Market Trends: Hedge Funds
In 2017 hedge fund managers continued to adjust to an evolving global regulatory environment and changing marketplace. The year brought investor scrutiny of the asset class and the evolution of new financial products, particularly digital assets.
Areas of substantial attention for hedge funds in 2017 included data protection and cybersecurity, the allocation of opportunities, the allocation of fees and expenses and the impact of new tax reform legislation.
Discussed below are additional areas of new and expanded legal and regulatory requirements that will continue to impact investment advisors in the future.
Cybersecurity and Data Protection. U.S. and EU regulatory agencies have established many new rules and guidance designed to bolster the cybersecurity and data protection programs of managers.
SEC and CFTC Enforcement. The SEC’s enforcement efforts have been focused on valuation; improper allocation of fees and expenses; “cherry-picking” profitable trades for personal accounts; policies and procedures to prevent the misuse of material nonpublic information; failure to register; and custody rule and other compliance rule violations. The CFTC is focusing on, among other violations, “spoofing” cases.
U.S. Tax Reform under the Tax Cuts and Jobs Act. The Tax Cuts and Jobs Act (the “Tax Act”) contains numerous provisions relevant to alternative investment funds, three of which are the following:
•Carried Interest. If a non-corporate taxpayer owns a partnership interest received in connection with the performance of services in an “applicable trade or business”, any capital gain allocable to such taxpayer in respect of specified assets held by the partnership for more than one year that would have otherwise been treated as long-term capital gain will be converted into short-term capital gain unless the assets are held by the partnership for more than three years.
•Elimination of Miscellaneous Itemized Deductions. The Tax Act eliminates the individual deduction for “miscellaneous itemized deductions”, meaning that investors can no longer deduct certain investment expenses such as management fees, loan servicing fees and fees to other third-party service providers.
•Tax on Gain on Sale of a Partnership Interest by Foreign Persons. Gain recognized by a foreign person on the sale of an interest in a partnership is treated as effectively connected with a U.S. trade or business if the partnership is engaged in a U.S. trade or business. A new 10% withholding tax is also imposed on the sale unless a non-foreign affidavit is provided by the seller.
The DOL’s Fiduciary Rule. The U.S. Department of Labor’s regulation defining fiduciary became applicable on June 9, 2017, although certain aspects were delayed until July 1, 2019. However, on March 15, 2018, a federal appeal court vacated the Department of Labor’s fiduciary rule and related exemptions in its entirety. As a result, the status of the rule continues to remain in limbo.
MiFID II. The second EU Markets in Financial Instruments Directive and the Markets in Financial Instruments Regulation (together “MiFID II”) came into effect and represents a major overhaul of regulatory and compliance obligations, as well as making significant changes to market structure and the trading of swaps and futures. Certain MiFID II changes will impact U.S. managers. For example, U.S. advisers which access EU markets by direct electronic access arrangements with EU broker-dealers are likely to face significant new requirements.
Cryptocurrency and ICOs. A number of new hedge funds focused on investments in cryptocurrency, initial coin offerings, future tokens, functional tokens and similar assets have launched. Another set of funds has launched that focuses on venture and private equity investments in companies developing blockchain and distributed ledger technology.
Increased Institutionalization. There has been an increased focus in investors’ due diligence on internal operations and compliance policies; increased negotiations of side letters or renegotiations of fund terms; lower or tailored fees; more investor-friendly terms; enhanced governance; increased transparency; more ERISA plan asset funds; and greater allocations to large, established managers with longer track records and significant infrastructure.
Managed Account Platforms. Various allocators, including sovereign wealth funds, state pension funds, large family offices, and fund of funds managers, have established managed account platforms to access the strategies of various underlying managers. Certain platforms are also designed to permit investors, through the use of increased leverage and trading/volatility exposures, to make more efficient use of their capital.
Fund of Funds Manager Non-Advisory Services. Fund of funds managers are increasingly asked to provide administration or platform-related services, in addition to or instead of traditional advisory services, such as manager diligence, service provider diligence, middle/back office operations, guideline monitoring, and tailored reporting.
Single-Investor/Single-Relationship Hedge Funds. In addition to the increased prevalence of managed accounts, the number of single-investor hedge funds and hedge funds for groups of affiliated or commonly advised investors continues to grow. These funds may allow for increased transparency, tailored fees, tailored liquidity and tailored investment guidelines.
Seeded Manager Launches. The demand for seed capital continues to exceed supply. However, a number of new seed funds and seed capital providers have begun to expand their efforts in this area. Founders’ classes (i.e., share classes with special benefits for early investors in a fund) continue to be popular for new launches and often incorporate some of the economic benefits of seed deals, often with fewer constraints.
Focus on Trading Documentation and Dealer/Counterparty Credit Risk. Managers continued amending their existing swaps documentation to accommodate new regulatory mandates. In addition, many managers will begin to prepare for the transition from LIBOR and other interbank offered rates to newly established risk-free reference rates that are expected to be introduced.
Reduced Prevalence of Certain Side Letter Terms. While side letters remain common and institutional investors demand a wide variety of special terms, concerns regarding regulatory scrutiny of side letters have led to an increased reluctance of managers to grant in a side letter any terms that may materially adversely impact other investors, such as preferential liquidity or portfolio transparency. Some managers have abrogated their side letters and either adopted a “no substantive side letter” policy, incorporated key side letter terms into fund offering/governing documents to benefit all investors or developed their own standard form of side letters which standardized the terms for common requests.
Co-Investments. Certain hedge fund managers have sought to use co-investment vehicles to handle excess deal capacity or to manage investments that do not fit into a commingled fund’s liquidity profile. These may be structured as single investor vehicles or commingled vehicles. Furthermore, hedge fund managers have increasingly used co-investment vehicle structures to offer investors exposure to high conviction investment ideas, including positions in publicly traded equities or other liquid investments.
Continued Pressure on Fees. The hedge fund industry is seeing pressure on fees. Recently launched hedge funds are routinely offering a founders’ share class with a 25% to 50% discount to standard hedge fund fees as an incentive to invest in their fund. The hedge fund industry has also seen an increase in the types of fee structures utilized. This includes an increase in the use of benchmarks, multi-year incentive fees, tiered management fees based on increases in fund assets under management, and “1 or 30” fee structures.
Blurring of the Lines Between Hedge Funds and Private Equity Funds. Certain hedge funds have incorporated terms that are akin to private-equity style funds recently in order to capitalize on advantageous trading opportunities in less liquid strategies. This is resulting in longer lock-ups, longer redemption notice periods, investor-level gates (sometimes in combination with fund-level gates), and committed capital structures for illiquid strategies.