Traditional liquidity solutions
There are a number of ‘traditional’, well known, structured solutions that are being implemented to mitigate current difficulties. These include:
• Side-pockets
• Gates
• Lock-ins
• Suspensions/staged redemptions
• Key man provisions
• Conversion to a closed-end fund
• Reduced fee structures
These solutions have highlighted a number of thorny legal issues, including the requirement to obtain investor consent to changes pursuant to the bye-laws/articles of association of the fund and the law of the country of residence. Amendments to bye-laws are likely to amount to a variation of class rights of shareholders (including those shareholders that may not ordinarily vote on matters) and require a vote in favour by 75% or more of those present or represented at the meeting of each class or by written resolution. However, given that from a commercial perspective it is often not practicable to seek and obtain the consent of every investor to a change to the PPM or bye-laws, the increased use of ‘negative’ or ‘deemed’ consent in these circumstances has increased.
Under the negative consent/deemed consent process, any investor who objects to the changes is afforded an opportunity to redeem their shares. Whilst there is no legal principle recognising ‘negative consent’ under either Cayman Islands law or BVI law, the effect of proceeding in this way is to mitigate the risk exposure to the hedge fund. However, proceeding in this way does not remove the risk to the hedge fund of a damages action.
Potential conflicts of interest between fund directors and the managers have been thrown into sharp relief. For example, a manager may have a vested interest in assisting certaininvestors to exit a fund in order to maintain an ongoing relationship. Often these liquidity solutions may not be available or attractive. For example, if a fund’s assets are 90% completely liquid, although a fund can satisfy redemption calls in cash easily for a large majority of its investors, those remaining will have a much larger proportion of their interests in the illiquid assets. Therefore, whilst it may be difficult to suspend redemptions (because NAVs are calculable), by permitting redemptions, the fund may prejudice the non-redeeming investors and leave itself open to complaints from both redeeming and non-redeeming investors. The traditional liquidity solutions may not therefore be the best way forward for either the fund or the fund manager.
Consolidation
Liquidity issues will be a driver towards greater consolidation of hedge funds and the spinning-out of key personnel.
Other than potential strategic advantages, consolidation has the advantage of increasing economies of scale. The inevitability of increased regulation in the sector and the advantages of pooling synergistic marketing and administrative resources will be factors in increasing activity. Back office, risk management, compliance, reporting and other increased costs will require a larger asset base to pay for them (especially during times of low or non-existent performance fees).
With many smaller firms struggling, the recent trend of seeking safety by selling out to, or joining, a bigger brand is expected to continue in 2009. This is not to say that selling out to a buyer must be a complete exit. In a majority of deals in the recent past, sellers have retained an interest in the fund or the fund manager. The synergies sought often apply only when those who have been involved in the previous success of a fund remain involved. Other reasons for spinouts and merger activity in the hedge fund market will include:
• Sales/spin-outs by distressed sponsors.
• Changes in strategy of existing fund sponsors.
• The need for disposals resulting from duplicate strategies or to remove balance sheet assets.
• Departure of key professionals from fund sponsors.
This article considers the key legal issues relevant to both the sale and acquisition of a hedge fund manager and the spin-out of a management team.
Issues to consider on a sale or spin-out
Executing an acquisition of a hedge fund manager or a spin-out raises many of the same issues that exist with any asset management purchase. There are, however, operational and cultural elements specific to hedge funds that require special focus.
STRUCTURE
A transaction will need to cater for the following:
• An acceptable valuation
• Sufficient minimum compensation to enable key personnel to benefit in upside post-closing and provide motivation
• Preserving inherent value, including client relationships
• Protecting a seller if a stake is being maintained going forward
• Avoiding undesirable tax consequences
Tax issues are beyond the scope of this article.
However, tax will obviously be a fundamental driver in how deals are structured. In particular, individuals will want to ensure, so far as possible, that any profits are treated as capital gains (18% tax) rather than income (up to 45% tax).
Above all, any deal involving a fund manager or team is fundamentally about the individuals who are moving.
VALUATION
A management firm is usually valued by reference to a multiple of revenues, EBITDA or assets under management. The multiple can vary quite widely and a successful manager can secure a higher multiple where future growth is expected. However, performance fee revenues are highly variable and non-recurring. In a market where performance fees are much lower than in previous years, a larger discount may be applied to the overall multiple (which itself will be lower). Other factors will include the stability of contractualcommitments of a managers’ clients and potential synergies.
