Perspectives on the Hedge Fund Industry in California
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Perspectives on the Hedge Fund Industry in California

Top hedge fund managers and service providers to the hedge fund industry discuss The JOBS Act, Form PF, and Succession Planning

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Introduction

This is the first in a series of white papers designed to chronicle current issues of interest to the hedge fund community. It represents the perspectives of numerous California hedge fund managers and service providers who attended two California Hedge Fund Association (“CHFA”) 2012 roundtable thought leadership discussions in Northern and Southern California. At these CHFA discussions, groups discussed various issues facing the hedge fund industry including Form PF, The JOBS Act , and Succession Planning. The sessions were moderated by CHFA Board Member Chris Ainsworth of Maerisland Capital and the following organizations participated: Engaged Capital; J.P. Morgan; Voyager Management, LLC; Citco Fund Services; Shartiss Friese LLP; Sunrise Capital Partners; Grant Capital Management; Pillsbury Winthrop Shaw Pittman; Sentinel Rock Capital, LLC; Dalton Investments; Woodruff-Sawyer & Co. Insurance Services; Empyrean Capital Partners; Cavalry Asset Management; Fintan Partners; Armored Wolf; Coast Asset Management, LLC; Paul Hastings; Criterion Capital Management.

Form PF - What hedge fund managers are doing about Form PF?

Form PF1 was designed to track and inform the Financial Stability Oversight Counsel (FSOC) of potential risk introduced to the financial system as the result of Hedge Fund Financing. It is composed of 5 Sections, covering 42 pages and over 2,000 data points requesting Firm and Fund information. It is generally agreed that all SEC registered advisers with greater than $150M in “gross” private fund assets, including hedge funds, private funds, private equity funds and liquidity funds, must file Form PF.

In the Los Angeles discussion, most discussion participants reported that Form PF has not been as onerous as originally feared and takes less time to complete than expected. However, the San Francisco group had almost the exact opposite reaction. A number of first time filers did the work themselves by hiring a consultant since they already had the skill set within their funds. Some people used their administrators for filing. Managers believed if the firm and the investment strategy were fairly easy to understand, it was relatively easy to fill in the blanks the SEC wanted filled in. One fund that does a mock audit every year found that it already had accumulated the data required as part of the audit preparation process.

Hedge funds running more complex strategies with larger amounts of leverage found the forms to very extremely difficult and had to spend many hours working through the documents to ensure the numbers matched as reported in various sections of the form. Some hedge fund managers reported having difficulty coming up with their data definition and then deciding whether to do the work internally or outsource it. Second round filers are looking for the best technology for filing out the form. Some reported the hardest part of completing the form is the data cleansing and matching all the assumptions that are made. One manager reported that it took over 150 hours to complete the form and said it was costly. In terms of the costs involved, there was a great deal of discussion about the expense of completing the material and whether it was a firm expense or fund expense. Ultimately, it was agreed that this is an expense of the manager and it is the advisor’s responsibility, unless the fund’s policies say differently. There was agreement about the need for expense caps and transparency with respect to what costs a hedge fund passes on to investors.

While there are many service providers available to help in filing Form PF, the consensus of the discussion groups was that many are simply information aggregators as opposed to people who are carefully putting the form together and working closely with the hedge fund managers to ensure a customized, accurate Form PF. For this and other reasons, some managers are taking a “wait and see approach” regarding Form PF and the process of preparing it. It remained unclear to most what the SEC is going to do with all the information gathered from hedge fund Form PF’s given the large amount of time and cost involved. Given the complexity of some hedge fund strategies (e.g. fixed income arbitrage funds) and the inflexible “one-size-fits-all” nature of Form PF, there was doubt expressed about how much value the form will give a potential investor. Most discussion participants thought that the data produced may not be useful for investors because of the difficulty of analyzing it and that it is unclear that many people will even know precisely how to interpret the data. However, most agreed that overall, Form PF is a step toward greater hedge fund transparency and may potentially serve the industry by making investors better informed and thereby, more comfortable with hedge fund investing.

There were doubts expressed in our discussion groups about the ability by regulators to combine the data gathered from Form PF’s in a meaningful way that will be of use to regulators and the general public. There was speculation that there will be a massive amount of data out there and that no one will know where to start in analyzing it because it has been gathered from different sources and is based on different assumptions.

It was noted in our discussion groups that on August 30, 2012, the Securities and Exchange Commission released the Dodd Frank Act’s mandated study on the financial literacy of retail investors which concluded among other things, that retail investors are largely uninformed about investing and financial matters generally. As a result, all agreed that there is still a great deal that the Hedge Fund industry can and should do to educate people about the important role hedge funds play in orderly financial markets. However, given the general lack of investment knowledge among most of the population, there are many questions as to best place to start the education process. Some good education sources are starting to emerge, including the Managed Funds Association and its website, www.managedfunds.org.

The JOBS Act - What are the implications?

U.S. regulators recently loosened restrictions banning private investment firms from advertising via provision contained in the Jumpstart Our Business Startups Act, or JOBS Act2. Most hedge fund managers participating in our discussions agreed that they do not plan to advertise and did not want their fund’s performance to be made public other than through their communications with qualified investors.

