APAC: Managed Accounts and Conflicts—Part 3: Separate Managed Accounts vs Funds of One
In our last post, we itemized several incentives motivating many institutional investors to favor management of their investment assets in a separate managed account (SMA) or fund-of-one as opposed to investing those assets in a commingled fund. A key distinction between investing assets in an SMA or fund-of-one that is often overlooked is that the owner/investor in an SMA directly owns those investment assets. This is not true of an investor investing in a fund-of-one. In the latter, the fund owns those assets, not the investor.
Typically, in a fund-of-one, the account is held at a major bank or prime broker, the account being registered in the name of the account owner. The account may be an existing account with existing assets or a newly created and newly funded account. The latter is more common since it is likely that an account funded with existing assets would not likely resemble the composition of investment assets that is the subject of the investment management agreement governing the SMA. Many fund managers would not want to re-position an existing portfolio to conform to the manager’s fund strategy.
A key reason many investors favor investing in an SMA is that termination rights ultimately vest in favor of the account owner no matter what the account agreement stipulates. How is this possible? The investment manager cannot exercise discretion over the account unless the account owner provides a power of attorney (POA) to the investment manager, giving authority to the investment manager to trade the assets of the account. To terminate the agreement with the manager, all the account owner need do is revoke the authority of the manager to trade assets of the account by providing notice to the fund manager or the bank/prime broker where the assets are held. The POA may be expressed in a separate document presented to the bank/prime broker, or it may be embedded—and typically is—in the investment management agreement governing the SMA.
Having invested 4 to 12 weeks in negotiating the SMA with the account owner and being further burdened with the attendant legal fees, the investment manager will not be happy when the account owner delivers a notice to the investment manager terminating the authority of the manager to trade the assets of the SMA where the agreement provided that “either party may terminate the agreement as of any anniversary date by prior written notice to the other party.”
What’s a manager to do?
Seasoned counsel could offer sage advice in this instance, but after the fact, there is little to be done to rescue this situation. Ex ante, counsel may have consulted with the investment manager and the prospective investor, explaining the benefits of a fund-of-one to both parties. The fund-of-one will not afford the investor the same degree of flexibility in terminating an investment in the fund, but will offer the investor the very attractive feature of limited liability protection, limit exposure to capital invested in the fund. Are you a fund manager investing primarily in non-U.S. securities on behalf of a non-U.S. person? Do you have no place of business in the United States? If so, then forming a fund constituted as a Delaware LLC would be a viable option. The time commitments and expense in forming the fund-of-one would approximate negotiating and re-drafting an investment management agreement prepared by legal counsel on behalf of the account owner.
This series of posts will examine the particular challenges posed to managers when managing a managed account alongside a hedge fund, in particular, conflicts of interest that often arise when a manager is managing a client account that implements or overlaps with a material number of securities held by the hedge fund. Along the way, we’ll suggest best practices to manage these conflicts. More to come on this! Watch for our next post.
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