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HEDGE FUNDS By Robert J. Kiggins, Esq. of McCarthy Fingar

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Title: HEDGE FUNDS By Robert J. Kiggins, Esq. of McCarthy Fingar


1
HEDGE FUNDS
  • By Robert J. Kiggins, Esq. of McCarthy Fingar,
    White Plains, NY
  • Presented on June 10, 2005

2
INTRODUCTION SURVEY- Hedge Fund History
  • Many think of this industry as a fairly new
    innovation, but its history began in the late
    1940s and perhaps even the early 1930s
  • Alfred Winslow Jones was the first fund manager
    to combine a leveraged long stock position with a
    portfolio of short stock positions in an
    investment fund.
  • Using a private limited partnership structure for
    his fund, Jones was paid on an incentive fee
    basis.
  • Investors in Jones' little known fund enjoyed
    very handsome returns as his fund outperformed
    all mutual funds of the time.
  • However, Karl Karsten came up with the technique
    (in concept) in 1931 in a book entitled
    Scientific Forecasting published that year.
  • For example, Karstens theory for small funds
    that could not diversify across entire markets
    was Buy the stocks in the group predicted to
    rise most in comparison with the others, and sell
    short the leading stocks in the group predicted
    to fall most
  • The hedge fund idea started as a risk reduction
    technique to reduce risk with respect to the
    direction of the market or individual securities
    (either entirely long, or entirely short). Hedge
    funds used hedging tactics (e.g. a combination of
    short and long positions) to pool investors'
    money and invest those funds in financial
    instruments in an effort to make a positive
    return
  • However, the chance for higher investment returns
    increased the popularity of hedge funds in the
    1960s
  • The nature of hedge fund management was shifting
    and managers took more risk by leveraging instead
    of hedging their positions.
  • When markets took a turn for the worst, these
    riskier strategies did not pay off, and hedge
    funds hit a difficult period from the mid 1960s
    to the end of the 1970s.

3
Hedge Funds Arent Usually Hedged
  • This history shows that even fairly early on the
    fact that something was referred to as a hedge
    fund did not mean that it was hedged with regard
    to all, or any, of its positions.
  • That is the case to this day.
  • In short, a hedge fund is descriptive of a type
    of entity an investment limited partnership
    (although offshore funds are typically
    corporations) that invests in securities.
  • A hedge fund typically is not actually hedged.
  • By 1980 and throughout the 1990s, with the
    arrival of derivatives, new styles of management
    were developed.
  • Consequently hedge funds became a more mixed
    group.
  • The hedge fund industry started to offer a
    greater array of products, using more complex
    strategies.
  • This was the start of a growth industry. Hedge
    funds became the investment worlds Holy Grail.
  • Big winner George Soros Quantum Fund
    allegedly made more than 1B contra ER II Regina
    (Great Britain) by betting against the (i.e.
    Pound) in Euro Exchange Rate Crisis of 1992
  • From 1994 to 1999, hedge funds performed
    phenomenally well as the Clinton bull market -
    unparalleled since the 1920s - was pushing
    returns to record highs. Many traditional money
    managers were becoming hedge fund managers. It
    seems that hedge funds could do no wrong.
  • Then reality struck when the Tech Bubble burst in
    2000. Even the high and mighty were struck down.
    My personal pick, albeit a 1998 event which did
    not result in the Fund going bust, was the
    Long-Term Capital Management fiasco.

4
The Story of Long Term Capital Management
  • Long-Term Capital Management, LLP (LTCM) was
    founded in March 1994 by
  • John Meriwether, the former head of the Salomon
    Brothers bond arbitrage trading group, an
    extremely profitable venture
  • along with a small group of associates most
    notably economists Robert Merton and Myron
    Scholes (of Black Scholes Options Pricing Formula
    Fame) who received the Nobel Prize in economics
    in 1997.
  • Organizationally, LTCM was a Delaware LLP which
    operated a Cayman Island Partnership called Long
    Term Capital Portfolio LP
  • Meriwether had left Salomon after its 1991 bond
    scandal. A Salomon bond trader illegally tried
    to corner the primary Treasury auction market by
    bidding in excess of the firms limits.
  • A ban threatened by the Fed prompted a run on
    Salomon which almost brought down the highly
    leveraged firm.
  • The situation was salvaged only by Warren Buffet
    taking over Salomon and the Fed reversing the
    ban.
  • Meriwether was fined a rather puny 50K for
    failure to supervise his traders

