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Marketing and Hedge Fund Regulations in the United States
Marketing Hedge Funds
Marketing is one of the most important functions of a hedge fund manager. Effective marketing increases the size of the assets under management, which leads to higher fees. Especially for a new fund, the world does not beat a path to the door of a new hedge fund, regardless of the freshness of the investment plan. For certain funds, past performance simplifies the marketing efforts, but the typical hedge fund needs to tell a story about its performance, good and bad.
WHAT IS HEDGE FUND MARKETING ?
Marketing is a well-developed discipline. Many consumer goods manufacturers spend considerable effort and expense in marketing their products. Surprisingly, most of the same marketing concepts that are used to analyze beer sales, paper goods, and cosmetics apply to hedge fund marketing. However, very few hedge fund managers start by identifying a need or want and design a product to satisfy that want. Instead, they begin with a particular investment expertise, develop a product, and then set out the sell what they have created. What the manager sells differs from fund to fund. Most managers sell performance. Some managers emphasize the investment process. A small number of fund managers can market the credentials of certain key employees. Many hedge funds market the uniqueness of their investment products.
Types of Hedge Fund Customers
Any attempt to develop a comprehensive marketing plan for a hedge fund must begin from an understanding of the types of hedge fund customers and the needs and wants of each particular group. The major groups of hedge fund investors are described in Chapter 3.
Marketing and Hedge Fund Regulations in the United States
This summarizes the regulations affecting hedge funds and hedge fund investors. To maintain an exemption from registration requirements under the Securities Act of 1933 and the Investment Company Act of 1940, hedge funds may not make general solicitations to sell their investments and may not advertise. This chapter discusses how hedge funds may market within the restrictions imposed on them.
In general, potential investors must approach hedge fund managers about making an investment. The manager may contact potential investors if they have already established a substantial relationship. Hedge funds turn to institutions that have preexisting relationships to introduce potential investors to the hedge fund: independent marketers, prime brokers, fund of funds managers, and high-net-worth divisions of stock brokerage firms.
Many contacts with potential customers that are permitted of a registered company may be prohibited from a hedge fund that relies on exemption from registration. For example, a news release, interview or speech at a conference might be considered a prohibited solicitation or advertisement if the speaker/writer works for an unregistered hedge fund and mentions the fund. Many hedge fund operators restrict web site pages to registered users that could legally invest in the funds.
It is important to emphasize that the restrictions apply to U.S. managers and arent typical of many other parts of the world. In Canada, where regulation occurs at the province, not the national government, level, advertising is permitted in some provinces and restricted in other areas. In some European markets, it is typical to register the hedge fund shares on a stock exchange, although purchases and sales typically occur away from the trading floor.
Marketing by Providing Services
One way to attract potential hedge fund customers without violating the restrictions on solicitation is to provide hedge-fund-related services to attract potential customers. Some organizations collect and publish performance data. Generally, these organizations dont provide the performance of individual funds. Instead, they publish composite performance, including benchmarks for specific hedge fund strategies. Some hedge fund marketers maintain collections of articles and research papers of interest to hedge fund investors. In the past, hedge fund organizations have distributed due diligence research to facilitate their marketing efforts. In fact, many hedge fund investors seek out fund of funds managers to benefit from the due diligence and portfolio management services these organizations provide.
Hedge Fund Marketing Plan
A hedge fund should have a marketing plan. A marketing plan lays out the key marketing strategies and objectives of the manager. The plan should describe the product positioning of the fund (how the fund compares with other hedge funds and other investment products). The plan should include an analysis of the market for this particular fund, including a measure of the size of the market, growth experience, and expectations for future growth. Several organizations have begun collecting industry data, which is invaluable in developing a marketing plan.
The marketing plan must address the most important marketing challenge for a hedge fundidentifying and marketing to prospective investors. Because of the restrictions on solicitation for U.S. hedge funds, several types of organizations are vital to hedge fund marketing, especially to new or young funds.