CONSENTS/INVESTOR RELATIONS
Where a manager is exiting or senior personnel are moving on, the relevant fund will need to consider how to communicate these changes to the existing fund investors. For example, will investors be offered a right to redeem? In addition, depending upon how the sale/move is being structured, a new regulatory consent or consent to a change of control of the manager may be required. Obtaining such approvals will need to be factored into timing. For example, an FSA change of control consent can typically take between 10-16 weeks to obtain.
MATERIAL ADVERSE CHANGE (‘MAC’)
A MAC provision allows a buyer to terminate a deal if a material adverse change, or effect, has occurred (generally, any event that has an adverse effect on operations that is material enough to either call into question the continued operation of the manager in the ordinary course of business or that has frustrated the purpose of any given transaction or contract). Present financial uncertainties may see an increase in the use of such provisions – for example, protecting the buyer from unknown events that substantially threaten the overall earnings potential of the target in a durationally-significant manner. A short-term lowering in earnings would not usually suffice. Sellers will attempt to further narrow the definitions of a MAC to limit the circumstances under which such an effect or a change will potentially be triggered.
ISSUES FOR THE MANAGEMENT TEAM
• Track Record – a key issue for the management team will be ownership/access to the historic investment performance. Access to this record will also be important for a buyer or strategic investor. The personnel that are moving will need to consider if the historical information accurately reflects their performance (e.g. is it relevant to the strategy going forward?) Are there confidentiality or other contractual restrictions that will prevent disclosure of the relevant data?
• IP – the management team are not likely to own any intellectual property in the model or trading systems or customer lists; this will belong to their employer (the fund manager). The team will need to either buy the intellectual property or re-invent the wheel.
• Governance – consideration will need to be given to the post-deal governance structure and which key decisions are to be made by each governing body or individual (e.g. the board of directors, investment committee and day-to-day managers). The strategic investor/buyer will certainly wish to have decision making authority in relation to key high-level actions that potentially erode value e.g.:
– significant changes in strategy;
– major acquisitions or disposals;
– capital expenditure or contract commitments in excess of pre-agreed limits;
– changes to the business plan or budget;
– borrowing limits and security packages;
– dividend policy;
– appointment and dismissal of key personnel; and
– material dealings with assets.
• Incentivisation – a buyer/strategic investor will obviously be keen to ensure key personnel are suitably incentivised and managers will wish to share in future upside and receive an ownership stake (thereby obtaining capital gains treatment resulting in lower tax rates for salaries and bonuses). In addition, an institution that is spinning-out a team will be able to incentivise individuals without paying bonuses (increasingly important for banks and other financial institutions). Incentivisation will usually be achieved through bonuses and the issue of equity interests to managers or options to acquire such interests (either shares/stock or partnership interests). Interests may also ‘vest’ over a period of time (3-5 years), meaning that they become free of compulsory repurchase restrictions. Until fully ‘vested’ the interests will usually be forfeited and repurchased under certain circumstances (e.g. resignation, retirement, death/disability and termination) with the price determined by whether the departing manager is a ‘good’ or ‘bad’ leaver. The definitions of these trigger departure events will usually be heavily negotiated. With a spin-out, the investor may require a restructuring or ‘re-setting’ of vesting provisions.
• Restrictive covenants and lock-ups – key personnel will be subject to post-departure restrictive covenants relating to:
– confidentiality;
– non-competition; and
– non-solicitation (clients and other employees).
The enforceability of such restrictions needs to be carefully considered. Restrictions on soliciting or advising clients after departing a firm can be documented in great detail, including specific lists of clients that are either off limits or conversely, the individual’s personal contacts and therefore not covered by restrictions. In addition, a buyer may insist upon a ‘lock-up’ prohibiting managers from transferring all (or an agreed portion) of their interests for an agreed period of time (e.g. 1-2 years).
ISSUES FOR THE BUYER/STRATEGIC INVESTOR:
• Due Diligence – a buyer of a fund manager or a strategic investor will wish to carefully review the existing offering documentation, management agreements and prime broker and administrator agreements. Issues to consider will include:
– limits on investment strategy drift;
– intellectual property ownership;
– investment parameters;
– key person provisions;
– in-kind distributions of securities;
– indemnification and exculpation conduct and standards;
– valuation of illiquid securities;
– restrictions on allocations to funds-of-funds;
– redemption rights;
– conflicts of interest;
– brokerage commissions and soft dollars;
– hypothecation rights; and
– transfer/change of control issues.
