Sidley Austin’s Global, Business-Savvy Funds Practice

Market intimacy can make firm “producers”, says Stephen Ross

Originally published in the December 2013 issue

New Sidley Austin partner and London Investment Funds practice head Stephen Ross is unusual in having, nine years ago, left a partnership at a “Magic Circle” law firm to become a director on the Executive Board of Man Group, the second largest alternative asset management business worldwide, where he also chaired the Risk Committee, carefully structured vehicles and robustly drafted documents, helping to navigate the firm’s legal commitments smoothly through the credit crisis. Ross’s move to Sidley Austin comes at a time when the firm is looking to expand and also deepen its London offering in the investment funds sector.

Sidley already has impressive pedigree worldwide, and especially in the US – it can trace its own history back to 1866 in Chicago and 1914 in New York, but today it is distinguished by its integrated critical mass across three continents of North America, Europe and Asia; and by the breadth of its asset management practice – a comprehensive listing of its awards stretches to around three times the length of this article and grows perennially. Sidley has 1,700 lawyers, over $1.5 billion in annual revenues, and is in expansion mode globally. Its distinctive, partner-led and conservatively run business is attractive and profitable enough to lure individual partners away from rival firms.

Sidley’s pragmatic approach has helped them to win business from many of the world’s leading hedge funds; they reckon they can name as clients 15 of the top 50 hedge fund managers in Europe and 31 of 50 in the US. This may be in part due to the breadth of the practice. Sidley is ranked as the sixth largest US firm and they are more interested in being the best than the biggest law firm. For the fourth year in a row, Sidley won more top rankings from US News than any other law firm, based on survey responses from 12,000 lawyers and 7,000 clients. Practice areas of particular relevance to hedge funds where Sidley won awards included Banking and Finance Law, Derivatives and Futures Law, Mutual Funds Law, Private Funds/Hedge Funds Law, and Securitisation and Structured Finance Law. Sidley also received a clutch of accolades from legal publisher Chambers, including Team of the Year for investment management in 2008 and 2013, while the Financial Times ranks Sidley as one of the most innovative global firms; myriad other awards are too numerous to list here.

London practice
The hire of Ross is a sign of a serious commitment by Sidley to the London investment fund industry. Ross wants to “re-energise the London team and build on the strong existing client base.” Recently an associate who had several competing offers was hired, as was former Simmons and Simmons managing associate James Oussedik, who trained in France before practising for PWC. Ross thinks it “quite a coup” to have garnered these two, as demand for good people remains strong. The London expansion is far from isolated; in the same month that Ross was hired the Singapore office took on Clifford Chance’s entire funds team, including local AIMA chairman Hang Ming Ho.

Sidley came to the London investment funds market in 2007. It is a full-service practice although Ross is adamant that Sidley only wants to compete in spaces where it can differentiate itself and be cost-effective. So Sidley is quite content to suggest that funds outsource some compliance functions to compliance boutiques, for instance.

Elsewhere, Sidley’s rather selective client roster means that the firm has far more latitude to advise the buy side without facing conflicts of interest. Sidley’s London hedge fund practice is still small enough to negotiate on behalf of substantial numbers of buy-side investing clients. In this practice, “secret side letters have become a complete no-no,” Ross says, as there are regulatory or commercial imperatives for disclosure. Regulators require any direct or indirect impact of side letter terms to be disclosed to all investors. Meanwhile on the commercial side, “most favoured nation” clauses and other stipulations will almost always force disclosure of concessionary fees or enhanced liquidity unless their impact is entirely ring-fenced.

Time on the buy side
Ross is ideally suited to lend impetus to Sidley’s expansion. One of the youngest partners made up, much of his early career was spent precociously co-heading Clifford Chance’s Private Funds Group until 2004, when he rode the trend of private equity funds becoming bigger and more institutionalised. This market-leading practice catered mainly for private equity funds but its expertise in financing and structuring secured one large hedge fund client, trend follower Man Group, which in 2004 asked Ross to head up a hybrid business unit that did legal structuring, product structuring and financing. Ross was installed on the Executive Board from day one, rose to Global Group General Counsel, and in total spent a decade at Man.

Yet before joining Man, Ross had made a deliberate decision to take a sabbatical, educational rather than recreational, and attend Business School for a few months, as he views some lawyers as “highly trained but narrowly trained”. Ross was worried about Rumsefeldian “unknown unknowns”, as he felt he had never studied management marketing, branding, corporate finance and accounting to the requisite level. He selected Wharton Business School for having a greater finance focus than Harvard. His only regret was that the soccer World Cup took place during his time at Wharton, and was not particularly easy to watch from the United States!

It is this wide-ranging preparation and experience which Ross is looking to apply to its fullest extent in the Sidley offering. The time at Man was particularly helpful in broadening the scope of Ross’s knowledge beyond the service-provider side: he is not aware of any other law firm partner in the fund segment who has “my level of industry and board-level exposure, which can be harnessed for client benefit.” Having been one of the largest procurers of external legal services when at Man, Ross knows the ropes in terms of client expectations, pressures and requirements.

During his decade at Man Group, the company underwent three distinct phases: the bull market, the credit crunch, and acquiring GLG. Ross feels most proud of navigating the ship in turbulent waters, when Man Group’s $15 billion of product financing, for bridging and strategic leverage, stayed intact throughout the 2008 crisis. This he partly attributes to “appropriately documented and legally sound” contracts and long maturity profiles. In particular, he recalls Glenwood as being “the first or second fund of funds to have permanent financing structures in place” – something that resonates with Sidley’s excellent reputation in debt issuance. Ross, who also held responsibility for prime brokerage and trading document desks, also admits that being a large customer of investment banks gave Man considerable clout. He points out that “as Man had about 100 managed accounts the ‘street’ was more circumspect about terminating financing,” even though notice periods to terminate were only around 60 days on the prime side. In contrast, Ross recalls how “more vulnerable clients were not treated so well”.

Ross’s role as General Counsel at Man was central to operations, as is evidenced by his place from the start on the Executive Board. “Man was the first firm to provide global distribution for hedge fund content,” says Ross, and the legal team were crucial here in legitimately re-characterising the legal format of assets to meet as many as 22 local regulatory regimes, which, for example, included 300,000 retail clients in Australia. Lawyers felt very welcome at Man Group. Former Man CEO Stanley Fink had read law as an undergraduate, and his successor Peter Clarke was a lawyer from Slaughter and May. “The value lawyers brought to the table was appreciated, and they were seen as ‘producers’ and as unlocking distribution,” says Ross.

The surge in regulation
The global financial crisis has put more pressure than ever on that role as ‘producer’ – the increase in cases of counterparty risks becoming counterparty collapses means that lawyers’ work is being tested, and has also led to the surge in regulation which has so dominated industry discourse for the last five years. Inevitably, this surge has created new challenges for all service providers. In fact, Ross seems generally concerned by a number of regulatory developments. He fears that reverse solicitation and private placements may become more difficult, and that if firms miss deadlines for AIFM applications they could lose the “grandfathering” afforded by transitional regimes and may be forced to cease marketing. Ross is not surprised that firms faced with regulatory enquiries will often just enter into settlements without admitting or denying guilt, since it can be so expensive and time-consuming to actively fight a case.

Ross ventures that “once the emotional and political commitment to sorting out the mess of the last decade settles down and new investment solutions settle down it should all calm.” Ross views a settled and calm regulatory environment as an essential backdrop for finding new uncorrelated risk-adjusted returns. Right now the fact that most flows go to the largest operators shows that people are hesitant about taking risks, and Ross thinks this is due, in part, to regulatory uncertainties and risk aversion.

This risk aversion is understandable after the losses sustained by many in the crisis, but good structuring prevented counterparty risk. Ross reflects that some longer-term fund structures – Man Group’s market-leading structured products – may have had performance issues after 2008, but they did not face structural flaws related to credit risk. In contrast, several Asian structured products were essentially underwritten by Lehman. “Man products were underpinned by Treasuries or top-quality banks,” he recalls.

