Editor: You have been selected to head a multi-practice team appointed by the New York State Comptroller Thomas D. DiNapoli to assist the $122 billion New York State Common Retirement Fund (CRF) with a broad mandate, including reviewing all investments related to the "Pay to Play" scandal; conducting due diligence on fund managers; determining CRF's contract rights and effectuating the exercise of those rights with respect to investments; advising on SEC issues; developing and implementing negotiations and litigation strategies where appropriate. Why do you think Day Pitney was chosen for this vital and critical task?
Wooden: In my opinion, the decision was based on our experience in representing public pension funds in particular as well as investors generally in connection with a wide variety of matters. Some of our public pension fund clients include the Treasurer of the State of Connecticut and the State of New Jersey Division of Investment. Our experience both from a pure investment perspective - understanding how private equity investments, hedge fund investments and other types of investments work and are structured - as well as having experience on the litigation and investigation side all came together to make us a good choice for this type of engagement.
Editor: What practice groups have been chosen to form part of the multi-practice team?
Wooden: The bulk of the team consists of lawyers from Day Pitney's Private Equity and Investment Funds practice group, the Shareholder and Securities Litigation practice group, and the White Collar Defense and Internal Investigations practice group.We also have lawyers with a focus on investment adviser compliance and fiduciary matters.
Editor: Is this just the beginning of this investigation?
Wooden: The New York State Common Retirement Fund has been focused on this investigation for some time now.However, there are a significant number of investment managers and placement agents referenced in the New York Attorney General's recent indictment, which is more than 100 pages in length.And, the criminal investigation is ongoing. Given this and the Common Retirement Fund's desire to be very diligent in protecting the assets of its beneficiaries, I would say that our investigation is still in the early stages.
Editor: You have had experience in assisting individual insurance companies in reviewing their investments with hedge funds and fund of fund vehicles. What procedures did you follow in helping these clients analyze whether these investments were appropriate from a legal stand point?
Wooden: The first step is understanding the regulatory requirements of insurance companies and the corresponding investment parameters.And, with respect to a particular investment, we make sure that we understand the character of the insurance company's assets that are being invested. Based upon that knowledge, we will then conduct a thorough legal due diligence that encompasses the investment fund documents, including opinions and side letter agreements. Based upon this review, we negotiate modifications to investment terms or special rights that are important to our client.One of the benefitsof reviewing a wide variety of investments for a number of institutional investors is that it provides our investment lawyers with a good overview of current market terms. Therefore, in addition to the pure legal analysis, we are able to provide our clients with insight on whether the terms of a particular investment is consistent with those in the market generally.
Editor: The Asset Manager's Committee (AMC) of the President's Working Group has developed certain best practice recommendations on how to build strong infrastructures and risk management practices and controls for non public investments, such as private equity and hedge funds. Do they differ substantially from those applied to publicly traded mutual funds?
Wooden: Because mutual fund investors are not required to be very sophisticated in investment matters and do not necessarily have the size in the marketplace to negotiate special terms or protections, the regulation of mutual funds has been more rigorous than the regulation of the private equity or hedge fund markets whose investors are required to be more sophisticated. The AMC focused on 5 key areas for best practices: disclosure, valuation, risk management, trading and business operations and compliance.The recommendations on disclosure for private investments utilized key elements of the public company disclosure regime.There is also an emphasis on increasingly stronger controls on risk management and the measuring of risk for private investment funds.The level of risk associated with these types of investment funds is materially different from mutual funds.So, this is a best practice area where there is a difference from what is necessary for mutual funds.Therefore, some of the recommendations differ substantially because of the unique aspects of the private equity and hedge fund markets while other recommendations are just moving closer to what we already see in the mutual fund context.
Editor: Why is frequency of reporting to investors by fund managers such an important factor in maintaining investor confidence?
Wooden: Frequency is important because investors want timely information to enable the investor to respond to market conditions fast enough to make a difference. In the public equities market an investor can get stock valuations almost instantaneously. Investors in private equity and hedge funds don't have that level of transparency. The time between market activity and knowledge of any change in conditions affecting an investment may be too delayed to provide investors with an adequate opportunity to protect themselves from losses. Reduced transparency has a more significant adverse impact in the hedge fund context, less so in the case of private equity. Private equity investors understand that their capital is locked up in these vehicles for up to 10 to 12 years.So, although the information is still important from a fiduciary perspective, having that information does not prove to be as helpful to them as it would be to hedge fund investors who, depending on the term of the lock-ups, have the ability to exit a hedge fund more quickly.
Editor: As an advisor to both public and non-public funds, what elements should be considered in describing a fund's risk-profile?
Wooden: One should examine the nature of the investments and the corresponding risks that accompany those investments. There are inherent risks associated with each investment style and strategy. If a fund's activities are substantially taking place in foreign jurisdictions, there are standard risks inherent in those types of transactions, which could include currency risk. Understanding portfolio concentration in given industries is another feature of a risk-profile. Another area that we focus on is key persons and succession planning - who is responsible for generating the prior returns and who is the investor relying on to generate future returns.I always ask our clients a question: if this person disappeared the day after closing, how comfortable would you feel about having your money with that manager?Liquidity is another area of focus - how liquid is the underlying investment portfolio and how flexible is the investment vehicle in permitting an investor to exit.Leverage and conflicts of interest are also key issue risk profile considerations.
Operational risk is an area that a lot of managers, investors and lawyers do not fully appreciate.How do you kick the tires on an ongoing basis to monitor operational risk and minimize the likelihood of a problem or identify a problem early enough to mitigate the potential harm it may cause to performance or reputation. What systems are in place? What are the ongoing checks and balances that take place on a day to day, month to month basis to identify problems, correct them and fix them before they become a problem for your client?This analysis is certainly important to a risk profile description.
Editor: In your experience what areas of fund management and oversight are most vulnerable to weakness?
Wooden: Two areas come to mind: one is liquidity risk. In the case of hedge funds in former times, managers and investors were fairly confident about when investors would be able to withdraw capital.After some lock-up period, this could be as often as quarterly.However, the market conditions of 2008 and the accompanying illiquidity (particularly with certain types of investment strategies) exposed an area of weakness in the hedge fund operating model.In 2008, the hedge fund industry saw unprecedented amounts of capital seeking to exit the market and many managers imposed "gates," which are provisions that allow fund managers to prevent withdrawals above a certain percent of the investment fund's assets.Investment managers enforcement of codes of ethics and compliance procedures is another area of significant vulnerability.In fact, the SEC has reported this as a frequent finding in its examinations of investment advisers.
Editor: Do you expect to see the same resistance or court challenges by hedge funds to the Obama administration's requirement of more disclosure that we had a few years ago when these proposals were first put forth?
Wooden: I don't expect to see the same court challenges principally because the prior challenges and litigation were based on the argument that the SEC exceeded its authority in enacting rules for the registration of investment managers. This time it's not the SEC taking the lead but the President and Congress, which will make any requirements less subject to challenge.
Editor: While tighter regulation of financial institutions is a given, what should regulators do to avoid trammeling innovation in the development of new financial products and prudent risk-taking?
Wooden: Any enhanced disclosure regulation should protect proprietary information in the form of trading models and investment strategies, the intellectual capital of these managers. It is important to keep managers appropriately incentivized to take appropriate risk and develop new products.So, regulators should make sure that a manager's confidential information is not shared with its competitors. Clearly, we are heading towards greater disclosure and coordination of information in the marketplace among the regulators, all with the goal of increasing confidence and protecting the financial stability of the market.
Published June 30, 2009.
