June 9, 2009

Alternative Investments: Legal Issues and Trends

Arnold & Porter Advisory

This article summarizes the key points from a panel discussion that Howard Rice recently hosted on the subject of current trends and issues related to private equity funds, hedge funds and hybrid funds. The panelists were Benjamin Berk, Anita K. Krug and Mark D. Whatley. Ellen Kaye Fleishhacker moderated.


Political Landscape. Since the beginning of the economic upheaval in late 2007 and in 2008, private investment funds — hedge funds, commodity pools, and private equity funds — have received a great deal of negative press coverage and blame for a variety of perceived ailments in our economy and financial system. Some key accusations include:

  1. Hedge funds are short sellers that attack companies and drive down their share prices in harmful and inappropriate ways. In 2008 their victims were financial institutions whose existence was threatened or snuffed out, causing harm to the overall financial system;


  2. Hedge funds are big participants in the credit default swap (CDS) market, which is considered the root of AIG's and other financial institutions' problems;


  3. Hedge funds are big investors in debt instruments, including loans that finance leveraged buyouts and various real estate-related instruments. Through those investments, they have created or added to a "shadow" financial system that has increased the total amount of leverage in the economy in ways that regulators and central bankers have been unable to see and evaluate;


  4. Private equity funds have borrowed and caused their portfolio companies to borrow huge amounts, often at very high ratios of total debt to EBITDA and through "covenant-lite" loan instruments. This has also increased the total amount of leverage in the economy and threatened the viability of operating companies that employ millions of workers;


  5. Fund managers have made a lot of money and have become high profile symbols of greed and excess; and


  6. The Madoff scandal was (inaccurately) billed as hedge fund fraud.

These, among other factors, have elicited cries for regulation and taxation of private funds of all kinds. 

Regulatory Landscape. Historically, different "industries" that participate in financial markets and offer financial services have been subject to different regulatory systems. Very generally speaking, each of these systems has been set up to further one or more of the following broad objectives: 

  1. Protecting investors and customers against fraudulent or deceptive practices (both Madoff-type "theft" and subtler practices in which investors pay for something other than what they thought they were getting);


  2. Protecting depositors and similar types of customers from losing money they have entrusted to financial institutions (generally by ensuring that those institutions are "safe and sound"); and


  3. Protecting the broad financial system from shocks that jeopardize its overall functioning.

Each of these systems, based on a particular statute or set of statutes passed by Congress, has tended to be dominated by one of these objectives. Thus, Federal securities laws, administered by the SEC, and commodities laws, administered by the CFTC, are primarily intended to accomplish objective #1 (protecting investors). Federal and state banking laws, administered by a variety of different regulators are generally dominated by objective #2 (safety & soundness protection of depositors). Insurance laws (the province of the states) are directed to different degrees by both objectives #1 and #2. The Federal Reserve is primarily concerned with objective #3 (systemic stability).

In addition to taking an enormous toll on homeowners, workers and consumers, the collapse of credit markets and ensuing economic upheaval have affected the health of or revealed weaknesses in the country's financial and market systems. A broad public discussion about the need for "reform" appears continuously in the press and the halls of government. For the first time in at least a decade, it is heavily laced with tension and confusion among the different types of regulatory objectives described above. An overarching question (not always asked) is whether and how the existing assembly of overlapping regulators and regulatory schemes that affect scores of interrelated "industries" and activities in the financial markets can simultaneously protect investors, borrowers, depositors, consumers, and homeowners and foster — or avoid stifling — the continuing development and evolution of vibrant markets that our economy requires? Addressing the immediate-term dangers to the nation's largest financial institutions, and the perceived need to take rapid action to stimulate the economy have been the new administration's and Congress' principal focus through the spring of 2009. Some legislators have proposed changes to specific laws, and some new tax changes. The SEC has made formally proposed some new rules and changes. But "reform" activities have so far been largely limited to general suggestions and the biggest changes are surely yet to be actually proposed. 


Registration. In late January, Senators Carl Levin and Chuck Grassley introduced the "Hedge Fund Transparency Act," which would require each private investment fund (including private equity funds, venture capital funds, and funds that invest in real estate-related securities, among others) to register as "investment companies" under the Investment Company Act of 1940. The implications of becoming so registered appear to be limited primarily to requirements to provide the SEC with very basic information about the fund's organization and aggregate holdings, although the actual language in the Hedge Fund Transparency Act requires annual identification of all of the fund's beneficial owners (investors). Despite the relatively clear language of the latter requirement, Senators Grassley and Levin have in press releases stated that they intend for the Hedge Fund Transparency Act to apply only to the owners of a fund's investment manager. That statement, combined with incorrect statements in the introductory materials related to the Hedge Fund Transparency Act to the effect that this legislation merely resurrects earlier attempts to require hedge fund managers to register under the Investment Advisers Act, suggests legislators' confusion about the nature of funds' organization, the roles of the various participants and constituencies and the requirements imposed by existing statutes.

