During the financial crisis of 2008, many hedge fund managers ("HF Managers") exercised their rights to restrict fund liquidity, using their frequently underestimated legal powers to put in place gates, suspend redemptions and even segregate illiquid fund assets for years in closed-end vehicles (so-called "side pockets"). Among other factors, this resulted in a substantial deterioration of liquidity for investors.
Single security deposit accounts held in trust (so-called "segregated managed accounts") emerged from the crisis as a favored structural solution, as they not only offer investors full transparency but also an effective protection against the above-mentioned liquidity constraints. In a segregated managed account, the portfolio's liquidity derives from the liquidity set by the underlying financial instruments, rather than by conflicting activities of other investors who may force the HF Manager to liquidate securities positions and thus take measures to restrict liquidity.
The experiences gained from the financial crisis caused Bayerische Versorgungskammer ("BVK"), the largest German Public Pension Scheme – with €50 billion AuM – to carry out an internal analysis of their existing hedge fund investments. This analysis indicated that it may be reasonable for a large investor such as BVK to invest in single hedge fund strategies via "managed accounts" ("MACs").
BVK established the following requirements for a managed account solution and a managed account platform ("MAP"), which differ from the traditional investment structures in hedge funds (offshore/ onshore):
- As a single investor, BVK shall – as in the case of a German specialized fund – be the sole indirect or beneficial owner of the assets.
- BVK shall be provided with full disclosure of all current positions of the HF Managers and the resulting market risks.
- Within the scope of a limited power of attorney, the HF Managers shall be granted management authority, which may be terminated by BVK at any time.
- With regard to the implementation of their trading strategy, the HF Managers shall have the greatest flexibility possible within the framework of applicable regulatory and supervisory provisions.
- BVK may individually negotiate the investment and liquidity guidelines with the respective HF Managers and may even carry out the cash management of investments via future contracts.
- In addition to selecting the HF Managers, BVK shall also select the other service providers, such as administrators, prime brokers and the custodian bank.
In order to meet the previously mentioned requirements, BVK decided to structure and launch its own BVK-controlled MAP solution. This involved the setting up of a structure legally independent from the platform operators, and the contractual integration of all service providers. Such integration was established by entering into agreements with the service providers, the terms of which provided maximum flexibility to BVK while contractually binding the service providers.
This analysis indicated that it may be reasonable for a large investor such as BVK to invest in single hedge fund strategies via "managed accounts".
The MAP's ongoing activities are coordinated and supervised by a specialized service provider, the MAP operator. The MAP operator is thus the most important service provider to BVK and responsible, among other things, for the following:
- Legal and operational launch of the MAP and new MACs on the MAP (as well as their liquidation);
- Legal and operational integration of fund infrastructure into the MAP and the negotiation of service contracts;
- Initial and continuous operational due diligence of the HF Managers and the fund administrator, the custodian bank and the prime brokers, if applicable;
- Recommendation of investment guidelines for HF Managers and negotiation of investment management agreements;
- Operative launch of commercial relationships and negotiation of broker agreements with prime brokers;
- Risk management and controlling and monitoring of compliance with investment guidelines, as well as examination of counterparty risks; and
- Provision of online reporting, allowing BVK to review any and all positions of the MACs at any time.
In addition, an independent administrator that calculates the net asset values of the MACs and renders other services, as well as a custodian bank, are contractually bound to provide services to the MAP. BVK thus outsourced all middle office and back office operations to specialized service providers, without giving up the unrestricted control of the MAP as shareholder or the ability to replace the service providers at any time, pursuant to the relevant agreements.
Legal Structural Objectives
With regard to the legal set-up of the MAP, the following objectives in particular had to be taken into account:
- BVK, as managing and representative body of twelve professional and local pension schemes ("BVK Pension Funds"), intended to reorganize part of its alternative investment portfolio (hedge funds, commodities and currencies) in connection with the set-up of the MAP. The investments that had been made via Luxembourg SIF FCPs (defined below) ("Asset Class FCPs") in other collective investment vehicles ("Target Funds") of different investment managers ("Portfolio Managers") should be made by contractually integrating such Portfolio Managers into the MAP.
- The BVK Pension Funds should be the sole eligible investors for the MAP and the portfolios of the Portfolio Managers to be integrated. The assets managed by the Portfolio Managers should be held directly by the respective sub-fund and controlled by the MAP and its service providers.
- Any dependence on the MAP operator and other service providers to the MAP should be avoided. In the interest of the BVK Pension Funds, it should be possible to replace these service providers as easily as possible.
- It was necessary to safeguard the eligibility of the indirect investments of the BVK Pension Funds under the provisions of the relevant investment law and insurance supervisory law.
Structuring of BVK Managed Account Platform
On the basis of the above structural objectives, it was determined to use the following legal structure.
A Luxembourg Specialised Investment Fund ("SIF") pursuant to the Law on Special Investment Funds dated 13 February 2007 ("SIF Act"), in the form of a stock corporation (Société Anonyme – S.A.) with variable capital (Société d'Investissement à Capital variable – SICAV) ("SIF SICAV S.A."), was chosen as the platform vehicle. The reasons for choosing a Luxembourg SIF included its flexibility regarding the investment policy, the lean regulatory regime accommodating to such vehicles (supervised by the Commission de Surveillance du Secteur Financier – CSSF), as well as its possible classification as a foreign collective investment scheme from a German regulatory perspective. In particular, the legal form of a Luxembourg stock corporation was selected in order to set up an independent corporate fund (rather than a contractually structured special fund dependent on a management company), which grants voting rights to its investors and is independent of the integrated service providers.
Moreover, for efficiency reasons, the SIF SICAV S.A. was structured as an umbrella fund with several subfunds. Each individual sub-fund is managed by a Portfolio Manager. If possible, the brokers/prime brokers preferred by each Portfolio Manager are contractually integrated with the relevant sub-fund and have entered into agreements with the MAP's custodian bank.
The SIF SICAV S.A. has a central administrator and a central custodian bank. The MAP operator has been integrated into the MAP by way of a tailored service agreement.
When defining the contractual relations with the Portfolio Managers and the MAP operator, particular attention was paid to the ability to replace the service providers. When drafting the relevant agreement, it was also important to ensure that, in case of the loss of a Portfolio Manager (e.g., due to insolvency or after notice of termination), the portfolio of the respective managed account would be properly liquidated and/ or that it could be hedged until the authorization of a new Portfolio Manager.
The legal form of a stock corporation ensures the desired controls and powers by the BVK Pension Funds. As sole (indirect) investors collectively represented by BVK and thus speaking with one voice, the BVK Pension Funds may appoint and dismiss the members of the executive board and exercise their voting rights with regard to any issue reserved to shareholders under Luxembourg law.
Within the structuring process, a number of specific legal questions arose. Key issues are discussed as follows.
Influence Over MAP and Control of Assets
BVK's desired "control" of the MAP and the assets managed by the sub-funds is structurally ensured on various levels:
- The assets of the MAP's individual sub-funds managed by the Portfolio Managers are managed for the respective sub-fund and held in custody by the MAP's custodian bank and/or the integrated (prime) brokers. No collective investment vehicle outside BVK's sphere of influence is interposed to accept a number of other investors in addition to the BVK Pension Funds.
- As any and all shares of the MAP's sub-funds are held by the Asset Class FCPs, and thus indirectly by the BVK Pension Funds, control is ensured by the exercise of voting rights.
- There is close communication between the members of the executive board of the SIF SICAV S.A. and the platform operator. Furthermore, periodic and prompt reporting by the SIF SICAV S.A. to the investors is required.
Permissibility of an Investment in MAP Under Insurance Supervisory Law
The BVK Pension Funds are subject to state regulation, which is largely in parallel to the regulatory framework governing the investments of German insurance companies. Therefore, it was necessary to structure the SIF SICAV S.A. and each individual MAC in a way to meet these regulatory requirements. A detailed discussion of the applicable legal requirements is beyond the scope of this article. Briefly, however, it is generally the case that the reorganization of the existing investments of the Asset Class FCPs, which will invest in the MAP's sub-funds in the future and will accordingly reduce their investments in (offshore) fund vehicles, is advantageous under insurance supervisory law, as such investments will be made onshore in Luxembourg and have increased liquidity and greater transparency.
Umbrella versus Stand-alone
An initial question regarding structure involved whether the launch of one/several umbrella SICAV or the use of a stand-alone SICAV would be advantageous for each managed account with regard to the legal and practical consequences. It was determined to select an umbrella SICAV, primarily for reasons of practicability and possible cost savings. Since an umbrella SICAV is a single legal entity (despite a basically unlimited number of possible sub-funds), it can be managed under corporate law in a more efficient way than a number of individual SICAVs, each with an executive board, general shareholders' meetings, disclosure requirements and so forth. In the case of an umbrella SICAV, efforts to amend organizational documents would not need to be undertaken for individual investment vehicles. The legal relationships with central service providers also can be implemented and later amended in a more efficient way and with less documentation requirements.
This increased efficiency should result in considerable cost savings with increasing volume. Furthermore, the launch of new sub-funds is easier than the launch of a new SIF SICAV S.A. investment vehicle for each individual managed account.
A potential disadvantage to using an umbrella SICAV might be increased liability risks, if such risks are required to be assumed despite the legal separation of liability among the individual sub-funds under Luxembourg law and under relevant contracts (contractual "ring fencing"). Any residual risks existing in this regard were analyzed for the United States and the UK, which are eligible as potential (prime) broker locations. Such risks were assessed as negligible, provided that appropriate contractual ring fencing protections are included in the relevant agreements.
Factors considered with regard to the selection of an umbrella SICAV include that only one central administrator and one custodian bank can be appointed under the CSSF's administrative practice (but the authorization of different (prime) brokers is permissible). While the integration of a single custodian bank seems to be less problematic, the integration of a single administrator could create problems in practice, if the trading strategies of the sub-funds are incompatible with the range of services of the administrator. Although subdelegation would not be excluded in principle, it is not certain whether the administrator would engage in such sub-delegation in practice. Alternatively, it might be decided to establish several sectoral umbrella SICAVs, which focus on certain alternative investment segments and have different administrators. In any event, BVK's determination was based upon the premise that the selected administrator could cover almost the entire range of the strategies of the individual managed accounts of the MAP to be traded.
Integration of a Central Investment Manager
Another important issue to be resolved was the question whether the respective Portfolio Managers should be directly instructed by the MAP as to the management of the relevant sub-fund, or whether it would be beneficial to interpose the MAP operator and/or a group company as a central investment manager to authorize the Portfolio Manager within the framework of a sub-delegation.
During the discussions with the various platform operators, it appeared, for a number of reasons, that the additional assignment of the function of an investment manager to a platform operator might not be practicable
There was no typical model of delegation and further sub-delegation, and it was determined that one model partially practised in the market (offshore) could not be implemented in Luxembourg for reasons of supervisory law. A corresponding analysis led to the conclusion that, depending on the complexity of the strategies pursued by the Portfolio Managers, a MAP operator could not unconditionally be requested to assume the role of an investment manager. Furthermore, a benefit of not having a central investment manager is that there is no risk that all sub-funds of the MAP would be affected if a central investment manager fails.
Accordingly, the MAP was structured without interposing a central investment manager, since this was determined to be more beneficial in principle, provided that adequate security mechanisms are implemented in the contractual provisions with the MAP operator and the Portfolio Managers.
The set-up of a proprietary MAP for investments in hedge funds (and other asset classes) may considerably increase the transparency and security of such assets without causing higher costs for investors in the medium term. These investment solutions likely will continue to make their way into the market, for the benefit of insurance holders, pension fund contributors and/or other end-investors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.