By Steven B. Nadel Esq., Seward & Kissel LLP
Friday, July 10, 2009 1:30:12 PM ET

Over the past year, the financial markets have experienced a series of unprecedented events, including the folding or near-folding of various investments banks and the bargain basement sale of some others, multibillion-dollar government bailouts, the collapse of equity values, massive subprime mortgage crisis, and huge Ponzi schemes.

Consequently, like most investments, hedge funds on the whole performed negatively in 2008; however, they nonetheless on average outperformed the broader indices by about 20%. Yet despite such outperformance, not only have there been significant hedge fund redemptions, but it has generally become increasingly challenging for most hedge funds to raise new capital from investors.

In my opinion, hedge fund managers will increase their likelihood for attracting new capital, if they adopt a number of steps designed to produce: (I) better investor/manager alignment of interests; (II) a culture of compliance, and (III) a greater level of investor transparency and education.

(I) Better Investor/Manager Alignment of Interests

There have recently been public statements made by a number of large institutional hedge fund investors questioning what they perceive to be an apparent misalignment of interests between hedge fund managers and their investors. Primarily, these statements have focused on issues with respect to hedge fund liquidity and manager compensation. The following sets forth the primary concerns of these investors and some suggestions as to how a manager might address them:

(a) Liquidity

* Concerns: The primary investor concerns that have been raised relating to liquidity are that some funds have unnecessarily long lock-up or holding periods, and some fund managers shouldn’t have used their gating, suspension or similar powers during the recent market crisis.

* Suggestions: With respect to long lock-ups or holding periods, managers must be sensitive to the paramount importance of liquidity to many investors in the current environment. Liquidity terms should be designed to match portfolio characteristics and also provide stability to the fund. Consequently, if a manager is seeking to establish a long/short publicly traded large cap equity fund, the manager probably should not impose a two year lock up on fund redemptions. Conversely, if a manager’s strategy is less liquid in nature, a longer lock-up is more likely to be warranted. In sum, fund investor liquidity should more closely reflect underlying investment liquidity.

With regard to the usage of gates, suspension provisions and other liquidity management mechanisms, managers (as well as investors) need to be mindful of the fact that a manager owes a fiduciary duty to the fund, including both to its remaining and redeeming investors. If paying out cash to redeeming investors could jeopardize the fund and the remaining investors, the surrounding issues need to be carefully considered. Given the fundamental conflict inherent in such a situation, it is imperative that any such decision not be made lightly, and in fact should be made with the advice of experienced, independent persons such as the fund’s outside directors and, in addition, preferably a specially established fund conflicts board. Once the decision is reached, appropriate guidelines should be adopted and consistently applied on a going forward basis, and then communicated to clients, so that investors can manage their own expectations.

(b) Manager Compensation

* Concerns: Those investors who have identified manager compensation as an issue have focused primarily on management fees that are, in their opinion, too high in some cases, and incentive compensation calculations that, in their view, do not take into account the underlying illiquidity and holding period of certain fund assets.

* Suggestions: The management fee rate currently charged by most hedge fund managers is 2% per annum. The 2% rate came into effect after many decades without any real increase from a 1% annual rate, despite the fact that manager overhead costs have continued to increase from year to year. Given the foregoing, one would think that the 2% rate is thus justifiable, however, some very large managers have been criticized that their management fee constitutes a de facto “profit center.” While some investors are now asking for a lowering of the management fee rate, a better long-term approach, in the author’s opinion, would be for such managers to seek to better educate their clients about the significant costs needed to be borne in today’s market in order to successfully operate a competitive, world-class hedge fund organization, including the extensive costs associated with adopting compliance protocols, attracting and retaining experienced personnel, and establishing state of the art multiple offices and information technology.

