Fund of One

Although not a new phenomenon, in the post-Madoff world there is an increasing desire for institutional investors in hedge funds to seek customised solutions from fund managers in order to gain more transparency, reduce liquidity risk, and influence portfolio construction in ways that cannot necessarily be achieved through a typical co-mingled investment pool.  These solutions primarily take the form of separately managed accounts or “funds of one.”  The use of such structures has increased as more public and private pension plans, sovereign wealth funds and other institutional investors have expanded their allocations to hedge fund products with a view towards segregation of assets and specialised management.  Although managed accounts and funds of one have many similar features, there are important distinctions.  This article will focus primarily on funds of one given the recent uptick in the use of this type of vehicle even though it remains somewhat below the radar within the broader institutional investor community.
 
What Is a Fund of One?
 
Simply put, it is an investment fund for a single investor.  But unlike co-mingled funds, a fund of one can be a highly-negotiated and customised undertaking between a fund manager and an investor.  It generally has the same look and feel of a co-mingled fund in terms of entity structure, delegation of management duties to the fund manager and counterparty relationships.  However, the interior architecture of the fund of one is where its uniqueness comes into play.  It can be flexible to meet the investment and risk objectives of the sole investor seeking more creative and protective access into hedge fund investing or expansion of its existing hedge fund portfolio.
 
Funds of one come in several varieties.  They can be structured as separate vehicles that engage in direct trading activities, separate feeder funds within master-feeder fund schemes, and even separate share or interest classes of existing funds.  In addition, they can be formed onshore or offshore depending on the tax character, domicile and preferences of the investor and/or the requirements of the fund manager.  From a cost-benefit analysis there are issues to consider within each variety when selecting the appropriate structure, such as the cost of construction and operation, protection against co-investor redemption risk and cross-class liability.  Funds of one also can be utilised for investors in fund of hedge funds.  It often is a convenient way for funds of hedge fund allocators to offer large institutional investors customised exposure to certain underlying managers and strategies.  Although funds of one are primarily used in the hedge fund space, in certain cases, they also can serve the interests of private equity fund investors seeking a more customised platform with a private equity sponsor.
 
The key difference between a fund of one and a managed account is the ownership and control of the assets.  In a managed account, the investor retains ownership and control, while in a fund of one it does not – even if the manager is given investment discretion over the assets in a managed account, the investor can exercise some measure of control through direct engagement of an administrator, prime broker and custodian, or by terminating the manager.  By contrast, in a fund of one, the assets are owned by the fund, not the investor, and control is in the hands of the fund manager – any control exerted by the investor would likely jeopardise the limited liability it is afforded by the fund vehicle.
 
Funds of one have benefits and drawbacks, a sampling of which are discussed below.  But on the whole, they are a useful means to gain protection from co-investor risk.
 
Benefits
 
Customisation of Strategy.  Where a fund of one is a stand-alone and not designated as a feeder fund in a master-feeder structure or as a separate class within an existing fund vehicle, it will afford the investor the opportunity to customise the strategy, portfolio construction, risk parameters and leverage guidelines with the fund manager. 
 
Enhance Transparency and Risk Management.  Funds of one can provide the investor with increased levels of transparency to monitor sectors, risk, performance and operational controls than could otherwise be offered in a co-mingled fund.  This is achievable where the manager is not subject to fiduciary duties to treat all investors equally as it would be in a co-mingled fund context.  While the level of transparency given to the investor will depend largely on individual negotiations with the manager – e.g., the manager may not want to provide position level data to the investor – the fund of one investor is likely to have a better look-through to the asset mix.
 
More Favourable Liquidity Terms.  For the sole investor, there generally will be an ability to have better liquidity terms.  These, of course, will be subject to negotiations with the manager and to the fund of one’s investment strategy.  Both factors will impact the ability of the manager to liquidate underlying assets in a crisis environment, thereby affecting how redemption frequency and notice requirements will be structured.  However, for an investor able to customise a strategy as to portfolio construction, risk and leverage, among other things, the investor and the manager should be able to agree on appropriate liquidity terms.  A cautionary note for funds of one that allocate to underlying hedge funds is that structuring liquidity at the fund of one level will depend mostly on liquidity profiles of the underlying hedge funds.
 
