Hedge fund M&A

By Ilan S. Nissan, Douglas C. Freeman and Solomon Wifa, O'Melveny & Myers

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Published March 26, 2009 at 2:39 PM

EXECUTIVE SUMMARY

The economic crisis continues to take its toll on the hedge fund industry.
M&A opportunities abound.
But acquirers must do their homework.

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Deteriorating economic conditions caused by the worsening global recession have spread to nearly every major sector of the economy.

The hedge fund industry is no exception and continues to be adversely affected by the economic crisis for many reasons: the continued lack of credit as financial institutions delever; proposed government regulations that, if adopted, would significantly change the way hedge funds do business; poor investment performance for most asset classes resulting in total industry losses last year of nearly $600 billion; and cash constrained investors in need of liquidity.

Because of these and other factors, many hedge funds have earned historically poor returns and have faced unprecedented redemption requests. The resulting shakeout in the hedge fund industry has seen a number of hedge funds fail, while others have tried to retrench and refocus, including by selling assets at deepening discounts. Some hedge fund advisers have begun to explore combining with other fund advisers to diversify their businesses and to opportunistically align with well-respected fund advisers or managers.

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We expect this trend will continue and that well-positioned hedge fund advisers and other private fund managers, including private equity firms, will increasingly seek to strategically acquire or combine with other private fund managers in the coming months.

Acquisitions of hedge fund advisers demand consideration of several important business, legal, tax and regulatory issues, and an acquirer must perform careful due diligence of both the adviser and the funds it manages. Conducting a thorough due-diligence review will require the acquirer to:

Review in detail the target's fund documents, management agreements, prime brokerage arrangements, credit facilities and existing policies and procedures.

Pay careful attention to existing employment arrangements and deferred compensation arrangements with the target's management. The acquisition of a hedge fund adviser is fundamentally the acquisition of a group of investment professionals, and "people" issues must be identified and addressed early.

Identify any regulatory approvals or consents that may be required in advance of closing the acquisition.

Understand the target's existing conflict policies, including, for example, the way the target values its assets, how it treats valuation errors and its policy for allocating orders. Violations of these policies may result in claims of regulatory or fiduciary duty breaches.

Carefully identify whether the proposed transaction will trigger any change of control or redemption provisions, as well as whether consent from the target's existing fund investors is required.

Understand the quantity and quality of the assets managed by the target adviser to determine the value of those assets and the target's existing economic arrangements. In some cases, those assets will be depressed or illiquid and their value may not be readily ascertainable, which complicates the financial due diligence process. In light of the number of recent alleged frauds by investment advisers, care must be taken to understand the target's historic investment strategy and the basis upon which the target's investments have been valued. Fundamentally, any red flags must be followed up closely, not the least of which is a reluctance by the target or, in some cases, its portfolio investments' management, to share relevant information. Similarly, acquirers should use this exercise to try to determine the reasons why the target fund adviser looks to diversify by joining with the acquirer.

The acquirer will also need to consider regulatory matters. For example, either the acquirer or the target may be a regulated investment adviser under the Investment Advisors Act of 1940 or similar foreign laws. The parties will also need to be mindful of the Investment Company Act of 1940 and its potential implications for such a transaction.

Even where the parties are exempt from applicable laws or regulations, care must be paid to ensure either continued exemption or compliance with the requirements of applicable regulations, including registration, if exemption is no longer available as a result of completing the transaction. Moreover, a number of private funds now have publicly listed investment advisers. In those cases, additional attention must be paid to the SEC's reporting and other requirements, or similar requirements of applicable foreign jurisdictions, as well as stock exchange listed company rules. In addition, it is widely expected that Congress will again try to regulate private funds and draft legislation has already been introduced.

The acquisition of a fund adviser is typically structured as an investment in or purchase of its interests. Examples include Nomura Holdings Inc.'s investment in Fortress Investment Group LLC, the acquisition by J.P. Morgan Chase & Co. of a majority interest in Highbridge Capital Management LLC and Citigroup Inc.'s purchase of Old Lane Partners LP. Key elements of the structure will include the following:

Sharing the target's existing economics: The parties will negotiate how they intend to share the management and incentive fees that the target adviser earns from its existing funds and new economic arrangements with respect to future funds. The target adviser's management team can oversee the management of their existing assets and, through negotiated terms, the acquirer and the target can agree to an economic arrangement regarding the target's management and incentive fees derived from its existing fund. The acquirer does not have to directly acquire the assets from the target's existing fund. Recent market conditions will put stress on some targets that are subject to "high water mark" or similar provisions that impose limitations on the target's ability to earn its incentive fee until losses are offset with future gains. Of course, the parties will have more flexibility to negotiate the economics on subsequent funds.

Revised management incentives: The acquirer will need to negotiate new management contracts or employment agreements with the target's investment professionals. The acquirer has substantial freedom in crafting revised economic arrangements and incentives with the target's management, notwithstanding the fixed economics of the target's existing fund. Because the primary focus of such a transaction is the acquisition of a team of professionals, structuring these arrangements must be designed to maximize retention of key individuals.

Separate or integrated operations: Conflicts of interest and other policies will be affected by the structure of the transaction. For example, if the target will be integrated with the acquirer's other operations, rather than running the target as a separate, stand-alone operation, or "silo," then the acquirer will need to be mindful of potential conflicts between the different investors of those funds, and that the acquirer may owe competing fiduciary duties to those different investor classes.

In addition to acquiring the fund adviser, some suitors may also want to acquire all or a substantial portion of the assets of the adviser's existing funds. Examples include Reservoir Capital Corp.'s purchase of a significant portion of the assets of Ritchie Capital Management LLC, the acquisition by a consortium of investors led by DeA Capital SpA of the Blue Skye Investment Group from D.B. Zwirn & Co., and Morgan Stanley's acquisitions of Brookville Capital Management LP and Oxhead Capital Management. Such a structure may allow the acquirer to diversify into different asset classes or to grow significantly its assets under management at attractive valuations. As with any asset sale, the acquirer can be selective in the assets it purchases and avoid assuming liabilities inherent in the target's existing fund structure. Asset sales will likely require consents at the fund level, including, potentially, from the fund's investors, from creditors of the fund, and potentially pursuant to transfer restrictions applicable to the specific assets themselves.

For fund targets selling assets to satisfy redemption requests, this structure may not be as efficient as the sale proceeds may need to be paid to the target fund's lenders to satisfy margin calls or pursuant to the terms of the target fund's loan documents.

Global economic factors have hit the hedge fund industry with unprecedented challenges over the last year. Current economic conditions hold out little promise for a quick end to these challenges and 2009 is widely expected to see further deterioration in global financial markets generally as the economy continues to delever on a massive scale. Notwithstanding these difficulties, well-positioned acquirers with clearly identified strategic objectives and careful execution will have real opportunities to acquire well-respected hedge fund advisers and diversify their existing funds by implementing a thoughtful acquisition strategy.

Ilan S. Nissan is co-head of O'Melveny & Myers LLP's global M&A-private equity group and is resident in the firm's New York office. Douglas C. Freeman is partner in the firm's M&A practice group, also in New York. Solomon Wifa is partner in the firm's investment funds and securitization practice group in London.

— Judgment Call —

Hedge fund M&A

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