San Francisco, CA (www.hedgeco.net) When a hedge fund or private equity fund manager (collectively, “private fund managers”) decides to organize a new fund, perhaps the most relevant information thata potential investor could be presented with would be the past performance of the existing funds advised by the private fund manager or a track record of the private fund manager developed at aprevious employer. The presentation and use of this type of information is generally referred to as “related performance” and it is a topic of great interest at the National Association of SecuritiesDealers (the “NASD”). This “great interest” by the NASD affects every private fund manager that expects to generate distribution of its fund through third party marketing agents or capitalintroduction services of an NASD member broker dealer.

It is the NASD’s position that Rule 2210 of the NASD’s Rules of Conduct prohibits NASD member brokers from using or distributing sales materials or other communications to the public that present related performance. This prohibition applies not only to information prepared by the member broker, but also to information prepared by a non-member, such as a private fund manager. Accordingly, it is illegal for a broker to present to its clients the marketing materials prepared by a private fund manager if such marketing materials include related performance. The NASD reaffirmed this position in an interpretive letter to the Securities Industry Association dated October 2, 2003.

Most private fund managers are not NASD member brokers in reliance upon the “issuer’s exemption” of Rule 3a4-1 under the Securities Exchange Act of 1934, and therefore, are not subject to the NASD prohibition on the use of related performance. As investment advisers to funds, private fund managers are subject to the anti-fraud provisions of the Investment Advisers Act of 1940 (the �Advisers Act�), whether or not they are actually registered with the Securities and Exchange Commission (the “SEC”) as investment advisers. The SEC, in a line of no-action letters dating back to 1986, has permitted the use of various types of related performance in communications to clients under very specific conditions and with prominent and adequate disclosure with respect to what the related performance is and is not. If you think life is unfair, you should also know that it is the position of the NASD that member brokers may publish or distribute sales literature for a public commodity pool that presents the same related performance information that appears in the pool’s offering document as prescribed by the Commodity Futures Trading Commission.

In a more recent interpretive letter (Davis Polk, December 30, 2003), the NASD attempted to draw a distinction between hedge funds and private equity funds for purposes of permitting the use of related performance. In this letter, the NASD took the position that a member broker may present related performance about a fund that is exempt from registration under Section 3(c)(7) of the Investment Company Act of 1940 (the “1940 Act”). A private fund that relies on Section 3(c)(7) must be completely comprised of “qualified purchasers,” which means an individual with $5 million in investments, or an institution with at least $25 million in discretionary assets under management.

Although many private equity funds limit themselves to qualified purchasers, that is not the case for all. It is typical for most hedge funds, and a great number of private equity funds, to rely on the lower “accredited investor” standard of Section 3(c)(1) in order to permit investment by certain “friends and family” types. An “accredited investor” need only have $1 million in net worth and an income of $200,000 in each of the past two years. As a practical matter, this standard will likely increase as a result of the new hedge fund adviser registration rule, Rule 203(b)(3)-2, which effectively prohibits the use of performance fees in a private fund unless all investors meet the definition of “qualified client” in Rule 205-3 under the Advisers Act. Because most private funds impose a performance fee, after February 1, 2006, new private fund investors will likely be limited to those with $750,000 under management with that particular manager, or $1.5 million in net worth.

So where does this leave private fund managers that hope to take advantage of a broker dealer’s capital introduction services? Unless the NASD can see its way clear to permit the use of related performance by member brokers for the benefit of their high net worth and sophisticated clients, member brokers will continue to direct clients to the private fund managers to obtain such information and hope that the NASD Enforcement arm does not view this activity as a circumvention of Rule 2210.

Note: White & Case LLP represents hedge fund and private equity fund sponsors and advisers, prime brokers, and administrators through its 38 offices in 25 countries around the world. For further information on the White & Case investment funds practice, contact:

Jay B. Gould, Esq.
White & Case LLP
San Francisco, California 94111
415-544-1112 (O)
310-800-6500 (C)
Jgould@whitecase.com

David A. Goldstein
White & Case LLP
New York, New York 10036
212-819-8757 (O)
917-891-8900 (C)
dgoldstein@whitecase.com