5
The Story of Long Term Capital Management (Contd)
  • The core strategy of LTC can be described as
    relative value, or convergence arbitrage
    trades try to take advantage of small differences
    and prices among closely related securities.
  • Definitions
  • On-the-Run Bond the most recently issued U.S.
    Treasury bond or note of a particular maturity.
    These are the opposite of off-the-run treasuries
  • The on-the-run bond or note is the most
    frequently traded Treasury security of its
    maturity. Because on-the-run issues are the most
    liquid, they typically are a little bit more
    expensive and, therefore, yield less than their
    off-the-run counterparts.

6
The Story of Long Term Capital Management (Contd)
  • Off-the-Run Bond . All Treasury bonds and notes
    issued before the most recently issued bond or
    note of a particular maturity. These are the
    opposite of on-the-run treasuries.
  • Once a new Treasury security of any maturity is
    issued, the previously issued security with the
    same maturity becomes the off-the-run bond or
    note.
  • Because off-the-run securities are less
    frequently traded, they typically are less
    expensive and therefore carry a slightly greater
    yield.
  • For instance, an off-the-run treasury bond might
    yield 6.1 versus 6.0 for a more recently
    issued on-the-run.
  • The yield spread represents some compensation
    for liquidity risk.
  • Over a year of trade a long off the run and short
    on the run will be expected to return 10 basis
    points per dollar invested. The key is that
    eventually the two bonds must converge to the
    same value.

7
The Story of Long Term Capital Management (Contd)
  • The strategy was used in a variety of markets
  • long swap government spreads,
  • long mortgage-backed securities versus short
    government,
  • long high-yielding versus short low-yielding
    European bonds,
  • Barring Market Disruptions these trades generally
    prove profitable
  • The problem of convergence strategies is it they
    generate tiny profits so that leverage has to be
    used to create attractive returns.
  • In the case of LTCM to control risk, the target
    ceiling risk level was set to the volatility of
    an unleveraged position in US equities.
  • Positions were obtained by portfolio optimization
    with a constraint on volatility, with some
    additional constraints such as liquidity and
    concentration of positions. Leverage had to be
    quite large.

8
The Story of Long Term Capital Management (Contd)
  • The fund was initially very successful
  • by the end of 1995-96 it achieved annual rates of
    return around 40
  • this was achieved largely through successful bets
    on convergence of European interest rates
  • that and the glitter of the sponsors made the
    fund very popular on Wall Street.
  • the fund was charging for this 2 of capital
    fixed fee plus 25 of profits
  • The Fund was very highly leveraged 125B assets
    over 5B equity
  • This gave the fund a 251 ratio of assets to
    equity
  • Fund leveraged through very favorable repo
    financing
  • Repo A contract in which the seller of
    securities, such as Treasury Bills, agrees to buy
    them back at a specified time and price. also
    called repurchase agreement or buyback.
  • However in 1997 the Funds return was down to
    only about 17
  • The US Stock return that year was 33
  • Credit spreads had narrowed accounting in large
    part for the lower return.
  • Leverage had decreased from 251 to 181 due to
    asset growth
  • Management concluded that the capital base was
    too high to earn the rate of return on capital of
    which they were aiming
  • 2.7 billion was returned to the investors
  • This cut in the funds capital to 4.8 billion
    and increasing its leverage ratio to around 281

9
The Story of Long Term Capital Management (Contd)
  • Troubles Begin
  • In May and June, 1998 there was a downturn in the
    mortgage backed securities market
  • There was a 16 loss of capital to the Fund
  • Capital dropped from 4.7B to 4B
  • Leverage increased from 281 to 381
  • Disaster then struck in August 1998
  • the Russian government devalued the ruble and
    declared a moratorium on future debt repayments
  • those events led to major deterioration in the
    credit worthiness of many emerging-market bonds
    and corresponding large increases in the spreads
    between prices of Western government and
    emerging-market bonds.

