HEDGE FUNDS

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.

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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

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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

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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.

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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

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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,

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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

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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

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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

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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 [phone] Ext. 251
• Email rkiggins_at_mfdds.com