Garret Filler recently rejoined Cadwalader, Wickersham & Taft as special counsel in the firm's New York office, where he represents both start-up and established hedge funds and private equity funds, as well as family offices, banks and broker-dealers. Filler assists clients with forming investment management firms and pooled investment vehicles; complying with regulations applicable to investment advisers and funds; and negotiating trading, credit and operational agreements. Prior to rejoining Cadwalader, he worked at start-up hedge funds and at several large hedge fund managers, including Citadel, D.E. Shaw and, for nearly a decade, as general counsel and chief compliance officer of Ellington Management Group (Ellington).
The Hedge Fund Law Report recently interviewed Filler in connection with his return to Cadwalader, during which he discussed numerous topics of import to hedge fund managers. This article, the first in a two-part series, sets forth Filler's thoughts on the cultures of private fund managers; selection of outside counsel, including law firm relationships with regulators and their willingness to enter into alternative fee arrangements; and counterparty risk. In the second installment, Filler will discuss family office transitions into asset managers; broker-dealer registration issues for fund managers; considerations when negotiating counterparty agreements; the implications to hedge funds of increased capital and liquidity requirements for banks and broker-dealers; and the impact of new margin requirements for uncleared derivatives.
For additional insight from Cadwalader partners, see "Best Practices for Hedge Fund Managers to Adopt in Anticipation of Enactment of FinCEN AML Rule Proposal" (Aug. 4, 2016).
HFLR: You worked in-house both at start-ups and at Citadel, D. E. Shaw and Ellington. From the perspective of a former insider, how are the cultures of private fund managers similar to each other, and in what ways do they differ?
Filler: An enduring attribute of private fund management firms, whatever the size, is that the culture is established by the founders. To launch a private fund manager, it helps enormously if the founders have a successful investing track record – the longer-running the better. That prior success provides the basis for their self-belief, along with their willingness and ability to risk their own personal assets to start a high-risk business in a competitive marketplace. The fund founders I've known have all been extroverted, confident, ambitious, smart and comfortable with complexity, uncertainty and ambiguity.
On the other hand, there can be significant differences between fund founders, too. Private fund founders can be detail-focused, or they can have a big-picture orientation. Some are very theoretically-minded, while others weigh experience and observation more heavily.
HFLR: To follow-up, do fund terms tend to differ between start-ups and well-established managers?
Filler: Except in a few rare circumstances where a start-up manager is essentially oversubscribed and can set the terms of its new fund almost unilaterally, start-up managers are in a substantially different position from large existing managers when it comes to establishing and negotiating investment terms, such as fees and lock-up periods, with investors.
At one extreme is the start-up manager who has all of the critical business terms dictated to him or her almost unilaterally by prospective investors. In those cases, you'll typically see things like lower fees and greater liquidity even as compared to other managers in the same strategy. You might also see managers granting investors greater transparency into portfolio holdings.
At the other end of the spectrum, there are examples where the manager voluntarily closes the fund to outside investors, so it doesn't have issues with respect to fees, liquidity or transparency.
In between are large managers with long track records of success that remain open to outside investors. They are understandably able to negotiate more favorable terms with investors than start-up managers. For example, they might set higher fees or more favorable expense terms. They might have longer lock-ups and reduced transparency into portfolio holdings. They might even, subject to applicable law, be less willing to provide information in response to investor inquiries and requests.
HFLR: How does a private fund manager select outside counsel?
Filler: To a great extent, private fund managers select outside counsel using the same process as any other business; they often use a similar process to the way they select other important service providers, such as basing the decision on pre-existing relationships or the recommendation of an industry colleague.
When a private fund manager is searching for counsel for a new matter, there's no one path to finding an outside lawyer, and usually, there's more than one person who can do a great job. Asking for a referral from a friend at a fund manager that's in the same (or an adjacent) strategy certainly increases the odds of identifying a subject-matter expert. Sometimes, a Google search of the areas of expertise you need for the new matter will yield published articles and commentaries, seminars, speaking engagements and biographies on law firm websites of lawyers with the exact experience you're looking for.
