Last week I attended the International Bar Association’s 13th Annual International Conference on Private Investment Funds
in London, England. Heading into the conference, I was interested in gauging the private investment community’s response to the political and regulatory spotlight shining on both hedge funds and private equity funds. For the most part, the speakers and participants in the conference confirmed that in the wake of the Great Recession of 2008, private investment funds, which may have flown under the radar only a few short years ago, are now, more than ever, finding themselves in the cross-hairs of federal and international regulators. Just last year, the United States Attorney’s Office’s successful prosecution of Raj Rajaratnam
for insider trading underscored the fact that the criminal prosecution of hedge funds and their principals makes for international front page news. And, if press reports are to be believed, dozens more insider trading charges relating to private investment funds are still to come. So, what does this heightened regulatory environment mean for private investment funds? Here are a few tidbits I learned in London:
Increased investor involvement: Private funds have had to learn to deal with heightened investor due diligence. Given investors’ desire to avoid associating themselves with funds that end up targeted by regulators, now, more than any other time, investors have asked for—and received—access to pick apart the books and records of private investments funds. This diligence includes not only a top-to-bottom review of a fund’s holdings, but in many cases, an in-depth analysis of the valuation of the fund’s assets.
Ensuring Regulators’ Understand a Private Investment Fund’s Trading Strategy and Valuation Process: Now that U.S. and foreign based regulators are focusing on private investment funds, those funds and their attorneys must ensure that regulators understand the nature of a fund’s trading strategy during the course of an investigation. Private investment funds typically engage in complex, intricate, and layered investment strategies that, while perfectly legal, may not be straightforward, especially to a regulator who has not had extensive experience with a particular strategy. Thus, private funds should be at the ready to explain, in detail, their strategies and valuation methods in order to beat back the potential preconceived notions of regulators regarding the propriety of a fund’s investment approach.
The Rise of the U.K.’s Financial Services Authority in Enforcing Insider Trading: To the extent private investment funds believed that international securities authorities were not as vigilant about investigating and enforcing insider trading as U.S. based regulators, the United Kingdom’s Financial Services Authority’s recent investigation and fining of David Einhorn and his firm, Greenlight Capital, Inc., suggests otherwise. In that case, the FSA levied significant fines against Einhorn and his firm for trading shares of a U.K. corporation on the basis of what the FSA believed was non-public information.
Increased monitoring of communications: Given the significant role emai
ls and instant messages have had in the latest round of insider trading investigations and prosecutions, in-house compliance units of private investment funds have begun regularly monitoring employee communications in an attempt to enable firms to stay ahead of the curve in determining whether their employees are engaged in improper or illicit trading.
Increase in litigation costs: The heightened scrutiny of private investment funds has led not only to increased legal fees for funds and their principals, but also has resulted in fund managers ensuring that their fund’s operative documents contain the broadest possible indemnification provisions. Moreover, this extensive regulatory environment has not gone unnoticed by insurance companies, which have raised their fees and premiums accordingly.
While attorneys focusing on private investment funds may not be able to foresee every regulatory issue that will confront those funds, everyone seems to be in agreement, particularly those attending the IBA Conference in London, that because more eyes are more carefully scrutinizing these investments, the era where private funds could fly under the radar is over.