Conflicts and Opportunities Offered by Concurrent Management of Employee-Owned Hedge Funds and Outside-Investor Hedge Funds

When a hedge fund manager manages concurrent funds with different investor bases, investors are reasonably concerned about how investment opportunities that fall within the mandate of both funds may be allocated.  For example, investors in one fund may be concerned that the other fund is “front running” the fund in which they are invested.  On “front running,” see “Hedge Fund Manager Kenneth Pasternak Cleared of Securities Fraud,” Hedge Fund Law Report, Vol. 1, No. 15 (Jul. 8, 2008).  Even short of that, managers must address concerns about the fair and transparent allocation of investment opportunities and managerial efforts.  As Gregory Nowak, Partner at Pepper Hamilton LLP, told the Hedge Fund Law Report in an interview, investors want to know that managers are “eating their own cooking.”  The potential conflicts inherent in simultaneous management of multiple funds can be especially pronounced when one of the funds is a proprietary fund, owned by employees of the management firm, and another fund includes outside investors.  If the employee-owned fund gains and the outside-investor fund gains less, does not gain at all or loses, there will be questions from the outside investors, as happened earlier this year to Renaissance Technologies.  Renaissance’s Medallion Fund, a hedge fund whose investors consisted of Renaissance principals and employees, gained 12 percent in the first four months of 2009, while Renaissance Institutional Equities Fund, with outside investors, lost 17 percent in the same period.  In a conference call with fund management, the outside investors demanded explanations for the divergent performance – even though the funds had significantly different investment mandates.  Against this backdrop, this article addresses the following questions: how common is the practice of operating an employee-owned fund alongside an outside-investor fund?  What are the benefits of such an arrangement?  Who constitutes a “knowledgeable employee” for purposes of beneficial ownership of an employee-owned fund?  And, what are the drawbacks of such an arrangement, and how can they best be managed?

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