MARKETING BUSINESS PARTNERS
Private placement rules place restrictions on the hedge fund that make it difficult to prospect for customers. Several types of marketing services have developed to supplement the efforts of internal marketing staffs.
Third -Party Marketers
Often, a new hedge fund manager has considerable investment expertise and little marketing experience or few contacts. These hedge funds may turn to third-party or independent marketing organizations. A third-party marketer must register with the National Association of Securities Dealers (NASD) as a broker-dealer in the United States because the organization is offering securities to customers (even though the securities are usually unregistered securities). These third-party marketers have already made contact with potential investors and have substantial relationships with these investors. The thirdparty marketers introduce these potential investors to hedge fund managers and receive compensation if the investors place funds with the manager.
Generally, the third-party marketer operates on the basis of exclusive relationships. The third-party marketer will agree to market no other hedge funds following the same strategy. The hedge fund manager agrees to work with no other third-party marketer. Sometimes, the manager will use a particular marketer exclusively in a single geographical area, so that the fund may work with one marketer in Europe and a second marketer in Japan.
The marketing organization may be paid a retainer to cover out-ofpocket expenses. The marketer will collect a portion of the fees the manager charges the hedge fund. Marketers typically collect 20 percent of fees, although the manager and the third-party marketer may work out a particular agreement to suit their needs. For example, the manager may put a limit on the number of years the marketer will participate in fees or participation rates may trail off over time. The manager may also create carveouts, whereby the marketing group will not get paid fees from a designated group of investors (preexisting investors and other investors specifically exempted from the agreement).
Advantages of Third -Party Marketers Third-party marketers can be very helpful to a hedge fund manager. Many hedge funds, especially young funds, do not have the marketing resources to promote the fund themselves. Third-party marketers can be particularly helpful in marketing the hedge fund to international investors. Third-party marketers can pressure a fund to adhere to a stated strategy and can help the manager design an investment plan that has maximum marketing appeal. The marketer should conduct thorough due diligence of the manager, which can help an unknown fund gain credibility.
Disadvantages of Third -Party Marketers The fees charged by third-party markets may seem high to hedge fund managers, even though the fees are paid out of incremental revenues. The efforts of an independent marketer may be unnecessary for a fund that has an attractive performance history. Also, if the manager has already identified many potential investors or if the reputation of the manager is sufficient to attract potential investors, it may prefer to market the fund in-house (discussed later) and avoid sharing fees with a third-party marketer.
Picking a Third -Party Marketer Just as an independent marketer should perform due diligence on the hedge funds it markets, the hedge fund manager should also research the marketer. There are wide differences in the experience and abilities of third-party marketers. The fund manager should inquire to make sure a third-party marketer has no conflicts of interest that could affect the marketers effectiveness. Finally, there can be considerable difference in fees and the hedge fund manager must decide how these fees correspond with marketing performance. Although many third-party marketers will merely introduce potential investors to a fund manager, other marketers will make significant efforts to motivate a potential investor to put funds in a recommended fund and to keep in touch with the investor and maintain a marketing relationship with the investor.
Using Traditional Brokers to Market Hedge Funds
Most brokerage houses have a group of brokers who concentrate on particularly high-net-worth clients. These brokers have substantial relationships with clients and can market hedge funds without violating U.S. restrictions on general solicitations and general advertising.
Brokers may market a small number of hedge funds to their high-networth clients. The list of funds may include funds run internally by another part of the brokerage firm. The brokerage firm may agree to market certain independent hedge funds, much like the third-party marketer already discussed. However, these brokers are more likely than a third-party marketer to have completed due diligence research on the funds they market. The broker will usually make a limited recommendation, by suggesting that the investors should investigate a particular hedge fund but also suggesting that the investors must make their own investment decisions on the basis of their own due diligence and the advice of the investors own lawyers and accountants.
Prime Brokers and Capital Introductions
Prime brokers began by offering safekeeping and securities lending services to hedge funds. Prime brokers now offer services from all parts of the bank or brokerage firm. Prime brokers have created accounting and risk measurement reports to assist the managers. To compete for business, prime brokers have begun to make capital introductions.
