Federal Hedge Fund Reform: Burden or Opportunity?
The global hedge fund industry had total assets under management in excess of $2.375 trillion in the first quarter of 2013 according to Hedge Fund Research, Inc (HFR).1 This number may be small compared with the over $55 trillion in world stock exchange market capitalization but the hedge fund industry has been growing since the early 2000s. According to analysts, hedge funds are set to attract a growing number of new investors, in particular pension funds, “despite lackluster investment performance for the industry for the past two years.”2 The Jumpstart Our Business Startups Act (JOBS Act) and related Securities and Exchange Commission (SEC) rulemaking would make it easier to market hedge funds, and may contribute to further growth.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and rules issued by the SEC and the Commodity Futures Trading Commission (CFTC) have had an impact on the previously lightly regulated private fund industry. Hedge funds did not cause the financial crisis of 2008, and most of Dodd-Frank is primarily targeted at the large banks that had to be bailed out. However, a number of provisions, most importantly provisions relating to private fund adviser registration, had a direct effect on hedge funds, resulting in new compliance requirements, greater transparency, and possibly increased SEC oversight. The SEC’s new chairman has already indicated that she plans to run an aggressive enforcement program focusing on issues beyond the financial crisis.3 The former head of the specialized Asset Management Unit in the SEC’s Enforcement Division has said that his division will focus on “investment advisers to alternative investments and private funds, and more specifically, hedge fund advisers.”4 Accordingly, while hedge funds may benefit from an expanding investor base, the JOBS Act, and new opportunities stemming from limitations on large banks, many hedge fund firms must also comply with new regulations and likely endure more regulatory interest in their activities. This article summarizes the main areas of new regulations, how the hedge fund investor base is evolving and the potential implications of the JOBS Act, and recent SEC communications regarding hedge funds.
Who Invests in Hedge Funds?
The hedge fund industry’s investor base has been changing. In recent years, institutional investors such as pension funds, endowment plans, and insurance companies have become increasingly important.5 According to analysts, this trend will continue despite investment returns that were below expectations in 2011 and 2012.6Bloomberg data shows that the HFRX Global Hedge Fund Index underperformed the S&P 500 Index in 2011-2012. However, industry-wide performance data can be misleading because there are huge discrepancies in performance among the thousands of funds included in the index. Pension funds may have good reasons to diversify their investments and look for potentially higher returns, but they may also expose their beneficiaries (e.g., retail investors) to potentially highly risky assets. According to an April 2013 survey by the Organisation for Economic Co-operation and Development (OECD), 22 of its 34 Member States surveyed have some sort of limit on pension funds investing in private funds.7 There are no such regulatory limits in the United States but pension fund managers and other institutional investors cite transparency as one of their main criteria for deciding which funds to invest in. According to the 2012 Preqin Hedge Fund Investor Review, “[t]ransparency has become increasingly important to investors; this was highlighted by an earlier Preqin study which revealed that 58% of respondents had rejected a fund investment opportunity in 2011 on the basis of a lack of transparency.”8 Dodd-Frank mandated regulations imposing new reporting requirements and other compliance obligations are pushing the industry toward more transparency, creating opportunity for growth.
Dodd-Frank and Hedge Funds
Investment Adviser Registration
The most important Dodd-Frank provision for the hedge fund industry was that private fund managers became subject to the same registration and other regulatory requirements that apply to investment advisers pursuant to the Investment Advisers Act of 1940 (Advisers Act).9 The SEC adopted its rule implementing the amendments to the Advisers Act in June 2011 (43 SRLR 1310, 6/27/11). Large fund managers with over $150 million in assets under management are now required to register with the SEC, and mid-sized fund managers with assets between $25 million and $100 million are required to register with the states in which they operate. These mid-size managers are not eligible to register with the SEC unless (1) a state registration exemption is available, (2) the managers have their principal office and place of business in New York or Wyoming, or (3) they would be required to register with fifteen or more states.10 The deadline for registration was March 30, 2012 and the SEC’s Division of Investment Management reported that more than 1500 private fund advisers registered by October 2012 (44 SRLR 2001, 10/29/12). According to information collected by the SEC, 48 of the 50 largest hedge fund advisers in the world are now registered with the SEC and fourteen of these registered after Dodd-Frank.11
Exemptions and Exclusions From Registration
The key registration exemption for hedge funds is the private fund adviser exemption available to investment advisers who have less than $150 million in assets under management and advise solely private funds.12 The exemption also requires that those relying on it report certain information about themselves and their advisory business by completing and updating a subset of information on Form ADV that SEC registered advisers must complete. These “exempt reporting advisers” must update the form at least once a year.
