M & A Law Prof Blog

Proskauer on Pay to Play

On August 3, 2009, the SEC proposed for comment a new rule under the Investment Advisers Act designed to address alleged “pay to play” practices by investment advisers when seeking to manage assets of government entities.

 

 

If adopted in its current form, the new Rule would prohibit investment advisers from

 

 

• providing advisory services to a government entity for compensation for two years after the adviser or certain of its associates make a contribution to a government official who can influence the entity’s selection of investment advisers.

• making any payment to a third party to solicit investment advisory business from a government entity.

The proposed Rule will affect virtually all private investment fund managers.  It takes aim at alleged “pay to play” abuses in New York and New Mexico and is intended to address policy concerns that such payments (i) can harm government pension plan beneficiaries who may receive inferior services for higher fees and (ii) can create an uneven playing field for advisers that cannot or will not make the same payments.

 

 

Proskauer has the full story here.

 

MAW

Och-Ziff and Black Market Capital

It is being reported that Och-Ziff, the hedge fund adviser, set a price range of $30 to $33 a share for its proposed initial public offering of 36 million shares.  When it occurs, this will be the third hedge fund or private equity fund adviser ipo after Blackstone and Fortress and marks a return of these ipos post-August market crisis.  KKR is the next one on-deck, but expect more of them.  I outline the reasons why in my recent paper Black Market Capital:

In my paper, I note that retail investors cannot invest in hedge funds or private equity funds but they can invest in the funds' managers. I argue that the trend of hedge fund and private equity fund adviser initial public offerings is in part due to the SEC rules which prohibit public investment in these funds. Prevented from buying the funds directly, public investors look for something replicating their benefits. The investment banks and other financial actors act quickly meet this demand, but with less suitable and riskier investment vehicles such as fund adviser IPOs, special purpose acquisition companies, business development companies, structured trust acquisition companies, and specialized exchange traded funds all of which largely attempt to mimic private equity or hedge fund returns and have been marketed to public investors on this basis.  I term these investments “black market” capital since they are a product of the ban on direct hedge fund and private equity public investing.  I argue that these investment tend to be more risky on an individual basis than the hedge fund and private equity funds they substitute for.  So, public investors who buy them bear more risk and together inject more risk into the US capital markets than if they were allowed to invest in the funds.  These are a perverse consequence of the SEC’s current prohibition.  I argue that the SEC should resolve these issues by amending the securities laws to permit public investors to invest directly in private equity and hedge funds. This would recognize the costs in the current regime, end black market capital and allow investors to access the benefits of hedge funds and private equity: excess returns and diversification.

You can download Black Market Capital here. 

Black Market Capital Quoted Extensively in the Financial Times Today

David Wighton, the New York Bureau Chief for the Financial Times, quotes extensively from my new article Black Market Capital in his lead-in article to today's Report on Fund Management in the Financial Times.  The article is entitled SEC seeming perverse about risk and is accessible on the FT website here.  You can also get it on the newstand.  A few quotes for flavor:

"Told you so," said many critics of hedge funds surveying the damage caused by the summer credit market turmoil. The high-profile collapse of several funds and the dismal performance of many others have provided just the ammunition the sceptics were looking for. Surely it proved that hedge funds were dangerous and should be kept out of the hands of retail investors, they said. How wise of the Securities and Exchange Commission to propose barring individuals with less than $2.5m (£1.2m, €1.8m) in liquid assets from investing in hedge funds, up from the current limit of $1m.

This is nonsense. Average hedge fund returns are generally less volatile than the equity market as a whole and you are much more likely to lose your shirt on an individual stock than on a hedge fund. The rules preventing small investors from putting money into hedge funds are positively perverse.

As Steven Davidoff, a professor at Wayne State University Law School, points out in a new paper, the rules have an even more perverse consequence.

Retail investors may not be able to invest in hedge funds - or private equity funds for that matter - but they can invest in the funds' managers, which Prof Davidoff argues are more risky.

"This is because the future income of an adviser is derivative upon the fund advisers' capacity to continually earn extraordinary positive returns." If they do not earn such returns, investors will shift money away, which means the impact on the investor in the manager will be greater than on the investor in the fund.

Prof Davidoff suggests that the spate of flotations of alternative asset managers - albeit slowed by the credit market turmoil - is partly the result of the rules against public issues by alternative funds. Prevented from buying the funds directly, public investors look for something that replicates their benefits. The financial industry quickly meets that demand. But it does so with less suitable vehicles such as asset managers, special purpose acquisitions companies and the growing array of exchange-traded funds and indexes that attempt to track private equity or hedge fund performance.

These vehicles, which Prof Davidoff dubs Black Market* Investments, tend to be more risky on an individual basis than the hedge fund and private equity funds they substitute for. So public investors who buy them bear more risk and together inject more risk into the US capital markets than if they were allowed to invest in the funds.

Investors' other option is to buy funds on non-US markets, a process that the SEC is considering making easier. But without the benefit of SEC regulatory oversight and the US securities law enforcement, Prof Davidoff argues that this would be more risky and costly than a prohibited US-based purchase of the funds.

Investors should be allowed to make up their own minds on whether hedge funds are good value for money. The asset qualification for retail investors should not be raised. It should be scrapped.

Check it out. 

