A Hedge Fund Investor's Call to Action
“The first thing we do, let’s kill all the lawyers.”
- William Shakespeare, Henry VI
When it comes to hedge fund legal documents, too often it is “heads the manager wins, tails the limited partner loses.” We think it is time for limited partners to wake up. Ironically, as much as the press likes to write about how greedy hedge fund managers are, they and their attorneys who draft the so-called “standard” hedge fund legal documents are, with all due regard to Shakespeare, not to blame. The fact is that limited partners sign the legal agreements and wire in the money. In that regard, limited partners only have themselves to blame.
The limited partner community needs to band together and start pushing back. Limited partners need to start demanding certain things that managers consistently leave out of their legal agreements. As hedge fund great Stanley Druckenmiller’s general counsel, Gerald Kerner, observed in a note on this subject in 2013, “Since your money is at stake you should police the documents yourself.” We completely agree!
Below is a short list of some of the items limited partners need to address with their managers. There are others – one-sided indemnification and exculpation provisions come to mind – but these, we feel, are the most important to protect investors and to level the playing field. It is, after all, a “partnership.”
No Side Letters. The manager should not enter into side letters. Period. If the manager wishes to give certain investors special terms, then they should put the terms in the legal documents so that all similarly situated investors get the same benefits. Where the manager wishes to grant preferential terms to certain investors, such as early “founder’s class” investors or larger investors, the manager may grant special rights. However, these concessions should apply uniformly to all investors similarly situated and, as a best practice, disclosed in the legal documents so that all investors are aware of the terms.
Side Pockets and Distributions In Kind. Investors should request the manager to agree to paying out redemptions only in cash (not in shares of a “liquidating trust” or similar side pocket). For some managers who invest in less liquid strategies, in-kind distributions maybe necessary in extreme cases, but they should be capped at no more than a reasonable percentage of the fund’s assets, and distributions should be based upon the pro-rata ownership of all investors in the fund. Also, no management fee should be charged on illiquid assets, and performance fees should only be paid when the asset is sold.
Transparency. The manager should agree to providing adequate reporting to all investors:
- Performance estimates on the same cycle for all investors so that no one gets more information than anyone else;
- Portfolio transparency and return attribution information, including the number of positions (e.g., concentration from the top 1, 5, 10, 30, etc. positions), exposure data, and any investments in index shorts and ETF’s; and
- An overview of any less liquid investments on a monthly basis.
Notice Provisions. The manager should agree to notify investors promptly (say, within five days) if:
- The fund changes its auditor, administrator or legal counsel;
- The fund or manage r loses any registration or license necessary to carry out business;
- A portfolio manager or senior employee leaves the manager or is convicted of or admits to a felony; or
- The fund, the manager, or any employee is made a party to a lawsuit, receives a subpoena from the SEC, or a law enforcement agency, or receives a notice of a regulatory investigation or inquiry from the SEC or any other securities regulator.
Manager Withdrawals. The manager should agree to notify investors promptly of any request for withdrawal of capital from its funds by the portfolio manager or any related entity or trust and that exceeds more than a small amount (for instance, 10%) of the aggregate investments on a cumulative basis in any rolling 12-month period. This is similar to a public company which must provide disclosure of changes in management’s ownership of the company’s shares. The manager should also provide on a quarterly basis the total amount of capital invested in the fund by the manager, its principals and affiliates, both through general partner and limited partner accounts.
Expenses. The manager (not the fund) should agree to cover any travel expenses, research costs, employee and consultant compensation, rent, the cost of annual meetings, newspaper, magazine, and other subscriptions, and similar overhead costs. A smaller start-up manager may need to run some necessary investment research expenses through the fund, but this should be capped and phased out when the manager’s AUM is sufficient for the management fee to cover this expense. Organizational expenses should also be capped. At the end of the day, the management fee should cover most operating expenses. To ensure compliance, the manager should provide an inventory of expenses following each year's audit.
Fees. IF the manager is successful in generating returns, then they will be more than fairly compensated. Indeed, we hope our managers make a lot of money because that means we are getting good returns. But a manager’s fee incentive must be aligned with the limit ed partners. Managers like to talk about “superior” performance, and hedge fund investors deserve better than index returns. Therefore, a manager should be open to a hurdle rate on performance fees , either tied to a benchmark or an absolute return. A catch - up provision, where the performance fee applies to the total return once the hurdle is reached, is acceptable. This avoids a manager being overly compensated for just staying in business.
No Loans of Fund Assets. The manager should agree not to loan or pledge fund assets to the manager’s principals, employees or affiliates. A hedge fund is not the manager’s piggy bank!
While this is not an exhaustive list, we feel that it is a good starting point. We may not get all of these items, especially from managers who have been in business for many years. However, if limited partners as a group started to demand these provisions, then hedge funds in general may become more like true “partnerships.” At the end of the day, it is all about partnering with managers whom you trust and who will produce the best risk-adjusted returns over a long period of time.
Alternative Investment Management, L.L.C.