Investing in Alternative Investments: Issues for CITs · PRIVILEGED AND CONFIDENTIAL ©2015...

PRIVILEGED AND CONFIDENTIAL

Investing in Alternative Investments: Issues for CITs

Cliff KirschYasho LahiriMark SmithMarch 19, 2015

©2015 Sutherland Asbill & Brennan LLPPRIVILEGED AND CONFIDENTIAL

Speakers

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Cliff KirschNew York, [email protected]

Mark SmithWashington, [email protected]

Yasho LahiriNew York, [email protected]


Why Are We Here?

• Collective Investment Trusts (CITs) are being approached by hedge funds (and, to some extent, private equity funds) seeking to access the pension plan market more effectively

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Growth of U.S. Hedge Fund Industry

Estimated Growth of Assets/Net Asset FlowHedge Fund Industry

Sources: HFR, Inc.; ThinkAdvisor.com; Institutional Investor’s Alpha

4


DB Plan Investments in Hedge Funds

Source: Pensions & Investments; investments include top 200 hedge funds.

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I. Hedge Funds: An Overview

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What is a Hedge Fund?

• Hedge funds are a structure, not an asset class• Wide array of investment strategies• Key elements:

Offer investors some liquidity In addition to asset-based fees, managers are paid incentive

compensation based on net asset value of the portfolio, including unrealized gains and losses, not on cash realized from the disposition of investments

Fully funded, investor commitments not drawn down over time

“Evergreen,” not self-liquidating

7Private Equity

OverviewHedge Fund Framework

Solutions to Hedge

Fund Issues

Select Hedge Fund Issues

Hedge Fund Overview


II. Select Hedge Fund Issues

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Selected Hedge Fund Issues

• Valuation• Liquidity• Other

9Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Effects of Inaccurate Valuation

• Since manager compensation is based on portfolio value, overvaluing the portfolio overcompensates the manager

• Valuation errors result in wealth transfers between existing and subscribing investors An inaccurately high value shifts wealth to redeeming

investors and other existing investors, because new investors are overpaying for their interests

The reverse is true for an inaccurately low value

10Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Key Valuation Issues

• Focus on information source and process, not identity of valuation agent

• Fair value How is the fund’s portfolio, which may include fairly esoteric

instruments, marked to market? Particular sensitivities:

Level 3 assets Manager-valued securities Dealer “quotes”

• Side pockets• Contingent liabilities

11Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Liquidity Issues

• Usually, there is a “lock up” period, after which there is periodic (e.g., quarterly) liquidity on specified notice “Lockups” can be “soft” (i.e., waivable upon payment of an

exit fee) or “hard” (i.e., not waivable)

• There are three other possible limitations on liquidity: Gates Suspension rights Side pockets

12Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Gates

• A “gate” is a pre-specified limit on the portion of a fund’s capital (or an investor’s capital) that can be redeemed on any given dealing day

• Issues Can be waived, but probably not on an investor-by-investor

basis Usually not “first in time, first in right”; rather, all redemptions

scaled back pro rata Redemptions which are scaled back sometimes get first

preference for the next redemption date There is sometimes a time limit by which redemptions must

be satisfied or else the fund is liquidated

13Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Suspension Rights

• Typically, the fund board or investment manager may have the right to suspend all redemptions due to extraordinary circumstances

• Issues Suspension rights have at times been read very broadly Result is that there is no guarantee of liquidity, at any price

14Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Side Pockets

• Side pockets are commonly used by hedge funds to deal with comparatively illiquid or difficult-to-value assets

• Assets are segregated, and the value of these assets is excluded for performance-free purposes until the investment is realized

• Side pockets have existed for a long time, but we are finding that they are used more frequently as hedge funds invest in more illiquid investments, and as a result of FAS 157

15Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Side Pockets

• Creation and use of side pockets can raise a number of issues: Generally valued at cost, but the discretion to carry at “fair

value” or cost or to write off can be an issue Determination to include an asset in a side pocket,

particularly for existing positions/investments Determination of when to remove an asset from a side

pocket If improperly structured, can be used to delay recognition of

losses

16Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


“Bad Apples”

• A few “bad apples” (e.g., Madoff feeders, Bayou Wood River) have garnered a lot of media attention

• Reputational risk, in addition to investment losses• Long-tail nature of hedge fund liabilities

Redeemed investors: Madoff trustee argues there can be a look-back period and recoupment of proceeds received

A new investor may have economic losses for liabilities (e.g., unpaid taxes) where it had no benefit from the activity that gave rise to the liability and had no direct exposure

17Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


IV. Hedge Funds: Legal and Regulatory Framework

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Regulatory Structure

• Hedge funds are structured to be exempt from the Investment Company Act of 1940 (‘40 Act) Why?

