Hedge funds generally have the following terms:

The amount and types of securities being purchased will have a significant impact on which model is chosen. As described above, hedge funds permit periodic redemptions and subscriptions. In addition, performance allocations and management fees are calculated on at least an annual basis. In order to have these provisions work properly, the manager must be able to calculate the fund's net asset value with certainty. If a fund's portfolio investments cannot be valued with a high degree of certainty, then a hedge fund structure and terms are not appropriate. One of the main reasons we have seen many hedge funds suspend redemptions since the fall is their inability to calculate the value of their assets. When setting up a credit opportunity fund that will use a hedge fund model, the manager must be able to perform the periodic net asset value calculation as required by the fund's organizational documents.

Side pockets are often used by hedge fund managers to circumvent the periodic valuation requirement. Side pockets are devices within a hedge fund structure that permit illiquid assets or comparatively hard-to-value assets (or assets that may become such) to be walled off from the rest of a hedge fund's portfolio so as to be housed in their own specially created compartments (or side pockets) within the hedge fund. The power to side-pocket assets is normally delegated to the fund manager, with the parameters of the manager's powers being fully disclosed in the offering documents of the hedge fund.

Once side-pocketed, the assets are treated separately from the rest of the hedge fund's portfolio, with each side pocket having its own distinct terms. Side-pocket provisions generally prohibit new investors from acquiring an interest in the side pocket and, likewise, prohibit exit from the side pocket by the existing investors. Upon the side-pocketing of assets, existing investors (with an interest in the particular side pocket) are, at that point, effectively locked into that side pocket (as far as those assets are concerned) while being free to redeem out their remaining investment in the rest of the hedge fund's portfolio. Side pockets can thus be thought of as subfunds of a hedge fund with their own unique provisions.

Side pockets may be of use to managers considering setting up credit opportunity funds, but managers should be aware that investors in hedge funds have often looked to limit side pockets to 15% to 20% of the aggregate net asset value of the proposed fund, although we have seen funds with side pockets as high as 40%.

We continue to see more hedge fund managers considering setting up credit opportunity funds with private equity terms because of (i) the inability of the hedge fund manager to be able to properly value the fund's assets (whether they be traditional distressed-debt securities such as high-yield debt or toxic assets such as credit-default obligations being purchased from banks or other lenders), and (ii) the side-pocket percentage limitations often imposed on managers by investors. It should be noted that we have seen some clients set up new funds that purchase distressed or toxic assets but limit those securities to a minority of the portfolio.

Managers using private equity fund mechanics may modify the terms of the fund to meet investor demands regarding liquidity and current income. Some of the terms we are seeing include:

These provisions are generally aimed at reducing the exposure of the investor to the fund and accelerating the repayment of the investor's capital. They also emphasize the belief by many investors that the opportunities presented by the market will be for a limited time frame.

We believe that traditional hedge fund managers will continue to be interested in looking at private equity fund mechanics for future credit opportunity funds because of the limitations imposed by hedge fund mechanics and the demands by investors. Managers will need to work closely with their counsel to make sure that the terms they are proposing are appealing to investors and also match up with the assets that will be purchased by the fund.

Tim Clark is a partner in the corporate group of Proskauer Rose LLP who specializes in hedge funds.