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Hedge Funds 2007

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10

blurring the line between

hedge funds and private equity

Stephanie R. Breslow

Schulte Roth & Zabel LLP

June 6, 2007

BLURRING THE LINE BETWEEN

HEDGE FUNDS AND PRIVATE EQUITY

Stephanie R. Breslow

Schulte Roth & Zabel LLP

New York, New York

I. THE PLAIN VANILLA OF HEDGE FUND AND PRIVATE EQUITY FUND PARADIGMS

A. Hedge funds invest primarily in marketable securities that are liquid and have a readily ascertainable market value.

B. Private equity funds invest primarily in unregistered securities, usually holding positions in private companies.

C. Because of the fundamental differences in their investments and strategies, hedge funds and private equity funds have traditionally had different fundamental terms:

1. Hedge Fund - Mark to market valuations used as a basis for (annual) incentive fee and (quarterly) management fee; frequent fund openings throughout the life of the fund; redemption rights provided throughout the life of the fund; participation by all investors in the same portfolio; "high water mark" but typically no preferred return; and minimal investor rights other than "vote with your feet".

2. Private Equity Fund - Mark to market valuations impractical; as a result, management fees are based on capital commitments regardless of appreciation, and incentive fees are paid only as gains are realized. The fund is closed to new investors after a fixed (typically 6 - 9 months) ramp-up period; investors have no redemption rights, but receive distributions as investments are sold; the fund has a fixed period during which it can make investments, and an outside date by which all investments must be sold; the manager must raise new private equity funds for subsequent investment opportunities; capital is drawn down over time as investments are made, and there is typically a preferred return to investors on drawn capital; because investors face long lock-ups (often 10 - 12 years), there are extensive contractual investor protections.

D. The different structures of hedge funds and private equity funds have also resulted in part from differences in their core investor base:

1. Hedge Fund-comparatively low minimum investor commitment (often less than $1 million) and high liquidity have caused hedge funds to be targeted heavily toward high net worth individuals, many of whom invest without counsel review of documentation.

2. Private Equity Fund - High minimum investor commitment (often $5 - $10 million) and long lock-ups have caused the investor base to be primarily institutional, with a particular focus on tax-exempts (pension plans, endowments). Counsel negotiation of documents is the norm, and many investors in this market are sophisticated evaluators of fund terms.

II. BLURRING THE LINE - THE CONVERGENCE OF HEDGE FUNDS AND PRIVATE EQUITY

A. Some hedge funds are beginning to face private equity problems and to adopt private equity solutions:

1. Side pockets - A fund may have the right to invest a portion of its portfolio (typically capped at 10% - 15%) in illiquid securities that cannot readily be marked to market. These investments may be held in "side pockets". Basic terms:

a. Only investors in the fund at the time the side pocket is created participate;

b. Management fees are paid based on investment cost;

c. Incentive fees are paid on realized profits once the investment is sold; and

d. Redeeming investors remain locked into the side pocket until it is liquidated.

2. Lock-ups - Some hedge fund managers are moving away from quarterly/annual liquidity in favor of longer lockups (often up to 3 years). Some funds impose lockups on each contribution, and others use preset withdrawal dates for all investors. Reasons for lockups include:

a. Startup managers seeking a chance to prove themselves and not be undone by a single bad year. (Especially important for managers using a buy-and-hold strategy).

- Solution: Single lockup at fund inception, followed by annual/quarterly redemptions thereafter.

b. Comparatively illiquid investment strategy (thinly traded securities; customized derivatives; emerging markets).

- Solution: infrequent, preset redemption dates with long notice requirement; right to roll over excess redemption requests to subsequent periods; right to freeze redemptions during unfavorable market conditions.

c. Selective managers seeking to weed out "hot money".

- Solution: Minimum holding periods from date an investor joins the fund (and perhaps also on an investor's subsequent contributions); some managers offer reduced fees in return for longer lockups.

3. Series Funds - Hedge funds containing a high proportion of hard-to-value securities may protect investors against dilution by offering shares in series, and permitting new investors to participate only in new investments.

4. Hybrid Funds - A fund that contains a combination of liquid and illiquid securities may permit redeeming investors to pull out their share of liquid proceeds, but remain locked into illiquid positions. Similar to side pockets, but does not provide any dilution protection on the illiquid portion of the portfolio. Accounting can be complex - some funds contain different fee arrangements for their liquid v. illiquid portfolios, but allow the manager to determine the allocation among strategies.

5. Commitment Funds - Some funds draw down investor capital over time, avoiding the drag on performance caused by holding a large portion of a portfolio as cash. This structure can be helpful where a manager's investment strategy will take time to deploy (e.g., bottom-up investing, emerging markets).

B. Hedge funds that begin to resemble private equity funds (whether through lockups, or because the basic portfolio is not liquid), or that raise capital from sophisticated institutions that are familiar with private equity documentation, can face investor requests for the types of protections that used to be more typical of private equity. Issues include:

1. "Key man" - withdrawal rights tied to loss of key personnel.

