To What Extent Is a Hedge Fund Bound, Legally and Practically, by Its Strategy as Stated in Its Governing Documents and at Marketing Meetings?
Private Equity Law Report
In the hedge fund context, strategy drift (also known as style drift) broadly may be defined as a material deviation from the investment strategy represented to an investor – in the fund’s governing documents as well as orally, for example, in marketing meetings – prior to and during the investor’s investment in the fund. Implicit in this definition is the notion that a hedge fund investor purchases a product. But there is a competing, often more apt, view of the hedge fund investment process which holds that sophisticated investors do not invest “in a fund,” but rather “with a manager.” While this distinction may be more theoretical than practical – manager selection matters profoundly even for less customized products like hedge fund replication ETFs, and even the most gifted managers have to articulate the layout of their product waterfront with reasonable clarity – it has important legal and drafting implications. Investors with a product-purchase view of hedge fund investing will demand more specificity in governing documents with respect to strategy, which will narrow manager discretion and expand the range of potential strategy drift claims. On the other hand, investors with a manager-commitment view of hedge fund investing will, other things being equal, require less granularity on strategy, and may compensate with deeper and longer manager due diligence. For this latter category of investors, once they have satisfied themselves as to the manager’s investment competence, talent bench, infrastructure quality, risk controls and related matters, they are apt to confer a wider discretion, and less inclined to bring strategy drift claims. But even managers who have earned the full faith and credit of their investors cannot offer apples and deliver oranges. Strategy drift claims tend to increase in frequency during and immediately following major market dislocations. There are two reasons for this. First, funds launched prior to such turbulence often do not include mechanisms adequate to deal with it, especially if the nature of the dislocation is relatively unprecedented. For example, many hedge funds launched prior to 2007 lacked mechanisms to deal with the illiquidity of 2008 in a manner satisfactory to investors. Second, managers – rightly and consistent with their fiduciary duties – want to stem losses or seize opportunities in times of dislocation. When such defensive or offensive moves work, investors applaud. (We have yet to find a strategy drift claim that follows a period of positive performance.) But when such moves fail, strategy drift claims often follow. In light of our current posture at what appears to be the tail end of a major market dislocation, this article focuses on strategy drift in the hedge fund context and in particular covers: two recent examples of strategy drift claims; what hedge fund “strategies” are and where they are stated; what strategy drift is and the types of legal claims it may give rise to; the relevance of materiality in assessing whether an alleged departure from a stated strategy may give rise to a legal claim; the legal consequences of strategy drift; and – probably most importantly – concrete steps that hedge fund managers can take to avoid allegations of strategy drift. One of the more heartening takeaways from this article is that, under appropriate circumstances, a manager need not be a “hostage to its documents.”