Posts Tagged ‘Fund managers’

Risk Choice under High-Water Marks

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Thursday March 20, 2014 at 9:03 am
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Editor’s Note: The following post comes to us from Itamar Drechsler of the Department of Finance at New York University Stern School of Business.

High-water mark (HWM) contracts are the predominant compensation structure for managers in the hedge fund industry. In the paper, Risk Choice under High-Water Marks, forthcoming in the Review of Financial Studies, I seek to understand the optimal dynamic risk-taking strategy of a hedge fund manager who is compensated under such a contract. This is both an interesting portfolio-choice question, and one with potentially important ramifications for the willingness of hedge funds to bear risk in their role as arbitrageurs and liquidity providers, especially in times of crises. High-water mark mechanisms are also implicit in other types of compensation structures, so insights from this question extend beyond hedge funds. An example is a corporate manager who is paid performance bonuses based on record earnings or stock price and whose choice of projects influences the firm’s level of risk.

…continue reading: Risk Choice under High-Water Marks

SEC v. Contorinis: SEC gets Powerful New Tool—For Now

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday March 16, 2014 at 9:00 am
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Editor’s Note: The following post comes to us from Paul N. Monnin, partner in the Litigation and Regulatory practice at DLA Piper LLP, and is based on a DLA Piper publication by Mr. Monnin and Zachary LeVasseur.

The Second Circuit Court of Appeals has broadened the Securities and Exchange Commission’s power to seek civil disgorgement of profits from insider trading violations even where an individual did not personally profit from the illegal trades.

In its panel opinion in SEC v. Contorinis, decided on February 18, the Second Circuit upheld a trial court order requiring that Joseph Contorinis, the former managing director of the Jeffries Paragon Fund, disgorge more than US$7 million in unlawful profits obtained by the fund as a result of Contorinis’s trading on material nonpublic information. This is despite the fact that he did not trade with his own personal assets and his personal compensation from the trades amounted to only US$427,875.

…continue reading: SEC v. Contorinis: SEC gets Powerful New Tool—For Now

Carried Interests: Current Developments

Editor’s Note: Joseph Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. This post is based on an article by Mr. Bachelder which first appeared in the New York Law Journal.

The tax status of so-called “carried interests,” held by private equity fund sponsors (and benefitting, in particular, the individual managers of those sponsors) is the subject of this post. A decision by the U.S. Court of Appeals for the First Circuit holding that a private equity fund was engaged in a trade or business for purposes of the withdrawal liability provisions of ERISA (Employee Retirement Income Security Act) has caused considerable comment on the issue of whether a private equity fund might also be held to be in a trade or business (and not just a passive investor) for purposes of capital gains tax treatment on the sale of its portfolio companies. Proposed federal income tax legislation, beginning in 2007 and continuing into 2013, also has raised concern as to the status of capital gains tax treatment for holders of carried interests. The following post addresses both of these developments.

…continue reading: Carried Interests: Current Developments

Valuing Private Equity

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday January 12, 2014 at 9:00 am
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Editor’s Note: The following post comes to us from Morten Sorensen and Neng Wang, both of the Finance and Economics Division at Columbia Business School, and Jinqiang Yang of Shanghai University of Finance and Economics.

In our recent NBER working paper, Valuing Private Equity, to value PE investments, we develop a model of the asset allocation for an institutional investor (LP). The model captures the main institutional features of PE, including: (1) Inability to trade or rebalance the PE investment, and the resulting long-term illiquidity and unspanned risks; (2) GPs creating value and generating alpha by effectively managing the fund’s portfolio companies; (3) GP compensation, including management fees and performance-based carried interest; and (4) leverage and the pricing of the resulting risky debt. The model delivers tractable expressions for the LP’s asset allocation and provides an analytical characterization of the certainty-equivalent valuation of the PE investment.

…continue reading: Valuing Private Equity

Are Hedge Fund Managers Systematically Misreporting? Or Not?

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday December 23, 2013 at 9:17 am
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Editor’s Note: The following post comes to us from Philippe Jorion and Christopher Schwarz, both of the Finance Area at the University of California at Irvine.

The hedge fund industry has grown tremendously over the last two decades. While this growth is due to a number of factors, one explanation is that its performance-based compensation system creates incentives for managers to generate alpha. This incentive system, however, could also motivate some managers to manipulate net asset values or commit outright fraud. Due to the light regulatory environment hedge funds operate in and their secretive nature, monitoring managers is generally difficult for investors and regulators.

In response, recent research has attempted to infer malfeasance directly from the distribution of hedge fund returns. In particular, the finding of a pervasive discontinuity in the distribution of net returns around zero has been interpreted as evidence that hedge fund managers systematically manipulate the reporting of NAVs to minimize the frequency of losses. This literature, however, has not recognized that performance fees distort the pattern of net returns.

In our paper, Are Hedge Fund Managers Systematically Misreporting? Or Not?, forthcoming in the Journal of Financial Economics, we show that inferring misreporting based on a kink at zero can be misleading when ignoring incentive fees. Because these fees are applied asymmetrically to positive and negative returns, the distribution of net returns should display a natural discontinuity around zero. In other words, there is a mechanical explanation for the observed kink in the distribution of net returns. We demonstrate this effect by showing that funds without incentive fees have no discontinuity at zero until we add hypothetical incentive fees to their returns.

…continue reading: Are Hedge Fund Managers Systematically Misreporting? Or Not?