More recently, from the regulators' corner, SEC Chair Mary Schapiro has stated repeatedly that she believes managers of hedge funds should be required to register as investment advisers, and has suggested that it may be appropriate also to require funds themselves to register under the Investment Company Act. The Commission has not made any proposals in those directions and, following the judicial invalidation of its attempt to eliminate the "private advisor" exemption on which most unregistered hedge fund managers rely, may suggest and await Congressional authorization.

Potential New Regulation of Fund Portfolio Investment Activities. Private funds' investment and trading activities have stimulated new concerns about the "systemic risk" they pose The "emergency" short sale reporting requirements imposed on "institutional investment managers" last fall are up for expiration and review in July. A few other changes have already been proposed. For example, the SEC has proposed new (and/or revived) substantive regulation of short selling activities (to bolster investor confidence and preclude "bear raids" that drive down stock prices). The SEC suggested, as possibly alternative or possibly combined measures, one or more of the following:

  1. Reinstatement of some form of the "uptick rule" that existed until 2007. The rule would prevent short sales at price lowers than the most recent previous trade. Alternate variations are requiring the short sale price to exceed: (a) the last price or (b) the national best bid.
  2. Implementing "circuit breakers" under which, if a stock's price declines by a specified amount, trading will be halted or the uptick rule will kick in.

Broad Financial Regulatory Reform. A number of suggestions have emerged from a variety of quarters for broad financial regulatory reform. For example, Treasury Secretary Geithner has proposed requiring that hedge funds deemed sufficiently large or highly leveraged be subject to net capital requirements and/or limits on leverage. He has also proposed regulating the over-the-counter (OTC) derivatives market. The latter proposal would (1) require that standardized OTC derivatives be cleared through "central counterparties;" (2) make aggregate data on standardized OTC derivatives available publicly; and (3) impose documentation requirements (regarding, for example, netting, margin and collateral practices) relating to non-standardized OTC derivatives.


There are also several current legislative proposals to change the tax treatment of funds, their sponsors and their investors. These include:

Carried Interest Taxation. In early April, Rep. Sander Levin introduced a bill in the house (HR 1935) that would tax the "carried interest" as ordinary income rather than long term capital gain (meaning that carried interests would be taxed at a 39.6% rate rather than a 20% long term capital gains rate.) The bill is very similar to legislation Levin unsuccessfully proposed in 2007. The bill technically applies if (a) a partnership holds securities, real estate, or commodities and (b) a person receives interests in that partnership in exchange for providing management, advisory or similar services to the partnership relating to those assets. In other words, this proposed legislation would affect hedge funds, private equity funds, venture funds and real estate joint ventures.

Proposed Taxation of Offshore Funds. On March 2, Senator Carl Levin introduced the "Stop Tax Haven Abuse Act." The stated rationale for the proposal was the "outrageous tax dodging" that he alleged that hedge funds and investment management businesses engage in by structuring themselves to appear to be foreign entities, even though their key decision makers live in the United States (US). Under the proposed legislation, if a foreign corporation (a) has more than $50M in gross assets and (b) is managed and controlled in the US, then it would be taxed as a US corporation. If enacted, this legislation would principally affect foreign hedge funds and foreign feeders managed in the US. Fund managers might simply respond by reorganizing offshore funds into partnerships (instead of corporations) and have each affected investor set up own blocker. It is not clear that these steps would avoid the impact of the proposed legislation.

UBTI Relief. Tax exempt organizations are taxed on unrelated business taxable income ("UBTI"), including income generated by debt to purchase securities and other assets. Rep. Sander Levin recently announced plans to reintroduce a bill that would exempt from UBTI debt that a partnership incurs to purchase securities, commodities, and similar assets. As a result, it would no longer be necessary to use a foreign blocker to block UBTI.


Given the current economic environment, fund-raising is dramatically more difficult than it has been in the recent past. Fund sponsors and managers should expect more pro-investor fund terms compared to prior years.

Private Equity Terms. Current trends in private equity fund terms seem to fall into three categories:

  1. Changes re alignment of interest. A key theme is to align interests between the fund general partners and the investors. To realign interests, expect to see (a) decreases in management fees; (b) more management fee offsets (100% for director's fees and at least 80% offset for advisory and other fees); (c) a significant push to increase general partner capital commitments; (d) premium carries only to apply if funds hit certain hurdles; and (e) more frequent clawback calculations.
  2. Governance issues. Another theme is to strengthen governance protections for investors. In this category, expect to see: (a) stronger key person provisions; (b) an increase in no-fault general partner removal clauses; and (c) requirements for funds to provide more information to their advisory boards.
  3. Investor liquidity issues. Investors are facing cash flow issues and need to rebalance portfolios. Funds are starting to use creative solutions to help their investors with liquidity issues by (a) unilaterally reducing capital commitments or deferring capital calls and (b) decreasing management fees. Sponsors are also showing an increased willingness to cooperate with secondary sales.

