really mean in the context of alternative private fund investing?
The challenge in answering this question is two-fold:
First, issues associated with private fund directors typically relate to foreign jurisdictions. One example is the Cayman Islands, where funds are often organized as corporate entities, versus the U.S., where partnership or LLC vehicles are typically used to organize private funds. Putting money into corporate entities in offshore jurisdictions that have historically been pro-manager-oriented means that U.S. investors must be sensitive to differences in foreign corporate governance standards to protect their interests.
Second, foreign independent fund directors in places like Cayman Islands are often associated with companies whose business is to provide directors to numerous funds in order to make money. While these companies may hold themselves out as providing “independent” directors, their livelihood is dependent on the good will of managers and their service providers to generate business.
Even though industry practice has evolved to the point where some fund boards now have three directors — two of whom are not affiliated with the fund’s manager — the term independent director may ring hollow unless investors can answer one important conflict-of-interest question:
Do the independent directors of an offshore fund stand to gain any financial benefit either directly (e.g., more board appointments from the same manager) or indirectly (e.g., the offshore company that they’re affiliated with receiving more board appointments) by voting in favor of a manager’s proposal?
Can you answer this question with respect to the alternative private funds that you’re currently invested in?
*Deutsche Bank, A Study of Investor Operational Due Diligence, Autumn 2012
Who Leaves First When a Manager or Fund Has Serious Problems?
The “Tell,” Part 1
Like a poker player, an investor may read the “tells” that an alternative investment manager and private fund provide in the absence of disclosure to protect its interest. Here’s one “tell” to consider:
Bad things can happen when fund principals scale back or cease their involvement with a private fund, such as a hedge fund or private equity fund. Investors protect against this downside risk through the use of “key person” legal provisions.
An area that gets less attention is the comings and goings of back office manager personnel who play important roles in areas like fund finance, accounting, and compliance. While these folks aren’t “key persons,” similar to portfolio managers, they may have exposure to material negative information on a fund or manager related to bad performance or regulatory matters long before investors find out about it.
If bad enough, these negative events may result in back office personnel voluntarily leaving a fund or manager to find better opportunities.
Monitoring the comings and goings of these employees through ongoing legal due diligence and the side letter process may provide a valuable legal and investment “tell” on the overall state of a manager or fund. After all, who has an easier time leaving a fund or manager due to material negative issues without raising attention? A “key person” portfolio manager with a substantial personal stake in a fund? Or a back office employee who is essentially an “at-will” employee with access to sensitive information?
Top 10 Quotes to Assist Decision-Making – and an Old Joke
When it comes to decision-making in investment law, we have a lot to say. Of course, sometimes someone else has already said it best. Here are quotes that inspire and humor us; hopefully they will help you along the way.
- “Once is happenstance. Twice is coincidence. Three times is enemy action.” – Ian Fleming
- “Anytime 4 New Yorkers get into a cab together without arguing, a bank robbery has just taken place.” – Johnny Carson
- “You can follow the action, which gets you good pictures. You can follow your instincts, which’ll probably get you in trouble. Or you can follow the money, which 9 times out of 10 will get you closer to the truth.” – From the movie Two Jakes, Robert Towne screenwriter
- “Everyone believes very easily whatever he fears or desires.” – Jean de la Fontaine
- “A desk is a dangerous place from which to view the world.” – John Le Carre
- “Whenever there is any doubt, there is no doubt.” – From the movie Ronin, by David Mamet screenwriter
- “Whom God would destroy, he first strikes blind” – A quote from a World War II German officer whose troops were about to be destroyed by the Red Army, expressing frustration at the German General Staff’s inability to properly assess field intelligence.
- “Men easily miss what is right under their eyes, that concealment can often be found in the obvious and that in some cases the most direct approach can become the least expected” – Basil Liddell Hart
- “The work of Wall Street often is to introduce people who should not borrow to people who should not lend.” – Quote appearing in The Wall Street Journal
- “Emanuel Lasker, a famous chess champion, was once asked why he had refused to accept the piece that his opponent had offered. He replied “When an opponent takes 45 minutes to decide on something that momentous, I don’t argue with him.”
Finally, an old Yiddish joke on the imperfect outcomes we face:
A matchmaker was desperately trying to convince a bride to proceed with a wedding and a groom she wasn’t crazy about. The bride protests: “I don’t care for the mother-in-law of the groom; she’s disagreeable.”
“But you’re not marrying the mother-in-law,” the matchmaker replies. “What you want is her son.”
“Yes, but he’s not good looking,” the bride laments.
“So? If he’s not attractive, he’ll be even more faithful to you,” the matchmaker asserts.
”He also doesn’t have any money,” the bride counters.
“Who’s talking money? Are you marrying money? It’s a husband you want.” The matchmaker does not relent.
“But he’s got a hunchback!” The bride finally exclaims.
“Well what do you want? He can’t have a single fault?”