10
The Story of Long Term Capital Management (Contd)
  • Those elements were very bad for the Fund because
    the fund had bet in mega fashion on the spreads
    narrowing. This was exacerbated by the fund
    sustaining major losses of other speculative
    positions as well. So
  • By the end of August, 1998 Fund capital was down
    to 52 of the equity capital the Fund had at the
    start of that year.
  • But that time the asset-base was about 126
    billion (an over 551 asset to capital ratio)
  • The fund was running short of high-quality assets
    for collateral to maintain its repo positions
  • The funds management spent the next few weeks
    looking for assistance in an increasingly
    desperate effort to keep the fund afloat
  • no immediate help was forthcoming
  • by September 19 the funds capital was down to
    only 600 million
  • fund had an asset-base of 80 billion to appoint
    its leverage ratio was approaching astronomical
    levels
  • doom was imminent

11
The Story of Long Term Capital Management (Contd)
  • Bailout
  • In a highly controversial move the US Federal
    Reserve put together a bailout
  • Many Wall Street firms had large stakes in the
    Fund and it was deemed that failure of the fund
    could lead to disastrous effects on the financial
    markets (the classic too big to fail case)
  • A liquidation of the Fund would have required
    dealers to sell of 10s of Billions of securities
    and to cover their numerous derivatives trades
    with the Fund
  • In addition since the Fund was organized in the
    Caymans it was not certain if US Bankruptcy Law
    would apply
  • 14 banks and brokerage houses including UBS
    Goldman Sachs and Merrill Lynch but not the Fed
    agreed to invest 3.6 5 billion of equity capital
    in the Fund in exchange for 90 of the firms
    equity
  • Existing investors would therefore retain 10
    holding valued at about 400 million (a competing
    offer from a wholly private group led by Warren
    Buffet would have cashed out the investors at
    250 million)
  • Control of the fund passed to a new steering
    committee and the announcement of the rescue
    eased concerns about the funds immediate future
  • By the end of the year the Fund was making
    profits.
  • Eventually the fund was unwound and by the end of
    1999 all money was repaid to investors

12
Anatomy of a Hedge Fund
  • The Fund
  • typically organized as a limited partnership,
  • although off-shore funds are often corporate
    entities
  • The Sponsor
  • the individuals or entity (might be a financial
    institution) who have organized and promote the
    Fund
  • The General Partner
  • typically (to limit liability) an entity
  • often an LLC or occasionally corporation
  • The Manager
  • investment adviser to the Fund.
  • The General Partner might be the Manager
  • or a separate entity might serve as the Manager.
  • Investors
  • they contribute virtually all of the capital to
    the Fund.
  • typically high net worth individuals or
    institutions

13
Anatomy of a Hedge Fund Contd
  • Limited Partners. In a Fund which is in the form
    of a limited partnership this is the investors.
  • liability is limited to their capital commitments
    to the Fund.
  • LPs do not manage or operate the Fund - that is
    the role of the General Partner
  • Capital Contributions.
  • The capital invested or to be invested in the
    Fund by the investors
  • to a limited extent, by the General Partner.
  • the general partner and the investors would each
    have commitments to make capital contributions in
    a specified maximum amount.
  • Uses of Capital.
  • Under the sole control of the General Partner
  • However, generally to pay fund expense and to
    make investments for the Fund
  • Investment Guidelines or Investment Policies.
  • These are the road rules to be followed by the
    General Partner in directing Fund investments.

