The last few years have seen a significant rise in the number and variety of hedge fund based structured products being offered to both institutional clients and private investors. This article explores their attraction for both the investor and the hedge fund manager, and addresses some of the specific regulatory challenges faced by the providers of such products.
A generic term with no accepted legal, tax or regulatory definition, the phrase "hedge fund structured products" encompasses any form of indirect or "notional" investment the returns on which are referenced to the returns generated by hedge fund strategies. More accurate attempts at definition are frustrated by the wide range of structures used and the almost infinite combinations of risk and reward, on single or multiple underlyings, that can be created.
propose a defined sub-set of hedge fund structured products, by offering a general definition of a "Fund Derivative Transaction". This is useful in the common circumstance where the structured product is an OTC derivative, either in itself (options, swaps and forward transactions) or "embedded" in a structured note as, for example, part of a wider MTN programme.
However, other types of "notional" or indirect investment are not easily classed as "derivatives" (e.g. cash-settled warrants) and therefore the generic term 'structured products' persists. What is common, and presents a number of legal and regulatory challenges, is the need of the issuer of (or counterparty to) the structured product to "hedge" its ability to meet the payout profile of the product. It may do so either "synthetically" or via taking a direct participation in the "underlying".
The rapid growth in hedge fund structured products has tracked the expansion in the investor base of hedge funds more generally, prompted in significant part by the interest in absolute return strategies that followed the collapse of the Telecoms, Media and Technology boom.
Structured products offer investors a number of perceived and real advantages to investors in comparison to direct investment in the underlying strategy or fund:
* First and foremost is the ability to alter the risk/reward profile of the underlying to precisely suit their investment objectives and tolerance for different types of investment risk. The most obvious example is the provision of capital protection, although other characteristics such as liquidity, correlation and volatility are also now addressed by increasingly sophisticated financial engineering techniques.
* Structured products can also overcome regulatory barriers or investment charter restrictions which prevent an investor investing directly in unauthorised collective investment schemes, which hedge funds typically are. The structuring of retail launches, in particular, is often significantly influenced by a desire to achieve eligibility for inclusion within commonly used tax-efficient wrappers such as SIPPs, ISAs or offshore wrapper bonds.
* More contentiously, some structured products attempt to achieve more tax efficient returns, in particular from a UK taxation perspective, by classifying returns as assessable to Capital Gains Tax rather than the Income Tax regime that would typically apply to non-distributing offshore funds.
* At a qualitative level, the attraction may be as simple as the structured product being a familiar instrument, the economics and risk of which are more readily understood than a direct investment in a hedge fund. Moreover, confidence may be drawn from the enhanced due diligence, active portfolio management, risk monitoring and (in some cases) independent portfolio valuations performed by the structured product provider, together with transfer of credit risk from hedge fund to product issuer.
* Finally, the structured product may also provide access to hedge funds that they would otherwise not be able to access, for example due to minimum investment levels.
There are also benefits for the reference hedge fund (and/or its manager). First, structured products may enable access to a wider investor base, providing a new source of funds and therefore of revenues. They may also provide a longer lock-up of fund allocations than direct investment and may result in reduced processing costs by aggregating investors.
Hedge funds can present a number of challenges, in particular valuation (they may not offer transparent and regularly published valuations of an investor's interest), control (they are frequently not subject to stringent legal or regulatory constraints) and liquidity. They do not typically provide immediate liquidity for an investor's interest, and often have infrequent dealings days with additional time passing between the date on which a redemption notice can be served and the date on which proceeds are paid out. Typically there will be no liquid secondary market. Often there are circumstances in which redemptions may be suspended or delayed pending various events or the imposition of "gates" or there may be circumstances in which a compulsory redemption mechanic can be invoked by the hedge fund or a distribution in specie made. Unexpected fees may be imposed by hedge funds (for example, redemption fees) which may have to be structured around when designing a product.
Additionally, there may be "style drift" or a wholesale departure from the published investment strategy of the hedge fund. Key service providers such as prime brokers may take steps which potentially have a significant impact upon the hedge fund manager's ability to continue to trade effectively.
Hedge funds take a wide variety of forms, with many factors that distinguish one underlying hedge fund from another. Structured products referencing hedge funds therefore need to be tailored to the specific characteristic of the reference underlying fund.
When advising a product issuer or providing a due diligence role for a potential investor all of the above will influence the review.
