Alternative investment managers are increasingly being approached by investors seeking access to a structure that provides a modified, more bespoke version of the manager’s overall portfolio strategy. Investors’ reasons for this may include: ESG allocation guidelines, an interest in different beta or volatility levels, a desire to capitalize on a market dislocation, or an appetite for a specific market sector or exposure. Often these investor requests are accompanied by a need to implement the modified portfolio for the investor quickly.
Investment managers have various options that may work to satisfy these investors, but should be mindful of the following considerations:
- Establishing a Separate Share Class in an Existing Fund
- Timing: Can be accomplished relatively quickly
- Documentation:
- Requires amendments to fund disclosure materials
- May create issues with the fund’s existing counterparty documents
- Requires the adoption of policies designed to ensure the proper allocations of fees and expenses within the fund
- Customization & Structure: Likely less tailoring available to the investor as compared to the other alternatives outlined below, since the investor is joining an existing structure with investors already in place
- ERISA: May create ERISA issues with respect to the “25% test”
- Additional Considerations:
- Typically, will give rise to cross-class liability exposure with the existing classes in the fund, unless the fund has been structured as a segregated cell company (which could require both existing investor and creditor consent, if being considered post-launch)
- Allows for multiple investors
- No additional infrastructure required
- Establishing a Separately Managed Account Arrangement
- Timing: Can be established very quickly, if there’s not extensive client negotiations
- Documentation: Does not require any offering documents (just an investment management agreement)
- Customization & Structure:
- Most flexible of all options in terms of individual investor tailoring
- Aside from the trading authority which is vested with the manager, the account is fully controlled by and in the name of the client, with corresponding portfolio transparency
- Sometimes set up as a “fund-of-one”
- ERISA: May subject the manager to onerous ERISA requirements, if it’s an ERISA client
- Registration & Compliance:
- An unregistered manager may have to register as an adviser with the SEC or at the state level, and may no longer be able to rely on certain registration exemptions
- May raise compliance issues under Sections 13 and 16 in terms of who is the responsible filing party
- Fees & Tax Treatment:
- Since the manager usually receives a performance fee as opposed to a performance allocation, generally there is no carried interest tax treatment
- Fees paid by the client to the manager are not deductible
- Additional Considerations:
- Can only accommodate one client
- Typically, no audit is required, unless requested by the client
- Manager will need an infrastructure to allocate trades and expenses, as applicable, among the separately managed account and other client accounts
- May expose the client to greater counterparty risk than a fund which has limited liability
- May raise most favored nation issues with other manager products
- Establishing a Traditional Hedge, PE or Similar Fund for the New Strategy
- Timing: Typically requires more time to establish and the costs will likely be higher than the other options
- Documentation:
- Requires a complete suite of offering documents
- Use of the flagship fund’s offering documents as a starting point may mitigate drafting issues somewhat
- May be able to leverage the existing fund’s counterparty documents when setting up the new fund
- Customization & Structure:
- Can be somewhat customized, if the investor’s investment is contingent upon having a say in the key fund terms to be included at launch
- May require the establishment of both a US and an offshore fund (depending on the strategy and type of investors)
- Registration & Compliance: Fund will be disclosed on the Form ADV, if the manager is SEC-registered
- Fees & Tax Treatment:
- Carried interest tax flow-through on an incentive allocation is possible
- Better tax treatment for US taxable investors with respect to manager compensation, especially as compared to a separately managed account
- Management fees paid by US investors are deductible, if the fund is a “trader”
- Additional Considerations:
- Will allow multiple investors to access the opportunity
- Audit is required
- Establishing a Special Purpose Vehicle (“SPV”)
- Timing:
- Quicker and less expensive to establish than a traditional fund described in 3 above
- Timing, however, may be delayed, if there is the need for an offshore SPV counterpart
- Documentation: Offering documents tend to be shorter than for a traditional hedge, PE or similar fund
- Customization & Structure:
- Usually more closed-end in nature with a limited offering and investment period, even when the investment assets are publicly-traded
- Capital is sometimes raised via a drawdown mechanism
- Generally, only holds one or a small number of investments within a theme (e.g., a subset of the main fund’s portfolio)
- Investors are normally given limited, if any, withdrawal rights
- Since SPVs tend to be set up very quickly, they offer limited customization opportunities to investors
- Fees & Tax Treatment:
- Typically, the manager receives a performance allocation or carried interest only upon a realization event
- Management fee is usually lower than any affiliated traditional fund
- Additional Considerations:
- Usually an audit is required and the manager (if registered) will have to include the SPV as a private fund on its Form ADV
- May give rise to allocation issues with the flagship fund, if similar positions are held in both vehicles
- Usually only meant for a small number of investors who can rapidly deploy their capital
- Timing:
