Pitfalls in side-by-side investing
In the wake of the Madoff scandal, certain substantial investors who might otherwise have invested in a manager’s hedge fund have insisted upon opening separate accounts where they and not the fund manager control custody of their assets. For hedge fund managers who accommodate such investors, or who otherwise manage separate accounts alongside their funds, a couple of caveats are in order — regardless of whether your separate accounts are long-only or pursue the same long-short strategies as your hedge funds.
Funds and accounts pursuing the same investment strategies, especially if they command different fees, must be treated pari passu in regard to both portfolio investments and trade executions. The SEC has sanctioned managers for favoring their more profitable investment vehicles with IPO allocations and other scarce investment products and would certainly react similarly to managers’ giving investment or trading preference to their higher-paying accounts.
If, on the other hand, your separate accounts are long-only (or otherwise strategically dissimilar from your hedge funds), you need to make certain that opposing positions (e.g., long versus short) in securities held in common by your funds and separate accounts and other conflicting investments between separate accounts and funds (e.g., interests in different parts of an issuer’s capital structure) are always defensible from the standpoints of the affected investors.
The possession by a manager of material inside information with respect to its investments in separate accounts or fund portfolios will require still another layer of protective compliance procedures and controls.