After last December’s revelation that the Office of the United States Attorneys had subpoenaed Level Global Investors as part of a widening insider trading probe, the New York hedge fund quickly did some damage control. The $4 billion firm — founded in 2003 by Anthony Chiasson and David Ganek, alumni of Steven Cohen’s SAC Capital Advisors — fired off a reassuring letter to investors.
“The Investment Manager and the Level Funds have professional liability insurance which we expect will cover our legal costs and expenses,” wrote Ganek, who, like Cohen, has used his wealth to build a lavish art collection.
In February, Level Global announced that it was shutting down; although his firm hasn’t been charged, Ganek found the investigation too distracting. The case highlights the growing role that insurance plays in shielding hedge funds, and their clients, from potential legal bills and in forestalling investor redemptions.
“This is the first time I’ve seen insurance used as a public relations mechanism for investors,” says James Beatty, a New York–based senior vice president in the financial and professional (finpro) division of insurance brokerage Marsh, commenting on Level Global’s letter. Marsh, which serves some 250 U.S. alternative-investment firms, has doubled its hedge fund clientele over the past year.
Hedge funds don’t lack for reasons to take out insurance. In the wake of the Bernard Madoff scandal and the 2008 financial crisis, unhappy investors have launched a slew of lawsuits. Making things worse, the industry faces growing scrutiny by regulators. This unwanted attention has led to criminal charges by the U.S. Department of Justice, whose war against insider trading recently notched a victory with an 11-year jail sentence for Galleon Group hedge fund co-founder Raj Rajaratnam.
James O’Brien, head of Marsh’s private equity M&A practice within the finpro unit, says he’s seen a 240 percent spike in hedge fund professional liability claims over the past five years. When redemption requests rose after the financial crisis broke, dozens of U.S. hedge funds erected gates, or limits on withdrawals. They also set up side-pocket agreements that created separate funds for illiquid investments. Such behavior has prompted lawsuits, as have accusations that funds changed their stated strategies.
Mindful of these and other risks, more hedge funds are taking out management and professional liability insurance. “We advise clients to purchase it if they can afford it,” says Douglas Hirsch, head of the financial services operations and litigation practices at the New York office of law firm Sadis & Goldberg.
Carrying insurance doesn’t always make hedge funds more attractive to investors, though. “We are now seeing investors require hedge funds to have professional liability and fidelity insurance,” says Marsh’s O’Brien. But for one prominent institution with hedge fund investments, it’s not a deal breaker. “We don’t require they have an insurance policy,” says the manager of a large state pension fund.
Besides investor lawsuits, hedge fund insurance covers legal fees stemming from investigations by the Securities and Exchange Commission and other regulators. It can also reimburse managers for indemnity obligations in their partnership agreements.
Despite growing demand, hedge fund insurance costs less than it did a few years ago. In 2009 premiums for professional liability insurance spiked about 35 percent in anticipation of a surge of claims that never fully materialized, says Richard Canter, COO of SKCG Group, a White Plains, New York–based insurance brokerage that caters to alternative-asset managers. Insurers started slashing premiums last year, but recent regulatory aggressiveness could mean new hikes.
Meanwhile, coverage has expanded. For example, it can now include informal as well as formal legal inquiries. Then there’s cost of corrections coverage, which reimburses managers for fixing a mistaken trade. Policies also cover most of a settlement with regulators. “In general, coverage is much broader and costs maybe half what it cost five years ago,” Marsh’s Beatty says.
Hedge funds are also buying separate fidelity policies to protect them against management and employee fraud such as stealing, changing the prices of trades or deliberately losing securities certificates.
A $5 billion fund typically spends about $400,000 annually for a policy that pays up to $20 million for any single claim, SKCG’s Canter says.
A recent SKCG survey of 250 hedge fund insurance purchases found that large firms typically bought $40 million or more in professional liability insurance, nearly triple what medium-size shops got. What’s more, the bigger funds paid proportionately less.
Once a hedge fund reaches $100 million in assets, lawyer Hirsch recommends insurance because the firm has deep-enough pockets. “It goes hand in hand with building the proper infrastructure and attracting more-sophisticated investors,” he says. • •
