THE CURRENT HEDGE FUND LANDSCAPE: LP AND GP PERSPECTIVES NAPPA 2016 LEGAL EDUCATION CONFERENCE Moderator:
Maureen M. Hazen, General Counsel, State Board of Administration of Florida
Presenters:
James Keith (JK) Brown, Executive Managing Director, Head of Investor Relations, Och-Ziff Capital Management Charles Nightingale, Head of Legal & Investment Structuring, PAAMCO Jedd Wider, Partner, Morgan, Lewis & Bockius LLP
June 21-24, 2016
New Orleans, Louisiana
Index
• Discussion Outline – Pages 3-6
• Current Investment Terms, Conditions and Issues – Pages 7-30
• State Board of Administration of Florida Hedge Fund Investment Policy – Page 31
2
DISCUSSION OUTLINE
Discussion Outline
• Fees – Management Fees – Incentive Allocations
• Liquidity – Accelerated Withdrawal Rights – Frequency of Withdrawals – Withdrawal Gates & Suspensions
4
Discussion Outline (cont’d.)
•Transparency – Reporting Items
– Notice Requirements – Extensive
– MFN Trends
– Confidentiality Issues and Public Records/FOIA Laws
•Operational – What are the expectations of institutional investors with respect to the
operations of managers? Any difference when it comes to start-up managers?
– How do investors expect managers to overcome the increasing barriers to entry, in particular with regards to operations and compliance?
– Selection and role of service provides; in-sourcing v. out-sourcing (e.g., CCO role)
5
Discussion Outline (cont’d.)
•Special Topics/Areas of Interest – Customized Hedge Fund Products
– Funds of one
– Managed Accounts
– GP Views on SEC Regulatory Trends
– LP Views on SEC Regulatory Trends; in particular, how has the SEC’s focus on hedge funds impact due diligence by institutional investors?
– Unique issues funding start-up managers: Due diligence, founders classes, seeding and anchor investors
– Views on Public Perception of Hedge Funds
6
CURRENT INVESTMENT TERMS, CONDITIONS AND ISSUES
Fees
• Standard Terms
– Management Fees
Monthly or quarterly in advance, typically at an annual rate of between 1%-2%
Management fee rate ladders sometimes tied to differing withdrawal rights
– Incentive Allocations/Fees
Annual 15%-20% on net profits (sometimes over a hurdle), subject to a loss carry-forward
Incentive allocation/fee rate ladders sometimes tied to differing withdrawal rights
8
Fees (cont’d.)
• Market Developments
– Management Fees
Investor push for discounts or ladders based on size of subscription (or commitment) or size of overall investment with Manager and its affiliates
– Incentive Allocations/Fees
Increase in commingled funds with no incentive compensation
Greater investor interest in bespoke products with no performance compensation or alternative performance compensation arrangements (e.g., multiyear performance periods or partial payment)
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MFN
• MFN → Investor Ask
– Existing Side Letters
Representation by GP/manager that no other side letters exist other than those previously disclosed
– Future Side Letters
Notice and copies of all future side letters
Applies to all preferential terms
Automatic unless investor notifies within 30 days
No tiering (preferably). If tiering, applies to aggregate investment by investor and affiliates in fund and all parallel funds and accounts
10
Reporting and Other Disclosure
• Reporting
– Standard Terms
Monthly performance estimates
Monthly capital statements
Quarterly performance reports
Annual audited financial statements
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Reporting and Other Disclosure (cont’d.)
• Reporting (cont’d.)
– Market Developments
Weekly performance estimates
Monthly portfolio summaries, including:
gross long positions, gross short positions, and net positions by strategy, security type, geographic region, and sector
top five long positions and top five short positions
performance attribution
leverage levels
Monthly portfolio holdings reports on a real-time or lagged basis
Monthly risk reports provided through a risk aggregator
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Reporting and Other Disclosure (cont’d.)
• Market Developments (cont’d.)
