On January 21, 2010, President Barack Obama - along with former Federal Reserve chairman, Paul Volcker - called for new restrictions on the size and scope of banks and other financial institutions to rein in excessive risk taking and to protect taxpayers. Often referred to as the “Volcker Rule,” the proposed restrictions mandate that “no bank or financial institution that contains a bank own, invest in or sponsor a hedge fund or private equity fund.”
On March 3, 2010, the White House released its draft of the proposed legislative amendments to the Bank Holding Company Act of 1956 that would put the Volcker Rule into effect. Among other provisions, the amendments define a “hedge fund” and a “private equity fund” as a company or other entity exempt from registration as an investment company under Sections 3(c)(1) or 3(c)(7) of the U.S. Investment Company Act of 1940 (the “Investment Company Act”) - the most common regulatory exemptions utilized by sponsors in the private investment fund industry. Further, the amendments define “sponsoring” any such fund as: (i) serving as a general partner, managing member, or trustee of a fund; (ii) in any manner selecting or controlling (or having employees, officers or directors, or agents who constitute) a majority of the directors, trustees or management of a fund; or (iii) sharing with a fund, for corporate, marketing, promotional or other purposes, the same name or a variation of the same name. Related Volcker Rule-style proposals have taken the rule one step further, by barring the retention of any equity, partnership or other ownership interest, or investment, in a hedge fund or private equity fund.1
Critics have attacked the Volcker Rule and these proposed legislative amendments for focusing unnecessarily on a business arena that had little to do with the current financial crisis, the genesis of which, they argue, was excessive exposure to real estate credit risk. According to the private equity research firm Preqin, U.S. bank-sponsored funds raised a total of $80 billion in private equity capital commitments since 2006 - representing only 1% of the aggregate assets sitting on the balance sheets of Goldman Sachs, JPMorgan Chase, Citigroup, Morgan Stanley and Bank of America. Some commentators have also attacked the Volcker Rule for its intrusiveness, assuming that its adoption would require banks to divest themselves of hedge fund and private equity fund businesses in fire sales resulting in losses of value as banks are forced to sell divisions to buyers armed with significant tactical leverage. The prospect of such forced divestitures is all the more unappealing in an economic climate that is unlikely to support favorable valuations, and in light of the “fire sale” experience of many major financial institutions in 2008 after the implementation of FAS 157.
In his written testimony before the Senate Committee on Banking, Housing and Urban Affairs on February 2, 2010, Mr. Volcker argued that “hedge funds, private equity funds . . . unrelated to customer needs and continuing banking relationships should stand on their own.” Based on such statements and the overarching requirement set forth in the proposed amendments that “appropriate Federal banking agencies shall jointly prohibit sponsoring or investment in hedge funds and private equity funds” by insured depository institutions, entities that control them or bank holding companies, the practical implications of the Volcker Rule, if enacted as law in its current form, are that banks that sponsor hedge fund or private equity fund businesses may need to sell them.
New Motivations for Old Transactions
Although acquisitions and divestitures of investment managers have become standard fare in the world of traditional money management, until recently, they were less common in the human-capital intensive and highly profitable, but volatile, world of alternative asset managers. From 2000 to early 2008, a number of high-profile sales of significant stakes in both hedge fund and private equity fund firms were completed, through private sales, quasi-public and public offerings, and combinations thereof. Prime examples of private sales of minority stakes include Morgan Stanley’s acquisition of a minority stake in Avenue Capital Group in October of 2006, Lehman Brother’s acquisition of a minority stake in the D.E. Shaw Group in March of 2007, Affiliated Managers Group’s acquisition of minority stakes in Blue Mountain Capital Management and ValueAct Capital in the fourth quarter of 2007, and The Carlyle Group’s sale of a 7.5% stake to the Mubadala Development Company, an affiliate of the Government of Abu Dhabi, in December of 2007.2
Additionally, there are examples of private minority sales that served as value-setting precursors to quasi-public and public offerings. Such sales include Fortress Investment Group’s sale of a 15% stake to Nomura Holdings in December of 2006 (two months before listing its shares on the New York Stock Exchange (the “NYSE”)), The Blackstone Group’s sale of a 10% stake to the China Investment Company in May of 2007 (one month before listing its partnership units on the NYSE), Apollo Global Management’s sale of a 20% stake to the Abu Dhabi Investment Authority and CalPERS in July of 2007 (one month before listing its units on the Goldman Sachs Rule 144A “GSTrUE” platform) and Och-Ziff ’s sale of a 10% stake to Dubai International in October of 2007 (one month before listing its shares on the NYSE). These examples and the others that accompanied them over the last decade marked a significant shift in the development of the once secretive private investment fund industry.