In addition to identifying outside counsel qualified to handle a new matter, you sometimes have the ability to select from among several good options. For a large enough project, a private fund manager might submit written questions to multiple law firms, review sample materials, request references or even hold a "beauty contest" – inviting finalists to make a pitch presentation.
One last point worth noting is that it's sometimes said, "There are those who hire law firms and those who hire lawyers." Real people obviously will be working on your projects, and their experience, expertise, perspective, communications skills, intelligence, creativity, practicality and responsiveness can make the entire difference. It's equally true that law firms themselves have reputations, and the reputation of the law firm can influence the comfort level of investors, counterparties and regulators.
HFLR: How important to the outside counsel selection process are relationships with regulators?
Filler: Not surprisingly, law firms will vary in terms of how close their lawyers are – or any individual lawyer is – with any particular regulatory authority. Being known to have a good relationship with particular regulators is definitely an advantage. It's also true that law firms practicing in a given space broadly enough or for long enough develop those relationships, because it's critical to clients that their lawyers be able to reach out to those regulators, either to obtain guidance or to get the regulator's view on the possible paths for the client to be able to proceed with its business.
HFLR: To what extent do law firms agree to alternative fee arrangements with private fund managers?
Filler: Times have changed in this regard, especially in the period since the financial crisis, with more law firms now willing to consider alternative fee arrangements for work that historically would have been billed on a strict hourly basis. Consequently, a variety of alternative fee arrangements may now be available to private fund manager clients, from a fixed percentage discount on hourly rates; a fee-capped or fixed-fee arrangement; success-based incentives; and of course a combination or hybrid of arrangements. I think it's also true, though, that the willingness of firms to undertake alternative fee arrangements varies widely from firm to firm and may depend upon the amount of business the client generates for the law firm.
HFLR: Do buy-side firms continue to worry about "Lehman risk," and if so, how are they handling it?
Filler: It varies from fund-to-fund, but most are at least thinking about their exposure to the credit risk of their dealer counterparties when they put in place trading and credit agreements, such as ISDAs, MRAs, GMRAs, futures agreements and prime brokerage agreements. More and more, funds are establishing relationships with multiple dealers so that, if necessary, they can transfer positions quickly.
Funds are also using tri-party collateral arrangements and focusing on their contractual rights in the event of dealer insolvency. And even though there's a lot of uncertainty as to how the new dealer insolvency framework will hold up in a distressed scenario, private fund managers are paying close attention to legislative and regulatory developments in this space.
Of course, the flipside of tri-party collateral arrangements is that they introduce the risk that the custodian will fail. Funds are trying to become more knowledgeable about the laws that apply to different types of custodians and how their assets would be treated in the insolvency of a custodian. Even outside the tri-party context, funds want to be able to assess their custodial arrangements and understand the consequences of, for instance, granting the custodian a right of rehypothecation.
[For more on the Lehman Brothers collapse, see "How Can Hedge Funds Get Their Money Out of Lehman Brothers International Europe?" (Aug. 5, 2009).]
HFLR: How will increased capital and liquidity requirements for banks and broker-dealers affect services provided to hedge funds?
Filler: Many hedge funds have already received requests from their trading counterparties to "re-paper" or "novate" services, and we expect this to continue. Increasingly, banks are moving their financing businesses to different legal entities in response to developments such as Basel III, intermediate holding company requirements and liquidity coverage ratio requirements.
For hedge funds, this means reassessing the risk of the particular dealer entity they're trading with and potentially re-evaluating whether the form of transaction being used is still the most efficient way of obtaining financing. For example, regulations imposed on banking entities are making ordinary financing transactions such as repurchase and stock lending facilities or long-term credit facilities much more expensive, and these costs are being passed along by banks to their customers.
Also, some of the new regulations impose greater costs on the world's largest banks, so some hedge funds are also considering trading with smaller banks that may be less capital and liquidity constrained under the new rules, although small banks may pose greater counterparty risk than the biggest banks.
[For additional insight on the impact of Basel III, see "Basel III Raises Prime Brokerage Costs for Hedge Fund Managers" (Feb. 18, 2016).]
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