USA: Investment Funds: Hedge Funds
Contributed by Schulte Roth & Zabel LLP
Many U.S. hedge fund managers were under meaningful pressure coming into 2020. Although, as an asset class, U.S. hedge funds had returned over +12% in 2019, an investment in the S&P 500 index did significantly better in the same period. Approximately $82 billion was redeemed from hedge funds for the year – the worst figure since 2016. Fund liquidations had outpaced new launches, and mean management fees had continued their steady decline.
At the same time, some U.S. hedge fund managers were cautiously optimistic. Predicting a correction, many surveyed investors had reported plans to increase their allocation to hedge funds in a shift toward uncorrelated or more defensive strategies. Amid such sentiment, some managers felt that the coming year might provide an opportunity to demonstrate their worth.
And did it ever. While the outbreak of COVID-19 in the first quarter initially forced many managers to focus attention on the threat of significant redemptions, we did not ultimately see a wave of hedge fund managers suspending redemptions or restructuring, and managers and investors alike quickly adapted to remote working and virtual diligence processes. Meanwhile, as the U.S. equity markets first plunged, swiftly rebounded, and then continued their steady march to new heights, managers seized the myriad opportunities arising from the disruption, and the most common U.S. hedge fund strategies ended the year with nearly-universal positive returns.
“Hedge funds” are investment vehicles that are positioned to attract capital from sophisticated investors to pursue investments in pools of assets that are relatively easy to value and trade. Somewhat distinguishable by reference to the investment strategy being pursued (i.e., the nature of the opportunity being targeted) and/or the investment program being implemented (i.e., the means by which the manager is exploiting the opportunity identified), hedge funds can be loosely grouped into categories. These include equities (including long/short equity), global macro, event-driven (including activist and risk/merger arbitrage), credit, relative value (including various other forms of arbitrage), managed futures, multi-strategy and “niche” (including cryptocurrencies and other digital assets). In 2020, the most obvious winning category among U.S. hedge funds was equities, delivering some +27% according to research firm Preqin. Within equities, funds pursuing investments in the technology, health care and energy and basic materials sectors excelled. Other event-driven and certain niche strategies also performed well. Relative laggards included credit (some +6%) and multi-strategy (some +7%).
Despite these encouraging results, the fundraising environment for U.S. hedge fund managers continues to be somewhat challenging, especially for nascent or less-established firms. Notwithstanding data indicating that early-life-cycle hedge funds outperform their larger, more-established brethren (true for each of the last eight years, according to Preqin), and excepting the success of some highly prominent launches, more-established managers have a significant competitive advantage in raising capital in times of crisis. During the peak of the COVID-19 disruption, many of these firms reopened previously closed funds to replace outflows or performance-based declines or build war chests to pursue specific opportunities. Some raised more-concentrated “best ideas” funds; others sought private equity-style commitments rather than the more typical fully-funded subscriptions.
The commitment feature is one of several closed-end fund features that has appeared in U.S. hedge fund terms in recent years. Along with longer lock-up periods and the re-emergence of the once-out-of-favor “side pocket” mechanism, it is a means for a hedge fund manager to preserve the flexibility that is considered optimal to capturing yield in a highly competitive market. This blurring of the lines separating hedge fund and private equity and other closed-end product terms has in some cases led managers to market “hybrid” funds, designed to hold a blend of both liquid and illiquid assets. The legal counsel that do best in representing managers developing such funds are those that have significant experience with both open-end and closed-end investment products. This is particularly true of certain strategies that lend themselves to hybrid fund terms, such as credit.
The marketability of funds that include such hybrid features has received an assist from COVID-19-related volatility. For example, one recent survey reported that approximately one-fifth of surveyed hedge fund managers were either currently offering funds with side-pocket mechanics or planning to do so in the next two years.
A related trend evident among U.S. hedge fund managers is that of established firms offering new, customized or bespoke products to investors while simultaneously continuing to manage their flagship hedge funds. This evolution or innovation can take the form of “best ideas” funds, long-biased funds (sometimes providing that performance-based compensation is due to the manager only if the fund outperforms a benchmark), funds that offer exposure to a specific subset of a flagship fund’s investment strategy, or other variations such as funds with narrower geographic mandates. In representing managers operating such funds, legal counsel needs to be cognizant of the complex issues, such as issues relating to trade allocations, conflicts of interest and valuations, that can arise in this context.
In an effort to attract investors, some managers have sought to address common investor requests (previously dealt with by side letters) in their fund documents, sometimes including a “most favored nations” provision for all investors. For new launches, “early bird” classes offering a fee discount and sometimes capacity rights (often at the same discount) are also regularly seen. More broadly, management fees have stabilized (albeit somewhat strategy- and size-dependent, and with many outliers) around 1.5% and incentive fees between 15% and 20%. In some cases, the incentive fee is subject to a hurdle rate, typically a relevant index but sometimes a fixed rate.
U.S. governmental and regulatory developments in 2020 included, most obviously, a change of administration late in the year, which will bring new regulatory priorities and an anticipated increased focus on hedge fund managers in the examination and enforcement programs. In addition, the year saw a plethora of other regulatory changes, publications and initiatives, including action by the Securities and Exchange Commission to amend several rules to harmonize requirements for exempt offerings, broaden the definitions of “accredited investor” in Regulation D under the U.S. Securities Act of 1933 and adopt conforming changes to various other rules, and adopt a new, “modernized” version of the rules regarding investment adviser marketing.
At the time of writing, the U.S. equity markets have recently been roiled by an expansive “short squeeze” campaign ostensibly coordinated by online retail investors using Reddit, a popular network of online communities, to target specific issuers. These issuers were known to have very high levels of short interest and be among the short positions of several prominent hedge fund managers. While at the time of writing the ultimate outcome remains unknown, numerous regulators have announced that they are reviewing whether laws were violated and whether regulatory changes are necessary to avoid similar market inefficiencies. It will be interesting to see what action is taken as short selling plays an important role in the efficient operation of the U.S. equity markets, exposing flaws and protecting investors.
In January 2021, the U.S. Treasury Department issued final regulations regarding the taxation of carried interest, which rules could impact U.S. hedge funds, among other investment funds. The regulations expound on a section of the Internal Revenue Code introduced by the U.S. Tax Cuts and Jobs Act of 2017 which increased the length of time for which a fund must hold assets in order for the capital gains received in respect of the carried interest on those assets to be taxed at the long-term capital gains rates (from one year to three years). The rules largely remain unchanged for investors. These changes will cause some managers to rethink their fund documents and structures.
Finally, the Environmental, Social and Governance (ESG) movement and its close relative, the Diversity and Inclusion (D&I) initiative, continue to gain traction among private fund investors and managers. Among ESG priorities, climate change is anticipated to be a major focus of the new U.S. administration, including at the SEC. In December 2020, the influential Institutional Limited Partners Association announced that more than 40 organizations had elected to participate as signatories in its diversity in action initiative. Even though this initiative was presented as a roadmap to the private equity industry, this and other prominent initiatives in the asset management space confirm that the ESG and D&I movements are here to stay. However, there are challenges to applying ESG and D&I policy-driven criteria to certain hedge fund strategies and programs. What works for a concentrated event-driven strategy may not fit a fund that trades frequently, for example. As always, it is important that managers consult experienced counsel and do not overpromise.