Currently, Ross observes that low interest rates make it very hard to launch structured products unless longer maturities or CPPI structures are chosen. The real obstacle to a resurgence of interest in structured products, however, is simply that “commission-based selling together with opacity, complexity and higher fees have become very unfashionable over the past five or six years.”

These drawbacks should not apply to regulated mutual funds, but they pose their own, different, challenges. Ross views ’40 Act funds as being more prescriptive than UCITS, in that, for example, they need “dedicated compliance officers with a very specific skill set,” and can also entail litigation risks associated with “retail” distribution. It is these high compliance costs that have encouraged some hedge funds to wind down ’40 Act funds, and also discouraged others from launching them given the challenging capital raising climate, Ross says.

Fund governance
Hedge funds are coming under greater scrutiny from directors as well as regulators, and Ross can understand why many jurisdictions and investors want fully independent directors. Although many people are debating how to define an independent director, Ross is unequivocal that “to eradicate conflicts entirely you should not have directors who are also service providers to funds they oversee.” Ross notes that Man Group has started asking directors to relinquish such commitments that could be perceived as generating conflicts. Sidley as a company does not provide “director services”. Ross elevates the director independence debate onto another level by setting an even higher bar, and suggesting that directors who derive the vast majority of their income from a single fund complex could also become conflicted as they are overly dependent on this client. The implication is that directors need to have reasonably diversified sources of income to rule out conflicts.

Yet no matter how strictly independence is defined, Ross advises that investors should not lean too heavily on directors for oversight and accountability. According to recent precedents, not only can some directors defer to more knowledgeable co-directors; directors collectively can also discharge responsibilities – and liabilities – to professional advisors. This is important because fund investors are rarely party to contracts including administration, management company and investment management agreements. And although investors may think they are deferring to fund directors in signing off on these agreements, investors are in practice deferring ultimate responsibility to the professional advisors – including lawyers – retained by the fund directors.

A robust structure
One of the surprises in the aftermath of the financial crisis is how well the legal structures on which hedge funds rely coped within a chaotic environment, and for Ross, the Cayman Islands are still a domicile of choice, although Sidley forms funds in many domiciles worldwide. When asked why Cayman remains the most popular fund domicile, Ross retorts, “Why wouldn’t it be – it has always worked rather well,” and then enumerates the advantages of the Cayman Islands. They are the oldest offshore centre with a 25 to 30-year track record, which helps to explain why the regulatory process is so streamlined. Rather than dealing directly with the regulator, hedge funds tend to use law firms as gatekeepers, and registration is “a somewhat straight-through process if you comply,” he says, in contrast to Ireland and Luxembourg which he views as being “more qualitative”. The global financial crisis – which threw up many potential conflicts and challenges for funds and their directors – “has not implied a lack of robustness of the Cayman legal system,” Ross contends. Yet Ross accepts that some investors will want an Ireland and Luxembourg domicile, and he recognises that smaller domiciles such as Malta may be more economical and flexible for some funds.

Ross has advised on all kinds of fund structures over the years, including private equity, structured products and regulated EU mutual funds. Regarding the convergence between private equity and hedge funds, Ross thinks that there are benign and malign motives for wrapping hedge funds in private equity or closed end fund structures. “The wrong way to structure hedge funds is to try and lock in assets solely for management fees or capital retention,” he says – and this argument also applies to exchange-listed closed end funds, which often have the added weakness of tending to trade at discounts. The correct motivation for a private equity structure is “to avoid liquidity mismatch and align interests and incentives with external stakeholders via carried interest or in the case of hedge funds to capture an illiquidity premium” – for instance for strategies that require longer-term capital. Indeed, many institutional investors are quite amenable to lock-ups, and lending to small and medium enterprises is one aspect of this trend.

Value for clients
Ross is straightforward in reiterating that Sidley only wants to take on work that it can do at good value for clients. Wide divergences between law firms’ quotes for similar work do not surprise Ross. Such price ranges “reflect different firms’ appetites for different types of work,” he says, with more innovative, bespoke and complex work carrying higher fees than more commoditised documentation that a particular firm may have done many times before.

