The Alternative Funds guide provides expert legal commentary on key issues for businesses. The guide covers the important developments in the most significant jurisdictions.
Last Updated: October 14, 2019
The alternative funds market covers many different strategies and many different vehicles. Indeed, it is almost easier to say what is not an alternative fund — and that was the approach taken by EU lawmakers when the Alternative Investment Fund Managers Directive (AIFMD) was drawn up. Any “fund” not within a fairly tightly drawn-up list of exclusions is an alternative fund.
To many market participants, however, alternative funds are divided into two principal sectors: hedge funds and private equity (including venture capital). Even this may be too simplistic; what of infrastructure, real estate and credit funds and what of those funds which defy easy categorisation? Perhaps the easier distinction is between open-ended funds (ie, those which afford investors periodic liquidity on demand) and closed-ended funds (which have fixed or even indefinite terms).
However funds are categorised, the alternative funds sector is a very significant part of the wider financial sector. Closed-end private funds have seen significant inflows. Each of the past few years has seen more money raised than in any other year. In contrast, the open-ended hedge fund sector has struggled. Many hedge funds have suffered a lengthy period of indifferent performance and many funds, irrespective of performance, have seen significant outflows. A number of long-established funds, including “big names”, have returned investor capital and either shut down completely or been transformed into family offices. Against this backdrop, fundraising has proved challenging to say the least, although institutional investors, such as pension funds, have affirmed their support for the sector as they look to diversify their portfolios and protect against market conditions.
In the hedge fund sector, new funds have primarily been long-short equity, macro, credit or multi-strategy funds. In addition, managers continue to search for new opportunities. In particular, there has been a number of funds (generally, relatively small) targeting cryptocurrencies and other digital assets as well as funds looking at new niche investments, such as in companies operating in the medicinal cannabis sector.
These investments also find a home in closed-ended private funds where popular strategies include private credit, venture capital, real estate, growth, early stage and buyout. Among the popular emerging asset classes are litigation finance and fintech venture structured products.
Some of the new asset classes give rise to particular regulatory, legal and ethical considerations. For example, the custody of cryptocurrencies and verification of ownership is particularly difficult. Whilst cannabis products may be legal in some jurisdictions, this is by no means generally true, even for medicinal cannabis. Managers investing in the sector need to be cognisant not only of the law in the jurisdiction in which they operate, but also the laws of those jurisdictions in which their investors and their service providers are located.
Whilst many of the basic concepts in fund structures remain unchanged, there are developments related either to the asset class or investor requirements. For example, credit as a strategy could be, and is, offered both within classic hedge fund structures and in classic private equity structures. Increasingly, it is packaged within a hybrid structure combining elements of both hedge funds and private equity funds. Thus, whilst a credit fund may have a relatively limited capital raise with drawdown of capital commitments in the way of a private equity fund, investors participating in subsequent closings may be admitted on the basis of the current value of the portfolio, as with a hedge fund, rather than the private equity model of cost plus an interest charge. Similarly, the fact that credit investments will throw off periodic income (in the form of interest payments) and/or reach maturity much sooner means that the general partner will often have much greater flexibility to “recycle” or reinvest both returns of capital and income than in a traditional private equity fund model.
One of the features of the alternative funds market, as a whole, is the increasing amount of customisation of products. Larger investors are increasingly seeking bespoke vehicles, such as funds of one or managed accounts, and managers are increasingly accommodating such requests, even for relatively modest amounts of capital. Some investors who are invested across a range of different investment funds of the same manager may seek a customised multi-strategy vehicle paying fees on the aggregated returns rather than on individual strategies.
Co-investment opportunities remain in high demand. Many of the largest and most active investors are actively seeking opportunities to invest significant amounts of money in concentrated positions. Indeed, they may allocate to a manager’s main fund primarily in order to access co-investment opportunities. Many managers have launched co-investment vehicles specifically to take advantage of this interest. On the downside, fees on these vehicles are low. Often, there is no management fee and any incentive compensation will typically be at a lower rate than the main fund and determined on the basis of realised returns over a preferred return.
Co-investment vehicles are representative of the general trend of alternative fund managers being more responsive to investor requirements. This is especially seen when considering the economic terms of alternative funds. Many funds, especially in the open-ended space, now offer a plethora of fee terms. Fees for large investors or investors who are willing to lock up their capital for longer will likely be discounted from headline rates. Investors may be able to select lower management fees but higher incentive compensation or vice versa. Founder and early-stage investors will expect a discount and large investors investing across multiple funds offered by the same manager may seek to negotiate an MFN based on their aggregate investment across all such funds rather than on a fund-by-fund basis.