• TUPE – The Transfer of Undertakings (Protection of Employment) Regulations 2006 (‘TUPE’) provide that if there is a ‘relevant transfer’ of an undertaking or part of an undertaking, TUPE will transfer to the transferee any of the transferor’s employees assigned to the undertaking (or part) transferred. If TUPE applies, it has the following three-fold effects:
– all employees automatically transfer;
– there are information and consultation obligations; and
– there are special protections against dismissals and changes to terms and conditions of employment connected with the transfer.
Accordingly, a buyer will need to carefully assess whether TUPE applies. Failing to take TUPE into account during a transfer can lead to legal difficulties such as unfair dismissal and liability for unpaid wages. The buyer is left to adopt the old terms and conditions of employment and if it attempts to change them the changes may be void. If an employee is dismissed for a reason related to the transfer, the dismissal is automatically unfair.
• Transitional Services – a buyer or strategic investor will need to consider how to deal with various logistical transitional matters, such as:
– physical location, and offices;
– insurance; and
– websites.
• Drag/Tag-along rights – a buyer/strategic investor will receive tag-along rights with respect to the managers’ interests and management will wish to receive a drag-along right in relation to the strategic investor’s/buyer’s interests. Tag-along rights allow minority share/stock or interest holders the right to sell to a purchaser where key management are selling-out. A drag-along right will allow management to force the minority holders to sell to a purchaser on the same terms and conditions.
• Post-deal management/governance and incentivisation of key personnel going forwards (see above) will obviously be important issues for a buyer and strategic investor to consider.
ISSUES FOR THE SELLER
The issue of consents/investor relations has been mentioned above. In addition, a seller may retain an interest in a management team which is being spun-out for a number of reasons, including (i) retaining a stake in the future success of a talented team and (ii) keeping links with valued former employees. Issues to consider will revolve around post-deal management/governance and incentivisation of key personnel going forwards (see above).
On a sale, in some cases, the consideration for the deal may involve a contractual ‘earn out’ requiring future payments to be made on the attainment of targeted future results.
If a team is moving without consent, a fund will also need to consider enforcing restrictive covenants and garden leave provisions.
DOCUMENTATION
Key documentation involved in a sale of a hedge fund manager or a spin-out will include:
• Non disclosure/confidentiality agreement.
• Lock-up agreement for key personnel.
• Sale and purchase agreement – this agreement will deal with the sale and purchase of the relevant manager and include details of the consideration/earnout, conditions, completion mechanics and warranties/indemnities. Typical warranties on the transfer on a hedge fund manager will relate to:
– past performance/track record;
– compliance;
– change of control;
– business plan; and
– client relationships.
• Shareholders’/LLP agreement – this will include the governance arrangements, rights of first refusal, tag and drag-along rights, and a vesting schedule by which key personnel forfeit shares in the event of their departure.
• Articles of Association/Charters/Bye-Laws – these will include share rights and restrictions, pre-emption rights on the issue and transfer of shares and provisions dealing with the mechanics of holding board and shareholder meetings.
• Employment agreements.
• Transitional Services agreement.
Other documentation will be required depending upon the structure of the transaction and for specific deal issues.
Conclusion
Managing and increasing liquidity is the key to survival for hedge funds in the current market. Once liquidity has become less of an issue for a fund or a fund manager, focus can shift to value-gain and investments. Liquidity may come from a number of sources, including the traditional methods of maintaining liquidity, but investors, managers and fund directors may take advantage of synergies between funds and managers to maintain and increase liquidity by spin-out, consolidation and M&A.
The sale of a hedge fund manager or a spin-out involves all of the issues that arise in an average M&A transaction. Along-side these however are more sensitive issues associated with the negotiation of an on-going relationship.
Imran Sami and Sam Tyfield are corporate partners at Katten Muchin Rosenman Cornish LLP, the London affiliate of US law firm Katten Muchin Rosenman LLP, a full-service law firm with more than 650 attorneys in seven locations, including Chicago, New York, Washington, D.C., Los Angeles and Charlotte. Their respective e-mails are imran.sami@kattenlaw.co.uk and sam.tyfield @kattenlaw.co.uk.