Hedge fund structured products have been around for many years, but are constantly changing and innovating to attract new investors. This progression can be seen in both the breadth of pay-off profiles available and the expansion of delivery structures in recent years, many designed to attract the retail investor into a traditionally institutional space. Structured products based on investment in closed-ended listed shares or taking advantage of the liberalised derivatives regime within UCITS III are good examples of this.
A reflection of the growing maturing of this market can be seen in the publication this year of the 2006 ISDA Fund Derivatives Definitions. The definitions have been crafted with an eye to the distinctive features of hedge fund underlyings when compared with traditional equity underlyings. For the structurer these definitions are intended to go some way towards mitigating the "basis risk" in writing structured products and for the investor at least the beginnings of some degree of consistency in terms of terminology and payout provisions.
Recent regulatory developments and legal risk Firstly, there are a number of risks that may be broadly gathered under the heading of "re-characterisation risks". By "re-characterisation risk", we mean the risk that a regulator takes the position that a particular hedge fund structured product should be viewed and regulated as a direct investment in the underlying hedge fund as opposed to the completely separate transaction intended by the product provider. Given that the primary objective of many products is accessibility and marketability, born of staying within a particular regulatory regime, this risk carries material consequences. But how real is this risk?
Traditionally the English courts have upheld the legal form of a transaction over its substance, if and when there is a workable rationale for it. (Welsh Development Agency v Export Finance Co Ltd  BCLC 148, CA). There is therefore a barrier to wholesale re-characterisation by a would-be litigant or the Financial Services Authority (FSA).
Two significant potential risks nevertheless, apply:
* Firstly, the promotion of the structured product may amount to the promotion of the hedge fund underlying which in turn will typically be an unregulated collective investment scheme. This places the promoter in breach of section 238 of the Financial Services and Markets Act 2000 (FSMA) which effectively prohibits the promotion of hedge funds to the general public. Moreover, private persons have a right of action under section 150 of FSMA if they suffer loss as a result of such contravention.
* Secondly, the product offering (especially those structured as notes) may itself be viewed as a collective investment scheme. Any person who operates a collective investment scheme must be authorised by the FSA to do so or, if already authorised, must also be specifically permitted by the FSA so to do. Consequently unauthorised operators would commit a criminal offence, risk enforcement action by the FSA (including injunction action and orders for restitution) and find themselves unable to enforce contracts made in the course of such activity. In addition, they would be liable to those with whom it has contracted for the return of any money paid, as well as compensation for any losses sustained as a result. The risk of such a "re-characterisation" may be acute where the issuer or counterparty (or affiliate) has discretion in connection with the composition and change of the reference underlyings. Similarly, various of the statutory definitions in FSMA that impact upon the classification of, for example, an open-ended investment company under English law are very uncertain in their application and may leave the product provider in some doubt about the category into which the product offering should fall.
It should also be noted that re-characterisation is only one of the regulatory tools the FSA has at its disposal. The FSA can use whichever of its rule-making powers and investor-education functions it believes is most likely to be effective in mitigating the risks, as it sees them, posed by (in particular, retail) structured products. Practically speaking, the more a promoter seeks to comply with the FSA's rules and policies designed to address these risks, the less likely the FSA will want to consider resorting to re-characterisation.The picture is further complicated by the impact of MIFID which will introduce for some regulated products a categorisation of 'complex' versus 'noncomplex' and growing EU Commission interest in the area, for example the EU Commission's Green Paper on enhancing the EU framework for hedge funds dated July 2005 and IOSCO's Consultation Report on "The Regulatory Environment for Hedge Funds" dated March 2006.
Re-characterisation is also a risk under the US securities laws (primarily the Investment Company Act of 1940 (the "Investment Company Act") and the Investment Advisers Act of 1940 (the "Advisers Act") for the underlying hedge funds and their managers.
In the United States, hedge funds typically rely on an exemption from the registration requirements of the Investment Company Act set forth in section 3(c)(7), which permits, among other things, investment funds to be formed and sold without registration, so long as interests in the fund are sold in the United States only to "qualified purchasers" as defined in the Investment Company Act. The question arises whether the investors in the notes must also be "qualified purchasers", that is whether the US Securities and Exchange Commission ("SEC") will look though the structured product issuer to treat the investment as a direct investment in the underlying fund. No clear answer to this question exists in a context in which the interests of the structured note investor and a hedge fund investor are exactly aligned, with the result that the cautious approach is to limit sales of structured products in highly sensitive transactions to "qualified purchasers" and to obtain appropriate representations from the investors as to their status as such. If such a re-characterisation were to occur, the hedge fund's exemption under 3(c)(7) could be invalidated and subject it to severe penalties for failure to register.