Capital introductions are not full-fledged marketing efforts. Instead, the prime brokers usually sponsor meetings and seminars where potential investors can meet the hedge fund managers who are customers of the prime broker. This limited introduction does serve to inform investors about some of the hedge fund choices they have. Most important, the introductions allow the hedge fund manager to approach interested potential investors without violating U.S. solicitation rules.
Funds of Funds as Marketing Organizations
Fund of funds managers are generally more effective at marketing than are individual hedge funds. By accepting investments from a fund of funds manager, the hedge fund manager is allowing the fund of funds manager to market the hedge fund to investors. Of course, the fund of funds manager may not even disclose the names of the hedge funds it carries, but it is all the same motivating funds from particular investors into particular hedge funds.
Sometimes, a fund of funds manager can develop a relationship with a hedge fund that closely links the fund of funds to individual hedge fund. Many hedge funds grant rights to early fund of funds investors. Some fund of funds investors may have the right to invest in a particular hedge fund, even if the hedge fund is closed to all other new investments. In this case, the fund of funds may market its product as a way to get access to a particular hedge fund.
IN -HOUSE MARKETING
A hedge fund may develop a staff to market directly to existing and potential investors. Hedge funds with established track records may be able to get marketing leads based on word-of-mouth contact with potential investors or from press accounts. These funds save all the fees that would otherwise be paid to third-party marketers or brokers. By keeping control of the marketing, a hedge fund can better determine how the fund is marketed and assure that marketers fairly describe the characteristics of this investment.
In most cases, a hedge fund must register as a broker-dealer if it markets its securities to investors. Securities laws provide an exemption for funds that have employees incidentally involved in marketing as part of a customer relations job or other staff function. To avoid the requirement to register as a broker-dealer, these employees may not be compensated on the basis of their success in marketing. However, even customer relations may create a need for the fund to register if the manager runs several funds.
The Securities and Exchange Commission (SEC) has not been watching for cases of hedge funds that fail to register as broker-dealers. It is possible that the SEC or other enforcement agency will begin to challenge hedge funds to register. It is also likely that disgruntled investors may sue a hedge fund manager to recover losses. The investor may claim that the hedge fund should have been registered as a dealer and violated securities laws in marketing its own shares to the investor. The success of the lawsuit will depend on the facts but funds can reduce this litigation risk by registering as a broker-dealer and requiring marketing and customer relations staff to pass the Series 7 and possibly the Series 3 exams.
OTHER MARKETING ISSUES
Hedge fund management companies face other marketing issues beyond making contact with investors. The most effective hedge funds combine asset management with a successful marketing strategy.
Attracting Seed Capital
In the venture capital industry, the early investments are called seed capital. Often, the investors that provide seed capital are called angel investors, presumably because these investors extract less onerous terms for this early investment than would be expected from an arms-length investor. A hedge fund also may get seed investments from the manager who creates both the management company and the fund. Sometimes an early investor (often a fund of funds) will make a substantial investment in return for a waiver of fees, preference in making additional investments, or ownership of part of the management company.
The manager must weigh the cost of this seed capital (fee sharing, etc.) against the benefits of an early substantial investment. The seed capital may be necessary to commence operation if a minimum amount of capital is necessary to implement a strategy or get credit lines with trading counterparties. The seed may motivate other investors to commit funds based on the leadership of the early investors. Other investors may refuse to invest more than 10 percent of any fund, so it may be necessary to get to some minimum size to receive consideration.
Early investors have much to gain and lose from an early investment. Early investments in new business ventures are more likely to be unprofitable than investments at a later stage. For hedge funds, this may also be true because the investment strategy is untested. Also, the new fund may not have accounting systems, risk control, depth of management, and other necessities and may not be able to put everything in place quickly enough to succeed. However, early investors often earn high returns, based on evidence that returns on young funds exceed the returns on established hedge funds. Some funds of funds invest in young hedge funds as their investment strategy.
