Introduction

During the past year we have seen, and expect to continue to see, an increase in the number of alternative investment funds being formed by hedge fund and private equity fund managers focused on distressed and special situation opportunities in troubled asset classes. While there are many variations to these products, the following is a synopsis of the key issues to consider when establishing such a fund:

1. Strategy.  Probably the most important issue to consider, the manager must determine, among other things, whether the fund will have a global or US coverage, any particular industry focus, portfolio concentration, types of instruments in which the fund will invest, availability of investments, and the likely duration of investments.
2. Subscription Terms.  Depending on the answers to 1 above, a manager will need to consider whether to establish a hedge fund-style periodic contribution mechanism, a private equity fund-style capital commitment/drawdown mechanism or a hybrid structure. If there will be few intermittent investments available, a private equity approach may work best, while if there are expected to be frequent liquid opportunities, a hedge fund model might be the better choice.
3. Withdrawal Terms.  Depending again on the answers to 1 above, the manager will also need to determine whether investor withdrawals will be permitted at all (and, if so, at what intervals), or alternatively whether to adopt a private equity structure with a specified term and no periodic voluntary withdrawals. As periodic voluntary withdrawals may be a bit challenging, especially with respect to certain portfolio assets, possible hybrid solutions might include the adoption of longer lock-up and notice periods, the implementation of either fund level or investor level gates, as well as the creation of illiquid investment “sidepockets” for a percentage of the portfolio.
4. Manager Compensation.  Generally, managers of troubled asset funds will charge a management fee in the 1% – 2% range, in addition to a share of the profits generated. The profit-based compensation will take the form of either a hedge fund-like incentive allocation (i.e., generally taken annually based on realized and unrealized gains) or a private equity fund-like carried interest (i.e., taken once investor capital is returned based on realized gains). In some cases, troubled asset funds that otherwise have subscription and withdrawal terms similar to a hedge fund may, for a variety of reasons, nonetheless charge a carried interest. In addition to the foregoing, depending on the level of the manager’s active involvement with the troubled asset and its issuer, the manager may derive special consulting, advisory or other fees from the issuer for such services, which fees are often applied to offset the management fee.
5. Structure.  If the manager is seeking to raise capital from both US and non-US investors, in all likelihood it will need to establish both a US-based partnership or limited liability company for US taxpayers and an offshore tax haven-based corporation for US tax-exempt investors and non-US investors. The manager will then need to decide whether to adopt a “side by side” structure or a “master-feeder structure” — a decision which will turn primarily on trading efficiency and investor slot needs. Furthermore, depending on the instruments in which the fund will invest and the tax, regulatory and other associated implications, the manager will probably want to reserve sufficient flexibility to trade outside the funds, when warranted, in special purpose vehicles and/or to trade in one fund and not another (note that appropriate disclosure will need to be inserted in the offering materials concerning the foregoing). Finally, in some cases, managers may be hired by a large strategic investor to pursue a specific troubled asset mandate, in which case the structure and other key terms will be driven by the specific needs of the investor and the agreed upon steps.
6. Valuation Policies.  Because many troubled assets will not have an easily obtained market price, it is imperative that robust valuation procedures be adopted, taking into account the latest SEC pronouncements on fair value, appropriate GAAP/FASB guidance, and such other information as is needed to fairly determine asset valuation.
7. Conflicts of Interest.  Since many of these funds are being established by managers who already have other existing more broadly focused funds in place, appropriate investment allocation policies must be established so that the manager is not viewed as favoring one fund over another. This is especially true where the existing fund has a significant loss for the year and thus the manager may have an economic incentive to favor putting assets into the new troubled assets fund which is more likely to generate an incentive allocation or a carried interest.

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If you have any questions concerning the foregoing, or would like assistance in establishing a troubled asset fund, please contact any of the Investment Management Group partners listed below.