Topps and In re: Appraisal of Transkaryotic Therapies

On Wednesday, Crescendo Partners announced in a press release that it would elect to exercise appraisal rights with respect to its 6.9% share ownership in Topps.  I noted yesterday that Crescendo's action might spur other shareholders to exercise appraisal rights in this deal.  The reason why is that unlike entire fairness litigation in Delaware, which is typically contingency fee based, shareholders in appraisal proceedings shareholders must front the costs. This creates a collective action problem among others -- shareholders, particularly smaller ones, do not want to bear these expenses, do not have the wherewithal to bring an appraisal action and are unable to coordinate their actions to do so.  I wrote yesterday that this is a problem ameliorated in the Topps deal now since shareholders know Crescendo will be bearing some, if not all, of these costs.  The consequence may be a higher than ordinary number of shareholders exercising appraisal rights.  And, the Topps merger agreement is conditioned on no more than 15% of shareholders exercising appraisal rights, so if a sufficient number exercise these rights it will give Eisner's Tornante Company and Madison Dearborn Partners a walk right and put the deal in jeopardy. Topps shareholders opposed to this deal now have an incentive to exercise their rights in order to attempt to crater it. 

There is another factor here which may raise the number of shareholders asserting appraisal rights:  The recent Delaware decision in In re: Appraisal of Transkaryotic Therapies, Inc. (access the opinion here; see my blog post on it here).  This case held that investors who buy target company shares after the record date and own them beneficially rather than of record may assert appraisal rights so long as the aggregate number of shares for which appraisal is being sought is less than the aggregate number of shares held by the record holder that either voted no on the merger or didn’t vote on the merger.  As Chancellor Chandler stated:

[a] corporation need not and should not delve into the intricacies of the relationship between the record holder and the beneficial holder and, instead, must rely on its records as the sole determinant of membership in the context of appraisal.

The court ultimately held that since the "actions of the beneficial holders are irrelevant in appraisal matters, the inquiry ends here."  [NB.  most shareholders own their shares beneficially rather than of record with one or two industry record-holders so this decision will apply to almost all shares held by Topps and in fact any other public company]

Post-Transkaryotic a number of academics and practitioners raised the concern that this holding would encourage aggressive investors (read hedge funds) to create post-record date/pre-vote positions in companies in order to assert appraisal rights with respect to their shares.  This would be particularly the case where the transaction was one being criticized for a low offered price. 

Topps appears to be a good candidate for this strategy.  The price offered by Michale Eisner's  consortium has been criticized extensively for being too "low" and led a number of proxy service firms to recommend against the merger.  In addition, the record date on the transaction was August 10, which provided a long period for investors adopting this strategy to purchase their shares.  Ultimately, it appears that we are watching the first test of the Transkaryotic opinion.  It will be interesting to see whether the potential concerns raised by this decision come to pass.  And perhaps food for thought for the Delaware Supreme Court if, and when, it ever considers the holding of the Transkaryotic case.

More on Black Market Capital

Allaboutalpha, a leading blog on the hedge fund industry, has a nice, extensive discussion of my latest paper:  Black Market Capital.  Black Market Capital discusses the federal regulation of hedge funds and private equity and the rise of fund adviser ipos, special purpose acquisition companies, structured trust acquisition companies and exchange traded funds all of which attempt to mimic hedge fund or private equity performance and are marketed to public investors on this basis.  My paper was posted to the SSRN last week.  According to Allaboutalpha: 

[Davidoff] concludes the paper by methodically walking through many of the positive arguments for hedge funds that we have also made on this website (he even cites some of the same sources).  This dispassionate, methodical style may destine Davidoff’s paper to be a beacon for the industry as it struggles to debunk commonly-held misperceptions. 

You can read their further analysis here.  You can download my paper on the SSRN here. 

Accredited Home: A Shareholder Speaks

Yesterday, Stark Investments converted its Schedule 13G with respect to Accredited Home Lenders into a Schedule 13D.  A Schedule 13D is required to be filed by any person or entity who holds greater than 5% of a publicly traded issuer.  The switch to a 13D is required whenever a previously passive investor changes their intentions with respect to control of the issuer.  Stark's letter is great reading, and I set it out in full as it again highlights the bind Lone Star is in.  Although their letter is a bit over-dramatic, I also tend to agree with Stark's fears that Accredited is likely to cut a deal with Lone Star despite Lone Star's relatively weak case.  Accredited's directors are likely to prefer the certainty of a lower deal versus the risk (however minute) that the Delaware court will rule against it, a decision they have substantial latitude to make since it is likely reviewable under the business judgment rule.  The letter is also yet more ammunition for those advocating the benefits of hedge funds as valuable shareholder activists.  Here it is:

Ladies and Gentlemen:

Stark Investments and its affiliated investment funds (collectively, “Stark”) hold approximately 8.2% of the outstanding common shares of Accredited Home Lenders Holding Co. (“Accredited”). Based upon publicly available information, Stark appears to be Accredited’s second largest shareholder. We are writing with respect to the Agreement and Plan of Merger dated June 4, 2007, as amended June 15, 2007 (the “Agreement”), with Lone Star Fund V (U.S.), L.P. and its affiliates (collectively, “Lone Star”) and the related litigation pending in the Delaware Chancery Court.