Hedge fund managers can turn to family and friends for seed capital. Often, managers who leave a broker-dealer, mutual fund, or another hedge fund can approach former work partners for early funding. Individuals who managed money for clients in a mutual fund, investment counselor, or trust department may be able to approach investors to move some capital to a new hedge fund if business conditions and employment provisions permit.
Pricing and Terms
The pricing and key terms offered to investors affect the marketing of a hedge fund to potential investors. The traditional marketing literature recognizes pricing as a key marketing variable. Hedge funds must also realize that setting incentive and management fees above prevailing levels will interfere with the growth in assets through marketing. Other provisions, such as lockup periods, hurdle rates, high-water marks, and clawback provisions, affect the desirability of a fund investment. Managers with excellent past performance may demand more restrictive terms, but even successful managers should decide how important these provisions are compared to more assets to manage. Large, successful funds that have little capacity to grow may prefer terms that make their assets more sticky (sticky money describes investments that tend to stay with the manager longer and despite poor performance).
Large investors may demand more favorable terms. Despite fee schedules listed in a private placement memorandum, investors that can place large investments with a particular hedge fund may be able to negotiate lower fees, shorter lockup periods, or other improved terms. Some large investors have been able to negotiate a waiver of all management fees and incentive fees of 10 percent. Many large investors demand complete transparency. Some investors receive daily detailed position information and can perform daily risk analysis of positions both within the hedge fund and aggregating the hedge fund positions with other assets in the larger portfolio.
Effective Marketing Presentations
The marketing presentation should be clear, but it need not be simple. Hedge fund investors are some of the most sophisticated investors and expect to see thoughtful, analytically sound analysis of the proposed investment.
Marketing presentations are much more effective if they include past performance. For many hedge funds, little past performance exists. Funds can use performance from previous employers if the hedge fund manager was responsible for the performance at the earlier entity and the hedge fund investments are similar to the earlier investments. Past performance is more convincing if it is audited. A hedge fund should seek permission to use past performance from another entity in its marketing material.
QUESTIONS AND PROBLEMS
12.1 The head trader of a XYZ Hedge Fund speaks at a conference and
describes the investment characteristics of convertible bond hedge funds without disclosing that XYZ Hedge Fund is a prominent convertible bond hedge fund. After the speech, someone from the audience approaches the speaker and ultimately makes an investment in XYZ Hedge Fund. Has XYZ violated U.S. securities laws prohibiting general solicitation?
.2 Suppose in question 12.1 the speaker is the director of marketing
who gets paid based on the amount of new money raised for the fund and the hedge fund is registered as a broker-dealer. Has XYZ violated U.S. securities laws prohibiting general solicitation?
12.3 Suppose in question 12.1 the speaker is a third-party marketer who uses XYZ performance to demonstrate the desirability of the convertible bond strategy. Has XYZ violated U.S. securities laws prohibiting general solicitation?
12.4 An investor is interested in investing in a long/short equity fund and compiles a list of two dozen candidate funds. She writes to all 24 and inquires about performance and fees. Is she violating securities laws in making a mass mailing? Can the hedge funds legally reply to the request for information?
12.5 You are a potential hedge fund investor and have been talking with an investment professional about Acme Limited Partners, a global macro hedge fund. You learn that your contact does not work for Acme and, in fact, markets several different hedge funds. Should you refuse to invest in Acme because the combined fees will be too high?
12.6Why do securities laws prevent a hedge fund from advertising?12.7A fund with $5 million under management contracts with a third-
party marketer to raise additional funds. The agreement calls for the marketer to receive 20 percent of all incentive and management fees collected by the management company for three years. The fund raises an additional $10 million and in the next year earns a 10 percent return before management and incentive fees of 1 and 20. How much does the marketer collect? To simplify the calculations, assume that the management fee is charged at the end of the year, so the entire $15 million earns the return.
.8 How much of the fee paid to the marketer in question 12.7 represents fees on money not raised by the third-party marketer? 12.9 A hedge funds prime broker introduces a potential investor to the fund in question 12.7. The investor places $1 million in the hedge fund. How much fee income does the prime broker collect if the gross return is 12 percent the next year?
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