Protection from Impact of Other Redeeming Investors.  The fund of one also gives the sole investor a unique advantage by reducing, if not eliminating, liquidity risk posed by other redeeming investors.  Without a multiplicity of investors, the sole investor does not have to worry that its portfolio will be compromised by the manager having to liquidate positions to satisfy other investors’ redemption requests.  And there should be little, if any, reason to incorporate a “gate” into the redemption terms.  The scenarios where liquidity risk is not entirely eliminated or where a gate could be built in are if the fund of one (i) is a feeder fund or otherwise has an overlap in holdings with other accounts or funds managed by the manager, or (ii) is not actually a separate fund vehicle, but rather a separate class in an existing structure.  These scenarios would still have the specter of liquidity risk for the investor, and in the latter case, a separate class would also be subject to cross-class liability issues (unless the fund’s entity structure eliminates this risk, such as with segregated portfolio companies in certain offshore jurisdictions).
 
Administrative and Operational Efficiency.  Funds of one, like co-mingled funds, entail less administrative and operational complexity for the investor than does a managed account.  For example, the manager undertakes the task to put in place administrators, prime brokers and custodians, and to negotiate ISDA agreements.  And once the fund is up and running, the manager handles the counterparty relationships and reconciles the accounting and other data aggregation functions to relieve the investor of these burdens.
 
No Fiduciary Liability.  Based on a lack of ownership and control over the fund of one’s assets, the investor does not have the fiduciary burden inherent in managed accounts where an investor has to perform due diligence on and contract directly with third party services providers and counterparties, or may have ongoing monitoring responsibilities and may have to deal with sudden adverse situations in the portfolio, which they are not equipped to handle.  And since the fund of one has a separate legal identity and management responsibility has been delegated to the fund manager (and a board, in the case of an offshore fund formed as a corporate entity), the investor has a shield to limit its liability.  This assumes that the investor remains passive with respect to fund governance.
 
Drawbacks
 
Ownership and Control Over Assets.  The flip side of limiting an investor’s liability with respect to a fund of one is that the investor has no ownership or control of the fund’s assets.  Although the central element of a fund of one is that it is a customised platform, the investor generally has no authority to direct the investment decisions and the management of the assets, unless certain consent rights have been negotiated with the manager (but even in that situation, an investor should use caution in determining what authority to reserve for itself so as not to lose its limited liability status).
 
Limitations on Ability to Exit.  Notwithstanding the customised nature of a fund of one, the investor’s ability to exit is dependent on the redemption terms negotiated with the manager.  Although the investor should have minimal or no co-investor risk, it cannot expect to have unrestricted exit rights as the manager will need to have the ability to effectively and prudently manage the liquidation of assets.
 
Price of Entry.  Because of the operational scale and infrastructure costs, managers generally will not set up funds of one unless a high minimum asset under management threshold can be met by the investor.  There is no hard-and-fast rule, but minimums can be as high as $100 million.
 
Cost.  The cost to investors of setting up and operating funds of one is considered “medium” as compared to “high” for managed accounts and “low” for co-mingled funds. 
 
Ramp up.  Like a managed account, the time within which a fund of one can fully deploy the investment capital contributed by the Investor can vary.  Even so, it is a longer period compared to existing co-mingled funds that accept new capital since co-mingled funds often have the ability to offset redemptions with subscriptions to minimise the disruption to a portfolio.  Ramp up periods for funds of one can be short, though, particularly where a fund of one is set up for an investor who is simply shifting its investment from a manager’s co-mingled fund – the efficiency of this is dependent on the extent to which a proportionate amount of assets in kind can be transferred from the co-mingled fund to the fund of one.
 
Consolidation.  As the 100% owner of a fund of one, the investor will need to consider whether it has to consolidate the fund on its books for accounting purposes.  This may or may not pose a burden for the investor depending on its own situation, but thought should be given as to how the structure of the investment terms will impact this.  For example, even though the manager maintains full control over the funds activities, if the investor has the ability to terminate the fund manager, then under accounting standards such as IFRS the fund may have to be consolidated on the investor’s books.
 
Conclusion
 
The fund of one concept offers unique benefits to institutional investors with sizeable investment mandates who don’t want to co-mingle their assets with other investors.  Investors can avoid certain downsides associated with co-mingled funds.  Not every manager is equipped to run a fund of one, but those that are may find this type of platform increasing in popularity.
 

Gregg S. Buksbaum is a partner in the Business Department of Patton Boggs LLP and a member of its Private Investment Funds Group, Securities and M&A Group, and International Business Group.  Mr. Buksbaum represents domestic and international fund sponsors in the formation of various types of investment funds and the execution of merger and acquisition transactions.  He also counsels these clients on securities regulatory matters.  Mr. Buksbaum also represents large institutional investors, including sovereign wealth funds and family offices, that invest in various types of private funds and acquire and sell portfolio company and real estate investments. 
 
Gregg can be contacted by phone on +1 202 457 6153 or alternatively via email at gbuksbaum@pattonboggs.com