14
Anatomy of a Hedge Fund - Contd
  • Management Agreement where the Manager is
    different from the General Partner there is a
    management agreement spelling out the duties of
    the Manager generally involving finding
    investments , monitoring investments and advising
    on strategies
  • Management Fee It is intended to pay for
    salaries of management personnel and costs of
    management.
  • Generally this will fall in the range of 1.5 to
    2.5 of the amount of the value of the Fund.
  • Taxed as Ordinary Income
  • Carried Interest This is the incentive
    compensation paid to the General Partner out of
    Profit generated by the Fund investments
  • Amount varies but generally is 20 of the Funds
    Profits
  • Taxed as Capital Gain

15
Anatomy of a Hedge Fund - Contd
  • Preferred Return In many cases the Investors
    are entitled to receive a specified return on
    their capital (e.g. 7 per year) before the
    General Partner receives Carried Interest.
  • Pure Preferred Return Investors get their
    Preferred Return and thereafter Profits are split
    in the ratio determined (typically 80-20 on the
    excess)
  • Hurdle Rate
  • After the Investors get their Preferred Return
    then there is a a Make Up to the General Partner
  • in the form of an incremental share of the
    Profits in excess of the Preferred Return
  • until the General Partner has receive the
    Carried Interest on all Profits
  • The term hurdle comes from the perception that
    the hurdle rate is the rate of return that will
    get someone "over the hurdle" to invest their
    money in the deal.
  • Clawback
  • As result of early portfolio gains followed by
    later significant losses
  • managers may receive carried interest
    distributions
  • in excess of their share of the fund's
    cumulative profits,
  • At the end of the Fund
  • the Funds cumulative profits are calculated
  • and compared with the distributions of carried
    interest made to the general partner during the
    life of the fund
  • To the extent the general partner has
  • received more than its agreed-upon share of the
    Fund's cumulative profits,

16
Types of Funds Venture Capital Funds
  • Basic Features
  • Invest in development stage businesses
  • Often are in the form of preferred stock
  • The hope is to cash out at profit on an IPO or
    sale of the business to a strategic buyer.
  • Often diversify by making numerous small
    investments.
  • The limited partners often
  • lack expertise in a certain industry or
  • do not have the information or capacity to make
    direct investments in privately held companies.
  • rely on the general partners to select and
    monitor appropriate investment opportunities
    through the venture capital fund
  • Economics
  • GPs Carried interest.
  • Based on realized capital gains plus the
    unrealized gains on marketable securities
    distributed to investors.
  • Typically range from 15 to 35 of the gains
    attributable to the investors capital
    contributions

17
Types of Funds Venture Capital Funds
  • Example
  • If GP provides 1.5 of the total capital and the
    investors 98.5
  • GP will receive 1.5 of the gains as a return on
    its capital investment plus 20 of the gains on
    the 98.5 of the capital contributions provided
    by the investors
  • Total profits interests of the general partner is
    20.12 representing
  • 20 of the total profits as carried interest and
  • The GPs pro rata share as an investor of the 80
    profits share going to the investors (1.5 of 80
    equals .12).
  • Preferred return
  • Not usually provided to investors
  • If provided, may vary from 6 to 12 depending on
    risk and interest rates
  • If provided, a GP Makeup is almost inevitable
  • Management Fee.
  • 1.5 to 3.0 of Capital Commitments
  • Generally, no decline in rate when Fund is fully
    invested

18
Types of Funds Venture Capital Funds (Contd)
  • Leverage
  • VC funds rarely have the ability to borrow money
  • Exceptions (on a short-term basis)
  • to cover expenses
  • make up for gaps in capital contributions.
  • Transferor and redemption
  • VC Fund interest are highly illiquid
  • transfers are generally prohibited without the
    consent of the general partner.
  • Redemptions and withdrawals are rarely allowed
  • Reinvestment
  • proceeds from sales of investments
  • rarely subject to reinvestment
  • Additional investors.
  • Generally closed to new investors within six to
    12 months after initial closing
  • Where allowed, subsequent investors often
    contribute their share of the cost of prior
    investment by the Fund (often with interest).
  • Closed to new money
  • is designed to keep things simple
  • and avoid the need for valuations of investments
    early in their life
  • valuations are imprecise (which can lead to
    disputes), complex and costly

19
Types of Funds LBO and Investment Banking Funds
  • General Features.
  • LBO/IB funds purchase all or significant portion
    of stock or assets of a target company.
  • investments takes the form of equity securities
    of a newly formed corporation which will acquires
    stock or assets of the target company.
  • borrow money to fund a large portion the purchase
    price
  • Cash flow from the acquired company is used to
    service and repay acquisition indebtedness.
  • Likely candidates for LBO's
  • stable cash flow
  • good market share.

