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Industry Voices

Commentary: When to escape the fund structure – separate accounts and funds of one

Much like travelers hoping for an upgrade to first class from coach, institutional investors have become enamored of special vehicles tailored just for them. The arrangement can either be as a separate account or a so-called fund of one, and may offer better economics, greater transparency, faster liquidity or other perks not offered in the investment manager's flagship fund. Some managers are happy to say "yes," perhaps to secure a cornerstone commitment, fill capacity or to add a marquee client for marketing purposes.

But investors and managers alike should not assume one structure is always better. Form should follow function.

Structure. The separately managed account is in the client's name and grants the manager the power to direct trades for the account. Typically, the SMA is set out in a relatively simple advisory agreement. A fund of one, or Fo1, however, is a separate legal entity, often a limited partnership or limited liability company. The fund manager acts as general partner or LLC manager, as the case may be, and the investor is the limited partner or LLC member. The agreement looks a lot like a fund agreement for commingled clients — albeit there is only one investor.

Economics. Clients can incorporate better or special economic terms via either an SMA or a Fo1. However, a manager might prefer the fund of one because incentive compensation should be taxable as capital gain rather than ordinary income.

Transparency. Both SMAs and funds of one can provide clients full, limited or no position-level transparency. Although full transparency was the holy grail for many investors after 2008, many clients now understand that full transparency carries burdens and risks. Worries include front-running, trading (or tipping) in possession of material non-public information and fiduciary issues, especially if the client has its own trading desk or permits personal trading by staff.

Termination. Even if an SMA has a lengthy notice provision, in reality, an SMA client can fire the manager pretty quickly, simply by taking away trading authority (although this might incite breach of contract damages). Some investors may want or need this protection in the unlikely event of a rogue manager, especially if derivative trading is permitted. It is harder for the client to fire the Fo1 manager because the client doesn't control account access.

Moreover, a manager might face significant costs and potential risks if the fund of one invests side-by-side with the manager's main fund. This is especially true for activist or illiquid security managers. These managers might face challenges if, say, they have to reduce their holdings in a Schedule 13D amendment during a bitter takeover contest, or to sell illiquid positions during a lengthy turnaround, or sell securities while in possession of inside information obtained via a standstill agreement or as a member of a creditors committee.

Disclosure and reputational risk. Clients with reputational concerns might shy from SMAs for activist or arbitrage investing. An SMA client might have to be listed in a manager's 13D as part of a "group." In a Fo1 structure, only the fund's name, not the underlying investor, would ordinarily be in a 13D.

Risk of loss. The Fo1 is a limited liability entity. SMAs, however, can lose more than committed capital in a mistaken derivative trade or rogue action. A client might interpose a "blocker" entity as its SMA party, but a separate account with extensive leverage or derivative trading may be uneconomic without recourse to the client's balance sheet. And a client might lose access to Wall Street if it ever allowed a blocker to default.

Counterparties. Brokerage for a simple long/short equity strategy with limited leverage and no derivatives can be set up quickly. Strategies with extensive derivatives or other over-the-counter trading will typically require expensive and time consuming ISDA counterparty arrangements. The new account could use the same forms as existing accounts, but typically the counterparties require new terms. A client could authorize an SMA to trade under the client's existing ISDAs but more often the client will opt not to do so because of logistical complications of booking trades across managers, and concerns with limited liability.

Trade allocation. Investment strategy largely dictates trade allocation issues. Passive long/short market-traded equities generally have fewer concerns than distressed debt, multiproduct, activist or macro strategies. Trading in certain debt and privately placed securities is limited to qualified institutional buyers (institutional investors with $100 million of qualifying securities), and ERISA plans cannot participate in certain investments. Trading across the manager's strategies might be impossible if the SMA's allocated portion would be an odd lot — often a $100,000 minimum for distressed debt.

Direct and indirect costs. The direct costs of establishing an SMA are modest. Ongoing indirect costs include operational and trading burdens imposed on both the manager's and the client's back office if the client will be managing (or even just reconciling) trade confirmations, collateral, margin calls, etc. Direct fund of one establishment costs are significantly higher. Counterparties generally require a prospectus for funds of one and managers' outside counsel often recommend one for regulatory certainty. New counterparty documents will be needed since the Fo1 is a separate legal entity.

Finally, a Fo1 will typically require an annual audit (to comply with the SEC custody rule), unlike an SMA. The client may avoid some indirect operational costs if it is willing to forgo trade reconciliation.

There is a need for clear planning before selecting a vehicle for a one-on-one relationship.

Edward H. Klees is a partner at Hirschler Fleischer in Richmond, Va., and chair of the Institutional Investors Committee, part of the American Bar Association's Business Law Section. Michael C. Neus is a senior fellow in New York University School of Law's Program on Corporate Compliance and Enforcement, and vice chair of the ABA Business Law Section's Institutional Investors Committee. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.