The new Alternative Funds 2021 guide covers 20 jurisdictions. The guide provides the latest legal information on fund structures, tax regimes, double-tax treaties, disclosure/reporting requirements, the legal structures used by fund managers, the rules concerning permanent establishments, the marketing of alternative funds, and FATCA/CRS compliance regimes.
Last Updated: October 14, 2021
Introduction to Alternative Funds
The Introduction to the 2021 edition of this Chambers Practice Guide is focused – not surprisingly – on the issues faced by managers in the midst of the COVID-19 pandemic, which followed hot on the heels of a high level of volatility in the oil market, as well as extreme uncertainty in the financial markets generally arising from a variety of geopolitical factors. At that time, many countries were facing renewed waves of the pandemic, and mass vaccination programmes were yet to commence. In sum, there was a high degree of nervousness.
Nevertheless, even then it was becoming clear that the alternative funds sector was weathering the storms of 2020 reasonably well and, as things turned out, many managers saw both positive returns and positive asset flows. Of course, many firms did fold, but certainly not as many as was perhaps anticipated at the start of the pandemic and, for many of those firms that did unfortunately fold, it could fairly be said that the pandemic probably only slightly accelerated the inevitable.
That is not to say that 2021 has been plain sailing. Although mass vaccination programmes and a better understanding of the pandemic have led to the lifting of many of the restrictions, it remains the case that life has not returned to normal. Many are still working remotely, either full-time or at least part of the time, and travel is still limited. Markets continue to be impacted by social, economic and political uncertainties. GameStop, Archegos and Greensill, among others, are names which send shivers down the proverbial spine of the financial markets. However, both managers and investors are optimistic about market opportunities, and alternative funds continue to report strong returns and capital inflows.
Equity hedge funds enjoyed excellent returns in 2020, especially those focused on the technology, healthcare or energy sectors, and this has continued through 2021. Even the lesser performing strategies, such as credit, have seen positive returns.
The fundraising environment remains challenging, especially for newer managers. Among the more established firms, previously closed funds have been opened to new investment, in some cases for the first time in a number of years. These openings may be to top-up diminished net asset value (whether through performance slumps, outflows or a combination thereof) or because the manager sees particular opportunities in the market and wants to make sure it has the capital to take advantage of them.
A related trend is for established managers to offer customised or bespoke products alongside flagship funds. These might be long-only or long-biased funds, or “best ideas”, or have a narrower sector or geographic scope than the flagship fund.
For emerging managers, although there have been a reasonable number of successful launches, launching – let alone getting to critical mass – is taking much longer than has historically been the case. However, many such emerging managers have taken advantage of developments in the business environment to reduce their costs and help them survive in a very competitive arena. For example, outsourced trading desks (and also outsourced operations and business resources in some cases) have helped cut costs. Remote working has reduced office costs, with some managers now just needing to rent occasional meeting space to go alongside a much reduced front office. Some landlords have embraced these developments; others have sought to recoup lost revenue in other ways or help existing tenants to leases negotiated before the new reality.
As always, emerging managers need to have some differentiator to help their chances of success. For many that is a focus on a particular niche, such as digital assets or healthcare.
Although credit hedge funds have performed relatively poorly in recent years, the market disruptions have presented – and continue to offer – opportunities for those with capital, and a number of established credit managers have successfully raised capital, especially those investing in fixed-income and asset-backed securities.
For all managers, it is vital to pitch their funds correctly. In economic terms, as indicated last year, management fees of around 1.5% are the norm (although again there are many outliers) and incentive fees tend to be around 17–18% in practice (the “rack rate” remains 20%, however). Some managers have introduced tiering in their management fees (ie, reducing the fee rate as assets increase) and others have added hurdle rates to their incentive fees, although this can give rise to tax issues if there is a possibility that a fee may accrue when the fund outperforms the hurdle (eg, an index), even though the fund itself has negative returns.
It is similarly important to ensure that the liquidity terms are right for the strategy and the investor base. Emerging managers may eschew long lock-ups, infrequent redemptions, long notice periods and the like in order to attract new capital, provided that the liquidity terms of the fund remain aligned to the liquidity profile of the portfolio.
Investors are increasingly focused on transparency and the quality of the reporting from their managers, as well as the manager’s approach to environmental, social and governance (ESG) issues, including diversity, equity and inclusion.