20
Types of Funds LBO and Investment Banking Funds
  • Economics
  • Carried interest - typically consists of 20 of
    the gains attributable to capital commitments
  • Preferred return generally 8 to 12 with a GP
    Makeup
  • Management fees 1.5 to 2.5
  • Based on Capital Commitment during Investment
    Period
  • Thereafter, based on capital not retuned to
    investor
  • Transaction fees
  • Management is quite likely to have opportunity to
    receive fee income directly from target
    companies.

21
Types of Funds LBO and Investment Banking Funds
(Contd)
  • Thus the question of whether fee income should be
    treated as Fund income is often intensely
    negotiated
  • Transfer and Redemption
  • Investors generally prohibited from transferring
    their interests without the consent of the GP
  • redemptions and withdrawals are rarely allowed
  • Reinvestment - reinvestment is rare
  • Additional investors same polices as with VC
    Funds discussed above

22
Types of Funds Hedge Funds
  • General Strategies
  • Invest in listed securities, options, futures,
    and currencies
  • Or other liquid financial assets
  • The ability to invest in illiquid securities is
    sometimes also given
  • However, often there are caps on investments in
    illiquid securities
  • Organization
  • Many different types of structures are used
  • Short-term trading is involved
  • So not as geared toward capital gains as other
    types of funds
  • This makes partnership qualification less
    critical provided entity level tax can be
    minimized
  • Generally the structure depends on the investor
    group to whom the fund will be sold
  • US taxable investors
  • generally domestic limited partnership structure
    is used to avoid entity level tax
  • Non-US investors and US Tax Exempt Investors
  • Entity level tax is undesirable
  • However, pass thru is often not wanted either
    (e.g. UBTI for tax exempts)
  • So many hedge funds organize in tax havens such
    as Cayman Islands and Bermuda

23
Types of Funds Hedge Funds (Contd)
  • Economics
  • Carried interest
  • Determined by reference to net asset value which
    takes into account unrealized as well as realized
    gains and losses.
  • The amount is typically 20 of the increase in
    NAV from one period to the next.
  • Generally paid annually
  • Clawbacks are unusual.
  • Higher Carried Interest rates of 25 or very
    exceptionally 30 are sometimes seen
  • Preferred returns
  • most hedge funds do not provide preferential
    returns
  • however funds which do often adopt a floating
    rate of return such as LIBOR -- the London
    Interbank offered rate
  • Management fees
  • usually an amount equal to a fixed percentage of
    NAV.
  • Typically these are paid quarterly in advance.
  • The general rate is 1 per annum
  • Transaction fees
  • these are not often present

24
Types of Funds Hedge Funds (Contd)
  • Leverage
  • leverage ratios of three to one are common
  • funds which pursue arbitrage opportunities in
    financial assets may have significantly higher
    leverage
  • Transfer and Redemption
  • general partner consent is required to transfer
  • redemptions are typically allowed after perhaps
    an initial lockout from one to two years
  • redemptions - made quarterly or semiannually
  • Reinvestment - universal
  • Additional investors - most hedge funds are open
    to new investors on redemption dates

25
Types of Funds Fund of Funds
  • Definition
  • This is a fund which invests in other funds
  • Rationale
  • access to deals
  • expertise
  • economies of scale
  • diversification
  • Access to deals
  • Many Funds require minimum investments that are
    beyond the reach of many individuals.
  • Regulatory reasons can restrict individual
    investors to those with net worth of 5 million
  • Expertise
  • lack of transparency in some markets
  • the only way to obtain certain market
    information is often to be an active market
    participant
  • fund of funds can bridge the information gap for
    investors
  • Economies of scale
  • Sponsor can the review prospective investments
    that would be prohibitively expensive if
    undertaken by each investor in paragraph

