The Sausage of Hedge Fund Marketing Materials - Part 1
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The Sausage of Hedge Fund Marketing Materials – Part I, “Are You Sure That’s True?”
By: Jeremy L. Hill
The review of hedge fund marketing materials can seem a rather straightforward task. FINRA and the SEC have prescribed rules on “communications with the public” and “general solicitation.” In addition, most firms have internal policies that guide the construction and publication of marketing materials. Following prescribed rules and internal policies may sound simple, but the review of marketing materials often falls into the rabbit hole of deciding whether a particular bullet point, phrase, sentence or number is in any way “misleading.”
Most of the existing technical and legal advice does not give actual live examples of how marketing materials are constructed, reviewed and published by hedge funds and their broker-dealer sales partners. This article attempts to give some flavor to the legal and compliance reviews that are part of hedge fund marketing materials.
Summary of Relevant Rules
The starting point for all discussions on hedge fund marketing materials is Regulation D, the exemption allowing for private sales of securities (fund shares) to accredited investors. With the passage of the JOBS Act in 2012, private funds are now allowed to engage in general solicitation without losing the offering exemptions afforded by Regulation D. Under Rule 506(c) hedge funds are allowed to undertake general solicitation. Although many hedge funds could avail themselves of general solicitation under Rule 506(c), most have not done so for fear of setting precedent and somewhat confusing regulatory intent surrounding this new rule.
The second rules-based pillar for the discussion of hedge fund marketing materials is the myriad of rules governing broker-dealer communications. Many investment advisers employ broker-dealers to help market and sell their hedge funds. Consequently, broker-dealer rules frequently control the substance of hedge fund marketing materials. For example, FINRA Rule 2210 is often a consideration as it governs all broker-dealer “communications with the public.”
Virtual mountains of legal memos have been written about hedge fund marketing rules. One need only google the subject to find all sorts of rules-based advice - from the history of the rules to tangentially related case law. The most important element to understand from all of the rules is that hedge fund marketing materials may not be misleading in any way. No matter the technicalities of the actual rule, all misleading statements, charts, graphs, figures and numbers are prohibited. That “misleading” is the basis of determining the viability of communications is not surprising since hedge funds are (of course) prohibited from employing any device or scheme to defraud existing clients and while marketing to prospective clients.
In FINRA IM 2210-1 it is stated that “members must ensure that statements are not misleading within the context in which they are made.” In essence, this means that hedge funds owe the duty of accuracy and hedge funds employing broker-dealers will be marketed under the additional stricture of “fair and balanced.”
Building a “Deck”
Most hedge funds will draft several different types of marketing documents. Many funds start with a “long deck” which provides as much detail as possible on the fund, the strategy, the management, and their administration. From this long deck, modular marketing materials are often drafted – a “short deck,” and various summary documents highlighting the strategy, performance and processes. By and large, funds market themselves based upon a proven tier of investor concerns: performance, team, everything else.
It is also important to understand the normal drafting process of hedge fund marketing materials. Most funds rely on junior employees to gather data and research as a first step. Then the senior marketing professionals act as the copy writers, often consulting with the portfolio managers. In further iterations, the senior managers such as the CFO, Head of HR, Operations and Risk may be brought into the process. Finally, the art team gussies up the document. Et voilà, new hedge fund marketing materials!
The obvious inefficiency in this drafting process is the lack of contemporaneous legal counsel input. By design or default, most of the regulatory and legal assessments of hedge fund marketing materials are part of the post-hoc regulatory approvals process, or immediately preceding that stage.
“You Actually Believe That?” Nope!
Let’s assume that a hedge fund is a U.S. domiciled, relative value, credit fund with a broad investment mandate (our hypothetical “Fund”). Further, let’s assume that the Fund is utilizing the services of a broker-dealer to market and sell the fund. Lastly, let’s assume that the Fund and the broker-dealer work closely together to draft the Fund’s marketing materials (i.e., from the very start of drafting both hedge Fund and broker-dealer marketing rules apply) which are only provided to Accredited Investors, QPs and Institutions.
In the Fund’s latest marketing materials, there is a section devoted to describing the state of the U.S. economy and well as the Fund’s global macro outlook. In the second sentence of this particular marketing piece, it states “The U.S. economy continues to grow nicely above trend and the reflation trade we saw at the beginning of the year is definitely back on.” The next sentence follows with “employment is continuing its never ending payrolls expansion which means consumers are going to have a lot more money and will ramp up discretionary spending.”