An A to Z Guide to Private Fund Investing
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.
7 Questions to Consider When Reviewing a Private Fund’s Offering Documents
As of September 2014, there were 2,691 investment managers registered with the SEC that advised at least one hedge fund, and 1,237 investment managers registered with the SEC that advised at least one private equity fund.*
What conclusions can investors draw from these figures?
First, there are a lot of hedge funds and private equity funds out there.
Second, thousands of offering documents have been prepared to market these hedge fund and private equity investment products.
Third, the quality of disclosure across these numerous offering documents may vary greatly.
Given this variability, based on my experience, here are seven questions to consider when reviewing the offering documents related to a private fund.
- Are the offering documents out of date?
- Do the offering documents contain “stale” disclosure on a manager or its investment fund product?
- Are the offering documents missing key information on a manager or its investment product important to an investor’s decision-making process?
- Are poorly drafted offering documents leading to confused or incomplete investment terms?
- Do the offering documents contain disclosure on material investment terms that are intentionally drafted in such a way to provide investors with just the bare minimum information legally required?
- Is the disclosure related to a particular fund consistent across all of its offering documents?
- Is manager disclosure in a fund’s offering documents consistent with the manager’s regulatory filings?
* Remarks by the Director of the Division of Investment Management – S.E.C., Practising Law Institute, Hedge Fund Management Seminar, September 11, 2014
A Change in Private Fund Terminology for a Better Investment Process
“Bad Terminology is the Enemy of Good Thinking”
-Warren Buffett
What do you think of when someone tells you to sign and enter into a “contract”?
If you’re like me, not necessarily pleasant stuff. Images of never-ending legal obligations, arcane legal terms and court proceedings can pop up. Many people become guarded at the prospect of having to sign a contract.
Or when you find out that someone is “selling” you? Do any of us like to think that we’ve easy targets to be “sold”?
This is precisely why certain sales people dislike using terms like “contracts” and “sales” with prospective customers. Why not use more pleasant words that take the edge off potentially negative thoughts? You don’t sign a “contract,” instead you sign an “agreement.” You don’t review a “sales” document, instead you review an “offering memorandum.”
I believe that using precise words to define things matters greatly in commercial transactions. The more precise, the better.
Why?
Carefully defined objects and terms in a commercial transaction have a way of concentrating a person’s thinking on the key issues at hand, both good and bad. In my opinion, this leads to a better decision-making process. Words that take the “edge” off of an object’s definition and service a transaction have the exact opposite effect.
Prior to a private fund’s initial closing, prospective investors are asked to review “Limited Partnership Agreements,” “Subscription Agreements,” and “Side Letter Agreements.” Agreements? Who has agreed to anything yet?
Let’s call these documents what they are more precisely during the document review phase: “Limited Partnership Contracts,” “Subscription Contracts” and “Side Letter Contacts.” If this helps focus more attention on the potential unpleasant aspects of entering into private fund “agreements,” so be it.
5 Lines that Hedge Fund Managers Use with Investors: Negotiating the Terms of Hedge Fund Investments
History doesn’t repeat itself but it does rhyme. The same can be said of negotiations that involve investors and hedge fund managers. Based on my experience, here are five lines that managers use with investors to negotiate the terms of their fund investments, along with some comments:
- “The term is there to protect investors…”
Funny how that argument can pop up in matters that involve fund expenses where investors’ hard-earned dollars are at stake. To quote Augustus, “Hasten slowly.”
- “You’re the only one who has objected to that term…”
Peer pressure sucks, doesn’t it? Raising an objection does not equate to unreasonableness based on what other investors in a fund have done or not done. The discussion should focus on the merits of the objection made, not a shadowboxing exercise with other investors.
- “My lawyer made me put that term in…”
The old good cop/bad cop routine. I like good cop/bad cop routines in movies, but in alternative investments? Not so much. If a manager can’t give investors comfort on why a term exists, there may be bigger issues at stake.
- “We don’t give exceptions to anybody…” (on why a manager won’t grant side letter terms)
In hedge fund lingo, “anybody” is sometimes defined not to include 1) manager personnel, 2) seed investors (who may have a large impact on a fund’s operations) and 3) potential investors in the future that a manager may pursue to invest in its hedge fund by granting preferential investment terms.
- “That term is industry standard…”
Private fund investments are subject to U.S. private placement rules and are privately negotiated. Given the sheer number of private hedge fund products that currently exist, an important issue to consider is what back-up data do certain people rely on when they claim that some fund term or legal condition is “industry standard”? Even in the absence of providing any back-up data, in my experience, this inconvenient fact does not stop certain people from making broad claims (more on this point in a future post). Fund terms can vary significantly from one hedge fund to the next and, in some cases, certain terms are cut differently for different investors in the same fund. Generalizations need to be approached with caution.
After all, everyone is entitled to their own opinions, but not their own facts.