Disclaimer: I am not a lawyer. These are just general observations from my non-lawyerly experience. For actual legal advice you should consult your counsel; ironically the same counsel that I will now suggest could be sucking blood out of your organization like a tsetse fly. But either way, don’t listen to me and listen to your lawyer (or a lawyer) instead.
We often see both new & old hedge fund managers make very common mistakes in their dealings with legal counsel. These mistakes can end up costing managers big bucks. At times this is by design. Some legal firms have habitually shown a tendency to exploit their client’s lack of knowledge about industry legal standards in order to rack up boatloads of unnecessary legal fees.
Here’s a countdown of 5 things hedge fund managers should be aware of to mitigate the blood-sucking potential of their own legal counsel:
- Charging $200k for boilerplate documents. This is the most common mistake we see early managers make; they use a ‘brand-name’ law firm, and then the law firm ends up charging insane amounts of money for inserting the fund’s name into the docs they’ve already used with 200 other funds. The reality is, out of all the service providers you use, investors care about legal the least. Instead of focusing on a ‘brand name’, focus on competence at a reasonable price.
Additionally, if you are amortizing fund start-up expenses that means investors are paying for overpriced docs, which will have an impact on your net returns and expense ratios.
- Non-standard language. The hallmark of bad legal docs is the inclusion of ‘non-standard’ terms, which generally means terms that are well outside industry norms and unfair to investors. Inclusion of these terms has two results:
(i) It erodes trust and creates immense discomfort with investors. (“He seemed like such a nice guy in person…but what is this all about?”)
(ii) It sets the law firm up to generate fees on side letters. Standard, fair terms are rarely challenged. If many institutions allocating to your fund need a side letter to waive aggressive terms it’s because your counsel is going full tsetse fly on you.
The hard part here, of course, is in knowing the standard. This is where managers (even seasoned ones) are at a disadvantage. It’s rare for a manager to know what’s considered normal across the entire hedge fund landscape, and they therefore have a natural tendency to defer to their own counsel to handle these matters (because that’s the point of counsel, right?)
In the absence of being able to share hundreds of legal docs here, I will give some examples and a basic piece of advice: apply some common sense. If a term seems unfair, unrealistic, and unreasonable, it’s probably because it is. Aggressive terms may seem better for you; but they’ll often bite you in the end. Examples of non-standard terms:
Non-standard #1. Language on valuation for a long/short fund: “The General Partner will mark-to-fair value the price of any security that it believes is not at fair value in its sole discretion…”
Standard. For a similar long/short fund: “The market value of positions in securities shall be as follows: securities that are listed on an exchange or the NASDAQ Global Market and are freely transferable shall be valued at their last sale price during the primary trading session on the date of determination, or, if no sales occurred on such day, at the “bid” price at the close of business on such day if held long…”
In order words: Long short funds use market to market pricing. Standard docs will explain how and when independent pricing is to be used, rather than just saying that the manager has full discretion to mark his positions up at will. (If only Ackman could mark up Valeant at what he believes it should be…)
Non-standard #2. Repeated insistence that the general partner can do a bunch of unreasonable things “at their sole discretion.”
Standard. Discretion when reasonable. Again; common sense. You can’t commit fraud or act in bad faith regardless of how many times you declare your ability to do whatever you want, so what’s the point?
3. Verbose & over-complicated docs. This is related to #4. Bad legal counsel has a tendency to over-lawyer docs with useless terms and clauses. Most PPMs are about 40 pages—if you are pushing 70 or 80 pages it means your counsel may have added a massive amount of baloney. Clear signs of potential trouble:
- When a domestic long/short fund has 3 pages on valuation of swaps and other instruments it will never use.
- When a liquid fund has half a dozen pages on nuances of withdrawals.
- When the tax treatment pages cover jurisdictions like Mongolia, Cambodia, and Uruguay. (These are unlikely to be your target audience.)
The result of uselessly complex docs is simply that it takes investors more time to close the deal, and it makes it harder for them to trust you. Complexity creates uncertainty, and the best legal docs tend to be fair, clear, and comprehensive within the bounds of reality.
- Encouraging fights. This is hugely important: Your counsel benefits from conflict. The best paying clients are the funds that spend a lot of time in court, not the ones that keep everyone happy. When your counsel starts encouraging you to exercise your ‘rights’ as laid out in their overly aggressive subscription documents they prepared for you, step back and recognize that they have an interest in seeing this become a problem. Your reputation and future in the industry relies on acting in good faith and doing right by your clients, regardless of the fine print in your docs.
(And if that’s not enough for you, fights tend to be time-consuming, costly, and leave both parties worse off.)
- Overdoing it. Legal is critical to the long-term survival of a business. One big compliance mistake could be the end of even well-established companies. Fund counsel, even the well-meaning variety, are paid to assess risk and minimize it. It’s their job. That being said, risk is a part of life, and the only way to completely eliminate your risk is to be out of business. As a manager, your job is to constantly understand the risks, and find a balance that allows you to manage them while continuing to operate your business. If you’re the only person in the industry undertaking a bizarre convoluted process to communicate with investors, perhaps it’s time to re-assess that balance.
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