Monthly statements of management fees and performance compensation
Monthly or quarterly valuation reports, including ASC 820 classification (highlight on Level 3 assets)
Annual reconciliations of audit versus capital account statements
Annual conflict of interest reports
Annual compliance certificates
Annual Fund-level tax reporting
ERISA Section 408(b)(2) service provider disclosure
Form PF
13
Reporting and Other Disclosure (cont’d.)
• Notice Requirements
– Standard Terms
Material amendments of Fund documents
Certain amendments to Form ADV, as required under applicable securities laws and regulations
Key person events (not majority)
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Reporting and Other Disclosure (cont’d.)
• Notice Requirements (cont’d.)
– Market Developments
Bad acts involving GP, Manager, or Investment Personnel
Breaches of standard of care/fiduciary duty
Breaches of Fund documents or side letters
Non-routine investigations or findings of violations of securities laws or regulations
Convictions, pleas of nolo contendere or guilty pleas to felonies or crimes involving fraud
Violations of other applicable laws, regulations, or investor policies, including ERISA (or comparable state law) or investor-specific investment restrictions
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Reporting and Other Disclosure (cont’d.)
• Market Developments (cont’d.)
Key person events (expanded application)
Other events impacting GP/Manager
Changes in ownership or control
Changes in investment and operations personnel
Bankruptcy or insolvency
Material adverse change to business, operations, or conditions
Legal claims
Any amendment to Form ADV
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Reporting and Other Disclosure (cont’d.)
• Market Developments (cont’d.)
Events impacting Fund
Changes in corporate structure
Changes in overall investment objective or strategy
Amendments to Fund documents, including valuation procedures
Changes in Fund administrator, prime broker/custodian, or auditor
Fund assets become “plan assets” under ERISA
Failure to value Fund assets in accordance with valuation procedures
Material decline in Fund’s net asset value
17
Reporting and Other Disclosure (cont’d.)
• Market Developments (cont’d.)
Events impacting Fund (cont’d.)
Investments in “side pocket” or other illiquid investments
Use of soft dollars outside the Section 28(e) safe harbor
Indemnifications claims
Indemnification advances/expense reimbursements
Legal claims or governmental proceedings
IRS audit
Imposition of a withdrawal gate
Suspensions of determination of Fund net asset value
Suspensions of withdrawal rights or payments of withdrawals proceeds
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Reporting and Other Disclosure (cont’d.)
• Market Developments (cont’d.)
Events impacting investor
Acts or omissions by GP, Manager or investment personnel causing investor to receive materially adverse publicity
Acts or omissions by GP, Manager, or investment personnel otherwise materially adversely affecting investor’s reputation
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Accelerated Withdrawal Rights
• Breaches → Investor Ask
– Prompt Notice
Breach of the fund documents
Breach of the fund’s standard of care
– Immediate withdrawal right, without any gate, lock-up, holdback, suspension, fee or other penalty
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Accelerated Withdrawal Rights (cont’d.)
• Regulatory and Legal Claims → Investor Ask
– Prompt notice
Non-routine investigation of securities law violation
Finding of securities law violation
Conviction, plea nolo contendere or guilty plea to a felony or a crime involving fraud
Violation of ERISA
IRS audit of the fund
– Immediate withdrawal right, without any gate, lock-up, holdback, suspension, fee or other penalty
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Accelerated Withdrawal Rights (cont’d.)
• Changes to the Fund → Investor Ask
– Prompt Notice
Change to the fund’s investment objective or strategy
Change to the fund’s corporate structure
Amendment to the fund documents
Amendment of the fund’s valuation procedures
Use of “soft dollars” outside the Section 28(e) safe harbor
– Immediate withdrawal right, without any gate, lock-up, holdback, suspension, fee or other penalty
22
Accelerated Withdrawal Rights (cont’d.)