26
Types of Funds Fund of Funds (Contd)
  • Investment strategy.
  • Better investment returns relative to mid-to
    long-term public equity market returns.
  • Most funds of funds focus on a particular
    category of underlying private equity funds
  • Organizational structure
  • typically limited partnerships.
  • The partners have capital commitments in
    specified amounts
  • The general partner is often organized as a
    limited partnership or an LLC
  • General partner of the fund sponsors typically
    do not organize a separate entity to serve as
    manager
  • Carried interest
  • Many of the funds of funds forego
  • Carried interest is still typical for a
    majority.
  • Generally arrived at by formula consisting of
    realized gain plus unrealized gain associated
    with marketable securities which are distributed
    to investors.
  • Carried interest is generally around 5

27
Types of Funds Fund of Funds (Contd)
  • Preferred return
  • most funds of funds provide preferred returns.
  • generally a fixed percentage annual rate of
    return
  • general range - from 6 to 12
  • preferential returns are almost overly combined
    with a general partner makeup
  • Management fees
  • Usually an amount equal to a fixed percentage of
    capital commitments
  • Management fees are typically paid by a fund of
    funds quarterly in advance
  • ranges - .75 to 1.5 of capital commitments
  • Often management fee rates decline when the fund
    is fully invested.
  • If no carried interest
  • a higher management fee
  • less likely to be reduced if the fund is fully
    invested

28
Types of Funds Fund of Funds (Contd)
  • Transaction fees
  • Unlikely
  • Size
  • certain critical mass is needed
  • to have access to deal flow
  • and to achieve economies of scale.
  • typically capital is 50 million to 100 million
  • Investor
  • profile high net worth individuals and small
    institutional investors paragraph
  • Leverage
  • fund of funds really has the ability to borrow
    money
  • except in short-term to cover expenses or bridge
    contributions

29
Types of Funds Fund of Funds (Contd)
  • Transfer redemption
  • Transfer only on the consent of the general
    partner
  • Redemptions and withdrawals are rarely allowed
  • Reinvestment
  • typical fund of funds calls for capital
    contributions as needed for investments or to pay
    expenses
  • once fully invested or after a specified
    investment.
  • A fund of funds ordinarily goes into monitoring
    and liquidation stage. Proceeds from underlying
  • Additional investors
  • most funds of funds are closed to new money
    within six to 12 months after the initial closing
  • investors after initial closing contribute pro
    rata share of costs of prior investment (often
    with interest)

30
Types of Funds Real Estate Funds
  • What they Do
  • These generally invest in large real estate
    assets
  • generally sponsored by experienced real estate
    owners or investment advisers
  • Investment strategy
  • superior return and risk reduction relative to
    direct real estate investments
  • generally structured with a specific investment
    focus such as
  • acquisition of real estate directly.
  • Acquisition of interests in properties on a
    joint-venture basis
  • investment in public or private operating
    companie
  • real estate loan origination or acquisition of
    real estate debt instruments
  • may also focus on specific real estate asset
    types such as
  • commercial office buildings
  • retail shopping mall facilities.
  • Multi-family properties or hotels.
  • They may also have an investment strategy that
    focuses on specific geographic regions.

31
Types of Funds Real Estate Funds (Contd)
  • Organizational structure
  • these are typically either limited partnerships
    or LLC's
  • principals organize a controlled entity to be
    GP or managing member
  • Principals may organize a separate entity to
    invest in the fund.
  • The general partner or managing member entity is
    typically either corporation or LLC
  • Principals may organize a separate entity to
    serve as investment manager or investment
    adviser.
  • Carried interest.
  • Calculate from realized gains which are
    distributed
  • May also be calculated at fixed intervals by an
    appraisal of assets.
  • Typically consists of 20 after Hurdle Rates are
    achieved.
  • Often subject to claw back final returns are
    really known until asset disposition
  • Preferred returns
  • a substantial majority of real estate funds
    provide preferential returns or hurdle rates
  • The percentage varies depending on the specific
    investment strategies used