On August 30, 2007, Lone Star publicly disclosed that it had made an offer to the Accredited Board of Directors to reduce the purchase price under the Agreement from $15.10 to $8.50 in exchange for resolving the pending litigation between Lone Star and Accredited. We believe that this offer is nothing more than an attempt to divert attention from the inherent weakness in Lone Star’s litigation position under the Agreement. Based on our review of the Agreement, it is evident that Accredited endeavored to obtain, and did successfully negotiate, unambiguous terms preventing Lone Star from terminating the Agreement based upon the changes in Accredited’s operations or financial condition that have occurred since execution of the Agreement. We read the express language of the Agreement as being clear that Lone Star assumed the entire risk of a diminution of value of Accredited in the present circumstances. The fact that these terms were obtained from a seasoned and sophisticated buyer of troubled assets, which was advised by a law firm that is a recognized expert in advising parties to merger and acquisition transactions, is clear evidence of Lone Star’s unqualified desire and intent to acquire Accredited while assuming the aforementioned risk.

We are pleased that the Board of Directors recognizes the strength of Accredited’s position under the Agreement and has rejected Lone Star’s revised offer. We support this decision and offer our support to the Board of Directors as it continues to appropriately carry out its fiduciary duties, which duties, in our view, require Accredited to pursue all available remedies under the Agreement. The strong protections included in the Agreement were designed to benefit and protect Accredited and its shareholders in circumstances such as those now faced by Accredited, and should be used accordingly.

We believe that the greatest risk now faced by Accredited’s shareholders is neither the possibility of further deterioration of the non-prime residential mortgage loan market in which Accredited competes, nor the risk of an adverse outcome at trial. The first risk was eliminated when Lone Star signed the Agreement and a proper application of the facts and law by the Delaware Chancery Court should eliminate the second risk. Instead, we believe that the greatest risk facing Accredited’s shareholders is that the Board of Directors will attribute too much significance to the unlikely possibility of an adverse outcome at trial and settle for a price far removed from the value of Accredited’s existing claims against Lone Star.

After a thorough review of the Agreement, the facts in the public domain (including the prevailing market conditions at the time the Agreement was executed) and relevant case law, we believe that the Delaware Chancery Court will see this case as we see it – an experienced and sophisticated buyer (with a long history of successfully stepping into adverse industry environments, purchasing companies or assets at distressed prices and reaping significant rewards when recovery occurs) that is now trying to back away from a transaction and the risks it explicitly agreed to assume, when it appears to have concluded that its timing was inopportune in this instance. Moreover, Delaware courts require parties such as Lone Star to meet a heavy, and we believe insurmountable here, burden of proof when attempting to terminate obligations in reliance upon material adverse effect (“MAE”) clauses of the nature contained in the Agreement. When Lone Star agreed to acquire Accredited, it did so after a long due diligence exercise and a multi-bidder process that Accredited detailed in its Schedule 14D-9, filed with the Securities and Exchange Commission on June 19, 2007. There can be little question that Lone Star was aware prior to signing the Agreement of the impact already being felt by Accredited as a result of existing and ongoing adverse market conditions.

As Accredited’s second largest shareholder, we fully support and encourage the Board to continue to make decisions consistent with the strength of Accredited’s legal position. It appears that we are certainly not alone in this assessment. Given that the trading price of Accredited’s common stock on the New York Stock Exchange has been materially in excess of $8.50 since the announcement of Lone Star’s offer on August 30, 2007, we believe the market also recognizes the weakness of Lone Star’s position and is anticipating a recovery well in excess of today’s closing price of $10.14. Given the significant number of Accredited’s shares that have changed hands over the past few trading days, any shareholder that does not agree with the strength of Accredited’s position has had ample opportunity to sell its shares at levels far exceeding Lone Star’s proposed amended price. Accordingly, we believe that the current shareholder base is strongly supportive of Accredited’s decision to enforce the Agreement’s terms and to pursue all available remedies thereunder. Please note that we currently expect to include a copy of this letter with the Schedule 13D filing that we plan to make next week. We are available to discuss these matters with you at your convenience.

Very truly yours,

STARK INVESTMENTS

/s/ Brian J. Stark

Brian J. Stark Principal

cc: Mr. Len Allen

Lone Star U.S. Acquisitions

House Hearing on Taxing Private Equity and Hedge Funds

The House Ways & Means Committee is holding hearings today starting at 10:00 a.m. on the taxation of private equity and hedge fund adviser compensation.  The meetings will be simulcast on the web live.   

In advance of the hearing, the Joint Committee on Taxation has released Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues:

• Part I
• Part II

Despite the long title, it is a fascinating look at the state and business of private equity and hedge funds.  In any event, the hearings show that the issue of fund taxation continues to have momentum.