Prior to the financial crisis, seller motivations included personal diversification of founder wealth, employee incentivization, access to greater distribution and other strategic resources, and establishing a stronger acquisition currency. Buyers were often motivated by the search for diversification of their revenue base and access to additional asset management products. With the onset of the financial crisis, however, the sell-side motivations shifted dramatically. The motivations included changes, sometimes fundamental, in fund strategy, the need to dispose balance sheets of non-core or even “toxic” assets and, of course, the financial distress or bankruptcy of the fund sponsor itself. Unlike their predecessors, these transactions were less about liquidity or expansion than they were about exits.3
Banks or similar financial institutions that actively own, operate or sponsor hedge fund or private equity fund businesses, then, have a wide array of precedent transactions to turn to when trying to anticipate what strategic, commercial and legal issues a sale or other divestiture of those businesses might involve. The principal question that looms, however, is what challenges are likely to be most prevalent when those sales or other divestitures are motivated - indeed, compelled - by law. It is unlikely that such challenges will be different from those that beset transactions that occurred at the height of the financial crisis, but three challenges are likely to require the most attention.
The first challenge is determining the desired structure of the divestiture itself - what exactly is going to be sold, to whom and how? The second challenge is determining how to address the needs and concerns of the existing third-party investor base - what concerns will they have, and, ultimately, what obstacles will they, or could they, pose? The third challenge is determining the needs and concerns of the investment professionals that represent the core asset housed within the alternative asset manager - how does one retain them, or what role are they, or can they be, expected to play? We examine each of these challenges below.
To the extent that the proposed legislative amendments that attempt to codify the Volcker Rule seek to prohibit banks or their affiliates from “sponsoring” hedge funds or private equity funds - that is, from assuming a position of control over any such funds - then the path to an exit from these activities is likely to take one of the following three forms. The first form is a relatively straightforward sale of 100% of the bank’s interest in the fund and its related alternative asset manager to an unaffiliated third party. Under this form, the buyer ends up owning 100% or a majority of the interests of the manager, and the investment professionals behind the fund’s performance end up with employment contracts and/or economic incentives in the form of minority equity stakes in the manager, the buyer or one of their affiliates.
The second form of exit is the “sponsored” spin-off or spin-out - a transaction that results in the buyer acquiring a minority interest in the divested manager, with the investment professionals taking the majority. In this scenario, the buyer provides the necessary cash and liquidity to facilitate the transaction, but otherwise “invests” in the management team and plays a supporting role, perhaps in the capacity of a key investor, a service provider or some other source of strategic resources once offered by the existing sponsor. The third form is a variant of the second, but does not involve a third party financing source. Instead, the spin-off occurs to the investment professionals themselves, with the original sponsor retaining a minority interest going forward.
Given the choice, it is safe to assume that banks - forced to sell their hedge fund and private equity fund businesses - are likely to prefer the first and second options laid out above, rather than the third. Both options are more likely to maximize their cash return in the sale and are less likely to open a floodgate for other management teams seeking to acquire a majority of the businesses that they manage. Nevertheless, particularly in the context of a compelled sale, the reality is that bank sellers may have to settle for the third option if neither the first nor second are readily practicable. The only buffer against this risk are the versions of the Volcker Rule that seek to prohibit banks from retaining any equity, partnership or other ownership interest, or maintaining an investment in, a hedge fund or private equity fund. In other words, if banks are truly required to exit from the hedge fund or private equity fund businesses entirely, then retaining an interest itself may not be a viable alternative.
In any event, understanding the impact of the Volcker Rule is to recognize that its mandate will limit the transactional options that banks will have in any effort undertaken in the pursuit of compliance. Although those limitations may, in some instances, obviate certain options that may be less favorable overall, those limitations are also likely to force banks to contend - perhaps more directly - with the investor challenges and management challenges discussed further below.
Investors usually place their money in the hands of alternative asset managers based on the track record and performance history of the professionals that manage the assets and, often, the deal flow and other resources of the sponsoring firm. In the face of a sale that could result in a change of the managerial guard or in the separation of the team from its sponsoring institution, investors are likely to be concerned with the future identity, stability and reliability of the fund itself. In other words, with a change in the fund sponsor and potentially its management base, where will future business opportunities, deal flow and resources come from, and can the new sponsor or managers deliver on the promise of their predecessors?