32
Types of Funds Real Estate Funds (Contd)
  • Management fees
  • these are usually annual amount equal to a fixed
    percentage of capital until 75 of the capital
    commitment is funded and invested
  • thereafter a fixed percentage of the NAV
  • typically paid quarterly or monthly in advance.
  • Fees generally range from 1 to 2
  • Transaction fees
  • affiliates of the principals may receive
  • property Management fees,
  • leasing
  • or other fees for properties owned by the fund.
  • These fees are typically not shared with the
    fund or the investors
  • Typical investors
  • high net worth individuals, pension funds and
    other institutional investors
  • generally do not include banks and insurance
    companies

33
Types of Funds Real Estate Funds (Contd)
  • Leverage
  • real estate funds typically employ leverage
  • additional leverage might be obtained by a fund
    level credit facility in addition to loans
    against assets
  • Transfer and Redemption
  • transfer requires consent of the general
    partner.
  • due to illiquid nature redemptions are not
    allowed except rarely
  • Reinvestment
  • real estate funds generally provide
  • A 2-3 year investment phase
  • A 1-2 year holding and monitoring period
  • A 1-2 year liquidation period
  • Proceeds from sales are generally not subject to
    reinvestment.
  • Additional investors
  • most real estate funds are close to new
    investors within 6- 12 months after the initial
    closing
  • additional investors leads to expense to value
    fund assets such as real estate appraisals

34
Key Structural Features
  • Limited Liability
  • Enabling state law legislation will provide for
    limited liability for LLC
  • E.G. Delaware debts, obligations and
    liabilities of an LLC whether arising in contract
    or otherwise are the sole responsibility of the
    LLC
  • Compare LLP the limited partners have limited
    liability but not the GP
  • Solution have an entity GP, e.g. an S corporation
  • However, keep in mind limited liability only
    extends to status based liability
  • Liability based on the personal conduct of a
    member or manager is not protected by the
    entitys limited liability
  • Under US Securities laws liability sometimes
    extends to persons who control another person
    such as a corporation that violates the laws
  • Veil piercing A somewhat open issue
  • Inadequately capitalized entities ??
  • Failure to follow formalities ?? But no real
    formalities and direct management by members is
    envisioned by the laws

35
Key Structural Features (Contd)
  • Multi-Tier Structures
  • Issue in LPs is how to organize the GP on
    account of the Unlimited Liability of GP
  • Classic solution was a corporate GP
  • To eliminate entity level tax and for pass
    through of capital gains S status elected
  • In fact, with hedge funds the GP was often a 2nd
    LLP with a corporate GP (three tiers)
  • This also eliminated entity level tax and
    preserved capital gains allocated to principals
  • Also allow division of Carried Interest and other
    economic attributes of the GP to be determined by
    contract instead of by share ownership
  • Now LLC (with no member having personal
    liability) has become the favored structure for
    Private Equity Funds

36
Key Structural Features (Contd)
  • Incentive Arrangements (Larger Funds)
  • Ideally to attract best talent (one notch below
    top fund management) is to have flexibility in
    allocating the Carried Interest
  • However, Sr. Fund Management not want to give up
    control and management so preference is for a
    form of ownership that separates control
    management from economic interests
  • Generally too Sr Principals will want ability to
    frequently change allocations of Carried Interst.
  • One structure that is used is LLC, with classes
    of membership interests, requiring establishment
    of separate capital accounts for each investment,
    and then allowing establishment of different
    sharing s for each transaction

37
Fiduciary Relationships Survey
  • Why would the limited partnership continue to
    matter if parties can obtain similar features
    along with partnership-type taxation by forming
    as LLCs?
  • the main distinct limited partnership feature is
    limited partners default non-management
    involvement
  • a firm can obtain the same feature in every state
    by forming as an LLC and opting for centralized
    management.
  • One major reason a significant amount of case
    law dealing with
  • the fiduciary duties of general partners in
    limited partnerships
  • specifically with waiver of such duties
  • this is especially well developed in Delaware

