GT Alert

For Hedge Funds, One Less Risk to Hedge - For Now

October 2003
By Steven M. Felsenstein and Joel S. Telpner, Greenberg Traurig

  View or download the PDF version of this Alert here.

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 investment company.
• 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 by broker-dealers.
• 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 staff recommendations.

What are the Details?

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 pools.

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.

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.

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.

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.

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.

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 return strategies.

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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