A similar re-characterisation issue was created under the Advisers Act for the manager(s) that is not registered under the Advisers Act by rules recently adopted by the SEC. Under the Advisers Act, a hedge fund manager must register with the SEC if it has more than 14 advisory clients. Generally each fund managed by the manager is counted as one client, but under the recently adopted rules, if a fund allows redemptions by investors within two years of their investment, the fund manager must "look through" the fund and count investors in the fund in determining whether it is advising more than 14 clients. (This assumes that the manager is either offshore or, if onshore, has at least $30 million under management.) If structured notes were recharacterised and treated as direct investments in the underlying funds by the SEC, managers of underlying funds could be required to count investors in the structured notes as investors in the underlying fund for purposes of satisfying the less than 14 client limit. These rules were vacated by a federal appeals court in a decision rendered June 23, 2006, which we do not expect the SEC to appeal to the Supreme Court. Assuming the decision stands, we also do not expect the SEC to re-issue the rules in modified form. Accordingly, pending further developments, this re-characterisation issue seems not to be a current concern.
Finally, issues might arise under the US Employee Retirement Income Security Act of 1974 ("ERISA") which, among other things, limits the persons from whom U.S. pension plans may acquire securities and limits the activities of any person that is treated as a "fiduciary" of a regulated pension plan.
Typically, an issuer of notes, or its selling agent, will address whether a note purchase is covered by an exemption from these rules by reference to the structured note. If the structured note is re-characterised, however, the note seller must also consider whether the purchase of the note by an ERISA regulated pension plan may cause the seller to become an ERISA fiduciary. In that event, the seller would effectively be treated as though it was investing in the underlying hedge fund on behalf of a regulated pension plan, and would be subject to the ERISA prohibited transaction rules. In some cases, the application of those rules without proper structuring and consideration could jeopardize the ability of the issuer to hedge its position in the structured notes by purchasing fund interests or of realising a profit from the transaction.
In addition, a plan's interest in a structured note that is re-characterised could be treated as an "equity interest" in the hedge fund for ERISA purposes. If more than 25% of the equity interests in a hedge fund are held by benefit plans, and any of the plans are regulated by ERISA, the hedge fund manager will also be treated as an ERISA fiduciary that is subject to the ERISA prohibited transaction rules. Accordingly, hedge fund managers typically seek to limit the percentage of their fund interests that are held by ERISA plans. As a result hedge fund managers will seek to limit sales of structured notes to U.S. pension funds if they believe the notes create a significant re-characterisation risk.
Due to the variety of products in the market, it is impossible to create a definitive checklist of structuring issues to consider when reviewing potential re-characterisation risks associated with a proposed fund derivative to be produced. However, at very least the following issues should be considered:
1. How close does the payout on the product track the performance of the underlying?
2. Who in substance bears the legal and economic risk of non-performance or default in respect of the underlying and is that risk passed on in-kind to the investor?
3. Is the payout capital guaranteed or at least principal protected and if so on what terms and in what circumstances?
4. What rights under the terms of the product does the investor have and how closely are they aligned to those a direct investor in the underlying would have?
5. Is the product fully synthetic in terms of how the payment obligations of the product issuer are hedged?
6. Who is promoting the product and what role does that promoter play in respect of the product payout?
7. In what legal form is the product structured and is there an issuing vehicle that pools investors' funds on a collective basis?
8. Is there a mandate granted by the investor as to the allocation of its investment and if so on what terms?
9. Who has discretion as to the allocation of investment funds and in what circumstances may it be exercised?
10. Is the issuer of the structured product contractually or practically required to hold the hedge fund interest?
Given the past practice of the UK regulators, it may be said that there is a relatively low risk that hedge funds structured products may be "re-characterised". However, as indicated above that is not the end of the story. In order to mitigate the risk even further, guidance can be taken from the FSA's statements regarding "wider range" products in its recent publications. For example, making sure that the disclosure provided to investors regarding the characteristics of the product and the special risks involved is clear and understandable could substantially reduce the risk. In addition, bearing in mind the list of factors set out above when structuring a fund-linked product may provide an indicator of where and when further issues may need to be resolved. Finally, The ISDA Fund Derivatives Definitions may provide the opportunity to adopt a set of terms which can be assumed to have been crafted at least with an eye to the legal risks for product issuers in issuing such products.
Nick Terras and William Yonge are partners and Kevin McGuire is counsel specialising in structured finance and hedge funds at the international law firm of McDermott Will & Emery, based in its London office. Ted Laurenson is a partner also specialising in structured finance, based in New York.