Black Market Capital

Last Friday, the Wall Street Journal ran an interesting article on the large number of individual investor comments the SEC is receiving for its pending rule proposal to raise the wealth requirements for investment in hedge funds and private equity.  Apparently, the bulk of these comments criticize the SEC for depriving these investors of the opportunity to invest in hedge funds and private equity.  These investors rather want unrestricted access to these investments.  The article was fortuitously timed as I have just finished up my summer writing project --  Black Market Capital -- which touches upon this subject and argues for just such investor access (download the article on the SSRN here).  I'll be presenting parts of this article to the securities reg. section meeting at AALS in January.  Here is the abstract: 

Hedge funds and private equity offer unique investing opportunities, including the possibility for diversified and excess returns. Yet, current federal securities regulation prohibits the public offer and purchase in the United States of these investments. Public investors, foreclosed from purchasing hedge funds and private equity, instead seek to replicate their benefits. This demand drives public investors to substitute less-suitable, publicly available investments which attempt to mimic the characteristics of hedge funds or private equity. This effect, which this Article terms black market capital, is an economic spur for a number of recent capital markets phenomena, including fund adviser IPOs, special purpose acquisition companies, business development companies, structured trust acquisition companies, and specialized exchange traded funds all of which largely attempt to replicate private equity or hedge fund returns and have been marketed to public investors on this basis. Black market capital has not only altered the structure of the U.S. capital market but has shifted capital flows to foreign markets and engendered the creation of U.S. private markets such as Goldman Sachs' GSTrUE. This Article identifies and examines the ramifications of black market capital. It finds this effect to be an irrational by-product of current hedge fund and private equity regulation, one that is likely harmful to U.S. capital markets. A solution is to restore equilibrium in U.S. markets and enhance their global competitiveness by amending the Investment Company Act and Investment Advisers Act to permit public offerings of hedge funds and private equity funds. Though further study is warranted, the economic benefits of such a regime prospectively outweigh objections previously raised by regulators and others. Current market volatility and distress does not affect this conclusion. Black market capital is also an example of the unintended effects of regulating under the precautionary principle and difficulty of regulating in an era of market proliferation.

Harvard's Hedge Fund Loss

The Wall Street Journal today is reporting that Harvard University's endowment fund lost about $350 million investing in Sowood Capital Management.  The amount is about 1.2% of Harvard's $29 billion endowment.  Last month Sowood suffered in the bond market a loss of about $1.5 billion, approximately half of its assets under management.  Earlier this week the hedge fund Citadel Investment Group agreed to buy much of Sowood's investment portfolio.  Citadel has made a bit of a business buying hedge fund distressed assets; last year it purchased the remainder of Amaranth's energy portfolio. 

The Harvard loss belies the fact that hedge funds and private equity have been very good investments for university endowments.  A recent paper, Smart Institutions, Foolish Choices?: The Limited Partner Performance Puzzle by Josh Lerner , Antoinette Schoar and Wan Wongsunwai found that, in particular, endowments' annual returns are nearly 14% greater than average investments in this investment class. And, according to the Wall Street Journal, the top 53 university endowments, with nearly $217 billion in assets, have invested about 18% of their money in hedge funds.  The superior returns are a testament to the investing skill of these endowment fund managers mixed, perhaps, with the good luck to have started investing in this area early before it became saturated with a high number of funds searching for return.  Still, the Harvard loss is a reminder that hedge fund investments carry risk, and some more than others.  But hopefully it will not be cited for the oft-made argument that hedge funds are too risky for investment.  Presumably, the very smart people at the Harvard endowment ran their risk analysis and considered the risks associated with this investment against the superior returns Harvard has made over the years.  Against this backdrop and the extraordinary returns gained, the loss is insignificant and worthwhile.  Good investment is often accompanied by total failure mitigated by diversification.  Here, Harvard can take solace in the fact that it only lost half of one investment, something that investors in many equity stocks cannot (remember Pets.com?).   

SEC Votes to Adopt Antifraud Rule for Hedge, Private Equity & Venture Capital Funds

The Securities and Exchange Commission yesterday voted unanimously to adopt a new antifraud rule under the Investment Advisers Act.  The new rule makes it a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements to, or otherwise to defraud, investors or prospective investors in that pool. The rule will apply to all investment advisers to pooled investment vehicles, regardless of whether the adviser is registered under the Advisers Act.

The rule comes on the heels of the D.C. Circuit's decision in Goldstein v. Securities and Exchange Commission, striking down the SEC's attempt to make all hedge fund advisers register under the Investment Advisers Act.  But, this new rule is much less ambitious.  It is more of a clarification of enforcement powers that the SEC likely previously had than anything else.  The SEC has yet to post the final rules release on its website, but the proposing release can be accessed here.  And more importantly, the SEC has yet to act on the more ambitious and controversial other rule proposed in that proposing release which would revise the definition of accredited investor under Regulation D to raise the required net worth thresholds for private investors to invest in private equity and hedge funds.   

Shareholder Rights: Comparing KKR, Blackstone et al.

The day before Independence Day, KKR & Co. LP filed its registration statement to go public in a $1.5 billion offering.  Another day another fund adviser ipo.  Anyway, out of curiosity, I've prepared a chart comparing the two ipos on key shareholder measures:

	KKR	Blackstone
Amount of Offering	$1.5 billion	$4.133 billion
Amount Sold by Current Partners in Offerng	$0	$4.57 billion with greenshoe exercise (it is more than the offering amount due to the concurrent sale of $3 billion in Blackstone non-voting units to the Chinese government)
Voting Rights	Only limited voting rights relating to certain matters affecting the units.  No right to elect or remove the Managing Partner or its directors. In addition, KKR’s current partners generally will have sufficient voting power to determine the outcome of any matter that may be submitted to a unitholder vote.	Same.
Cash Distributions	Quarterly cash distributions to unitholders in amounts that in the aggregate are expected to constitute substantially all of our adjusted cash flow from operations each year in excess of amounts determined by the Managing Partner.	Same.
Priority of Cash Distributions	First, so that unitholders receive $______   per common unit on an annualized basis for such year; Second, to the other holders of Group Partnership units until an equivalent amount on a per unit basis has been distributed to such other holders for such year; and Thereafter, pro rata to all partners. After ______, priority allocation ends and all partners receive pro rata distributions.	First, so that common unitholders receive $1.20 per common unit on an annualized basis for such year;   Second, to the other partners of the Blackstone Holdings partnerships until an equivalent amount of income on a partnership interest basis has been allocated to such other partners for such year; and Thereafter, pro rata to all partners.   After December 31, 2009, priority allocation ends and all partners receive pro rata distributions.
Pre-ipo Partner Distributions	Distributions of $______       million.	Distributions estimated at $610.4 million.
Highlighted Return of Selected Underlying Funds	20.2%	22.6%

(Blanks in the KKR column are figures KKR will fill in in subsequent registration statement amendments)

So, there is not much difference between the two in terms of shareholder voting and distribution rights.  Both equally disenfranchise investors and both have the same distribution policies giving priorty distribution to investors through a set period of time.  KKR has yet to disclose this period but it will likely be similar to Blackstone's and end on December 31, 2009.  If I were aninvestor I'd be a little worried about the quantity of distributions thereafter as it will likely be well past the current private equity boom and the funds' new partners will likely be chomping for market-rate compensation by then.  Ultimately, the only significant difference on the above chart is that the KKR partners are not selling in the ipo which is a good sign, but they may be effectively making a sale through a significantly large pre-ipo cash distribution -- the KKR registration statement has yet to disclose the exact amount of the distribution.

So, ultimately, in terms of shareholder and distribution rights they both appear to be equally troublesome.  Also, for those who are wondering, the Fortress and Och-Ziff ipos are a bit different in terms than KKR and Blackstone but effectively accomplish the same shareholder disenfranchisement and distribution policies. 

(Source:  Blackstone Prospectus; KKR Registration Statement)

Yet Another Alternative Asset Manager Going Public (Och-Ziff)

Och-Ziff Capital Management Group LLC today filed a registration statement for an initial public offering of up to $2 billion of series A stock units.  Och-Ziff is one of the largest alternative asset managers in the world, with approximately $26.8 billion of assets under management as of April 30, 2007.  It is run by former Goldman Sachs Group Inc. equities trader Daniel Och, and was founded with Ziff family money.  The number of shares and the price for the offering weren't disclosed.  But all of the offering proceeds will go to the current partners of Och-Ziff.  Yet another pay-day for hedge fund managers. 

And it is yet another offering where investors will have only limited voting rights.  According to the registrations statement, the current owners of Och-Ziff will retain their ownership interest through Class B share units which will have no economic rights but will have voting rights.  So long as these Class B owners continue to hold more than 40% of the total voting power of the outstanding shares, the Class B holders will have the right to designate nominees for election to the company's board of directors, based on their ownership of outstanding voting securities.  Initially, this will give the Class B shareholders the ability to designate five of the seven nominees for election to the Och-Ziff board.

Not a great deal -- once again fund managers are not only cashing out, but doing so in a way which disenfranchises investors -- setting the stage for future conflict.  Still, this is a bit better than Blackstone which gave its investors no voting rights.  For those still contemplating investing, you'd likely be much better off investing directly in Och-Ziff's main fund (OZ Master Fund, Ltd.) which Och-Ziff disclosed has returned 17% since inception a total return basis, net of all fees and expenses compared to only 11.6% by the S&P 500 during the same time.  But, unfortunately, SEC rules foreclose this for all but wealthy investors (see my post on this irrational distinction here). 

The filing also shows that the industry still sees an active ipo market for fund advisers in the wake of the Blackstone ipo.  This appears true despite the recently introduced congressional bill to tax as corporations publicly traded partnerships that directly or indirectly derive income from investment adviser or asset management services.   In the past few weeks, GLG Partners LP, Europe's third-largest hedge-fund manager, announced that it will go public in the United States through a $3.4 billion transaction with the Special Purpose Acquisition Company Freedom Acquisition Holdings Inc., creating GLG Partners Inc. a publicly traded company on the New York Stock Exchange.  In addition, Pzena Investment Management, Inc, a value-oriented investment management firm with approximately $28.5 billion in assets under management also filed to go public.  And Third Point LLC , a New York-based hedge-fund firm with $5.1 billion in assets under management founded in 1995 by the notorious Europe-hater Daniel S. Loeb , announced on June 14 that it plans to raise $666 million in an IPO on the London Stock Exchange.  So it goes . . . .

GLG Partners Goes SPAC

GLG Partners, the leading European hedge fund adviser with over $20 billion in assets under management, today announced that it would go public in the United States.  GLG will accomplish this transaction through a reverse merger with Freedom Acquisition Holdings, Inc, a special purpose acquisition company currently listed on the American Stock Exchange.  Upon consummation of the transaction, FAH will rename itself GLG Partners, Inc. and re-list on the New York Stock Exchange.  The transaction values GLG at $3.4 billion dollars and FAH´s current shareholders will hold 28% of the new entity.

