Hedge fund legal construct outlook

Hedge funds are a legal construct rather than an asset class now. Part of the construct involves investment agreements that are often absurdly on-sided. After last year’s lousy performance and record levels of hedge fund closures, and with the balance of supply and demand tilted in investors’ favor for the first time in years, even some star managers are now on the back foot. It’s time for investors to push for their rights.

Fees are central to this conflict. But the issue goes beyond that to more qualitative areas.

A fund’s outside investors are in fact usually more limited than general partners. A hedge fund manager can have dictatorial powers to change his investment style at will; to appoint the directors who nominally oversee his fund; to create unruly investments in “side-pockets” where they can be left indefinitely to mature or die and to decline investors’ redemption requests in full or part.

Blocking withdrawals has most annoyed investors lately. Many wanted to pull money out as the hellish 2008 ground to a close, because they either needed it elsewhere or wanted to stash it somewhere less risky. But plenty of managers blocked withdrawals, claiming this was best for their fund investors overall. Many investors instead saw at least some instances of this as the managers acting in their own interest.

Usually limited partners, i.e. investors have at least two options in response. One is to pull their cash, as soon as they are able. The other is to insist that new funds – and maybe even old ones – take a fresh approach to the relationship between fund managers and investors.

That’s not to say full-on democracy is the order of the day. Hedge funds are mostly still private partnerships involving wealthy and sophisticated investors, who hand over money because they trust specific fund managers’ judgment. But investors could, for example, insist on a vote on critical actions like gating. Or they might propose requirements for more obviously independent governing boards for funds.

The typical fund general partners might see such moves as too much of a change from standard operating procedure. But it would be harder to argue against it. If those changes started happening, though, it would be a signal that investors had taken the initiative and started to redesign the hedge fund legal construct to suit their interests better.