Notwithstanding the sweeping regulatory changes that are affecting the hedge fund industry, the greatest pressure on hedge funds to change their ‘standard’ investment terms will come from institutional investors. The risk, however, is that a standard becomes self-fulfilling and that terms get included or rejected by both manager and investor solely (or mainly) on the basis of whether it is ‘market standard’ without consideration of the individual characteristics of the relevant fund product.
Removal of the manager — whose fund is it anyway?
Investors realise that a fund exists to provide investors with access to a specific manager’s skill set, although a fund in which they invest should be ‘their’ fund. Historically, however, the manager’s view has been that a manager’s fund should be ‘its’ fund. Should it be possible for a fund to remove its manager or would the removal of the manager be a Pullman-like intercision?
It is difficult to think of the circumstances in which a fund would want to remove its manager besides having the power to terminate for cause (e.g. breach by the manager or the insolvency of the manager or the fund). If an investor were not happy with the performance then, subject to the terms of its investment, it could just redeem from the fund and hence terminate its relationship with the manager.
In theory, however, having the power to remove the manager on notice gives the fund (and its governing body) some teeth at least. The ‘standard’ notice that is required to be given to terminate a hedge fund management agreement is 90 days. Yet, in some circumstances, a shorter period may be acceptable to the manager and in other circumstances it may not be unreasonable for a manager (especially a start-up managing a single fund) to want to receive a longer period.
Usually the fund’s governing body can elect to terminate the manager’s appointment without the approval of investors but, given the link between the fund and its manager and the fact that any disgruntled investor should be able to redeem, the decision by a fund to remove its manager is probably not one that should be made by the board alone.
Surely a decision to remove the manager should require the approval of investors?
Governance — sack the board?
Historically, the primary role of the governing body has been more about keeping the fund offshore for tax purposes, but now investors expect the board to have much more focus on their fiduciary obligations to protect the interests of the investors, principally by taking a more active role in the oversight of the fund’s operations.
The Weavering case has sparked tremendous debate about the role of a fund’s governing body and, in particular, the future of the typical board of non-executive directors. This debate is beyond the scope of this article, although it is clear that the investors’ role in governance should be to appoint/remove the governing body and that these voting rights should not be reserved to the manager. Historically, members of the governing body serve for no fixed term but perhaps their appointments should now be subject to annual approval?
Investors should not have unrealistic expectations of a fund’s governing body, although if a governing body fails to fulfil its duties then investors should have recourse against it. Typically, however, the members of the governing body will be entitled to be indemnified by the fund and this indemnity may render any potential recourse inadequate, especially as the ‘standard’ indemnity covers negligence.
In light of the Weavering case, investors are likely to question this standard indemnity and demand that sufficient D&O insurance be in place.
One final point on governance: it is also standard practice (and a ‘term’ of sorts) for the same legal counsel to advise both the manager and its fund vehicle. Given the increased focus on governance by investors and the higher expectations of the governing body in terms of protecting investor interests, it is not certain that this practice should survive, especially in relation to side letter or managed account negotiations.
Liquidity management — is ‘gate’ a 4-letter word?
Bad memories of 2008/2009 are still fresh in investors’ memories and liquidity management, in general, and gates, in particular, are not liked (to put it mildly). When developing a hedge fund product, however, consideration must be given to how liquidity can be managed in a way that can best balance the competing interests of redeeming investors and remaining investors, in both normal and exceptional liquidity conditions. Care needs to be taken with the construction of the redemption terms of a hedge fund and the starting point has to be the liquidity profile of the target portfolio.
Gates can still have a role to play in aiding portfolio construction and liquidity management and they should not be an automatic red flag: hedge funds are not ATMs and investors should consider the protections they will have when they choose to remain invested as well as when they choose to redeem.
Investor-level gates are generally viewed by institutional investors as being more acceptable than fund-level gates, although the justification for any gate, the drafting of its provisions and the structure of the fund need to be carefully considered in each individual case. For example, an investor-level gate and/or a feeder fund-level gate may be inappropriate in a master/feeder structure, given that the underlying pool of assets will be held by the master fund and that there may be at least one other feeder fund invested in the same master fund. Despite this point, most gating provisions still seem to be drafted on the basis that the underlying portfolio is held by the relevant feeder fund. The same can also be said about the drafting of redemption fees/penalties.
Investors and managers should work together to agree new ways in which liquidity can be managed without relying on the classic options to defer or suspend.
If the liquidity profile of a fund (which can essentially be defined as its dealing frequency combined with its redemption notice period) is designed for normal liquidity conditions then a fund should be able to modify its liquidity profile in exceptional liquidity conditions.
Remuneration — does the AIFMD point the way forward?
The ‘2 and 20 model’ has arguably been the standard hedge fund remuneration model for longer than 20 years. The combination of ‘high water marks’ and ‘skin in the game’ has been heralded as a model of alignment of interests. Whether because of regulation or, more likely, pressure from institutional investors, however, it is clear that this standard fee model will be replaced with a new standard that better aligns the interests of the investor and the manager.
Managers should consider whether the employee/partner remuneration principles of the Alternative Investment Fund Managers Directive (e.g. a percentage of variable remuneration consisting of shares in the fund and the deferral of a percentage of variable remuneration for three to five years) should be better applied, not to the remuneration by the manager of its employees and partners, but to the remuneration by the fund of the manager itself.
Mindfulness and the avoidance of self-fulfilling standards
Many ‘standard’ models, terms and practices in the hedge fund industry have been self-fulfilling for a very long time. Managers and investors need to work together to question any such standards.
A hedge fund’s structure, documentation and launch process have become too commoditised. Developing the investment terms during the launch process or analysing those terms during investor due diligence both require good advice and, what Ellen Langer describes as, mindfulness. Whether or not a term is ‘market standard’ should not be the only question that is asked or even the primary question. If this happens then the risk is that the anti-icer switch is checked “off” when it is actually icy outside.
James Tinworth is a funds partner specialising in investment management and investment funds work with a focus on offshore hedge funds and their management groups. He advises on the structuring, establishment, operation and restructuring of investment funds, advises investors on the legal issues relating to investments in investment funds, manages projects related to fund vehicles or fund management groups and advises on compliance and regulatory issues for investment managers. James drafts and negotiates the full range of fund-related documentation.
Stephenson Harwood is a full-service international law firm with more than 100 partners and 600 staff worldwide. Its Funds and Financial Services Group is a leading diversified funds practice with specialist expertise in hedge funds. The firm provides comprehensive advice to hedge funds, their managers and investors, principally through its offices in the international financial centres of London and Hong Kong. For more information, please visit www.shlegal.com.