For Hedge Funds, One Less Risk to Hedge - For Now
By Steven M. Felsenstein
and Joel S. Telpner, Greenberg
View or download the PDF version of this Alert
On Monday, September 29, 2003, the staff of the SEC released its recommendations
on hedge funds. And as the Wall Street Journal reported, "Hedge Funds may
have dodged a major bullet."
|"Whether or not registered under
the Advisers Act, now is a good time for hedge fund advisers to
review their existing policies regarding potential conflicts of
interest and other best practices."
For nearly a year the SEC staff has been studying the booming hedge fund
industry with an eye towards taming a virtually unregulated investment frontier.
Much to the relief of the hedge fund industry, the staff recommendations
are far milder than many had predicted.
What did the Staff Recommend?
- That all hedge fund advisers register as investment advisers under
the Investment Advisers Act.
- That registered investment companies that invest in hedge funds have
policies and procedures assuring that those investments be valued in a
manner consistent with the Investment Company Act and that the fees and
expenses of these hedge funds be disclosed in the fee table of the registered
- That hedge funds that permit investments only by "highly sophisticated
investors" be permitted to engage in general solicitation and advertising.
- That the staff and the NASD monitor capital introduction services
- That the SEC issue a concept release to examine the wider use of hedge
fund investment strategies in registered investment companies.
What does this Mean for Hedge Funds?
First and most importantly, these are only recommendations by the SEC
staff. They must be acted upon by the SEC Commissioners. On occasion, the
views of the Commission have diverged significantly from the conclusions
of the staff. Several commissioners have already expressed concern that
regulating the hedge fund industry might not make sense. The SEC commissioners
could choose not to implement any of the staff’s recommendations or could
modify the recommendations significantly. In addition, any recommendations
would be subject to public comment and potential revision as a result of
such comments. Finally, the time required for the issuance of proposed rules
and the receipt of public comments could require a considerable period of
time, particularly if the comments are contentious. Significant time could
pass before regulations are ultimately enacted by the Commission. Nevertheless,
some hedge fund managers may decide to take the dive now and voluntarily
register under the Investment Advisers Act or comply with some of the other
What are the Details?
How did the Staff Define Hedge Funds?
The staff noted that there is no precise legal definition of hedge funds.
For purposes of the recommendations, the staff loosely defined hedge funds
as entities that hold pools of securities and other assets that do not register
securities for sale under the Securities Act and which are not registered
as investment companies under the Investment Company Act. Further, the staff
noted that hedge funds are characterized by a fee structure that compensates
the adviser based on a percentage of capital gains. Excluded from this definition
of hedge funds are venture capital funds, private equity funds and commodity
Who Would be Required to Register Under the Investment Advisers Act?
Virtually all advisers of hedge funds would be required to become registered
investment advisers under the Investment Advisers Act. Under the Investment
Advisers Act, advisers with 15 or more clients must register as investment
advisers. Current SEC rules permit advisers to count a "legal organization"
such as a hedge fund as a single client. However, the staff recommends revising
the rule to require that hedge fund advisers "look through" the hedge funds
they manage and count each investor as a separate client of the adviser.
Pragmatically, this would force most hedge fund advisers to register under
the Advisers Act.
If the changing definition of "client" forces the registration of hedge
fund advisers, hedge funds could be forced to significantly restrict their
target audience in order to permit the adviser to continue to receive "performance-based"
compensation. This would significantly restrict access to hedge funds. As
a consequence of registering the adviser to a fund under the Advisers Act,
the minimum investment requirements for hedge funds would increase to either
a minimum investment of $750,000 or a minimum net worth requirement on the
part of the investor of $1,500,000. Funds permitting investors not meeting
these requirements would be precluded from paying a performance fee to the
hedge fund adviser.
