Jan. 7, 2021

Five Topics for Hedge Fund Managers to Keep on Their Radar for 2021

January is the perfect time to look back at the previous year – and to consider what one might expect in the new year. There is no doubt that the coronavirus pandemic derailed any predictions for 2020, and it is likely that its effects will continue to be felt through at least the early part of 2021. Although the hedge fund space is not immune to the pandemic’s ramifications, it is also affected by other events, developments and trends. To that end, the Hedge Fund Law Report is highlighting five topics that hedge fund managers should keep on their radar for 2021, along with five articles from the archives on those topics, which include the upcoming appointment of a new SEC Chair and why that could mean heightened focus on insider trading; increasing pressure to improve diversity in the industry; the continuing trend of private credit and direct lending strategies; the end of the London Interbank Offered Rate (LIBOR); and more targeted cyber attacks on fund managers. Next week (the week starting January 11, 2021), the HFLR will resume its normal weekly publication, which will feature the first installment of a two-part interview with Steven Peikin, former Co‑Director of the SEC’s Division of Enforcement.

What Fund Managers Can Learn From “Tipper X”

SEC Chair Jay Clayton stepped down from his position at the end of 2020. Thus, President-Elect Joe Biden will have the opportunity to appoint the new head of that important regulator. One name that is on nearly all media lists of potential replacements is Preet Bharara, former U.S. Attorney for the Southern District of New York. Although the SEC has always targeted insider trading, if Bharara were to become the new SEC Chair, that could mean increased focus on insider trading – a topic near and dear to Bharara, who led a task force created to develop proposals for updating the law on insider trading. The possibility of that increased focus – coupled with the heighted insider trading risks created by the new work-from-home environment – should motivate fund managers to examine their existing insider trading policies and procedures. To help mitigate enhanced insider trading risks, fund managers should consider the perspective of Tom Hardin, founder of Tipper X Advisors LLC; former long-short equity analyst focused on the technology sector; and known as “Tipper X,” one of the most prolific informants in securities fraud history as part of “Operation Perfect Hedge,” the government’s crackdown on insider trading in the hedge fund industry. The first article in our two-part series based on an interview with Hardin presents his insights on how private fund compliance staff can prevent and detect insider trading activity, including best practices for training employees, ensuring prudent email use, preventing employees from rationalizing their insider trading, restructuring employee compensation to avoid incentivizing risky behavior and identifying insider trading activity. The second article analyzes ways regulators combat insider trading activity and the impact of insider trading cases on the regulatory environment. See “Coronavirus May Increase Risk of Insider Trading” (Apr. 30, 2020); and “Advisers Must Have Strong Insider Trading Controls or Risk SEC Sanctions” (Apr. 2, 2020).

Addressing the Lack of Diversity in the Financial Services Sector

The Black Lives Matter movement has prompted a national discussion on racial equity that is reaching all areas of society and the economy. People of color have long been underrepresented in, and neglected by, the financial services industry. Women are also proportionately underrepresented in the sector in ownership and management positions, as well as rank-and-file employment. Few hedge fund managers currently have formal structures in place to correct underrepresentation, and research shows that organizations often perceive themselves as more diverse than they actually are. In conjunction with an open-minded work climate, however, diversity can lead to a number of benefits, including stronger performance; fewer errors; increased creativity and cooperation; and greater empathy. The first article in our four-part series discusses the lack of diversity within the financial services and alternative investment management industries and explains why fund managers should focus on increasing diversity. The second article analyzes diversity training; performance ratings and hiring tests; grievance procedures; and specific actions managers can take to promote diversity and inclusion. The third article explores implicit biases, their harms and whether they can be reduced in both the short and long term. The fourth article evaluates methods for constraining decision making and examines the role that legal and compliance leaders can take to promote diversity and reduce implicit biases. For more on diversity, see “How University Endowments Approach Diversity at Asset Managers and Racial Equity in Investments” (Nov. 12, 2020).