The above two sentences, seem benign. However, they present two legal and regulatory risks. Firstly, these two sentences are opinion written as fact. Secondly, the statements are at best unclear and quite possibly untrue.
First, any untrue fact should be corrected. It is critically important for legal counsel to be able to spot opinions about markets, economics, correlations, and assets masquerading as facts. That means the counsel reviewing hedge fund marketing materials should have a decent understanding of risk markets and economics and work with the drafters to verify and correct obvious factual misstatements.
In assessing these two statements, the all of the following are highly debatable: (i) the U.S. economy is growing above trend; (ii) the reflation trade is back on; (iii) payrolls expansion is never ending; (iv) consumers will have more money; and, (v) the consequences of all of the preceding will be greater discretionary spending. Each and every one of these statements is uncertain and contingent on many other factors. For example, although the growth rate of U.S. Real GDP has gone up over the past year and half, it is nowhere near as robust as measurements in 2014 and 2015. Thus, the veracity of “nicely growing above trend” is an opinion that largely depends upon reader’s definition of “nicely,” “growing” and “trend.” The same type of analysis can be applied to (ii) through (v), above.
After spotting and correcting any factual errors, counsel should add qualifying language and delete certain types of statements. In many corridors, economics is lovingly referred to as the “dismal science.” There are reasons for that and legal and compliance professionals should be on the lookout for any forward-looking economic statement of certainty (e.g., higher GDP will result in greater discretionary spending). The use of the word “will” to describe an economic outcome is a definite yellow flag. In this example, “will” should be changed to “may.”
Lastly, after correcting obvious factual errors and adding appropriate qualifying language, inserting the voice of the Fund (i.e., the drafter) is usually preferred. The use of “in our opinion” or “we believe that” most definitely decreases the likelihood that these types of statements are considered misleading in any way. And, that’s the whole point – a reducing the legal risks of statements that may be or become misleading in hindsight. Making sure that facts are actually facts and qualifying opinions is a good starting place.
In Part II of The Sausage of Hedge Fund Marketing Materials (“You Can’t Say That”), hyperbolic language and suspect financial correlations will be discussed. Stay tuned.
END NOTES
1. This article assumes that “hedge funds” or “private funds” are subject to U.S. rules and defined as “investment advisers” under the Investment Advisers Act of 1940.
2. To the extent a hedge fund is a Commodity Pool Operator or trades in commodities, rules of the Commodity Futures Trading Commission and the National Futures Association may also be a consideration.
3. The “holy grail” of all things investment advisers is the “Lemke book,” officially titled “Regulation of Investment Advisers (Securities Law Handbook Series)” published by Thomson Reuters. In addition, many prominent investment management law firms addressed hedge fund marketing materials in firm-branded articles or blogs when the JOBS Act was passed. My point: there’s lots of rehashing of rules, but little in form of how hedge funds actually apply the rules when grinding the sausage of marketing materials.
4. Pursuant to Section 206 of the Advisers Act and FINRA Rule 2210.
5. Please note that this article focuses entirely on marketing material as distinct from offering, purchase and funding documents.
6. Clearly there is no one way or “normal” way to draft hedge fund marketing materials. However, with much observation and experience, it can safely be said that a “research, copy, compare, iterate, cut, add, make nice approach” is about as normal as it gets.
7. Frequently, the GC or outside counsel sets initial regulatory parameters, renders generalized guidance, and participates in higher level discussions. However, it is virtually unheard of for the legal advice to be part of the granular (i.e., word-by-word, number-to-number) drafting process.
8. Berger Legal works with a lot of different hedge funds, asset managers and financial institutions. The hypothetical fund described herein, does not represent any specific fund, nor is it modeled on any existing client or investment fund or strategy.
9. It is very common for hedge fund marketing materials, especially quarterly updates and letter formats, to include stream of consciousness economic thinking from the portfolio managers.
10. Note that the Median US Real GDP Growth Rate since the measurement started in 1933 is 3.20% and the mean is 4.33%. http://www.multpl.com/us-real-gdp-growth-rate
11. Or, assuming it is factually correct “has historically resulted in higher discretionary spending,” etc.