USA: An Introduction to Investment Funds: Hedge Funds

USA: Investment Funds: Hedge Funds 

Contributed by Schulte Roth & Zabel LLP

“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 such as: 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/blockchain and other digital assets).

In 2020, as the COVID-19 pandemic roiled global markets, U.S. hedge fund managers pounced on the resulting dislocations and delivered strong risk-adjusted performance for the year, with equities and event-driven strategies, in particular, finding many attractive opportunities across the technology, health care and energy and basic materials sectors. Notwithstanding that 2020 presented a challenging environment for fundraising (especially for nascent or less-established firms), many U.S. hedge fund managers ended the year with significant gains.

In 2021, while “meme-stock” short squeezes, pandemic-related supply concerns and macroeconomic issues, such as fears of inflation, led some U.S. hedge funds to sustain losses, generally U.S. hedge fund managers enjoyed another good year. The asset class gained approximately 13%, according to data aggregator Preqin, with positive inflows in every quarter. While all major strategies reported positive performance for the year, event-driven and other equities strategies were again the standouts, and sub-strategies such as commodities and digital assets also performed well. Amid a more accommodative environment, new launch activity outpaced fund liquidations and the industry saw several $1 billion+ “mega” launches. Certain of the largest, most-prominent hedge fund managers took the opportunity to return capital to investors and accept new subscriptions into classes with longer lock-up periods or other manager-friendly differences.

Opportunities for U.S. hedge fund managers pursuing equities strategies are by no means confined to publicly-traded equity securities and 2021 was a year in which these managers had notable success in private markets. In recent years, investors have supported an increasing level of such “crossover” investment activity, whereby U.S. hedge fund managers traditionally focused on the public markets have moved into private markets to compete with venture capital firms and others for pre-IPO equity investment opportunities. To facilitate crossover investments, U.S. hedge fund managers have increasingly built closed-end fund-like features into their fund terms. Longer lock-up periods, “side pocket” mechanisms (with generous caps) and commitment classes are all means by which U.S. hedge fund managers are preserving the flexibility to make such investments. 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 crossover equities, credit and blockchain and other digital assets.

A related trend evident among U.S. hedge fund managers in 2021 was 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 complex issues, such as issues relating to trade allocations, conflicts of interest and valuations, that can arise in this context.

“Niche” alternative assets remain a particularly hot segment of the private funds industry and many U.S. hedge fund managers are actively marketing niche products. For example, 2021 saw an explosion in the number of new fund sponsors, the amount of new capital and the diversification of strategies in the digital assets space, with several sponsors now managing billions of dollars and some even becoming public companies. Demand for litigation finance funds and other specialty products, including fintech, healthcare, life settlements, CLO equity, music rights and “ESG” products, is also high. And just as managers of open-ended funds continue to move into less liquid asset classes, sponsors of closed-end funds are also exploring ways to hold their assets and capital longer, as exemplified by the move by one prominent venture capital sponsor during 2021 to overlay what appears to be a form of liquid feeder fund on its existing closed-end fund complexes.

In an effort to attract investors and minimize the expense of side letter negotiations, managers continued in 2021 to seek to address common investor requests in their fund documents, sometimes including a “most favoured 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 fee rates remain stable (albeit somewhat strategy- and size-dependent, and with many outliers) at around 1.5% and incentive fee rates 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. Hedge funds with multi-year lock-up periods may also offer to calculate incentive fees based on performance over the entire lock-up period.

In April 2021, Gary Gensler took the helm of the SEC as its new chairman. The new administration has an ambitious agenda that includes anticipated rulemaking and increased enforcement and examination activity. In November 2021, Chairman Gensler said that he had asked his staff to consider recommendations for private fund managers with respect to fee transparency, side letter transparency, performance metrics transparency, conflicts of interest mitigation and prohibition and enhanced Form PF reporting. The SEC also has pursued several enforcement actions related to digital assets issuers and exchanges and taken aim at other cryptocurrency products, arguing that they constitute securities. The SEC brought proceedings in 2021 against a prominent alternative data vendor, leading many U.S. hedge fund managers to re-assess their diligence efforts with respect to the use of alternative data to inform trading decisions. The SEC also brought a novel proceeding relating to “shadow trading,” a form of insider trading where a person uses confidential information about one company to trade in the securities of an “economically linked” company, such as a competitor in the same industry. The level to which ESG issues are integrated by managers into their investment analyses, and the quality of the related disclosures, also remains a hot topic for the SEC and other regulators. Additionally, this administration will oversee the transition to the new “modernized” marketing rule for fund managers, which was adopted in late 2020 with a compliance date of November 4, 2022.

Several legislative proposals to amend the U.S. Internal Revenue Code have recently been introduced in Congress, some of which will likely have an effect on the taxation of hedge funds and their investors, as well as the taxation of performance-based compensation. The "carried interest" proposals, if enacted, would revise the current laws pertaining to the taxation of performance-based compensation in order to make it more difficult, or in certain proposals nearly impossible, for hedge fund managers to be taxed on their performance-based compensation at long-term capital gains rates. Under current law, performance-based allocations from investment funds can be taxed at long-term capital gains rates generally only to the extent that the holding period of the realized investments, from which such allocations were made, exceeds three years.