News analysis

Author: | Published: 1 Jul 2008
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UK has hedge funds in its sights

The UK Financial Services Authority (FSA) is targeting hedge funds over market abuse allegations. And if it can't prove insider trading, it's going after internal controls.

"I would not rule out a situation where the FSA takes action on insider trading, doesn't have enough to prosecute, but is so disappointed with the internal controls it finds that it takes action on those as a consolation prize," said Martyn Hopper, regulatory partner at Herbert Smith.

"I have certainly heard FSA officials talk about their concerns about systems and controls."

The FSA signalled its intent in October by publishing Market Watch 24. There it declared that senior management at hedge funds hold ultimate responsibility for compliance with the market abuse regime. "This proved that the FSA has hedge funds in its sights," said Patrick Buckingham, regulatory partner at Herbert Smith. "And now funds have had a couple of months to digest Market Watch 24, it is only a matter of time before action is taken."

Hedge fund managers will have the onerous job of considering and checking their compliance with market abuse rules. Principles-based regulation such as Market Watch 24 allows the flexibility to create a bespoke system, but does not offer much prescriptive guidance.

But the FSA is keen to act soon. Due to the fact that many hedge funds have small compliance resources, they may not be able to get up to speed in time. Indeed, there has been speculation that the HBOS scandal would be the perfect opportunity for the FSA to swoop.  NP

 The main points of the FSA's Market Watch 24
  • Hedge fund senior management is solely responsible for its market abuse regime. This responsibility cannot be delegated.
  • All hedge funds should have independent monitoring of their market abuse controls and procedures. In addition, the FSA highlights the potential benefits of automated controls in IT systems to identify or restrict market abuse.
  • A list of all securities that inside information has been received on must be kept and trading on these securities must be restricted. The FSA notes the benefit of Chinese Walls, but concedes that they are not always appropriate, depending on the size of the funds.
  • All staff must receive appropriate and regular market abuse training.
  • There is a general responsibility to ensure that confidentiality is stressed where needed. This is part of the FSA's plan to reduce the dissemination of information and rumours.
  • Hedge funds are recommended to consider the benefits of recording telephone lines. The FSA also asks hedge funds to consider their remuneration structures.
  • Long-term structures may reduce the attraction of committing market abuse for short-term gain.  


 European Spacs don't need formal regulation

Special Purpose Acquisition Companies (Spacs) are so transparent that market forces will be enough to regulate them. "We shouldn't chip away at the general structure. It would be a great shame to ignore the genesis of Spacs and fiddle with them," said one panel member at the IFLR capital markets forum in April.

"Some US Spacs have tried to change standard terms and have been beaten back. The European market has an opportunity to police itself and say 'that's a bridge too far' if anyone steps out of line."

Spacs are set up to attract investors who buy shares in an investment company and then get to vote on a potential acquisition. They play on the entrepreneurial record of those setting them up, rather that the financial records of investment managers in other permanent capital products.

And it is this structure that reduces the need for formal regulation. Typically, Spacs require 80% of shareholders to agree with a proposed acquisition. Anyone who voted against has the opportunity to get out what they paid.

The fact that Spacs are equity products also helps. Euronext Amsterdam is where the majority of European Spacs are traded and the panel described the benefits:

"A Spac unit is a tradable instrument from day one. If the market doesn't like a proposed acquisition, the share price will drop and this is an indication that the shareholder vote will fail," said a panel member.

"But if the share price spikes, the market likes the acquisition. Any Spac unit holder that disagrees with the acquisition can sell over the exchanges. They will often profit and the shareholder vote will go through at near enough 100%."

This point also acted as a veiled warning to London. If Spacs are the future of permanent capital, then London will have to make some changes to compete. At the moment, London rules mean that as soon as a Spac announces a proposed acquisition, shares are suspended.

"This unwinds what can be an incredibly transparent structure," concluded the panel. NP

Debt buy-backs force change to documentation

The trend of private equity houses buying back their own debt has worried banks into changing their lending documentation.

