Institutional Investor's Alpha Magazine - April 2009 - (Page 13) Hedge Fund Industry Adapting To Shift in Investor Strategies Amended Fee Structure, Regulatory Changes Seen Likely lpha spoke with Dechert financial services group partners David A. Vaughan and Kevin P. Scanlan about the state of the hedge fund industry today. Vaughan’s practice focuses on securities and futures laws affecting investmentmanagement products. Scanlan’s practice concentrates on the structuring and formation of and investment in international and domestic private investment funds. Q: What potential changes in hedge fund terms are likely as a result of recent events? Kevin Scanlan: Although we haven’t seen much of this yet, we think managers will request that investors agree to changes in the calculation of the incentive fee to permit the assessment of an incentive fee even while the fund is under the highwatermark. The incentive fee is important since it is typically used to pay year-end bonuses, which enhance the ability of fund managers to retain their employees. A sell an interest in a fund to another investor. In this case, neither the buyer nor the seller have to know who the other party is; but the more traditional approach to secondary transactions is to have a general partner or a placement agent introduce the seller to a potential buyer, and they negotiate directly. Vaughan: Secondary transactions are actually beneficial to funds, because when one investor sells to another, the fund doesn’t have to release cash. We might see them become more common even among funds that don’t have serious redemption issues, because these transactions allow the fund to create a less liquid portfolio. What kind of regulatory changes are pending that could impact the hedge fund industry? Vaughan: Many people view hedge fund manager registration as likely. Also, there is some push to require hedge funds to register in some form with the Securities and Exchange Commission. Registration would serve the purpose of letting the SEC know how many are out there, but the Commission doesn’t want to drive hedge funds and their managers offshore. So there would need to be international cooperation. Scanlan: One of the main concerns of hedge funds to SEC registration is that it would impede their investment strategies or require disclosures that would harm their objectives. The industry will need to work with regulators in order to help focus their attention on regulations that will be helpful to investors but not harmful to the objectives of the funds. What strategies seem most popular with investors now? Scanlan: In this economy, investors seem to see a lot of good opportunities in distressed securities. But traditionally, funds investing in distressed securities have required lockup periods of around five years. For investors more concerned about liquidity, they’ve been seeking out funds that invest exclusively in publicly traded equities. Vaughan: Futures are also a popular investment. Even if an investor doesn’t like where the price is going, it is possible to liquidate through a futures exchange. What issues have arisen recently in dealing with large amounts of redemptions from funds? Vaughan: Redemptions have become a concern even among funds that are doing well, often because the investors themselves are worried about their cash flow. There is no one-size-fits-all strategy, and most funds will look at a combination. We’re seeing some funds offer their investors a lower fee structure to stay in. Others are paying redemptions in kind; that is, giving the investor securities instead of cash. Kevin P. Scanlan David A. Vaughan David Vaughan: The structure of incentive fees might also change to a longer time frame. For example, if you have a strategy designed to perform over three years, you might calculate the fee over three years. Have secondary transactions in hedge fund interests become more common, and how are they structured? Scanlan: In many cases, a secondary transaction, in which you sell your interest to a third party, is the only immediate option available when a limited partner needs to get out of a fund that has suspended redemptions. In this regard, there are Web sites where one investor can post an offer to Scanlan: With a rush among some shareholders to redeem from a fund and the inability of the fund manager to honor such redemptions due to illiquidity in the portfolio, a number of funds have moved their illiquid securities into side pockets, where the securities are held until they can be sold or valued. Others have transferred the most illiquid portions of their portfolio to a special-purpose vehicle and given redeeming investors an interest in the special-purpose vehicle. Contact Information David A. Vaughan, Partner Alternative Investment Funds, Financial Services New York, Washington +1 212 698 3652 / +1 202 261 3355 david.vaughan@dechert.com Kevin P. Scanlan, Partner Alternative Investment Funds, Financial Services New York +1 212 649 8716 kevin.scanlan@dechert.com April 2009 • This Sponsored Q & A was prepared by the Special Projects Department of Alpha
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