Other exemptions are available to foreign private advisers,13 venture capital fund advisers,14 and commodity trading advisors.15 In addition, certain exclusions from SEC regulations are available for banks, broker-dealers, and family offices.16 The most famous hedge fund to rely on the family office exemption was George Soros’s hedge fund, which returned all remaining customer money in 2011 to avoid registration with the SEC.17
New SEC Reporting Requirement: Form PF
Information provided by registered or exempt funds on Form ADV is publicly available. In addition, certain registered private fund advisers are required to disclose confidential information to the SEC on Form PF.18 The new form’s primary purpose is to help the Financial Stability Oversight Council monitor risks that the private fund industry poses to the U.S. financial system.19 Advisers have to report performance results and other sensitive information about their funds. Form PF must be filed electronically and the information contained in it is not publicly available. However, the SEC has indicated that disclosures in those forms will be used for regulatory, inspection, and enforcement purposes, particularly performance results disclosed in the forms.
Remember the CFTC
Private funds, which typically do not trade in futures and had little, if anything, to do with the CFTC prior to Dodd-Frank, now also have to concern themselves with the agency’s rules. Because of their swaps activities and the rescission of the CFTC Rule 4.13(a)(4) registration exemption, many hedge fund managers have had to register as commodity pool operators (CPO) and/or commodity trading advisors (CTA) with the CFTC. If fund managers are required to register, they must comply with reporting obligations to the CFTC and the National Futures Association (NFA), the self-regulatory organization in charge of administering all filings for CPOs and CTAs.20
Even if fund managers qualify for an exemption or exclusion, the determinations to be made under the new regime are more complex and onerous than prior to Dodd-Frank. The primary exemption from CPO registration most hedge fund managers are now able to rely on is the de minimis exemption for private funds that engage in limited trading of swaps and other ‘commodity interests.’21 To avoid CTA registration, registered and exempt investment advisers have several choices.22 However, these exemptions require fund managers to carry out careful and fairly complicated calculations to ensure that their swaps activities do not exceed applicable thresholds.
April 5 marked the JOBS Act’s first anniversary. The SEC has not finalized any of the rules it is required to issue to implement the law. The agency released its proposal to eliminate the prohibition on general solicitation and general advertising in private offerings last August. The JOBS Act is primarily meant to assist small and medium-size businesses in obtaining financing through securities markets. Legal experts advising hedge funds and other private funds described the proposal as one that would “dramatically expand” marketing options in private placements (44 SRLR 1706, 9/17/12). In order to rely on the rule, issuers would have to take “reasonable steps” to verify that the purchasers are all accredited investors in Rule 506 private placements. The proposal did not prescribe what concrete steps would be considered “reasonable.” Instead, the SEC listed certain factors that issuers would typically have to consider to satisfy the standard. This “facts and circumstances”-based approach would leave companies, including hedge funds, with a fair amount of flexibility and initially there was much excitement in the alternative investment industry.
The proposal attracted over 200 comment letters from interested parties. BlackRock Inc., the world’s largest investment manager, was “pleased to see that the Commission determined not to mandate additional, specific requirements for private fund advertising.”23 Prominent law firm, Sullivan & Cromwell LLP, agreed with the SEC’s approach and stated in its comment letter that “any set of prescribed verification methods would be overly burdensome in some cases, while ineffective in others.”24 The Managed Funds Association (MFA), an influential trade group representing the global alternative investment industry, supported the proposal but also recommended that the SEC adopt a more definitive “safe harbor” standard within the rule.25 The MFA suggested that if an investor unequivocally affirms that it is an accredited investor in writing then the issuer should be deemed to have satisfied the rule’s requirements.