2. "For cause" - withdrawal rights based on manager bad acts, or material portfolio losses.

3. "Exclusivity" - limits on other funds and activities by manager; promise that appropriate investments will come exclusively to the fund; promise of dedication of time by key principals.

4. Side letters - customized fee and redemption arrangements; most-favored nation.

5. "Clawbacks" - manager obligation to return incentive fees if there are subsequent losses.

6. Preferred return - sometimes accomplished by measuring performance against an index.

6. More rigorous negotiation of documents.

C. At the same time, the emergence of private equity funds of funds has caused some private equity managers to rely more heavily on high net worth individuals as part of their investor base. As a result, they are facing issues that used to be of greater concern to hedge fund managers, including:

1. Heightened disclosure standard appropriate to comparatively "retail" offerings.

2. 3(c)(1) "slots" issues.

3. Placement/solicitation issues.

D. Some asset classes straddle the line between private equity and liquid securities. Sometimes, the same investment strategy will be used by one manager in a hedge fund format and by another in a private equity format. Examples of borderline asset classes include:

1. Distressed debt.

2. High yield debt.

3. Trade claims.

4. Mortgage-backed securities/asset-backed securities.

5. Emerging market securities.

E. It is often easier to raise capital using a hedge fund structure than a private equity structure because:

1. Investors have greater liquidity; and

2. The fund can have unlimited openings, so it can be started with a relatively small amount of capital in the expectation that more capital will be raised over time.

F. However, there is a cost to forcing relatively illiquid assets into a hedge fund structure:

1. A portion of the portfolio may have to be held in liquid securities in order to meet anticipated redemption requests, even if these investments are inconsistent with the fund's general investment strategy;

2. If redemption requests exceed anticipated levels, it will be necessary either to distribute illiquid securities in kind or to freeze redemptions. Both of these results are very unpopular with investors;

3. Long lock-up periods can postpone this problem, but do not solve it; if anything, infrequent redemption dates can increase the risk that a large percentage of capital will be withdrawn at one time;

4. If a hedge fund structure is used for assets that cannot readily be realized at their mark-to market values, inequitable results may occur when admitting or redeeming investors at inaccurate values, or making distributions in kind; and

5. If investors pay their full capital commitments at closing into an investment program that will take time to deploy, there will be a drag on performance.

G. It is far easier to structure a fund using a private equity structure, or at least some of its components, than to restructure a hedge fund to add restrictions on liquidity later on. For this reason, hedge fund managers should know the basics of private equity structuring, even if they do not think of themselves as private equity players.

H. A knowledge of private equity structure and terminology can also help demystify the comments of prospective institutional investors who review hedge fund documents from a private equity perspective.

COMPARISON OF HEDGE FUND

AND PRIVATE EQUITY TERMS

| | |HEDGE FUND |PRIVATE EQUITY FUND |

|1. |Investments |Liquid investments, usually publicly traded |Illiquid investments, generally privately held |

| | |securities |securities |

| | | |Typically locate investments over a period of 3-7|

| | |Generally, fully invested at all times |years following closing |

|2. |Capital |Capital contribution up front (trading in public |Capital commitment drawn over time as investment |

| | |markets means capital can be put to use right |opportunities are located |

| | |away) | |

|3. |Valuation |Portfolio has readily discernible market value; |Periodic market valuation of portfolio is |

| | |easy to value periodically |difficult; assets typically valued upon sale |

|4. |Incentive Allocation |Periodic incentive allocation (typically annual) |No incentive allocation until investment actually|

| | |on both realized and unrealized gains |realized |

| | |Almost always 20% with high water mark; |Incentive allocation taken after investors |

| | |occasionally hurdle rate with a catch-up |receive either (i) return of capital plus hurdle |

| | | |on all investments that have been sold, plus |

| | | |allocated expenses; or (ii) return of all |

| | | |invested capital and all expenses, including cost|

| | | |of investments not yet sold, plus hurdle. |

| | | |Typically 20% over a hurdle rate with a catch-up:|

| | | |effective break-even fee varies based on level of|

| | | |catch-up; occasionally move to higher fee level |

| | | |(e.g., 30%) after high return threshold. At end |

| | | |of fund (or periodically), adjust to ensure |

| | | |General Partner hasn't received more than would |

| | | |have if allocation calculated on an aggregate |

| | | |basis ("GP Clawback") |

|5. |Management Fees |Quarterly management fees based on NAV of |Quarterly management fees based on capital |

| | |portfolio; usually 1% p.a. |commitments during investment period and based on|

| | | |cost of unsold investments thereafter; fees vary |

| | | |based on investment program; can be 2%-2.5% in |

| | | |some cases; usually at least 1-1.5% p.a.; |

| | | |sometimes varies by investor based on the size of|

| | | |commitment |

|6. |Other Fees |Usually no other fees |Other fees - break-up fees; directors fees; |