GLG was formed by three former Goldman Sachs wealth managers in 1995 as a division of Lehman Brothers.  GLG is now independent, but Lehman still owns a stake in the company, and last week GLG co-founder Jonathan Green sold some of his ownership stake to, Istithmar, an investment arm of the government of Dubai and Oppenheim, the largest private bank in Germany, giving each a 3% stake. 

The GLG transaction comes on the heels of Friday´s successful offering by Blackstone and is yet another U.S. public offering by a private equity or hedge fund fund adviser.  It is notable for this and another reason.  GLG is using the SPAC mechanism to go public.  I´ve blogged before about how the growing presence of SPACs and private equity/hedge fund advisers highlight the absurdities of the Investment Company Act.  Public investors are shut off from investing in private equity and hedge funds by this law.  However, these investments offer desirable and unique characteristics such as alpha.  So, investors desiring these benefits substitute the next best thing, that is the advisers and SPACs.  But both of these investments have their own problems and are likely more risky than the funds themselves.  GLG is now pushing the envelope by combining the two. 

But, there are two good things about this transaction.  First, it highlights the strength of the U.S. capital market and its continued ability to attract foreign listings.  Second, chalk another one up for Perella Weinberg partners which advised GLG -- after a slow start they are picking up steam in the league tables. 

Hedge Funds Good

Ivy Asset Management in conjunction with Columbia Business School released two studies today related to hedge funds.  According to the press release:

The first is entitled, "Do Activist Hedge Funds Create Value", and looks a hedge fund shareholder activism.  According to the study, based on nearly 800 events in the United States from 2001-2005, hedge fund activists are significantly more successful than other institutions, such as pension funds and mutual funds, in their activist efforts. Two thirds of the time they are successful in achieving their stated goals or gaining significant concessions from their target. The study finds that activist hedge funds generate above benchmark returns of 5% to 7%. Interestingly, hostile activism received a more favorable market response than non hostile activism.

The second study entitled, "Which Shorts are Informed? A Practitioners Guide", found that over 12.9% of the volume on the New York Stock Exchange was generated from short selling both large and small stocks and that this number has been increasing over the last few years. This study shows that
institutional short sellers have in fact " ... identified and acted on important value-relevant information that has not yet been impounded into price" and that within 30 days the most heavily shorted stocks did indeed change in relative price by 1.43% (19.6% annualized). In addition, the findings showed that short sellers " ... are important contributors to more efficient stock prices."

I'll add links to the actual studies once they are posted (a quick search on the SSRN found nothing).  But these new studies are likely to add to the growing body of literature finding substantial beneficial micro and macro market effects in the rise of hedge funds.      

The SEC and Hedge Funds

I'm spending the summer researching and writing on the sometimes irrational effects of SEC regulation of hedge funds and private equity.  In this vein, I'd like to recommend a recent short essay on the SEC and hedge funds by Troy Paredes, a law professor at Washington University School of Law.  The article is entitled Hedge Funds and the SEC: Observations on the How and Why of Securities Regulation.  Here is the abstract:

This short Essay addresses three topics on one aspect of the hedge fund industry - the SEC's recent efforts to regulate hedge funds. First, this Essay summarizes the regulation of hedge funds under U.S. federal securities laws insofar as protecting hedge funds is concerned. The discussion highlights four basic choices facing the SEC: (1) do nothing; (2) substantively regulate hedge funds directly; (3) regulate hedge fund managers; and (4) regulate hedge fund investors. Second, this Essay addresses the boundary between market discipline and government intervention in hedge fund regulation. To what extent should hedge fund investors be left to fend for themselves? Third, this Essay highlights two factors impacting regulatory decision making that help explain why the SEC pivoted in 2004 to regulate hedge funds when it had abstained from doing so in the past. These two factors are politics and psychology.

The essay is a follow-up to his longer article:  On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission.  For anyone with an interest in the SEC's repeated seemingly inexplicable attempts in this new millennium to regulate hedge funds, they are both must reads.   

The Battle for Topps

The battle for Topps Company, Inc. continues to heat up.  On May 24, 2007, the company announced that it had received a $416 million offer from its rival, The Upper Deck Company, to acquire Topps for a price of $10.75 per share.  Topps currently has an agreement to be acquired by a group consisting of The Tornante Company LLC and Madison Dearborn Partners, LLC for $9.75 per share in cash.  The Tornante Company is headed by former Disney CEO Michael Eisner.

Last week, Deal Book reported that the hedge fund Crescendo Partners, owner of 6.6% of Topps, was alleging that certain Topps board members have conflicts of interest that prevent the company from negotiating in good faith with, Upper Deck.  Deal Book reported that "[i]n a letter sent to the company’s board of directors, a Crescendo Partners managing director Arnaud Ajdler, who is also a Topps board member, said the chief executive of Topps, Arthur Shorin, “does not want to see the company started by his father and uncles fall into the hands of a longtime rival.”

Crescendo today sent a second letter to the Topps board which states in part:

Finally, in your communications, you like to repeat that Crescendo wants to take over Topps without paying stockholders for their shares. Once again, you are misleading your stockholders. When a buyer wants to take a company private, as Mr. Eisner and Madison Dearborn are attempting to do, the buyer pays stockholders a premium for their shares. While this premium is typically 20 to 30%, you have approved a transaction that would pay stockholders a meager 3% premium and a significant discount to where the shares are currently trading. As you well know, Crescendo is NOT trying to take the Company private. If the ill-advised Eisner merger is voted down, Crescendo will ask its fellow stockholders, the true owners of Topps, to replace seven of the incumbent directors on the Board with a new slate. This well-qualified slate is committed to taking all necessary actions to improve the company's capital structure and operations for the benefit of ALL the stockholders. As detailed in our proxy statement, we believe that the Company could be worth conservatively between $16 and $18 per share if managed properly.

