By Mikhail Iliev, Who's In My Fund? -- Hedge fund investors have won a surprise upper hand in the tug of war with managers for power and transparency.
The Delaware Supreme Court recently ruled that an investor in the bankrupt hedge fund Parkcentral Global should have access to the names and addresses of the fund's other investors. The ruling in favor of Brown Investment will make it easier for other investors to investigate claims against closed hedge funds.
Parkcentral lost between $2 billion and $3 billion in November 2008 on its commercial mortgage-backed securities investments and is being sued by investors to recover some of the money.
Chief Justice Myron Steele wrote in the August ruling that federal regulations which protect the privacy of financial institution customers do not pre-empt a Delaware law that "entitles [hedge fund investors] to access partnership information and records if they make a reasonable demand for a purpose reasonably related to their interest."
The ruling may be a useful tool for investors against managers who use divide-and-conquer tactics to avoid responsibility for losses. “Pooled investments [like hedge funds] provide a largely unregulated way for hedge fund managers to make money for themselves," attorney Amir Alavi, who tried the case for Brown Investment, said in a statement after the trial. “This ruling helps those who lost money in poorly managed funds to find other investors and join together to take legal action,” Alavi added, and may discipline managers who “lacked diligence and proper risk analysis.”
“An individual investor who lost $1 million in a hedge fund, for example, wouldn't want to spend $200,000 to $300,000 on forensic accounting to see whether there's a legal claim,” Alavi said.
Even though the case is limited to Delaware, it is still massively important in the world of hedge funds. A vast number of U.S. hedge funds are legally formed there. Delaware is also known for its business-friendly corporate laws and most state supreme courts look to Delaware for guidance on corporate issues.
The case is a step in the direction of increased hedge fund transparency and may bring hedge fund investors closer to the level of disclosure available to investors in public companies. Large investors in public companies are obligated to disclose their holdings in public companies and every investor, large or small, is invited to shareholder meetings.
To be sure, the hedge fund industry is likely light-years away from that level of disclosure. Hedge funds are largely exempt from the more meaningful disclosure requirements of the securities laws and fund managers pride themselves on their near-paranoid secrecy and proprietary trading platforms which they claim are key to deliver the promised alpha to their investors. Yet, this case will likely change the way investors and hedge fund managers deal with each other, at least when their fund has suffered catastrophic losses.
Still, the Delaware decision is not exactly throwing open the floodgates of hedge fund investor activism. The ruling is technically limited—it did leave the door open for managers to protect the lists of investors by simply stating in the fund’s partnership agreement that the lists are privileged and cannot be disclosed.
Moreover, large managers have no trouble attracting investors and can still dictate terms favorable to them. If a successful multi-billion fund such as Bridgewater wants to admit you as an investor, would you really be going through its partnership agreement with a fine-tooth comb looking for ways to increase transparency?
Nonetheless, the general tide in private money pools may be turning pro-investor. Private equity investors are already banding together and stumping for better terms. The Institutional Limited Partners Association advised its members to ask private equity fund managers for fee sharing and to insist on new provisions for stronger clawbacks of fees paid out to general partners. And as the Wall Street Journal reported in August, the atrocious environment for fund-raising has caused general partners to start listening and stop dictating. The article, “The Terms They Are A Changin’,” also reported that some private equity funds are reducing their carried interest and investment management fees.
Private equity investors have typically enjoyed more clout than their hedge fund counterparts. “That industry is dominated by powerful pension trusts and other big institutional investors who often sit on the same advisory committees for a private equity fund,” Chadbourne & Parke attorney and private equity fund expert Adam Gale told Who's In My Fund?, “and can contact any other investors in their fund without violating any confidentiality arrangement.” Because private equity investors often have to stay with their investment for up to 8 years, they get together and vote on various issues, Gale added.
There are hardly any advisory committees in hedge funds because investors there are locked up for a year or two only, Gale said. If hedge fund investors do not like the fund they can redeem out of it, he added.
If pension money starts coming to the hedge fund world in large quantities, lock-up periods become longer or the fund has suspended redemptions we may start seeing similar activism flourish there, Gale said.
Still, as private pools of money chasing abnormal alpha, private equity and hedge funds are more similar than they are different. On the strength of the Delaware decision, hedge fund investors can now band together and share costs on due diligence and claim enforcement. Who knows, they may even start demanding better terms, like their counterparts in private equity.
Mikhail Iliev is a contributing editor of Who's In My Fund?, a site which groups hedge fund investors by investment, allowing them to communicate directly and discretely with each other in a secure environment and share news and opinion on their investments. Mikhail practiced law for 11 years as an associate at Dewey LeBoeuf, LLP and as Senior Vice President at KBC Financial Products. He has extensive experience in the field of securities law and private investments and has advised clients on financing and offering matters for domestic and offshore funds, mergers and acquisitions and securities regulation. He is also a visiting professor at Segal Graduate School of Business in Vancouver, Canada where he has taught courses on securities regulation and ethics.