Although a concerned client base is usually reason enough for a sponsor to understand the challenge investors might pose in the context of a compelled hedge or private equity fund sale, the crux of that challenge is more specifically a function of the legal leverage investors are often afforded in the language of the organizational documents (usually limited partnership agreements) that govern most funds or under the U.S. Investment Advisers Act of 1940 (the “Advisers Act”). More often than not, these organizational documents mandate investor approval or may require significant amendments in order to accommodate common sale transaction structures. For instance, a change of control of a general partner or investment advisor, a transfer of a general partner interest, a substitution of one general partner for another or the waiver of the contractual commitment of the incumbent general partner to fund capital along with other investors, may require, whether by express contractual provision or by operation of applicable law, some percentage of the investors to agree (or at least not object).
The effort to marshal that agreement, which is usually sought in the form of investor waivers or consents, can be complicated by key investors who enjoy the benefit of special arrangements, memorialized in the form of so-called “side letters,” or fund structures that have investors sprinkled across multiple parallel funds or separately managed accounts, each of which contain their own unique negotiated arrangements and challenges. All of this assumes that the sponsor is able to determine from whom and under what circumstances such agreement is required under applicable law. The most common challenge is the deemed assignment provision of the Advisers Act - the provision that treats certain managerial changes of control as investment advisory agreement “assignments” for purposes of the Advisers Act requiring “client” consent. Divestitures also often raise difficult questions under Delaware limited partnership laws, many of which have yet to be tested in the courts. With this complex array of questions and potential pitfalls, it is no wonder that investors want, and usually feel that they can ask for, something in exchange for their agreement - whether it is an economic concession or otherwise.
In the hedge fund context, some investors, especially those with pressing liquidity needs of their own, may be willing to furnish a waiver or provide their consent in exchange for the ability to withdraw their capital, whether partially or completely, notwithstanding previously agreed-upon “lock-up” arrangements or suspensions of redemption rights that are in effect. Similarly, private equity fund investors might offer their waivers or consents in exchange for reductions in their unfunded commitments. The other economic concession sometimes sought by investors is a straight reduction in the management fees and incentive allocations - the so-called “carried interest” - that sponsors of such funds charge for their services. In any event, in the absence of an otherwise clear path to consummating a divestiture without investor support, banks faced with divesting themselves of hedge fund or private equity sponsorship are likely to have difficult economic negotiations ahead of them.
One route sponsors can take to manage and navigate through those challenges is seeking the views of the fund’s advisory board - usually comprised of representatives of the fund’s most significant investors. The advisory board is often consulted by a fund’s general partner when the fund desires to take a course of action that deviates from what is permissible under the terms of the fund’s organizational documents. New investment programs not originally contemplated, making investments that otherwise violate predetermined investment limitations and a whole host of other significant actions often require the approval, binding or otherwise, of the advisory board. However, apart from their potential contractual dimensions, the practical reality is that the advisory board represents yet another seat at the negotiating table. Furthermore, advisory boards generally do not show up at the table alone. In some recent sale transactions, they have retained counsel, engaged financial advisers and were generally prepared to make their voices heard, though they often avoided making a formal decision either way. The advisory board thus represents an important conduit through which incoming general partners and sponsors may be able to gauge what the investor base is likely to expect or requires in exchange for its blessing.
But getting the advisory board on board with a transaction sometimes only gets the transaction part of the way there. Sale transactions, especially those transacted under the type of duress one might expect when they are compelled by force of law in times of financial distress, are likely to elevate and provide a forum for underlying differences amongst the investors themselves. Large, cash-strapped institutional investors, for example, are more likely to seek economic concessions, such as withdrawal rights or reductions in unfunded commitments. Other investors, however, may prefer to protect the value of their investment portfolios, including those held through their hedge fund or private equity fund investments, in which case they are more likely to support the management team and sponsor going forward. The goals of institutional investors seeking liquidity and those investors seeking to protect their portfolios can be diametrically opposed. Of course, even investors seeking to protect their portfolios may be keen to benefit from fee and other concessions negotiated by the more distressed investors - getting opportunistic benefits in the process.