Remarks to the Independent Directors Council Annual Fall Meeting

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday November 13, 2013 at 9:21 am
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Editor’s Note: The following post comes to us from Norm Champ, director of the Division of Investment Management at the U.S. Securities and Exchange Commission. This post is based on Mr. Champ’s remarks at an Independent Directors Council Annual Fall Meeting; the full text, including footnotes, is available here. The views expressed in this post are those of Mr. Champ and do not necessarily reflect those of the Securities and Exchange Commission, the Division of Investment Management, or the Staff.

It is a privilege to appear before a group that is so important to the strength and integrity of the fund industry. Independent directors have significant responsibilities, and it requires tremendous effort and time on your part to do your job well. I applaud your efforts to learn from the professionals who are participating in this conference. The insights of the panels you heard yesterday and this morning, and those you will hear after lunch will provide valuable information.

The importance of mutual funds in the lives of American investors is clear. Mutual funds hold close to $14 trillion of the hard earned savings of over 53 million American households. The majority of Americans access the markets through mutual funds. They invest in funds, and hope their investments will grow, for many reasons—to make a down payment on a house, to save for a college education, and ultimately to pay for a retirement.

…continue reading: Remarks to the Independent Directors Council Annual Fall Meeting

UK Treasury Releases Draft Alternative Investment Fund Managers Directive

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday June 9, 2013 at 9:59 am
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Editor’s Note: The following post comes to us from Glynn Barwick, counsel in the Business Law Department at Goodwin Procter and member of the firm’s Private Investment Funds and Financial Services Practices, and is based on a Goodwin Procter client alert by Mr. Barwick.

The UK Treasury has recently published a new, and near final, version of the implementing Regulations for the Alternative Investment Fund Managers Directive (the “AIFMD”). (We have commented on the consequences of the AIFMD for EU managers and non-EU managers in our 4 January, 11 January, 27 February and 27 March client alerts.) This updated version of the implementing Regulations represents a considerable improvement for managers compared to the initial draft.

In summary, with effect from the implementation date (22 July 2013), European managers of Alternative Investment Funds (“AIFs”) – essentially:

  • (a) any European manager of a PE, VC, hedge or real estate fund will need to be authorised in its home member state and comply with various requirements regarding the funds that it manages concerning information disclosure and third-party service providers; and
  • (b) any non-European manager of a PE, VC, hedge or real estate fund will need to comply with various marketing and registration restrictions if it wishes to obtain access to European investors.

This post discusses the major changes to the AIFMD implementing Regulations.

…continue reading: UK Treasury Releases Draft Alternative Investment Fund Managers Directive

The Separation of Investments and Management

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday April 29, 2013 at 9:28 am
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Editor’s Note: The following post come to us from John Morley, Associate Professor of Law at University of Virginia School of Law.

This paper suggests that the essence of these funds and their regulation lies not just in the nature of their investments, as is widely supposed, but also—and more importantly—in the nature of their organization.

Specifically, every enterprise that we commonly think of as an investment fund adopts a pattern of organization that I am calling the “separation of investments and management.” These enterprises place their securities, currency and other investment assets and liabilities into one entity (a “fund”) with one set of owners, and their managers, workers, office space and other operational assets and liabilities into a different entity (a “management company” or “adviser”) with a different set of owners. Investment enterprises also radically limit fund investors’ control. A typical hedge fund, for example, cannot fire and replace its management company or its employees—not even by unanimous vote of the fund’s board and equity holders.

I explain this pattern of organization and explore its costs and benefits. I argue, paradoxically, that the separation of investments and management benefits fund investors by limiting their control over managers and their exposure to managers’ profits and liabilities.

…continue reading: The Separation of Investments and Management

Hedge Fund Governance

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday April 15, 2013 at 9:41 am
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Editor’s Note: The following post comes to us from Houman Shadab, Associate Professor of Law at New York Law School.

Concerns about the internal governance of hedge funds have dramatically increased in recent years. During the financial crisis of 2008, investors became frustrated when numerous hedge fund managers suddenly prevented them from withdrawing their capital yet nonetheless continued to charge them fees. Since the financial crisis, concerns about hedge fund governance have focused on transparency, operational practices, and the growing view that fund directors do not effectively monitor fund managers.

In my paper, Hedge Fund Governance, which was recently made publicly available on SSRN, I provide the first comprehensive scholarly analysis of hedge fund governance. In doing so, my paper makes several contributions. First, it contributes to the literature on corporate governance by conceptualizing the unique way in which hedge funds are governed and situating their style of governance within established paradigms. I argue that hedge fund governance is a type of responsive managerialism.

…continue reading: Hedge Fund Governance

Enforcement Priorities in the Alternative Space

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday January 16, 2013 at 9:14 am
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Editor’s Note: The following post comes to us from Bruce Karpati, chief of the Division of Enforcement, Asset Management Unit, at the U.S. Securities and Exchange Commission. This post is based on Mr. Karpati’s recent remarks before the Regulatory Compliance Association, which are available here. The views expressed in this post are those of Mr. Karpati and do not necessarily reflect those of the Securities and Exchange Commission, the Commissioners, or the Staff.

I plan to speak about the Enforcement Division’s and in particular the Asset Management Unit’s priorities in the hedge fund space. I’ll discuss the importance of specialization and expertise to this effort; the risks for investors; how these risks are informed by the hedge fund operating model; and how a hedge fund manager’s business may be at odds with the manager’s fiduciary duty to the fund. I’ll also discuss the types of misconduct we’ve seen crossing our desks in the Asset Management Unit, and I’ll conclude with certain best practices to avoid the specter of an enforcement referral or inquiry.

…continue reading: Enforcement Priorities in the Alternative Space

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