NY Metro Hedgefund Law & News

A Glimpse of the Future - Hedge Fund Study Bill Received in Senate

Congress is looking at a Hedge Fund Study Act. Currently the bill (HR 6079) has been passed by the House and received by the Senate. To become law it would have to be passed by the Republican Senate during the current post-election congressional session.

Given the need for Republican support passage does not seem assured. However, the bill was introduced by Rep. Barney Franks who is expected to become Chairman of the House Financial Services Committee in the 110^th Congress so it is in all likelihood at least a glimpse of things to come.

The areas which would be studied are:

(1) the changing nature of hedge funds and what characteristics define a hedge fund;

(2) the growth of hedge funds within financial markets;

(3) the growth of pension funds investing in hedge funds;

(4) whether hedge fund investors are able to protect themselves adequately from the risk associated with their investments;

(5) whether hedge fund leverage is effectively constrained;

(6) the potential risks hedge fund pose to financial markets or to investors;

(7) various international approaches to the regulation of hedge funds; and

(8) the benefits of the hedge fund industry to the economy and the markets.

A report would be issued not later than 180 days after enactment as to:

(1) any proposed legislation relating to appropriate disclosure requirements for hedge funds;

(2) the type of information hedge funds should disclose to regulators and to the public;

(3) any efforts the hedge fund industry or regulators of financial institutions should undertake to improve practices or provide examples of successful industry initiatives; and

(4) any oversight responsibilities that members of the President's Working Group should have over the hedge fund industry, and the degree and scope of such oversight.

Fortress Investment Group LLC

This hedge fund group filed its "red herring" with the SEC yesterday and is apparently the first US listed IPO of a hedge fund company. The offering is $750 Million of equity interests. The company will trade on the NYSE under the symbol FIG.

After the smoke is cleared the company will still be 90% controlled by its 5 principals: Peter Briger, Wesley Edens, Robert Kauffman, Randal Nardone and Michael Novogratz.

An equity holder does not become an investor in the various funds run by Fortress but rather in Fortress itself.

According to the red herring pre-tax distributable earnings of Fortress have grown from $54.8 million for 2003 to $240.1 million for 2005. Distributable earnings is a measure of the income earned during each period which the company will use in the determination of any periodic dividends to its equity holders.

It is unclear what percentage of distibutable earnings Fortress will pay to equity holders.

However, no matter what the percentage share, the payout to equity holders will suffer if the funds managed by Fortress don't perform well going forward. Given performance volatilities in the industry this one doesn't look like a widows and orphans stock.

Study Shows Hedge Fund Activism Works

A study dated October 2006 by an NYU Business School group shows that markets generally react favorably to hedge fund activism.

The study found, among other things:

• that over a 61 day period preceding and following the filing of a 13D firms targeted by hedge fund activists had an average abnormal return of 10.3%.
• over 60% of the time the hedge funds are successful in getting the target's management to acquiesque to their demands
• while accounting preformance of the target does not generally improve the activists are able to extract cash from the target for the shareholders by increasing debt capacity and paying higher dividends

The study appears on the Web and makes interesting reading indeed.

A Primer on Hedge Fund Classification

Private investment (i.e. hedge) fund strategies may be classified in many different ways. Of necessity any classification is a somewhat artificial abstraction. Moreover, given the creativity of the financial community new strategies are constantly being developed which, while generally not revolutionary, do make the hedge fund landscape one that is constantly shifting.

That being said, one common classification system divides the private investment fund universe into four different categories, each with different expected risks and return characteristics. This system follows:

1. Relative value strategies

Strategies in this category include the following:

·       Equity Market Neutral

·       Convertible Arbitrage

·       Fixed Income Arbitrage

·       Statistical/index Arbitrage

·       Other

Relative value strategies have historically produced relatively low to medium returns with lower risk. These strategies are therefore often associated with the preservation of capital and are likely to capture only a portion of the return in periods of strong market performance. These strategies attempt to take advantage of relative pricing discrepancies between instruments such as equities, debt, options and futures.

Managers may use mathematical, fundamental, or technical analysis to arrive at valuation differences. At times, certain securities may be mispriced relative to the underlying security, related securities, groups of securities or the overall market.

Many hedge funds employing these strategies use leverage and seek opportunities globally.

2. Event driven strategies

Strategies in this category include the following:

·       Distressed Securities

·       High Yield

·       Merger Arbitrage/Risk Arbitrage

·       Other Event Driven

Event driven strategies are intended to produce medium to higher returns with medium to higher risk. These strategies generally have the objective of growth of capital.

Strategies in this category focus on “corporate life cycle^” investing. They include strategies that involve investing in opportunities created by significant corporate events, such as mergers and acquisitions, bankruptcy reorganizations and share buy-backs. Leverage may be used by some managers to increase the exposure to an investment. Fund managers employing these strategies may hedge against downside market risk by using derivative strategies such as purchasing put options or put option spreads.