What is certainly the case is that the historic “2 and 20” hedge fund is no longer the norm. Although the headline incentive compensation may still be set at 20%, there may be a plethora of reasons why it is discounted. Where investors are locked up for an extended period, the incentive compensation may be determined by returns over that period, although this can give rise to tricky tax issues for managers and, in some cases, investors. As for the management fee, investors do not expect this to be a profit centre for managers (many smaller managers actually struggle to cover their costs). Sliding fee rates, where the rate decreases as assets increase, are becoming increasingly common and the typical fee is now around 1.5%.
Similar trends are seen in the closed-end space. Discounts are increasingly available to first-close investors or investors committing shortly thereafter. These discounts might be up to 50 basis points. Large investors may seek to negotiate a similar fee break, even if not coming in at first-close, and many funds now offer fee breaks according to size of commitment. Whereas fees have traditionally been charged on committed capital, in some funds, fees are only paid on invested capital or, if on commitments, only for a limited time. For smaller funds, LPAC seats or preferential co-investment rights are often offered as first-close incentives.
There is less pressure on incentive compensation (carry) than in the hedge fund space, in part because such compensation is only paid on realised returns over a preferred return. In the current, low-interest environment, some managers have looked to reduce the preferred return with mixed success. Many funds use subscription lines or other financing to make investments prior to drawing down capital. In such situations, there may be some negotiation about when the preferred return should commence. The back-ended “European” waterfall, where investors receive back their capital plus a preferred return before the general partner receives any carry, is very much preferred by investors who may also seek interim clawbacks of carry and/or joint personal guarantees of clawbacks from carry participants. Escrow accounts for a portion of the carry are also a common investor request.
Most funds now include much greater disclosure around fund-borne expenses than was traditionally the case. In part, this is in response to regulatory initiatives (the US Securities and Exchange Commission has been particularly active in this field, but European regulators are not far behind), but also to meet investor expectations. Whilst many investors are focused on the overall expense ratio (and may seek caps or other limits – managers should be particularly careful as to what is included in any cap or other limitation), they also demand much greater transparency over expenses and may object to certain expenses—in particular, anything viewed as manager overhead (notwithstanding the downward pressure on management fees referred to above).
Perhaps one of the most significant trends is around Environmental, Social and Governance (ESG) investing. Many large investors are increasingly demanding that managers take account of ESG factors in their investment process and increasing numbers of managers are proactively developing ESG policies. Whilst ESG investing actually has its roots in United Nations initiatives (such as the Sustainable Development Goals), initial take-up was primarily within Europe, both from managers and investors. However, the concepts are gaining traction globally, including in the United States. Investor pressure, especially from the increasing influence of millennials, as well as regulatory and policymaker focus will, over time, see the vast majority of managers develop ESG policies and perhaps sign up to global standards, such as the United Nations Principles for Responsible Investment (UNPRI). Some managers, particularly in the private equity sector, may even go further and offer products which not only take account of ESG factors when making investments, but, in addition, aim to deliver a measurable positive social and environmental impact alongside investment return—impact investing.
There are many different considerations within ESG investing and not all will be relevant to all investments. Environmental factors may include climate change and carbon emissions, waste and pollution and resource depletion. From a social standpoint, working conditions (including modern slavery or the use of child labour), health and safety, impact on indigenous peoples, employee relations and especially diversity in all its forms may be relevant considerations, whilst governance covers matters such as executive pay, board composition, corporate tax strategy, bribery and corruption and political influence. The approach to ESG investing will vary from manager to manager and, as indicated, will be dependent, in part, upon the investment strategy and asset class. Thus, a real estate fund manager may look to ensure that buildings are energy efficient and built from sustainable materials, whereas an equity manager might be more interested in the governance of an investee company. For this reason, it is not desirable that ESG compliance be mandated by regulators, but, rather, managers should take the initiative to develop and explain their approach.
ESG considerations are not just relevant to the investments that alternative fund managers make, but also to the structure and operations of alternative fund managers themselves. In particular, an increasing number of investors expect their managers to foster diversity within their organisations as well as ensure that all employees are appropriately and fairly compensated.
Governance and conduct are also very much in the focus of regulators around the world. It is not that long since many alternative fund managers were subject to little substantive regulation. Whilst still not as highly regulated as the retail asset management market or other financial sectors, the vast majority of alternative fund managers now find themselves subject to ever-increasing amounts of regulation. In part, this is in response to the sheer size of the alternative funds market and its impact on the global financial markets. Ever since the 2008 financial crisis, regulators have sought to develop policies to address risks to financial stability, especially given the growth of the non-bank finance sector (in which alternative funds are major participants) and, for right or for wrong, the alternative funds market is very much within the cross-wires. In many cases, regulatory initiatives are focused on the alternative fund managers, but products, especially alternative funds which can be sold to the retail or quasi-retail sector, are also subject to regulation. The sector can expect increasing regulation around disclosure and transparency (especially on costs and charges), distribution, governance and accountability, business continuity and market conduct.