Ross insists that the laudable desire to save costs should not lead to the value added at the legal structuring stage being underappreciated. Even for funds pursuing plain vanilla strategies and trying to save costs, Ross advises against reproducing almost verbatim another fund’s prospectus. He suggests that “you have to understand the prospectus and critically evaluate which bits to carry over and which bits not to, as you can only copy something that you understand how to copy.”

For instance, if liquidity or side pocket clauses are copied the implications of these clauses have to be understood, and it seems that in the aftermath of 2008 many funds and investors did not, and regretted sloppily drafted documents.

This is especially clear during challenging times. Ross recalls how Man spun off its brokerage as Man Financial, which was subsequently re-named as MF Global. Within nine months a trader called Evan Brent Dooley (who is now in prison) had carried out unauthorised trades, taking principal instead of agency risk. Fortunately for Man Group, their legal bases were well covered, because the IPO prospectus had contained an explicit warning about potential for errant traders trading as principal. Ross has also seen fund prospectuses becoming more and more prescriptive and detailed on risk warnings and restrictions – but there is also an apparently opposing trend, of regulators insisting on condensed, short-form summaries such as KIIDs (Key Investor Information Documents), intended to avoid over-burdening retail investors with complexity.

Ross has overseen plenty of litigation, and has recently been closely monitoring the UK Supreme Court’s judgments on the generous treatment of Lehman non-segregated creditors. This may be one case where Ross concedes that diligent structuring has not had its intended effect, due to the vagaries of an arguably politically sensitive judicial process. Although Man Group (GLG) took the trouble to properly segregate its assets, in practice the UK judgments means these ring-fenced assets are being aggregated into the same bucket as those that were not in fact properly segregated.

Competitive value
The Sidley value proposition extends to fees as well as experience and quality of advice. It is no accident that the law firms with the most hedge fund clients are not Magic Circle firms, since few hedge funds are prepared to stomach their fees, and they do not feel their corporate image and ethos is necessarily reflected in such firms. Ross says that the levels of fees that can be borne by start-ups means that law firms are effectively sharing risks with these entrepreneurial teams. He thinks Sidley can offer competitive value for various reasons. Whereas some law firms have as many as six associates per partner, Sidley’s ratio of two to one makes it very much a partner-led practice where a high proportion of the work paid for is actually carried outby partners. This reduces inefficiency.

On cost over-runs Ross says, “It is good client handling to keep them apprised of where you are on the clock – and if you give inaccurate estimates or unrealistic assumptions you will not keep clients.” Sidley will sometimes quote fixed fees as part of a constructive long-term view on the relationship.

In Ross’s opinion a global firm is best placed to advise hedge funds in this new era. He argues that Sidley provides “a deep understanding of clients’ business and a more integrated service than using a patchwork quilt of local firms,” and this worldwide coverage can be sought-after, for instance, by sovereign wealth funds that want to comply with OTC derivatives rules everywhere. Sidley’s global perspective helps hedge funds to explore ways of executing ideas in different ways to manage the most onerous rules. Ross thinks that Europe is struggling to implement its Financial Transaction Tax (FTT) as there are so many different ways to trade, including synthetically and from other locations.

On clearing, Asia is “well behind the US and EU in terms of Dodd Frank and EMIR roll-outs,” so again there may be routes around these regulations. In general Ross thinks Asia and the Middle East are likely to follow the lead of Europe and the US, where the heavy intensive work can be done beforehand. For instance, Ross notes the “all-pervasive nature of English law” is seen in the Hong Kong or UAE definition of a collective investment fund being very consistent with the UK one. This plays to Sidley’s international strengths.

This global reach combined with deep knowledge of the market is a compelling proposition if it can be delivered. Stephen Ross, with his intimate, insider knowledge of the buy side, can only help in Sidley’s aim to offer an even deeper funds practice in London, and to be ‘producers’, adding value on top of the necessities.