| | | |advisory fees; acquisition/disposition fees; |

| | | |generally shared with investors |

|7. |Admission of Investors |On initial closing and periodically (monthly / |On initial closing and optional additional |

| | |quarterly) thereafter through the life of the |closings up to 6-9 months after the initial |

| | |fund; possible because portfolio NAV always known|closing; need outside date before investments |

| | | |have time to appreciate |

|8. |Treatment of Additional Investors |Admitted based on portfolio NAV as of such date; |Treated as if admitted on the initial closing |

| | |no retroactive management fee |subject to interest charge for interim period; |

| | | |must pay their share of draws made to date; |

| | | |existing investors get refund, which increases |

| | | |their unused commitments; pay retroactive |

| | | |management fee plus interest |

|9. |Term |Perpetual, but investors can withdraw from the |Fixed term and investors generally cannot |

| | |fund; see below |withdraw from the fund (except in the case of |

| | | |legal requirement) |

|10. |Withdrawal/ Distribution |Investors may withdraw periodically (usually at |Investors have no withdrawal rights (except in |

| | |year-end) subject in some cases to lock-ups |the case of legal requirement); capital returned |

| | |(e.g., 3 yrs. from date of initial investment); |and profits distributed as investments are sold |

| | |generally no other distributions |subject to reinvestment, if any; remaining |

| | |General Partner also has right to force investors|investments sold or distributed in kind at end of|

| | |to withdraw |term |

|11. |Investment Transparency; |Investors do not know what portfolio contains, |Investors receive advance notice of each |

| |Excusal/Default |and do not receive advance notice of investments;|investment; do not have to fund if would cause a |

| | |since all capital is funded up front, there is no|regulatory problem ("excusal"); forfeit portion |

| | |risk of investor default |of their investment and experience other |

| | | |penalties if fail to fund without excusal |

|12. |Investor Protections |Securities laws protect investors against |Partnership common-law duty of loyalty protects |

| | |self-dealing by the manager; issues include |investors against self-dealing by General |

| | |principal trades, agency cross trades and soft |Partner; partnership agreement and offering |

| | |dollars |memorandum typically modify this duty by |

| | |High water mark - if fund NAV declines, General |describing what competing activities are |

| | |Partner must earn back losses before can take an |permitted/ forbidden; issues include successor |

| | |incentive allocation in subsequent periods |funds, allocation of deals meeting the fund's |

| | |Periodic withdrawals mean investors can vote with|investment objective, dedication of time by |

| | |their feet; as a result, documents are less |principals and diversification limits |

| | |heavily negotiated |GP Clawback - investors receive amounts received |

| | | |by General Partner in excess of what General |

| | | |Partner would have received if returns were |

| | | |calculated on an aggregate basis |

| | | |Escrow or Guaranty – a portion of the performance|

| | | |fee allocated to General Partner may be reserved |

| | | |or placed in escrow, usually one half of the |

| | | |after-tax amount paid to General Partner, to |

| | | |cover GP Clawback; in other cases, principals may|

| | | |guarantee clawback |

| | | |Write-downs - sometimes there is a write-down of |

| | | |unrealized losses for poor performing investments|

| | | |Other protections may include investor right to |

| | | |require fund dissolution or end investment period|

| | | |based on "cause"; loss of key principals or |

| | | |"no-fault divorce" |

|13. |Regulatory Issues |Securities Act of 1933 (private placement; 10b-5)|Same regulatory issues, except re: ERISA, can |

| | |Investment Company Act of 1940 ("1940 |rely on VCOC/ OC/REOC to go above 25% benefit |

| | |Act")-3(c)(1), 3(c)(7), 3(c)(5)(c) exceptions |plan participation |

| | |Investment Advisers Act of 1940 ("Advisers Act") |Sometimes make parallel vehicles to address |

| | |– 203(b)(3) exemption |regulatory issues re: particular |

| | |ERISA - 25% limit |investors/investments (e.g., group trust for |

| | | |tax-exempts); fact that fund takes controlling |

| | | |interest in companies means may face greater |

| | | |issues in regulated industries (e.g., BHCA, |

| | | |PUHCA, media and insurance regulation) |

|14. |Tax Issues |UBTI: offshore vehicle for foreign and tax-exempt|UBTI; FIRPTA; allocations issues (especially |

| | |investors; deferral; trading v. investment |where investors receive all invested capital |

| | | |before incentive allocation); tax distributions |

|15. |Hybrids |Sometimes have "side pockets" for illiquid |Typically do not hold minority stakes in publicly|

| | |investments; almost a mini-private equity fund |traded securities except as a step toward taking |

| | |within a hedge fund; typically limited to a |a control position (e.g., "bridge financing"); |

| | |fraction of the fund's portfolio; fewer |may invest cash temporarily in high-grade |

| | |protections than in a private equity fund |securities (e.g., T-bills; government securities)|

| | | |pending long-term investment, sometimes such |

| | | |investments do not count toward hurdle and are |

| | | |not charged incentive allocation |

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