Hedge Fund Terms. Fees and liquidity terms are the focus of the changes in hedge fund terms most discussed in today's market.

  1. Liquidity. Following widespread invocation of "gates," use of liquidating funds, and even suspensions of redemption rights in 2008, investors are focused on improving the liquidity of their investments in hedge funds. For their parts, managers and sponsors are more focused on being able to manage surges of redemptions that overwhelm their ability to liquidate portfolio assets in an orderly fashion. Techniques include: (a) extending the period over which redemptions are paid out; (b) expanded use of gates; (c) imposing "individual" gates; and (d) longer lock ups or broad manager discretion to suspend redemptions. Expect more negotiation with larger investors over liquidity terms and the need to justify liquidity limits based on desired — and fully disclosed — portfolio activities.
  2. Fees. Investors are discussing changes in the ways fees — particularly performance-based fees — are calculated. Some areas of discussion include: (a) tailoring fee structures more precisely to the particular strategy; (b) a greater focus on hurdles; and (c) the use of clawback procedures, even if this is generally not thought to be suitable for a fund, such as most hedge funds, that permits periodic redemptions. There has also been more scrutiny of fees on "side pockets"; where a fund has multiple side pockets, investors may look for clawbacks or reduced management fees.
  3. Other Trends. Other pressures from investors include: (a) more demands for portfolio transparency; (b) more assurances about valuations; (c) assurances regarding back office capability; (d) assurances about stability of manager personnel (including descriptions of internal compensation arrangements); and (e) requests for separately managed accounts.

Hybrids. Some hedge funds that include investment in illiquid securities and securities for which they believe an extended "maturation" period is required have developed "hybrid" terms that are more like private equity fund terms. These include staging capital contributions with "commitment" periods, long lockups, "clawbacks" of incentive allocations over lockup periods, and various versions of "side pocket" accounting. These developments are generally intended to mitigate the potential for mismatch between the portfolio liquidity and investor liquidity and/or between investment objectives/philosophy and investor liquidity, as well as to adapt compensation arrangements (and attendant incentives) to particular portfolio emphases and investor interests. Private equity funds have adopted "hybrid" terms that incorporate hedge fund concepts in order to facilitate making short-term investments in public markets and reinvesting the proceeds after a sale (as well as perhaps reinvesting the general partner's carried interest and therefore increasing the general partner's percentage interest in the fund over time). Hybridization efforts often seem relatively simple when described in broad, conceptual terms. But they typically raise numerous subtle issues in the implementation and usually make a fund's documentation and ongoing administration significantly more complex. In addition, many investors are wary of funds that do not fall into the category they are most familiar with investing in (i.e., "hedge fund" or "private equity fund"), and may not have the capacity to evaluate hybrid funds effectively.


The regulatory focus on hedge funds after Madoff is misguided because Madoff didn't run a hedge fund and the hedge fund registration-related proposals that have been proposed wouldn't have prevented the losses. The most meaningful result of Madoff so far is an appropriate increased emphasis among investors on due diligence. Lessons for investors include: (a) understand the manager's strategy and risk; (b) there are no stupid questions – if you don't understand what the manager said, don't invest; (c) consider consulting an expert; (d) in hedge funds, look for gates and the ability to suspend redemptions; (e) review the fund's financial statements – they should be available and audited – also, are the results and asset levels consistent with what is in the marketing materials?; (f) read the footnotes, that is where the action is; (g) contact the auditor — at the very least, to be sure it really exists; (h) verify the fund's custodial arrangements, including contacting custodian(s); (i) if different than the custodian, verify prime broker arrangements; (j) verify third party administration arrangements, and inquire about particular challenges and notable aspects of the relationship; (k) interview the relevant investment manager personnel and ask hard questions; (l) if the investment manager is registered as an investment adviser, review public registration-related filings for consistency and red flags; (m) however, do not let the fact that a manager is registered substitute for substantive inquiry and follow-up; (n) do a background check on key manager personnel; and (o) don't end your diligence after you have made the investment decision — refresh inquiries periodically.

The panel discussion summarized above took place on April 16, 2009. The PowerPoint slides from the panel can be found here.

If you have questions about any of the issues raised in this article, please contact Benjamin Berk at 415.399.3064, Ellen Kaye Fleishhacker at 415.399.3079, or your usual Howard Rice attorney.

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