Participants in our discussions suggested that they perceived too many pitfalls to advertising and that it may not be worth the risk. For example, one manager said that he does not plan to expose details regarding his fund to the outside world because it goes against legal agreements pertaining to disclosure he has with his investors. Most hedge fund managers stated in our discussions that they do not see advertising as an advantage, but instead, as a potential source of litigation and liability.

Some participants in our discussions stated a belief that the JOBS Act will allow large hedge funds to differentiate themselves by branding and creating the perception that they are superior by virtue of their sheer size and recognizable brand name. It was agreed that this could make it more difficult for small funds to complete. There was also general agreement that large funds have more to gain from this type of advertising activity compared to small funds that potentially assume more risk with less margin for error should they opt to advertise.

Some participants in our discussions concluded that if a fund is looking to broaden its asset base, get more high net worth clients, and draw more assets from investor populations that have not traditionally invested in hedge funds, there may be some advantage to advertising as authorized by the JOBS Act. Others in our discussion group suggested that that because for newly launching and smaller funds, raising capital in this market environment is difficult, using advertising to find new investors may be necessary to help get them off the ground and build a critical mass of assets under management.

Most managers agreed that they must ask themselves: “what do I want to be?” and suggested that managers may be wise to stay away from retail level investors that are not sophisticated about investing, regardless of the JOBS Act. The general consensus in our discussions was that retail investors are often chasing a return and often lack a sophisticated understanding of the investment process. As such, they are probably not ideal investors for hedge fund strategies.

Some in our discussions speculated that if advertising under the JOBS ACT led hedge funds to become better understood by the general public, maybe it would be positive for the entire industry (i.e. “the rising tide could lift all the boats”). However others noted that the inverse could also prove to be true and a large, well-known hedge fund fails, such an event could severely damage the reputation of the entire industry and hurt all hedge funds.

It was agreed in our discussions that the “crowd funding” aspect of the JOBS Act which appears to allow for certain investments to utilize a wider pool of small investors with fewer restrictions may actually turn out to be very harmful in the long-run because it allows public solicitation over the Internet from a very broad audience via a process that has little accountability. Participants in our discussion were particularly troubled by the fat that if such investment vehicles stay under certain minimums they do not appear to require SEC registration and can apparently operate without oversight. Regardless, “crowd sourcing” his is how some private companies have started raising capital in recent years and the trend toward this model seems to be strengthening and the view of our discussion participants, this could create a lot of problems.

Succession Planning - What Are Hedge Fund Managers Doing?

It was agreed among all discussion participants that succession planning, while one of the most critical aspects of the hedge fund business, remains one of the most overlooked aspects of the business and that most hedge fund managers do not think about succession when launching.. This is because for many hedge fund managers, it is hard to think about their mortality and to think about other people doing what they are doing should they no longer want to, or be able to run their fund. More generally, participants in our discussion agreed that succession planning is a cultural and social issue in many instances and thus very difficult to navigate in most organizations. At the same time, participants in our discussions agreed that having a cogent, well-articulated, demonstrable succession plan is essential for raising capital and to a more secure future for any hedge fund. Many agreed that a robust succession plan can also be used as a talent retention strategy and to build equity in good employees because those employees who know there is a path toward future shareholding in a hedge fund are better incentivized to stay at the fund. It was agreed by many our discussion sessions that succession planning is very difficult to do retroactively and that the best course is to address succession planning early in the life of a hedge fund.

In relation to a succession plan, it was noted that some hedge funds take out an insurance policy on the Chief Investment Officer (“CIO”) and other key leaders of the hedge fund in the event something happens to those individuals and capital is needed to either replace such leaders or to effectuate an orderly wind down of a hedge fund.. Some hedge funds have also proactively laid out a plan for an organized equity earn-out over a period of time whereby certain more junior members of a fund are groomed to take it over to keep it going when the founders and more senior team members leave. This approach is of most use to hedge funds that are dependent on certain junior managers who, as a general matter, tend to stay in a position for a 4-5 year period and then move on to launch their own hedge funds unless properly incentivized to stay.

Most in our discussion agreed that when it comes to constructing an orderly succession plan, larger funds with more of a business history have an advantage given their typically larger, senior investment teams and large resource base, often generated from massive management fee revenues and in some cases, revenues from a public offering. Using such resources, larger hedge funds can more easily pay to retain key junior team members and more readily create a culture of succession among such personnel. This is as opposed to newer, smaller hedge funds in which typically, a single founder has put in a great deal of equity in to start the business and expects to be fully paid back before allowing others to share in profits as part of a succession plan.

Finally, many in our discussion groups noted that when launching a hedge fund in today’s challenging economic environment it is important to think about succession planning and many other business issues (as opposed to simply focusing on investment issues) up-front and to think of oneself as running a business as opposed to simply running an investment fund. Many agreed that it is critical for a hedge fund founder to decide early on if he/she is simply planning to run an investment fund that will function for only so long as the founder is involved or, alternatively, if he/she is looking to run a durable business enterprise that will survive his/her departure. If the founder’s plan is the former, then a robust succession plan may not be necessary (though investors may demand one regardless). If the founder’s plan is more along the lines of the latter, then a robust success plan is mandatory.
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