Copyright 2004 Dechert LLP. All rights reserved. Materials have been abridged from laws, court decisions, and administrative rulings and should not be considered as legal opinions on specific facts or as a substitute for legal counsel.

The Right Time to Move Cash by George J. Mazin

Dechert LLP

HedgeFundManagerJune 2005

This article appeared in the June 2005 issue of HedgeFundManager, published and reproduced

with permission of Pageant Media. www.dechert.com

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Exit strategies

The right time tomove cash

www.hfmanager.com

In recent weeks the press has reportedKen Griffin, founder of Citadel Group, is

considering plans to take it public. A publicoffering would presumably make it possibleto value the enterprise on the basis of pub-lic company multiples and provide a mecha-nism for the founder to obtain liquidity forhis interest in the business. Importantly itdelinks to a large extent the decision to exitthe business from the decision to cash out.He can sell his equity and maintain his roleat the company, or retire but maintain hisinvestment.

For many hedge fund managers, goingpublic is not a viable option. These man-agers must obtain liquidity the old-fash-ioned way, by selling their interest in thebusiness. Likely buyers may include em-ployees, existing partners, a strategic buy-er, or even a competitor.

A sale to employees is best accomplishedthrough a long-term succession-planningprogramme. A business can be institution-alised and an exit mechanism createdthrough the transfer over time of thefounder’s equity to key employees. Wherethe business is formed by several partners,a buy/sell arrangement may facilitate theability of a partner who desires to withdrawfrom the business to sell their interest tothe continuing partners. The buy/sell agree-ment may specify the purchase price, mayestablish a formula for doing so or may relyupon a third-party valuation.

This article will consider some of the ma-jor issues that must be negotiated whenselling to a strategic buyer or competitor.

The hedge fund industry remains a service business. Frequently, the buyer may

George J Mazin of Dechert navigates the paths that shouldbe negotiated when selling to a strategic buyer

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Exit strategies

be unwilling to purchase the entire interestof the seller in the investment managementfirm being sold. In order to provide an in-centive to the seller to stick with the business and preserve relationships withinvestors, the buyer may seek to acquirecontrol but leave the seller with a

significant stake in the business, creatingboth downside risk and upside potential.

The agreement may include an option forthe buyer to purchase the remainder of thebusiness at some point in the future, gener-ally based upon the value at such laterdate. In some cases the seller may have aput, affording them the ability to exit thebusiness once a prescribed time period haslapsed. In other cases the buyer may pur-chase 100% of the business, but build insignificant incentives (retention bonuses,earn outs or contingent purchase price) toinduce the seller to remain involved in thebusiness, or impose penalties (covenantagainst competition, clawback) if the sellerfails to remain involved.

Purchase priceThe purchase price will invariably be estab-lished on the basis of a multiple of earnings.Depending upon the nature of both the buy-er and the investment strategy employed,greater weight (or a higher multiple) maybe ascribed to management fees than in-centive fees. Since incentive fee revenuestend to be more volatile, buyers may not bewilling to pay as much for an unpredictablerevenue stream which varies greatly fromyear to year.

Sellers often believe they are sellingtheir business too early in its life cycle. Asa result the seller may believe the multipledoes not fairly reflect the future growththe buyers will enjoy as a result of pur-chasing the business. Conversely, the buy-ers may fear they have purchased too late.They may be concerned the business hasplateaued and future revenue growth willbe flat, in which case they will be unwillingto employ a high multiple to value thebusiness.

To provide an incentive to sell, the pur-chase price may include a contingent ele-ment. Additional purchase price will be paidif certain targets are reached, such asgrowth in assets under management.

This component of the purchase priceserves two purposes. First, it provides anincentive for the seller to continue to growthe business despite the sale. Second, itprotects the seller against selling at a pricewhich is unreasonably low. If the businesscontinues to grow, the seller benefits from ahigher purchase price. If the anticipatedgrowth does not occur, the buyer will notfeel they have overpaid for the business.

Contingent payments serve one furtherpurpose. A principal of the firm being sold islikely to be an entrepreneur, accustomed tomaking all the decisions associated withrunning the business without being second

guessed. After the sale, the former entre-preneur will end up working for someoneelse. To prevent the seller from walking outthe door as soon as the new owners refuseto pursue a desired initiative, a contingentpayment puts the seller at risk of foregoinga significant amount of money if they leaveprematurely.

In some cases, the buyer may negotiate aclawback. This protects the buyer against a contraction in the business. If investorswithdraw as a result of the change in con-trol, or if there is a sustained period of poorperformance, the sellers may be required toreturn a portion of the purchase price.

Covenants against competitionAs a condition to paying the seller a signifi-cant sum of money, the buyer will requirethe seller to commit to refraining from com-peting against the buyer and to agree not tosolicit the company’s employees or in-vestors. These covenants will continue forso long as the seller remains employed andwill typically extend for a period of time(generally as short as a year and as long asthree years or more) after the employmentrelationship terminates.

Subject to these broad parameters, thereare a multitude of issues to be negotiated instructuring these covenants. For example,will the seller be released from thecovenant if they are fired or forced to re-sign? Will a competing business be definedbroadly so it encompasses the entire invest-ment management industry, or will it belimited by geography or a particular seg-ment of the business, for examplelong/short hedge funds.