• Changes to Service Providers → Investor Ask
– Prompt notice
Change in ownership or control of GP or manager
Bankruptcy, liquidation or insolvency of GP or manager
Material adverse change to business of GP or manager
Change in the fund’s administrator, prime broker, custodian, auditor or legal counsel
– Immediate withdrawal right, without any gate, lock-up, holdback, suspension, fee or other penalty
23
Accelerated Withdrawal Rights (cont’d.)
• Amendment of Fund Documents → Investor Ask
– Right to withdraw prior to effective date of amendment if investor does not consent to any amendment requiring investor consent
– Withdrawal not subject to applicable notice requirements, gate, lock-up, holdback, suspension, fee or other penalty
24
Accelerated Withdrawal Rights (cont’d.)
• Withdrawals by Insiders → Investor Ask
– Notice of intended withdrawal by the GP/manager, any key person or any affiliate of 25% or more over a rolling 12 month period, excluding withdrawals of performance compensation or for tax purposes
– Right of investor to withdraw at same time of (or prior to) insider’s withdrawal date
– Withdrawal not subject to applicable notice requirements, gate, lock-up, holdback, suspension, fee or other penalty
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Accelerated Withdrawal Rights (cont’d.)
• Violations of Investor’s Applicable Law, Regulation or Policy → Investor Ask
– Immediate withdrawal right if investment would violate:
Securities laws or regulations
ERISA or comparable state law
Investor-specific statutes, regulations or policies, including placement agent policies
– Withdrawal not subject to applicable notice requirements, gate, lock-up, holdback, suspension, fee or other penalty
26
Payment of Withdrawal Proceeds
• Withdrawal Gate → Investor Ask
– The withdrawal gate will not apply for more than 12 consecutive months after the initial withdrawal date
– The withdrawal gate will apply equally to all investors making a withdrawal on the same withdrawal date
27
Payment of Withdrawal Proceeds (cont’d.)
• Distributions in Kind → Investor Ask
– 3 days’ prior notice of intended distribution in kind
– Right of investor to not accept distribution in kind, in which case the GP/manager agrees to use best effort to liquidate the fund assets
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OPERATIONAL DUE DILIGENCE AREAS OF FOCUS
Core Information Technology and Business Continuity Planning
Counterparties, Cash, Margin and Collateral Risk Management
Structural, Taxation and Corporate Governance Considerations
Pricing and Valuation
Accounting and Risk Reporting Oversight
Business Support, Systems and Infrastructure
AREAS OF FOCUS
Trade Origination, Record and Settlement
Compliance and Regulatory
Reputable and Appropriate 3rd Party Providers
Cash Controls and Safeguardi ng of Client Assets
cornpleteAlpha For illustrative purposes only. PAAMCO may use some or all of the techniques described in this document.
See applicable endnote.
PAAMCO
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OPERATIONAL DUE DILIGENCE IMPERATIVES
A willingness to be subject to a full Operational Due Diligence review and to provide the
requisite transparency
Corporate governance and legal framework such that the interests of investors are
appropriately safeguarded
Adequate segregation between investment activities and control functions. Critical to
this is the existence of an experienced individual (typically a CFO or COO) who
manages operational risk and is responsible for independent risk oversight
A written pricing policy that details appropriate methodologies and independence in the
valuation process
Counterparty terms that are appropriate to the strategy of the fund
Competent and independent external administrator and auditor
An adequate program of compliance that should meet regulatory requirements and
provide a framework for reasonably safeguarding investor interests
Adequate controls that support the safeguarding and management of fund assets
A dual signatory policy for the control of cash and asset transfers
A generally stable operating environment with appropriate safeguards and controls to
support security of data and infrastructure, with policies and procedures covering
backup and disaster recovery
For illustrative purposes only. PAAMCO may use some or all of the techniques described in this document.
See applicable endnote.
PAAMCO
30
1
cornpleteAlpha
STATE BOARD OF ADMINISTRATION OF FLORIDA HEDGE FUND INVESTMENT POLICY
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