The debt issued for previous buy-outs is trading at a discount, making it an attractive investment for private equity. But the banks are worried because if it is bought up the private equity houses will own debt and equity in the same company – giving them greater control.

Danish telecommunications company TDC, which is owned by a private equity consortium, did this recently by buying back ?200 million of its loans at a low rate of 90-95%.

"Typically, any money available should go to repaying the debt. This is messing with the natural order of repayment," said a private equity partner at a magic circle firm.

"It will affect how banks draft their documentation; they will definitely want to try and stop it. Financing partners at our office have already started working on redrafting terms."

Most UK loan contracts require a two-thirds majority to implement an accelerated default procedure. If a private equity house holds a substantial proportion of the debt in one of its companies, it could frustrate lenders in a default or a restructuring. It could also block votes on other aspects of loans such as pricing, security or seniority.

"It gets problematic if people are wearing both hats. It also raises the issue of fiduciary duties and when they apply," said the private equity partner.

If redrafting doesn't deal with banks' concerns, they could push for proposals similar to those in the US. There, the Loan Syndication and Trading Association has clarified a strong position on the transferability of loans. Borrowers and any of their affiliates are restricted from purchasing their own bank debt. Private equity houses are deemed to be affiliates to companies they have invested in.

"Exceptions are sometimes negotiated allowing a private equity sponsor to purchase up to a certain percentage of a portfolio company's bank debt. This is usually less than 30% in order to prohibit the sponsor from gaining a blocking vote," said Jones Day partner Andrew Barker.

"Additionally, banks will sometimes allow a private equity sponsor to own the bank debt on the condition that they cannot exercise any voting rights, so they cannot impact enforcement and other decisions." NP

Clear Channel infects global lending

Despite the Clear Channel dispute being settled out of court in April, the case is infecting lending deals at least as far away as Europe.

In May, private equity houses Thomas H Lee Partners and Bain Capital agreed to funding of $17.9 billion ($36 per share) for their purchase of Clear Channel Communications. Previously, the bank syndicate had refused to fund the buyout price of $39.20, prompting legal action for breach of contract.

This workable solution (subject to shareholder approval) is welcome news to the parties involved in the transactions, but the case is disrupting other deals.

"I was working on a deal this week where one of the lending banks was a party to the Clear Channel case. The borrower wanted special reassurance that the bank would not renege on the deal," one partner in London told IFLR.

"But the bank was hardly going to say, 'we're not going to lend to you either', so it just gave the normal assurances. In the end, the deal didn't go through anyway."

The straining of relations between borrowers and banks could have a profound effect on the market. This is not the only acquisition finance case going on, as IFLR highlighted in its May issue and reported when the PHH deal fell apart in January.

Given that Clear Channel involved six lenders (Citigroup, Credit Suisse, Deutsche Bank, Morgan Stanley, Royal Bank of Scotland, Wachovia) and one of them is already facing questions from borrowers, further cases could make the leveraged lending market even more conservative.

The fact that the case was settled means that the debate on how a US court would enforce the breaking of a commitment letter continues – no one knows if the judge would enforce specific performance or impose damages.

"If the original terms were enforced, then the banks would be back where they started," said the partner. NP

Spacs hits Asia

The burgeoning trend of Special Purpose Acquisition Companies (Spacs) has finally hit Asia, with China's first high-profile case.

Heckmann's $625 million takeover of China Water is the first large Spac acquisition of a Chinese target. Credit Suisse and DLA Piper acted as Heckmann's financial advisor, and counsel in both the US and Hong Kong.

The first Spac in China was Jaguar's takeover of China Cablecom in April, but the deal was only $34.3 million.

While the products have become commonplace in Europe and the US over the last year, their growth is still relatively nascent in Asia.

That said, several Spacs have been formed to acquire companies in India and some Indian companies are looking to use the vehicles to acquire foreign companies. But the disclosure requirements of the Securities Exchange Board of India (Sebi) prevent companies with no track record from listing which may restrict Spac growth there. TY

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