Also up for discussion is whether the sell-er will be restricted from accepting an in-vestment from an investor or prospectiveinvestor, or merely restricted from activelysoliciting or encouraging the investor towithdraw capital from the fund advised bythe company that was sold. The seller willstrongly prefer the latter approach, arguingthat a larger institutional investor should beable to invest with them if they are leavingto launch their own fund, so long as the in-vestor does not reduce its investment in thefirst fund. Restrictions will also be imposedprohibiting the solicitation, or in some cases, hiring (whether or not solicited) ofemployees of the prior firm.

SEC consentThe seller may either be registered, or inthe not-too-distant future, will be re-quired to be registered, as an investmentadviser with the Securities and Exchange

George J MazinMazin (NewYork) hasmore than 20 years’experienceandconcentrateshis practiceon domestic

(US) and offshore hedge funds,venture capital and private equityinvesting, and broker-dealer andinvestment adviser compliance.

Peter AstlefordAstleford(London) hasmore than 20years’experienceadvising fundmanagers,banks andbrokers with

around 15 years’ extensive experience in the developmentand growth of the Europeanhedge fund industry.

Dechert LLP Hedge Fund Partners

“In order to provide anincentive to the seller tostick with the businessand preserve relationshipswith investors, the buyermay seek to acquire control but leave the sellerwith a significant stake in the business”

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Commission (SEC). Consent from theregulator to a sale or change of control ofa registered investment adviser is not re-quired under the Investment AdvisersAct. However, an amendment to the ad-viser’s Form ADV will be required to re-flect the change in ownership. Once filed,this information will be publicly avail-able. In addition, regulators in other ju-risdictions outside the US in which thefirm does business may have the right topass on the transaction.

More significantly, a change in control ofan investment adviser is treated as an as-signment of an investment advisory agree-ment under the provisions of theInvestment Advisers Act. The Act furtherprovides that the advisory agreement maynot be assigned without the consent of theclient. While the SEC generally treats afund (and not the investors in the fund) asthe ‘client’ for these purposes, it will nottreat the consent of the general partner ofthe fund to be an effective consent due tothe inherent conflict.

Absent a controlling provision in thepartnership agreement which spells outthe mechanics for obtaining consent, con-sent can be obtained through the approvalof the change by an independent repre-sentative acting on behalf of the limitedpartners, or by a majority in interest ofthe partners. While not clearly required,affording a right to redeem to those in-vestors who are unhappy about thechange may be prudent.

Finally, consideration must be given towhether affirmative written consentshould be required, or whether acquies-cence through silence and a failure to ob-ject (negative consent) would be sufficient.While affirmative consent is the preferredapproach, negative consent can be effec-tive where there is proof of delivery of thenotice, coupled with the passage of a suffi-cient period of time and the absence of anobjection or request to redeem.

Integration issuesWhere the buyer is a competitor of theseller or otherwise engaged in the invest-ment management industry, buyer andseller will face a host of integration is-sues following the acquisition – from personnel issues to technology to over-lapping products. However, one criticalintegration issue is compliance. The twocompanies will have to designate a chiefcompliance officer on a going-forwardbasis, who will be faced with the task ofintegrating two sets of compliance poli-cies. Often, when the two policies are

lined up against one another, there willbe a variety of inconsistencies or con-flicts between the two. The failure to rec-oncile the two promptly following theclosing of the transaction puts the com-pany at considerable risk. It will, at aminimum, create confusion among em-ployees as to the applicable rules and atworst, subject the company to the poten-tial of an enforcement action.

RepresentationsIn structuring a transaction, the sellerwants to be sure it will be able to retainall or as much as possible of the consider-ation it has received. The buyer is lookingfor the ability to recoup a portion of thepurchase price if it does not get what itbargained for. The mechanism for resolv-ing these conflicting objectives is the representations and warranties and in-demnification provisions in the purchasedocuments. The buyer may seek to exactbroad and extensive representations from the seller concerning the businessbeing sold.

These representations may cover the fi-nancial condition of the business, pastperformance, accuracy of disclosure doc-uments, absence of litigation or claims,including investor complaints or regulato-ry proceedings, the disclosure of materialcontracts and commitments, transactionswith affiliates and compliance with laws.The seller will seek to narrow the repre-sentations and ask the buyer to rely uponits own investigation of the business.

If any of the representations turn out tobe untrue, the buyer’s remedy is to assert

a claim for indemnification. Effectively,the buyer is seeking a purchase price ad-justment. The indemnification provisionsmay be subject to considerable negotia-tion, including the minimum claim eligiblefor indemnification, the time period forasserting a claim and the ability to set offthe claim through a set-off against futureamounts owing to the seller.

When to sell is a personal decision thatis made based upon a variety of factors,including a desire to create liquidity for aninvestment that may represent a signifi-cant portion of the seller’s net worth, adetermination that the value of the busi-ness has plateaued, a desire to make alifestyle change or a determination thereis strong demand in the market for the as-set being sold.

Whatever the reason for selling, struc-turing a sale transaction is complex andrequires great care in order to maximisethe selling price, while imposing thefewest restrictions on the seller and re-sisting efforts to shift the risks of thetransaction to the seller.

Exit strategies

David VaughanVaughan(Washington)has more than12 years’experienceworking withhedge funds,private USfunds, retail

and private offshore funds and private and offshore variableinsurance products.

Stuart MartinMartin(London) hasmore than 15 years’extensiveexperience inadvisingfinancialservices

businesses on product and fundstructuring and establishmentincluding hedge funds and otherfunds utilising alternative assetstrategies.

Dechert LLP Hedge Fund Partners