This is yet another example of the increasing potential for conflict between private equity and hedge funds as hedge funds emerge as activist investors in search of extraordinary returns and the private equity bubble rages.  But more immediately, the Topps Board now has a competing bid and a hostile proxy contest on its hands formented by one of its own members.  Stay-tuned. 

The First U.S. Listed Hedge Fund (Sort of)

Man Group plc, the U.K. based hedge fund operator listed on the London Stock Exchange, has filed a registration statement for an initial public offering of what is being touted as the first U.S.-listed hedge fund.  According to the registration statement, the fund will be listed on the New York Stock Exchange and called the Man Dual Absolute Return Fund.  It will be organized as a closed-end management investment company.  The initial public offering price is $20.00 per common share with a minimum purchase in the offering of 100 common shares. 

The fund is being marketed as a public hedge fund and so, accordingly, the fund will seek  "risk-adjusted [positive] returns with minimal correlation to the returns of major global equity and bond  market indices" (i.e., it will be an alpha fund).  Between 80% and 85% of total managed assets will be devoted to a U.S. quantitative long/short equity strategy with the remainder largely invested in a managed futures program called AHL Core.

But, for those now salivating over the chance to invest in a U.S. based hedge fund, don't get too excited yet.  Since the fund will be making a public offering it will become subject to the Investment Company Act (ICA).  This will require the fund to operate in a markedly different manner than typical hedge funds:

• Restricted Leverage.  Unlike normal hedge funds which use extensive leverage and borrowings, this fund will be limited by the ICA to borrowings of no more than 33 1/3% of the fund's total managed assets.
• Restricted Hedging.  Hedge funds have their name because of their unrestricted use of hedging.  Yet, the ICA limits the use of derivatives and permits only covered hedging.
• Restricted Liquidity.  Hedge funds typically permit redemptions on a quarterly to yearly basis.  This fund will be a closed-end fund and there will be no ability to redeem shares.  Like other closed-end funds, this one is accordingly likely to trade at a discount.
• Fees.  Funds subject to the ICA are limited under federal law and NASD rules as to the fee they can charge.  But hedge funds typically charge the so-called two and twenty.  There is a two percent administration fee and a payment of twenty percent payment of profits over a hurdle rate to the fund manager.  The Man fund registration statement has the adviser management fee blank, but the fund will not be permitted under the ICA to charge a profit participation fee.  The result is that the administration fee will likely be higher than the two percent to compensate but total compensation to the fund manager significantly less.  While fund holders might at first blush be happy about this where would you, as a hedge fund adviser prefer to work? Consequently, the fund adviser may not be able to recruit the best talent. 

There are other differences that I won't go into here.  Ultimately, the ability of this fund to earn the extraordinary risk-adjusted positive returns that hedge funds have become known for is uncertain in light of these substantial differences.  Accordingly, this fund would be better termed the first hedge fund-lite offering in the United States.  But, until the SEC ends its hostility to hedge funds and reforms the ICA to permit their public listing, this is probably the closest to a real hedge fund U.S. retail investors can get.  Whether it will successfully earn those hoped for positive uncorrelated returns is another matter.    

Oaktree and GSTrUE

The Los Angeles Times is reporting that Oaktree Capital Management LLC, an alternative investment firm with over $40 billion in assets under management, has sold approximately 14% of itself for more than $800 million to less than 50 investors.  It was previously reported in the Wall Street Journal that Oaktree was circulating an offering memorandum to sell a 13% interest in itself for $700 million.  Oaktree is the latest firm to cash in on the private equity/hedge fund boom and follows in the heels of Fortress Investment Group's successful public offering and Blackstone's pending one. 

The Oaktree offering is private and its shares will trade on a new private market developed by Goldman, "GS Tradable Unregistered Equity OTC Market" with the catchy acronym GSTrUE.  Information about the market is limited as Goldman has done nothing to publicize it and Oaktree is apparently its first listing.  But, according to reports, Goldman is hoping that GSTrUE will become a viable alternative listing market for hedge funds, private equity and operating companies who wish to avoid SEC regulation.  Accordingly, the market will be limited to qualifying investment funds with over $100 million in investable assets.   

GSTrUE, however, will live under the shadow of U.S. regulation.  In order to avoid triggering Exchange Act reporting requirements for any listed company, Goldman and any such listed U.S. entity will need to make sure that the company does not exceed more than 500 shareholders.  This will likely place Goldman in the position of forced market maker when the cap is reached.  It will also even further reduce liquidity by limiting the number of trading shareholders and shares traded.  Moreover, Goldman has not disclosed whether there will be any other market makers for this market, but given the likely low liquidity and shareholder trading limitations, Goldman is likely to set fat spreads on trades.  Pricing is also likely to be opaque due to information and analysts' coverage gaps.  While Goldman has incentives to maintain lower spreads in order to attract listings, these problems may be why Oaktree's offering values it at only $5.7 billion, a much lower valuation than Fortress and the one mooted for Blackstone.  Time will tell if GSTrUE is a success, and it is certainly a worthwhile economic experiment on the validity of private markets, but I believe that GSTrUE's handicaps will likely make it more of a stepping stone for companies on their way to a full public market listing more than anything else. 