Investment limitations Disclosure/transparency Disadvantageous mutual fund tax regime

19Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


3(c)(1) Exemption

• 3(c)(1) funds may not have more than 100 beneficial owners and fund interests must be privately placed Counting investors in a 3(c)(1) fund is an arcane exercise in parsing

no-action letters.• To invest in a 3(c)(1) fund, a Collective Investment Trust must be

an “accredited investor” Any trust, with total assets in excess of $5 million, not formed for the

specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person.” Investment Company Act Rule 501(a)(7).

• “Sophisticated person” A person who has such knowledge and experience in financial and

business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such person comes within this description. Investment Company Act Rule 506(b)(2)(ii).

20Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


3(c)(7) Exemption

• 3(c)(7) funds may only be offered and sold solely to “qualified purchasers”

• To invest in a 3(c)(7) fund, a CIT must invest not less than $25 million on a discretionary basis This threshold is higher than the threshold for individuals,

who generally must own $5 million in investments

21Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


‘33 and ‘34 Act Analysis

• No ‘33 Act public offering. Hedge fund interests are privately placed pursuant to Rule 506 of Reg. D (i.e., limited to accredited investors) or Reg. S. Could, in theory, have a public offering after the JOBS Act

(rarely used)

• Generally, limitations on number of investors to avoid ‘34 Act reporting company status Exception: “Retail” funds of funds

22Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


ERISA Considerations

• Robust fiduciary diligence process (e.g., liquidity, diversification, fees, valuation, manager experience, indemnities)

• Indicia of ownership rule• UBIT• No ERISA PTEs for affiliated hedge fund investments

or hedge fund revenue sharing• Consequences of ERISA restrictions


ERISA Restrictions

• Investments in hedge funds by certain pension plans raise special issues for hedge fund managers If equity participation in a hedge fund by “benefit plan investors”

exceeds 25% (the 25% Limit), hedge fund assets may be considered “plan assets” for the purposes of ERISA and the Internal Revenue Code of 1986 (the Code)

If a hedge fund does not comply with the 25% Limit, serious consequences would ensue: Fiduciary duty: Hedge fund manager would be subject to

the general fiduciary requirements of Section 404 of ERISA, which is more stringent than the fiduciary duty created by federal common law (Capital Gains)

Prohibited transactions: The hedge fund’s activities would be subject to Section 406 of ERISA, Section 4975 of the Code, and DOL guidelines

24Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Hedge Fund Managers

• Generally, a hedge fund manager must register as an investment adviser with the SEC if the manager has regulatory assets under management (RAUM) in excess of $100 million

• Mid-size advisers: Managers with RAUM between $25 million and $100 million may also be required to register with SEC

• There are exceptions Private fund advisers, VC advisers, foreign private advisers Some register in order to manage ERISA plan assets

(“QPAM” status) Marketing considerations

25Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


CFTC

• If a hedge fund trades futures, the manager is generally also regulated by the CFTC. There are significant exceptions to this rule.

Qualified Eligible Person “QEP” exception:

A QEP includes any person, acting for his/her own account or for the account of a qualified eligible person, who the commodity pool operator reasonably believes, at the time of the sale to that person of a pool participation in the exempt pool, or who the commodity trading adviser reasonably believes, at the time that person opens an exempt account, is (among other things):

A “qualified purchaser” (as defined under ‘40 Act);

A bank collective trust, with total assets in excess of $5 million, not formed for the specific purpose of either participating in the exempt pool or opening an exempt account, and whose participation in the exempt pool or investment in the exempt account is directed by a QEP (must meet “Portfolio Requirement”). 17 C.F.R. § §4.7(a)(2), (a)(3).

“Portfolio Requirement” means that a person (i) owns securities and other investments with an aggregate market value of at least $2 million; (ii) has had on deposit with a futures commission merchant (“FCM”) at least $200K in exchange-specified initial margin and option premiums for commodity interest transactions in the six months prior to opening an account with a CTA or selling a pool participation to such FCM ; or (iii) a combination of the two

26Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Non-U.S. Law

• Foreign domiciles (UK, Cayman, Bermuda, etc.) also have regulatory regimes, which must be considered

27Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Legal Structure

• Hedge funds offered to U.S.-taxable investors are generally Delaware partnerships or LLCs

• Hedge funds offered to U.S. tax-exempt investors and to non-U.S. investors tend to be Cayman, Bermuda or BVI corporations