Then there are a host of other investor types in between whose unique needs and interests could serve to complicate or otherwise prevent any divestiture from resulting in what might otherwise be a “clean” break. For example, though they are generally less significant by dollar size, disgruntled retail investors can attempt to rebalance their relative importance through the threat or commencement of litigation against outgoing sponsors, even where the management team in question will continue to manage the fund post-closing. Recent lawsuits have charged, for example, that a sale, even if permissible under the letter of the fund’s organizational documents, represents a fundamental alteration to the security that was marketed to the investor at the time the fund was formed. Another distinct investor group can include employee security funds - vehicles capitalized with sponsor-employee money from hundreds or even thousands of sponsor employees that invest in parallel with other sponsored funds but that are generally prohibited from being shifted as part of a sale transaction. These funds receive specific U.S. Securities and Exchange Commission (“SEC”) orders enabling them to be exempt from the registration requirements of the Investment Company Act. Thus, a sale transaction that purports to sever its ownership from the bank sponsor whose employees’ money was used to fund the security fund when it was established in the first place is simply a non-starter. Employee security funds are invariably left behind, but enter into sub-advisory arrangements with the incoming adviser.
Apart from the government, investors are the most important external constituency that a bank or similar financial institutional will likely face in the context of a compelled hedge fund or private equity fund sale transaction. The most important internal constituency, however, are the investment professionals who are actually behind the fund’s performance. It is for this reason that a sale or other divestiture of one type or another, compelled by law or otherwise, is typically only feasible if key elements of the management team remain in place and support the transaction. That is, since the value of the business itself is inextricably linked to the people that operate it, a divestiture of an alternative asset manager that does not include those people is likely to be highly value-destructive (if achievable at all).
For this reason, the investment professionals themselves can take on a number of roles in these transactions - whether as the prospective buyer or as yet another constituency whose professional, as well as economic, “happiness” is among the primary considerations both former and future sponsors must address to get the transaction to the finish line. Divestitures create periods of significant uncertainty and instability, and a group of managers concerned about their futures might be well positioned (or well advised) to seek opportunities elsewhere. In grappling with the ever present retention issue, tough questions will abound. What will be the role of management going forward from a decision-making and culture perspective? What tools will be used to encourage management to stay? Will management be offered an equity interest, presumably subject to retention tools such as vesting and forfeiture? How will that equity interest compare, if at all, to their existing compensation and economic incentives? How will the separation of outgoing management be handled vis-à-vis their prior fund sponsors? How does one address the needs of the employees or other professionals of the sponsor whose knowledge is critical to facilitating the sale, but whose future in the business following the sale is less clear? The views of management on these issues can be critical, as a lack of perceived strategic or cultural fit can stop a transaction before it starts. The multiple variations of these questions are often at the heart of what makes all sale transactions, let alone those compelled by law, so challenging.
Attention must also be paid to the potential for inter-managerial conflicts. Hedge fund and private equity fund management groups are rarely homogeneous. There can be generational issues between individuals or groups within management assigned to different asset classes, investment strategies and geographic locations. Such differences can result in sale transactions that produce not one, but perhaps multiple resulting operations, with disparate management teams each going their different ways and each representing a management constituency whose needs may need to be addressed in the context of all of the other transactions. Each group may hold a valid claim to the existing fund’s track record and historical performance, or at least a piece of it, and tough negotiations are likely to result as different management groups fight for their right to use or claim ownership of that important marketing device. Like the opportunistic buyer who uses the leverage of a compelled sale to its advantage when negotiating the terms of the transaction, disparate or conflicting groups within management may well seek to do likewise.
The foregoing description of the challenges likely to be faced by financial institutions sponsoring alternative asset managers in a post-Volcker Rule world is an attempt to inform the reader of the most significant commercial and legal issues that are most likely to be encountered. This description, however, is not intended to be exhaustive. Other challenges that will undoubtedly characterize these transactions include valuation challenges. How does one value the stable management fees versus the relatively volatile performance or incentive fees fund sponsors and advisers earn in the context of a compelled sale? How should the incentive fees be valued when there is uncertainty as to the underlying portfolio? Then, there are structural issues - not all hedge fund or private equity fund transactions must be consummated through a sale or transfer of the ownership stakes in the general partner or adviser. They may, for instance, be accomplished through asset sales or some other combination of transaction steps. With such variations, it is difficult to draw general conclusions of what can be expected or anticipated, and it is important to seek experienced advisers at an early stage.
Nevertheless, if there is anything that can be said with certainty, it is that engaging in a divestiture compelled by law will likely amplify the issues that sellers of alternative asset managers have faced throughout the last decade in the context of similar transactions. Accordingly, participants in these transactions are more likely to achieve the most favorable result for their stakeholders by arming themselves with the knowledge of the suite of options, tools and other methods employed in the past to address similar transactions completed under a wide range of circumstances. Such participants would also be well served by maintaining their vigilance in the face of the challenges described above - challenges that will have a fundamental impact on their ability to maximize value in the face of an ever-changing regulatory landscape.