NB. The L.A. Times is reporting that Oaktree shares are now trading on GSTrUE at $50 a share after being offered at $44.  It would be more interesting to know the bid/ask spread. 

Acxiom's Hedge Fund Problem

Today, MMI Investments L.P., the hedge fund and Acxiom’s second largest stockholder owning 8.2% of the company, disclosed a letter delivered to the Acxiom board of directors in opposition to Acxiom's agreement last week to be acquired by Silver Lake Partners and ValueAct Capital Partners in a transaction valued at $3 billion (the letter is annexed to MMI's 13D amendment filed today).   ValueAct Capital Partners is also a hedge fund and so the news and blogs are highlighting this as a clash of two hedge fund trends:  hedge funds taking on private equity roles and hedge funds as activist shareholder investors.  It is also yet another real example this week of shareholder resistance to private equity/hedge fund buy-outs -- the other two being Clear Channel and OSI Restaurant Partners.  More interesting to me was the following language in MMI's letter to the Acxiom board:

Our concerns about valuation are only amplified by our frustration with both the timing and structure of this transaction. Given the strategic initiatives currently underway (and recent earnings pain that your existing stockholders have had to bear) we struggle to understand why this is the right time to sell our company. Moreover it is our belief that the “go-shop” mechanism is a poor substitute for a full auction for a comprehensively marketed property. We can only hope that the “go-shop” for our company is a genuine one, with clear, concise, and thoughtful distribution of information, and thorough outreach to potential buyers from Acxiom’s industry, as well as those in comparable or tangential industries, and financial buyers (many of whom have significant experience and resources in the marketing data and informatics industry).

Acxiom has yet to file the acquisition agreement.  But according to a conference call last week, Acxiom's "go-shop" is a relatively robust form of the provision.  Pursuant to its provisions, Acxiom will have 60 days to solicit other superior proposals, and if it agrees to one, is required to pay only a reduced break-up fee of 1% of the equity value of the company.  Nonetheless, on that same conference call Acxiom management disclosed it permitted only one other bidder to conduct due diligence prior to agreeing to the ValueAct transaction, and only then because Acxiom was approached.  According to Acxiom, the transaction will require a 2/3rd majority vote of Acxiom's shareholders to win approval.  Given this requirement, shareholder resistance and the fact that Acxiom stock is trading above the offer price, the current offer appears to be only an opening gambit, yet again highlighting the perils of "go-shops" and the head-start and cover they provide to a chosen acquirer.

Update:  Acxiom filed its merger agreement later today; it contains the above provisions.   

AFL-CIO Opposes Blackstone IPO

The FT is reporting that the AFL-CIO has written the SEC arguing that private equity group Blackstone's planned initial public offering should be halted.  According to the Financial Times, "the union says that the unique structure chosen by Blackstone’s senior executives to raise funds from stock markets while keeping a tight grip on the running of its business is an attempt to evade the coverage of the Investment Company Act of 1940."  (Update:  a copy of the letter can be downloaded here).  In brief, the AFL-CIO is arguing that a majority of Blackstone's assets are in the form of carried interest that has been “marked to market” . Carried interest is the term for the 20% Blackstone takes on deal profits over and above its 2% administration fee.  The AFL-CIO is arguing that because the carry is only paid when a deal reaches certain profit milestones, it is a form of call option.  Call options are securities, and given that more than 40% of Blackstone's assets are in carry, if the union is right Blackstone would fall under the regulatory schematic of the Investment Company Act of 1940 as an investment company unless another exemption applied.

The argument is a clever and convoluted one, but is almost certainly an incorrect interpretation of the definition of a call option under the Act.  The alternative view would arguably pick up a number of regular operating companies and investment banks who have profit participation contracts and mark those profits to market.  Not to mention the argument would cause serious doctrinal problems for the SEC which recently let the similarly-structured Fortress ipo go forward without claiming the Investment Company Act applied (the AFL-CIO attempts to get around this problem by claiming that Blackstone's practice of marking-to-market makes it distinct from Fortress and is the key to qualifying the carry as a security). 

But the  AFL-CIO is absolutely correct that the Blackstone offering is an attempt to evade application of the Investment Company Act.  Under the Act, it is very clear that the Blackstone funds themselves as currently structured cannot currently be offered to the public.  But, Blackstone is getting around this prohibition by selling shares in itself, the fund advisor.  Blackstone's evasion is permissible under the current structure of the U.S. securities laws.  Despite almost certainly being wrong, the AFL-CIO argument does highlight the out datedness of the Investment Company Act and the increasingly bizarre results it engenders.  Investing in a private equity fund adviser is essentially equivalent to investing in the funds themselves.  There should be no regulatory difference in their regulation by the SEC, and no ability for private equity funds to game this regulation as Blackstone is doing here.  In fact, if anything investing in the adviser is more risky.  The subject is for a more extended post, but it is far past the time that the SEC updated the Investment Company Act, which was passed in 1940, to regulate mutual funds for the modern age of hedge funds and private equity.