Hybrid fund vehicles urged to implement rigorous Chinese Walls

03 Nov, 2014

Hedge fund managers launching or acquiring equity stakes in private equity or venture capital firms must ensure they have adequate Chinese Walls in place to prevent conflicts of interest arising through separate vehicles, according to Seward & Kissel.

A growing number of hedge fund managers are seeking to diversify their businesses and provide allocators with more investment options by entering the private equity or venture capital space. It is important, however, that hedge fund managers do not trade off any material, non-public information (MNPI) that may be privy to the private equity side of the business.

“It would be a rare scenario where MNPI leakage occurred but managers need to have measures in place to stop it. If a private equity manager has MNPI information on a company, there must be safeguards in place to ensure that it does not get misused by hedge fund managers. It is essential these businesses have clear compliance guidelines in place to reduce MNPI being misused. This could require a clear paper and physical separation between the private equity or venture capital side of the firm and the hedge fund arm,” said Steven Nadel, partner at Seward & Kissel in New York.

This convergence between the two asset classes is evident in a study published in February 2014 by Seward & Kissel. It found newly launched US hedge funds were imposing tougher redemption terms on investors.  Eighty-nine per-cent of new funds restricted redemptions to a quarterly or longer-term basis in 2013 compared with 64 per-cent in 2012. The number of funds employing a hard lock up, usually of one year, rose dramatically from 8 per-cent in 2012 to 27 per-cent in 2013.

A report by the prime brokerage arm of J.P. Morgan in March 2013 acknowledged there had been a surge in hybrid fund structures buoyed by growing investment opportunities in less liquid distressed assets. Basel III and various national regulations are forcing banks to deleverage and restructure their balance sheets by devolving themselves of illiquid, non-core assets such as collateralised loan obligations and residential mortgage backed securities. Many hedge funds are establishing private equity vehicles or structures to take advantage of these investment opportunities.

Some have advised hedge fund managers against establishing private equity businesses, citing their lack of expertise in the asset class. Many hedge funds are traders, for example, and will have limited experience of actually running a company. Nadel disagreed.   “Hedge fund managers have shown repeatedly that they can expand their expertise and enter into diversified business lines. We have seen hedge fund managers launch not just successful private equity vehicles but liquid alternatives structures,” said Nadel.

Others have warned hedge funds face a liquidity mismatch with some of their private equity ventures. These hedge funds are usually adopting a lock-up of one year despite investing in highly illiquid companies whereas private equity typically imposes a 10 year lock-up. Should these investments turn sour, investors could be left unable to redeem. Investors have taken note with the bulk of pension funds remaining averse to these investment vehicles. 

Another challenges lies with remuneration, added Nadel. “The compensation structure of a private equity vehicle is very different to that of a hedge fund. At a hedge fund, the carry is paid annually while in private equity and venture capital, it is usually not made until the final realisation on profits is apparent at that vehicle. In private equity, remuneration is sometimes not paid for several years so managers need to be careful in what they promise their employees,” said Nadel. 

hedge fundsventure capitalprivate equitySeward & KisselJ.P. MorganBasel IIIfees