Generally, hedge funds charge incentive compensation annually based on realized and unrealized gains. However, since some funds invest in assets that may take a long time to realize due to their illiquid nature or for other reasons, some large investors are of the view that the incentive compensation on such assets should not be charged on an annual basis. There are a number of suggested ways to handle this concern ranging from “side pocketing” such assets into a separate fund account and not charging incentive compensation on such assets until there is a realization event (assuming the fund’s governing documents allow for it), to implementing a private equity fund-like “clawback” mechanism on the incentive compensation and paying back to the investors any overcharging on the incentive compensation derived from the initial unrealized value calculation as compared to the incentive compensation based on the actual realized value calculation. Each of these approaches has drawbacks and advantages. The manager will need to weigh the various approaches carefully taking into account tax, structure, liquidity and other relevant factors.

(II) A Culture of Compliance

Given the concerns that have arisen following the Bernard Madoff and similar scandals, as well as other frequently cited industry issues related to conflicts of interest, personal trading, insider trading, asset valuations and the like, many investors now seem to believe that their money is safer at a large SEC-regulated institution. While history would often seem to dispute this theory, managers should still take these concerns very seriously. The following are a number of suggestions that managers may wish to implement in some fashion in light of the foregoing:

(a) Adopt written compliance procedures. Regardless of whether a manager is SEC-registered or not, it should consider adopting and implementing a set of policies intended to cover the primary areas of concern, e.g., personal trading, gift policies, valuation, insider trading, trade allocations, conflicts of interest and custody of assets. Moreover, someone at the firm should be appointed to monitor compliance with these policies and train firm personnel on a periodic basis.

(b) Conduct a comprehensive compliance review. The manager should also entertain the idea of having an outside legal or compliance expert come in to review the firm’s compliance practices and identify any areas of sensitivity. Once the third-party review is completed, the firm’s internal compliance personnel should discuss the findings with management and make appropriate operational adjustments as needed.

(c) Foster enmeshed independence. The entire firm should operate in a manner designed to eliminate, to the greatest extent possible, conflicts of interest, undue influence, “front running” and similar issues. This may require the creation of “Chinese walls” or other information barriers and restricted/watch lists, as well as overall protocols meant to ensure impartiality and the proper exercise of the manager’s fiduciary duty to its clients.

(III) Greater Investor Transparency and Education

An unfortunate adjective often closely associated with hedge funds and their managers is that they are “secretive.” While this characterization is a bit unfair, given the many filings that managers are often required to make under the Securities Exchange Act of 1934 and other relevant laws and regulations, managers would nevertheless be well served to address this characterization head-on.

Here are a number of suggestions that managers may want to consider:

(a) Regulatory filings. While not obligated in all cases to do so, managers who are making a regulatory filing may wish to notify their investors when such filings occur and identify how those filings may be obtained.

(b) Top position transparency. Subject to limits imposed by the manager to ensure portfolio strategy confidentiality, since managers are already generally required under GAAP to disclose on an annual basis their positions greater than 5%, managers should consider voluntarily providing such information on a more frequent basis (perhaps quarterly).

(c) Exposure transparency. More managers may wish to consider disclosing on a periodic basis their key portfolio exposure information.

(d) Investor education. As already alluded to above, managers must become more consistent in terms of how, when and what they communicate to their investors. Subject of course to confidentiality concerns, many common investor concerns can be easily addressed, if managers take a more proactive approach with their investor base and keep clients apprised of important fund developments in a timely manner.

Conclusion

While there is no panacea to reinvigorating hedge fund investment, and while performance is obviously the main cure, the points raised above are meant to create a long-term shift in manager/investor relations that will strengthen the industry for many years to come.

Steven B. Nadel is a partner in Seward & Kissel’s Investment Management Group who specializes in issues relating to the establishment and ongoing operation of hedge funds. He is also the founding editor of The Private Funds Report, the Group newsletter. He can be reached at nadel@sewkis.com or 212-574-1231.

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This article originally appeared on HedgeWorld.com on July 10, 2009

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