• “Master Feeder” (or “hub and spoke”) structures, allowing one master trading vehicle to serve multiple feeder investment vehicles, are common

Cayman “Master Fund”which acts as trading vehicle

(taxed as U.S. partnership)

Delaware LP(“onshore fund”)

Cayman Company(“offshore fund”)

Investment Manager (also general partner

of Delaware LP)

Management and Performance FeesManagement Fee and Profit Share

U.S.-taxable investors(limited partners)

non-U.S. and U.S. tax-exempt investors

(shareholders)

28Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


III. CITs: Additional Documentation for Hedge Funds

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Process

• Stage 1: Due diligence on prospective funds• Stage 2: Negotiation and execution of legal

documents

30Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Documentation

• Review PPM Also review ancillary documents (e.g., partnership

agreement, investment management agreement, other material agreements)

• Execute subscription agreement• Negotiate and execute side letter

At a minimum, “plan assets” side letter Other possible side letter provisions

Most favored nations “Key person” provisions Comfort as to issues raised in diligence

31Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


IV. Private Equity Funds: An Overview

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Comparison of Hedge and Private Equity Funds

Hedge Funds Private Equity Funds

Capital Contributions Fully funded at time investor becomes a shareholder or limited partner

Investor’s capital commitment drawn down over time

New Investors/Investments

Generally accepts new investors (or additional capital) based on fund’s net asset value

Not accepted after short initial offering period

Liquidity Generally allows withdrawals at specified intervals, subject to certain limitations

None

Distributions Generally none (though some onshore funds provide tax distributions)

Cash is distributed as investments are realized (subject to certain restrictions)

Management Fees Based on fund’s net asset value (which includes portfolio appreciation)

During investment period, based on capital commitments; thereafter, generally based on invested capital (less write-downs)

Performance Compensation

Percentage of increase in fund’s net asset value (i.e., net realized and unrealized gains)

Percentage of cash distributed—no compensation for increase in value of an investment until realization

33Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


What Is a Private Equity Fund?

• Like hedge funds, private equity funds are a structure, not an asset class

• Focus on illiquid investments; wide variety of investment strategies (LBO, distressed debt, mezzanine, real estate, venture capital, etc.)

• Key elements: Capital is drawn down as needed No investor liquidity Economics and fees based on cash distributions (not

marked-to-market value of positions) Limited investment periods and life

34Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Key Private Equity Fund Terms

• Investment period PE funds may only draw down capital to make investments

for a limited investment period (typically 35 years, but varies depending on strategy)

Subsequent draw-downs typically permitted for fund expenses (including management fees), to complete existing investments, and to fund follow-on investments (typically subject to a cap of 15%)

Early termination of investment period for “cause” standard, but similar “key man” and “no-fault” termination rights are heavily negotiated

35Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview


Key Private Equity Fund Terms (cont.)

• Distributions and Carried Interest Waterfalls Example:

1. 100% of proceeds to investors until return all capital contributed;2. 100% to investors until receive 8% IRR preferred return on

invested capital;3. 100% to the GP until it receives 20% of distributions pursuant to

clauses 2 and 3;4. 80% to investors and 20% to GP

Aggregate vs. deal-by-deal Preferred return (typically 8%) GP catch-up Other issues:

Current income from unrealized investments Write-downs of unrealized investments Fee waivers/reductions

36Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview



• GP clawback of carried interest Escrow of carried interest distributions Guarantees on clawback? Net of tax?

• Management fees 1-2% fixed fee; initially based on commitments, but based

on invested capital after commitment period Recent pressure to reduce fixed fees for larger funds Offsets for transaction, directors and similar fees

37Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview



• Removal/termination Key person rights

Personnel covered and scope of trigger Investor voting threshold to implement

“No fault” GP removal with supermajority consent GP removal or fund termination for “cause”

“Cause” definition Usually requires final judicial determination of “cause”

• Clawback of distributions to investors Subject to statute of limitations Aggregate cap on clawback

38Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview



• Fund term Typically 10 years (but varies depending on strategy) Extensions, perhaps with investor or advisory committee

approval

• Investor defaults Remedies and penalties

39Private Equity


Solutions to Hedge

Fund Issues


Hedge Fund Overview

PRIVILEGED AND CONFIDENTIAL©2015 Sutherland Asbill & Brennan LLP

This communication cannot be used for the purpose of avoiding any penalties that may be imposed under federal, state or local tax law.

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Investing in Alternative Investments: Issues for CITs · PRIVILEGED AND CONFIDENTIAL ©2015...

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