Tuesday, December 1, 2009

What Fund Offering Terms Should Omani Institutional Investors Negotiate? Part II:
Hedge Funds

Institutional investors’ appetite for hedge fund investments has grown substantially in the last decade, propelled by the promise of reduced volatility and risk coupled with capital preservation and the delivery of positive returns under all market conditions. As a result of mushrooming investor appetite, the number of hedge funds increased to more than 8,000, with approximately US$1.9 trillion in assets under management, by the end of 2007. However, since then the industry has undergone a massive contraction, with assets under management shrinking to an estimated US$1.4 trillion by the end of 2008, and below US$1 trillion by the current date. This contraction was caused by weaknesses in risk management and due diligence processes amplified by the adverse effects of substantial leverage, liquidity and counterparty risks in the global recession.

In this article we briefly examine certain key terms that Omani institutional investors (e.g., pension and other government funds, private financial institutions and banks) should consider negotiating for in relation to their investments in hedge funds.

  • MFN Clause: The most-favoured-nation clause generally guarantees the institutional investor treatment no less favourable than that accorded, in the past or future, to any other investor in the fund. Any such preferential treatment must be disclosed to the institutional investor, together with the option to elect to receive such treatment itself.

  • Fees: Management fees should be calculated as a per annum percentage of the fund’s net asset value, and performance fees should be subject to a high water mark. In addition, any early redemption fees should be payable only during the applicable lock-up period, and no placement, organizational or other fees should be chargeable to the institutional investor’s account unless otherwise agreed and disclosed on an item-by-item basis. The calculation of all fees should be confirmed by an independent audit to provide transparency to the institutional investor, and all fees should be commercially reasonable.

  • Change of Control, Key Person and Strategy Disclosure: Notice of any change in control of the fund manager, any variations in its key persons’ involvement in the investment activities of the fund and any material change to the fund’s overall investment objective should be promptly given to the institutional investor and trigger a right of withdrawal from the fund, without application of any early redemption fees.

  • Redemption Intervals and Notices; Gating: Hedge funds generally allow periodic redemptions of fund interests (e.g., monthly, quarterly, semi-annually), subject to substantial prior notice from the redeeming investor and the potential imposition of a gate (i.e., a limitation on the total amount of redemptions permitted on a given redemption date, usually set at 10% of fund net asset value). Institutional investors should negotiate preferential redemption terms (e.g., in the form of shorter notice periods and diminished gating thresholds) to guarantee sufficient liquidity of their investments.

  • Compulsory Redemptions: The right of the fund to compulsorily redeem an institutional investor’s fund interest should be limited to cases in which an independent counsel’s opinion confirms potentially adverse legal or regulatory consequences to the fund should the institutional investor continue to hold its fund interest.

  • In-kind Distributions: An institutional investor should ensure its right to receive all redemption amounts and other distributions from the fund in cash, unless it specifically agrees to receive in-kind distributions, in which case it should request the right to establish a liquidating trust to receive the in-kind distributions.

  • Transparency: An institutional investor should ensure the right to receive monthly capital account statements and regular risk profile reports, together with quarterly (unaudited) and annual (audited) capital account statements.

  • Transferability of Fund Interest: An institutional investor should seek a carve-out to any transfer restrictions imposed on its fund interest to permit transfers to its affiliates (e.g., when the institutional investor is undergoing a reorganization) without requiring the fund’s consent.

  • Valuation: The fund’s asset valuation procedures should be fully disclosed, including any methods used to value hard-to-value assets. As a general matter, illiquid or special situation assets should be valued by an independent valuator and not at the fund manager’s discretion.

  • Alternative Investment Vehicle: Where the fund elects to establish an alternative investment vehicle to pursue a particular investment opportunity, the institutional investor should have the right to “opt out” of the vehicle upon prior notice.

  • Soft Dollars: The fund manager should confirm to an institutional investor that any “soft dollar” credits derived from brokerage transactions effected for its capital account will only be used to obtain investment research and brokerage services for the benefit of its account.

  • Liability: An institutional investor should ensure that its liability for the fund’s debts and obligations is limited to the investor’s contributed capital and that, following its withdrawal from the fund, it will have no further liability.

  • Privileges and Immunities: Certain institutional investors may, under Omani laws, benefit from immunity from certain domestic and international laws which would otherwise be applicable to them. No provision of any fund document should prejudice such immunity unless deliberately waived by the institutional investor.

  • Forum Selection: Omani courts should have exclusive jurisdiction in respect of any legal action brought against an institutional investor relating to its investment in the fund.

  • Fund and Manager Representations: Each of the fund and its manager should represent to the investor that no action is being threatened against them and that any information provided to the investor is true and complete and no material fact has been omitted.

  • Controlling Nature of Side Letter: An institutional investor entering into a side letter arrangement with the fund should ensure that, as a contractual matter, where any inconsistency or contradiction between the fund’s agreements and the provisions of the side letter arises, the side letter will control in all respects.
Investing in hedge funds continues to present an attractive option for institutional investors which offers a broad range of investment strategies and considerable portfolio diversification opportunities within a flexible and sophisticated structure. Nonetheless, the liquidity and operating failures experienced by many hedge funds during the financial crisis have highlighted inherent weaknesses within industry practice which investors must guard against going forward.

It is crucial therefore, for Omani institutional investors to seek preferential side letter terms such as those described above before investing to minimize investment risk, ensure high levels of transparency and better align the fund’s investment strategy with the investor’s investment objectives and portfolio diversification and regulatory requirements.