The private equity sector remains buoyant, with some significant capital raises and strong returns, especially among newer managers raising their first (or early vintage) funds. The impact of the pandemic on sectors such as travel, hospitality and commercial real estate, among others, has given rise to many opportunities for managers with long-term capital. Where the underlying investments are income-producing, this might allow a degree of liquidity for investors or alternatively scope for additional investments.
Increasingly, investments proposed for a new fund may be held by an affiliated fund pending the new fund’s capital raise. This is especially the case for co-investments where the existing fund will buy the whole allocation and then sell to affiliated funds subsequently.
There has been very significant activity in the special purpose acquisition company (SPAC) market; indeed, SPAC IPOs represented more than 50% of all IPOs in the first quarter of 2021. Whilst a number of regulatory concerns have been raised that have impacted the SPAC market to a degree, SPACs have afforded an exit opportunity for many private equity funds from some of their investments and there remains significant activity in IPOs, back-end business combinations and SPAC private investment in public equity (PIPE) investments.
One of the consequences of the pandemic was that some private equity funds were not able to exit some of their positions prior to the fund’s expiration date. Whilst in some cases assets were sold on a distressed basis or further continuations were sought, in other cases a continuation or follow-on fund has been raised to allow the asset to be held for an extended period. In some cases, these are for single assets and in others a broader portfolio. Needless to say, the transfer of an asset from the original fund to the new involves a number of conflicts of interest.
Co-investments remain popular with both managers and investors, especially in the activist and distressed debt space, and may be offered by both hedge funds and private equity funds. These allow managers to take concentrated positions without some of the concerns around liquidity and capacity. Many of the largest and most active investors are actively seeking opportunities to invest significant amounts of money in concentrated positions. There are an increasing number of managers looking to establish vehicles to accommodate multiple co-investments – often via a segregated portfolio company with a segregated portfolio per investment or per investor. However, the fees on such vehicles are low. Often, there is no management fee and any incentive compensation will typically be at a low rate and determined on the basis of realised returns over a preferred return.
An increasing number of “hybrid” funds are inhabiting the space between open-ended hedge funds and closed-ended funds, such as private equity funds, especially in the credit space. These hybrid funds may have some features of both open-ended funds and closed-ended funds. For example, instead of the fully funded subscriptions typically found in a hedge fund, investors may be required to enter into a capital commitment to be drawn-down as investment opportunities arise, and investors may participate in existing assets at fair value instead of cost plus an interest charge, reflecting the fact that assets held in a hybrid fund often have a readily assessable market value.
Conversely, the redemption terms may be “stretched out” with longer lock-up periods, less frequent redemptions and “fast pay, slow pay” provisions where, on a redemption, an investor receives a cash payment in respect of its interest in a fund’s liquid portfolio, but may continue to be exposed to a proportionate (as at the date of redemption) part of the fund’s illiquid portfolio until realisation of the relevant asset(s). In some cases, where income and realisation proceeds would otherwise be reinvested, an investor may be afforded an opportunity to be paid out their capital as it naturally matures instead of having a redemption or withdrawal right. Hybrid credit funds that have carried interest terms will usually distribute income as it arises and, if so, will typically operate a “European” waterfall, whereby investors receive a return of all invested capital and a preferred return (often at 6–7% for credit) before the carried interest arises. This avoids issues with having to track which investment produced the income.
As mentioned above, and as highlighted last year, a manager’s approach to, and application of, ESG principles is ever more important to investors as well as the manager’s own team. This has extended to diversity, equity and inclusion (DEI) both within a management company and also at the investment level, especially in the private equity sphere. Increasing numbers of managers have become signatories to initiatives like the UN Principles for Responsible Investment, and some have signed up to the Institutional Limited Partners Association’s “Diversity in Action” initiative. An increasing number of investors are demanding positive action, which may include the exclusion of certain categories of investment or companies from a portfolio and/or calls for voting and other rights to be exercised in a way that fosters DEI or other positive developments. Many managers are highlighting their policies and procedures, and increasing numbers of funds are being launched with apparent ESG credentials. However, at the same time, regulators have flagged concerns that some of these are not in fact what they purport to be and that managers are not in fact doing what they say they are doing.
What this highlights is the importance of a manager crafting an ESG or DEI policy that actually reflects their approach and process and is relevant to their strategy and portfolio. The application of ESG or DEI policies does not absolve a manager of its fiduciary duties; rather, such policies should work in tandem with, and be complementary to, the manager’s fiduciary and contractual obligations. As such, it is vital that all the investment team are actively involved in developing a policy and actively implement it in their day-to-day roles. Investors have high expectations, but delivery on a realistic set of principles is far more important than empty promises.