38
Fiduciary Relationships (Contd)
  • Partners have duties to refrain from
  • self-dealing
  • appropriation of partnership assets and
    opportunities,
  • competition with the partnership
  • mismanagement
  • Courts have compared general partners to
    corporate directors
  • Use of the business judgment rule.
  • See Wyler v. Feuer, 85 Cal. App. 3d 392, 149 Cal.
    Rptr. 626 (1979)
  • Trustees of Gen. Elec. Pension Trust v. Levenson,
    1992 WL 41820 (Del. Ch. 1992). The Texas Revised
    Partnership Act applies an ordinary care standard
    subject to a business judgment rule taken from
    corporation law. Tex. Rev. Civ. Stat. Ann. art.
    6132b-4.04(c), (d))
  • This makes the legion of corporate business
    judgment rule cases arguably applicable.

39
Fiduciary Relationships (Contd)
  • Waivers
  • Delaware statutory law Del. Code 17-1101
    explicitly provides that GP duties and
    liabilities may be expanded or restricted by
    provisions in a partnership agreement
  • So in Delaware the keys for a GP are
  • Disclosure of conflicts of interest in Fund sales
    materials
  • Enumeration of permitted conflicts of interest
    activities of the GP in the Partnership
    Agreement.
  • Cases have allowed waivers
  • GP to purchase assets of liquidating partnership.
    See In Re Cencom, Civ A No. 14634, 1996 WL 74726
    (Del Ch Feb. 15, 1996)
  • GP to take advantage of partnership opportunity.
    See Kahn v. Icahn, Civ A No. 15916, 1998 WL
    832629 (Del Ch Nov. 12, 1998)
  • Eliminate the duty of substantive fairness in
    transactions between general partners and their
    partnerships, at least as long as the limited
    partners have had an opportunity after full
    disclosure to vote on the transaction. See Sonet
    v. Timber Co. L.P, 722 A.2d 319 (Del. Ch. 1998).

40
Fiduciary Relationships (Contd)
  • Cant Go Overboard with This
  • a very broad provision in a partnership agreement
    in effect negating any duty of loyalty
  • such as a provision giving a managing partner
  • complete discretion to manage the business with
    no liability
  • except for acts and omissions that constitute
    willful misconduct
  • will not likely be enforced
  • .See, e.g., Labovitz v. Dolan, 189 Ill. App. 3d
    403, 136 Ill. Dec. 780, 545 N.E.2d 304 (1989)
  • Also need to watch provisions allowing
    management to compete
  • this sort of provision would be expected in the
    typical limited partnership, which manages a
    portfolio of assets rather than running an
    ongoing business.
  • However, its generally a No-No where a partner
    seizes on the provision
  • not merely to engage in a different business
  • but to undercut the other partners and take over
    the business of the partnership
  • Laibowitz
  • that the general partner refused unreasonably
    to distribute cash
  • thereby forced plaintiffs to continually dip
    into their own resources in order to pay heavy
    taxes on large earnings
  • in a calculated effort to force them to sell
    their interests to
  • an entity which GP owned and controlled
  • at a price well below at least the book value of
    those interests.

41
Fiduciary Relationships (Contd)
  • Delaware Approach to Waivers
  • First, the strongly worded statutory protection
    of freedom of contract
  • focuses the courts attention on the language and
    structure of the contract in the first instance.
  • This strongly discourages courts from
    substituting judicial default rules for clearly
    articulated contractual duties.
  • Second, the courts have reserved a category of
    fundamental, non-waivable fiduciary duties.
  • This default category effectively encourages the
    parties to substitute their own customized duties
  • These should reasonably meet the needs of the
    particular situation rather than risking
    invalidation of the waiver.
  • Third, to the extent that default duties are
    subject to waiver without displacement, the
    waiver must be explicit in order to be enforced.
  • Combined with the disclosure requirements of the
    federal securities laws and the other
    circumstances
  • serve to call the partners attention to the
    partnership agreement,
  • this ensures that limited partners are likely to
    be aware of any fiduciary duty waivers.

42
The End
  • If You Have Further Questions Contact
  • Robert J. Kiggins, Esq.
  • McCarthy Fingar
  • Tel 914-946-3817 Ext. 251
  • Email rkiggins_at_mfdds.com
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