Hedge Funds As Shadow Banks and Direct Lenders

The coronavirus pandemic roiled the credit markets and placed unprecedented financial stresses on businesses, creating opportunities for fund managers to pursue private credit strategies and direct lending – something that many managers were already doing. In fact, direct lending strategies have been growing in popularity since the 2008 financial crisis. The 2008 crisis resulted in a tangle of regulations that forced banks to step back from providing credit to companies and individuals, among other historical business lines. Recognizing a market opportunity, other financial intermediaries – including hedge and private equity funds – stepped in to fill that void. As asset managers continuously search for yield, the investment strategy of direct lending has risen in popularity, with alternative lenders typically charging higher interest rates than traditional lenders. Engaging in those direct lending practices, however, can pose a number of challenges from a tax perspective, particularly for non‑U.S. investors, that affect hedge fund managers undertaking those efforts. Accordingly, a number of structures have been developed to permit non‑U.S. investors to participate in that investment strategy. The first article in our three-part series discusses the prevalence of hedge fund lending to U.S. companies and the primary tax considerations for hedge fund investors associated with direct lending. The second article explores structures available to hedge fund managers to mitigate the tax consequences of pursuing a direct lending strategy. The third article provides an overview of the regulatory environment surrounding direct lending and a discussion of the common terms applicable to direct lending funds. See “Key Compliance Issues Facing Credit Managers During the Pandemic” (Sep. 24, 2020); and our two-part series on direct lending funds: “Structural Approaches to Address Liquidity Considerations and Ensure Regulatory Compliance” (May 28, 2020); and “Five Structures to Mitigate Tax Burdens for Various Investor Types” (Jun. 4, 2020).

The SEC Weighs In on LIBOR Transition

The London Interbank Offered Rate (LIBOR) is scheduled to essentially cease to exist at the end of 2021, unless that date is extended. LIBOR has been a key benchmark interest rate for many years. It is cited in many settings throughout the financial services industry, including loans; derivatives; hedging; risk and performance benchmarks in client contracts; client reporting; marketing and disclosure documents; vendor contracts; and even certain SEC exemptive orders. Over the past few years, however, confidence in LIBOR has been shaken by a rate-fixing scandal and dwindling activity in the markets that feed the rate. Thus, in 2017, the U.K. Financial Conduct Authority decided that, as of the end of 2021, banks would no longer be required to submit the rate information on which LIBOR is based. Consequently, LIBOR eventually may no longer be published or may become unreliable and unusable as a benchmark rate. The end of LIBOR is likely to affect multiple areas of an investment adviser’s operations. Thus, the SEC published a Staff Statement on LIBOR Transition (Staff Statement), which contains useful indications of the regulator’s thinking about the LIBOR transition and also suggests concrete steps that market participants – including hedge funds – should take to address it. This guest article by Anne E. Beaumont, partner at Friedman Kaplan, discusses the key takeaways of the Staff Statement for private fund managers. See “Advisers Should Be Planning Now for the End of LIBOR” (Oct. 29, 2020); “What Private Fund Advisers Need to Know About Transitioning Away From LIBOR” (Aug. 13, 2020); and “Hedge Fund Managers Must Prepare for Benchmark Regulation” (Feb. 11, 2016).

Strategies and Tactics for Developing an Effective Tabletop Exercise

Cybersecurity has become a growing concern in the assessment management industry, with private funds being specifically targeted on a number of occasions. For example, an Australian hedge fund was forced to close after a cyber attack in September 2020 triggered by a fake Zoom invitation led to the mistaken approval of $8.7 million in fraudulent invoices. In addition, three British private equity firms were victims of an elaborate cyber attack that fraudulently induced them to wire $1.3 million, of which nearly $700,000 was never recouped. The recent rise of highly sophisticated cultural engineering attacks against fund managers has raised concerns in the industry – and prompted the SEC to issue a risk alert on the topic. A tabletop exercise can be used to test whether a response plan functions as desired and to identify gaps and other weaknesses in a firm’s cyber preparedness. The Hedge Fund Law Report and the Cybersecurity Law Report presented a seminar, entitled “Conducting an Effective Tabletop Exercise,” which delved into the appropriate development and conduct of tabletop exercises. The first article in our two-part series on the event addresses how fund managers can effectively develop tabletop exercises, including whether they should be conducted in-house or externally; who should participate; what role counsel should play; and how frequent and long they should be. The second article outlines ways advisers can successfully conduct tabletop exercises, including their content and scope; participant engagement; common errors; and follow-up. See “Six Ways For Fund Managers to Prepare for the SEC’s Focus on Cybersecurity and Resiliency” (Apr. 30, 2020); and our three-part series on how fund managers should structure their cybersecurity programs: “Background and Best Practices” (Mar. 22, 2018); “CISO Hiring, Governance Structures and the Role of the CCO” (Apr. 5, 2018); and “Stakeholder Communication, Outsourcing, Co-Sourcing and Managing Third Parties” (Apr. 12, 2018).