28/07/2010 Author: Amy Hirsch

Comment: Amy B Hirsch

The hedge fund world has always had third-party marketers. At first, it was simply one investor recommending a fund to another investor. Then groups such as Far Hills appeared; independent and knowledgeable about the strategies their managers employed, such firms serve a valuable role in the investor world. They provide the manager with valuable advice on how to structure products, they create marketing material, and they teach the manager how to present his or her firm. They provide access to investors the manager would have never met, and often facilitate the RFP and due diligence response process for the manager. So what is the issue?

Sometime after 1999, third-party marketers, with a sleeve filled with the latest hedge fund managers du jour, started appearing at every hedge fund conference. It seemed like there was no method to the mix of managers, except that no two typically traded the same strategy. A third-party marketer might represent a long/short equity manager, a distressed manager and a commodity trading advisor, with a 50/50 chance that they would know anything about the underlying strategy or portfolio. Their real job was to get the manager in the door, so they could explain themselves. Still, many investors did not realise the relationship they had with the third-party marketer was not primary; the investor was merely an ends to a contingency fee being paid.

The true concern is the conflict of interest that is imbedded in the relationship between the fund manager and the third-party marketer, to which the manager typically pays a percentage of the management fee and incentive. This fee structure, if not fully disclosed, is assumed. The conflict is not truly in any lack of disclosure, but rather the arrangement itself. Potential clients may presume that the third-party marketer has done some form of due diligence, say perhaps a background check, or has at least verified the track record of the manager they are selling.

The role of third-party marketers is something of a grey zone. It has not yet been determined if they are ‘brokers’, classified as persons who participate in the sale of a security. A broker, as defined by the SEC, is someone who receives trailing commissions (as do third-party marketers), solicits or negotiates the transaction (as do third-party marketers), or receives other transaction types of compensation (as do third-party marketers).

I believe that the issue is whether or not the action of introducing a client to a manager is actually a transaction or sale of security. The third-party marketer does not actually affect the outcome of the introduction; they merely introduce the two parties. The ‘transaction’ is effected when the client signs the subscription agreement and wires the cash to the fund custodian.  There is, however, no grey area at all when the third-party marketer is paid in soft dollars. In this case, they must be affiliated with a broker-dealer. Herein lies the issue of due diligence and manager knowledge.

The biggest issue now is the change at the pension plan sponsor level, which is now responsible for ensuring they know every third-party marketer they deal with. This sounds very simple at first blush; you ask everyone if they are a third-party marketer, right? Not so simple. Relationships can change, people shift from one firm to the next, and some folks outright lie. A person who is not considered a third-party marketer may end up working at the fund they are selling.

When plan sponsors meet anyone, they have to understand if they are dealing with someone who will receive compensation for any introduction they make to the pension. This now includes brokers that have capital introduction units, independent third-party marketers, consultants who wear different hats, trustees who wear different hats and other characters who will pop up looking for remuneration.

Pension fund trustees can be penalised (albeit we are not certain how) if they do not follow this new rule. In addition to plan sponsors, it is imperative that investors of all types – whether being introduced to a hedge fund, private equity fund or plain vanilla long-only manager – ensure they understand the relationship between the introducing party and the manager.

Finally, investors should never assume that due diligence or reference checks have been done, that the introducing party has any investment with the manager, or even worse, that the manager actually has an agreement with the introducing party