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.
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
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
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.
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
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