3. Directional strategies

Strategies in this category include the following:

·       Hedged Equity

·       Equity non-hedge

·       Emerging Markets

·       Market Timing

·       Global Macro

Directional strategies are intended to produce higher than average returns with higher than average risk. These strategies generally have the objective of aggressive growth of capital.

Strategies in this category often involve buying and/or selling a security or financial instrument believed to be significantly underpriced or overpriced by the market, relative to its potential value. This discipline may concentrate on a specific company, industry or country.

The strategy deemed most familiar to investors is the long/short (hedged equity) strategy, which typically involves a core holding of equities which the manager owns (^‘long positions^’) hedged at all times with short positions (sale of equities borrowed, not owned) giving the portfolio an overall long or short exposure. This type of net long or short exposure distinguishes this strategy from a Relative Value strategy which seeks to neutralize market risk by holding a portfolio as near as equally balanced between long and short positions in related equity securities.

4. Multi-strategy

A multi-strategy approach, as the name suggests, involves allocating investments across a  range of strategies depending on where the manager believes the best opportunities can be found.

Economists (Narrowly) Say Hedge Funds Underregulated

By a narrow margin, a majority of a poll of some 40+ WSJ polled private economists thinks hedge funds are under regulated.

The main worry - borrowing and the use of leverage - and its potential spill over effect if another fund goes down in flames.

So there are calls for stricter margin requirements being made. Another area under scrutiny is hedge fund relationships with their broker-dealers.

The counterbalance to more regulation is fear of driving hedge fund business to less regulated locales offshore. Also the SEC suffered a big embarrassment when the courts recently ruled it overstepped its regulatory authority in trying to register hedge fund investment advisers under the '40 Investment Advisers Act.

Given that legislation is often reactive - I am willing to wait for another big blowout (inevitable?)before getting too waxed. After that all bets are off.

Hedge Funds - State Regulation

A hedge fund has to look at the state securities laws of each state having residents to whom it intends to offer and sell interests in itself.

Generally, the states have registation exemptions similar to SEC Reg D. These generally require the filing of some type of notice with the state and the payment of a filing fee.

In addition a state may have its own "home brew" registration exemptions. These vary greatly from state to state. Some of these exemptions require filings and fee payment. Others do not require any such filings.

A fund must be aware of these state laws and comply with them. The general effect of non-compliance with a state's laws is that investors resident in that state will have a right to rescind their investment with the non-complying hedge fund.

Hedge Fund '33 and '34 Act Exemptions

A hedge fund does not have to register and deliver a prospectus under the US Securities Act of 1933 ('33 Act) as long as the interests in the fund are not publically offered (known commonly as a "private placement"). The SEC has provided by rule a number of safe harbors from '33 Act registration - perhaps the most famous of which is known as "Reg D".

Perhaps the most used rule within Reg D is Rule 506 which allows an offering to be made without '33 Act registration, via private means, for up to an unlimited amount, to an unlimited number of "accredited investors" and up to 35 non-accredited investors. "Accredited investors" are essentially institutional and high net worth individual investors.  Modified prospectus delivery type requirements apply to non-accredited investors.

Under the US Exchange Act of 1934 ('34 Act) companies with $10M or more in assets and having 500 or more record equity securities owners or whose shares are exchange listed for trading are required to file reports on operations with the SEC. These are essentially the famous 10-K, 10-Q and 8-K reports.

Generally, hedge funds seek to avoid reporting by not listing and having fewer than 500 equity security owners of record.

Hedge Fund - Investment Company Registration Exemptions

There are 2 principal exemptions from SEC investment company registration that hedge funds can use.

First, SEC registration as an investment company is not required if the hedge fund has fewer than 101 investors. There is a "look through" rule that generally has the effect of counting each limited partner in a partnership as an investor. So, in general, a hedge fund which is organized as a limited partnership and which has over 100 limited partners will in all likelihood not be able to take advantage of this exemption.

Second, SEC registration as an investment company is not required if all the investors in the hedge fund are "qualified purchasers." A qualified purchaser needs $5 million in "investments" if he is an individual and $25 million in "investments" if it is an institution. So a hedge fund can theoretically have as many qualified purchasers as it wants. In reality, the maximum is 499, to avoid becoming a company that has to file public reports on its operations with the SEC.

Hedge Funds - Securities Law Registration Issues

Three major types of registration issues arise for hedge funds:

1. Does the fund have to register with the SEC as an investment company?

2. Does the fund have to register interests in the fund (e.g limited partner interests) with the SEC as securities?

3. Does the fund have to register interests in the fund with any state securities regulators as securities?

Generally speaking it would be a most unhappy fund that would be required to answer yes to any of the foregoing.  Fortunately, again in general, there are exemptions from registration available in each of the foregoing areas that most hedge funds can be structured to take advantage of.

These exemptions will be discussed in detail in separate articles on this site.

Pirates Defections

5  Pirates (Pirate Capital) employees are alleged to have jumped ship.

Reports are not clear whether the defections are related to the fund's recent regulatory woes.

The regulatory woes were over a failure to file position reports with the SEC. The Pirates defense on this has apparently been that an inadvertent, and now corrected, minor foot fault was about all that was involved.