How this issue is decided could prove to be a function of whether the
Commission believes that access to hedge funds (at least as we know them
now) should be severely cut back, denying many investors the chance to make
such an investment. If the Commission concludes that an investment in a
hedge fund is not appropriate to many investors, and that they should not
be able to make such an investment, registering advisers might close such
investors out of hedge funds. If the Commission believes that such investments
should be permitted subject to appropriate disclosure and regulation, then
registration of hedge fund advisers might have to make some provision for
performance compensation in some funds.
What Would be the Consequences of Registration?
The major impact on newly registered hedge fund advisers could be the
imposition of the Advisers Act’s limitation on "performance-based" compensation.
As discussed above, this could require a substantial redirection of marketing
and ownership of hedge funds. A substantial segment of hedge fund investors
that will not meet the definition of "qualified clients" could be barred
from access to many advisers and products.
Other consequences that would generally be viewed with favor by investors
also could result from registration. First, hedge fund advisers would become
subject to ongoing inspection and examination by the SEC. Second, the SEC
would be authorized to collect information about the activities of hedge
fund advisers and the hedge funds they manage. Third, hedge fund advisers
would become subject to disclosure requirements covering matters such as
relationships with prime brokers and potential conflicts between hedge funds
and other separate accounts managed by hedge fund advisers.
What are the Changes Proposed for Registered Funds?
Registered Funds investing in hedge funds, including funds of hedge funds,
would be required to implement policies and procedures that ensure that
their boards value their interests in hedge funds in a manner consistent
with the requirements of the Investment Company Act. Further, registered
funds would need to include in their fee tables the estimated expenses of
the underlying hedge fund interests.
How Would the Rules Regarding the Marketing of Hedge Funds Change?
If the staff’s recommendation was to be adopted, the prohibition on general
solicitation or advertising in offerings by hedge funds would be eliminated
for hedge funds that permit investments only by highly sophisticated investors
(so called Section 3(c)(7) hedge funds). The result could be a strange contrast
of increased public solicitation of investors for hedge funds, coupled with
a severe restriction on access to such funds by investors that, perhaps
for the first time, are exposed to hedge fund advertising.
What Would the NASD’s Role Be?
The NASD would be encouraged to continue to monitor prime brokers’ capital
introduction practices. Further, the NASD would be expected to assure that
broker-dealers’ suitability and other regulatory obligations are met in
connection with the offering of hedge funds.
What Other Recommendations did the Staff Make?
The staff recommended that the Commission encourage all participants
in the hedge fund industry to embrace existing "best practices" and adopt
additional best practices to supplement conflict management policies and
procedures. This has the potential to cause significant changes in the industry,
perhaps without the protection of public rule-making procedures. In general,
when investment industry committees define "best practices" they strongly
impact the conduct of participants, even though the process is not governed
by the safeguards built in to the adoption of rules by the Commission.
On a positive note, the staff would also like the Commission to promote
greater investor education regarding hedge funds, focusing, in particular,
on the potential for fraud in hedge funds and the correlation between risk
and return. Finally, the staff recommended that the Commission undertake
a study on whether (1) registered funds should be able to use greater leverage,
(2) absolute return strategies have a positive effect on aligning the interests
of the hedge fund adviser with investors where the adviser’s performance
fee is tied to receiving the absolute return and (3) additional investor
education would be necessary in connection with greater use of absolute
What Should Hedge Fund Advisers Do Now?
Non-registered hedge fund advisers may wish to consider the benefits
and detriments of becoming registered under the Advisers Act although there
is no obligation to do so at this time if the adviser has fewer than 15
clients and the adviser does not hold itself out generally to the public
as an investment adviser.
Whether or not registered under the Advisers Act, now is a good time
for hedge fund advisers to review their existing policies regarding potential
conflicts of interest and other best practices. The staff report accurately
noted that unregistered advisers are subject to the anti-fraud provisions
of the Advisers Act.
If you would like more information on the SEC staff report or would additional
information regarding hedge funds or the Investment Advisers Act, please
feel free to contact Joel Telpner
at (212) 801-6598 or Steven Felsenstein
at (215) 988-7837.
© 2003 Greenberg Traurig
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