However, many commenters including investor advocates and consumer groups argued that the lack of clear guidelines will increase the danger that unqualified persons are lured into inappropriate investments. Opponents also argued that smaller businesses and startups, the intended beneficiaries of the JOBS Act, often do not have the resources and expertise to make appropriate determinations and could be discouraged from taking advantage of the new rules. Americans for Financial Reform, a coalition of unions, non-profits and investor groups, commented that hedge funds should not be allowed to take advantage of the new rule. They argued that “at no time during the debate over the JOBS Act did Congress make the case that its intent was to allow unlimited advertising by hedge funds and private equity funds.”26 Some commentators contend that the JOBS Act is just a “sneaky way to deregulate” and the new advertising rule would help hedge funds “separate inexpert individuals from their savings.”27
In part because of concerns surrounding hedge fund advertising, the SEC has progressed slowly to complete the rule.28 There were reports of internal disagreements within the SEC about whether to add conditions and investor protections to the rule and Congress held hearings on why the SEC missed the July 2012 deadline to complete the rule. The SEC’s Investment Advisory Committee, formed pursuant to Dodd-Frank, unanimously recommended that the SEC change the proposal to provide “clear and enforceable standards for verification, as opposed to reasonable belief, of accredited investor status.”29 The SEC’s new Chairman Mary Jo White does not seem inclined to immediately overhaul the proposal. She indicated that she would push for finalizing the rule in its current form and address any investor protection concerns separately.30
The rule is likely to be adopted in its current form but its impact is not yet clear. It may provide certain hedge funds, especially newer smaller and midsize funds, with opportunities to gain clients and increase their asset base. The rule may also inject more transparency into the hedge fund world, which is in line with regulatory trends and the expectations of larger institutional investors. As one analyst put it, the rule “simply clears up the lines of communications for those who already are permitted in the club.”31 Another analyst argued that the ability to advertise to accredited investors will not mean that much to most hedge funds.32 The largest and most successful hedge funds already have plenty of clients and do not need to rely on advertising to attract investors. In addition, private fund advisers registered with the SEC are subject to restrictions on advertising under the Advisers Act (45 SRLR 444, 3/11/13) and may want to avoid attracting too much of the SEC’s attention. An added concern is that the de minimis exemption from CFTC registration available to fund managers specifically requires that the offered investments are not marketed to the public. Industry organizations asked the CFTC to provide guidance and “harmonize” its rules with the new JOBS Act provision but such guidance has not yet been issued.33
Recent SEC Statements on Hedge Funds
The SEC’s budget request for 2014 stated that “one of the SEC’s top priorities is to hire 250 additional examiners to increase the percentage of advisors examined each year, the rate of first time examinations, and the examination coverage of investment advisors and newly registered private fund advisers.”34 Form PF will be an important source of data for SEC examiners and hedge funds must “foster a compliance culture” to avoid getting caught up in lengthy examination proceedings or an enforcement case.35 There has been closer co-operation between the SEC’s examinations and enforcement divisions and more examinations seem to lead to the initiation of enforcement investigations. The SEC remains focused on fraud, but will also place an emphasis on the quality of disclosures and uncovering misrepresentations especially when it comes to fees and expenses charged to investors.36 Hedge fund managers must be particularly mindful of potential conflicts of interests, allocation of expenses among investors, and risk management.
The hedge fund industry is more regulated now than it has ever been and the SEC has made it clear that it is interested in exercising its oversight and enforcement role more aggressively in this space. Stricter regulatory requirements and scrutiny may help convince institutional investors such as pension funds to increase their alternative asset allocations. Along with more transparency, these investors also often demand a more flexible fee structure, which means increased compliance costs could go hand in hand with decreased fees.37 Investors do not want additional compliance costs passed along to them.38 But a hedge fund that manages to convince a large institutional investor to raise its allocations by just a couple of percentage points could see a relatively big increase in assets under management. Some hedge funds also may benefit from an increased ability to market themselves when JOBS Act rules are finalized. Accordingly, new regulations may create opportunities for some hedge funds to expand that mitigate the burden of increased compliance costs.