Posts Tagged ‘ Hedge fund ’

Hedge Funds – A New Era of Transparency

Hedge funds play a critical role in capital formation, and are increasingly influential participants in the capital markets.  The hedge fund industry is transitioning from a secretive industry to a widely-recognized and influential group of investment managers.

Mary Jo White’s speech at the Managed Funds Association Conference on October 18, 2013 underscores the transformation of the hedge fund industry and highlights the important changes in the regulatory landscape pertaining to the hedge fund industry. I had previously commented on this here.

The changes introduced by the Dodd-Frank Act and the JOBS Act may be described as tectonic shifts for the hedge fund industry.  The Dodd-Frank Act required most advisers to hedge funds and other private funds to register with the SEC and directed the SEC to collect information, on a confidential basis, from private fund advisers regarding the risk-profiles of their funds. See further on the Effects of the Dodd-Frank Act on the Hedge Fund Industry here.

Similarly, the JOBS Act, directed the SEC to lift the decades-old ban on general solicitation that applied when companies or funds make private securities offerings under Rule 506 of Regulation D.  As a result, as of September 23, 2013, hedge fund managers are free to communicate with investors and the public. They can advertise, talk to reporters, and speak at conferences.  See further on Lifting the Ban on General Solicitation  here.

Mary Jo emphasizes in her speech: “Our knowledge of the markets and understanding of your businesses is also enhanced when [private fund managers] provide us with non-public data on [private] funds’ risk profiles, which is required by new Form PF mandated by the Dodd-Frank Act. Form PF provides information on the types of assets [private fund managers] are holding to help to inform government regulators tasked with monitoring systemic risk. Using this information, regulators can then assess trends over time and identify risks as they are emerging, rather than reacting to them after they unfold [. . . ] This era of hedge fund transparency is also new for [the SEC]. We need to continuously ensure that we – as regulators – are asking for the right information, in the most appropriate way.”

The effects of the new era of hedge fund transparency are still largely unclear and will continue to motivate and dominate my work. There is some anecdotal evidence that the SEC may be struggling to ask “for the right information, in the most appropriate way.”  Several previous articles and three works in progress, including a forthcoming survey study on Form PF, evaluate if the SEC’s evaluation of systemic risk data in Form PF can facilitate regulators’ assessment of: “trends over time and identify risks as they are emerging.”  Another work in progress evaluates the effects of new Rule 506 (c) on the hedge fund industry.


The Hedge Fund Industry after the Lift of the Ban on General Solicitation

The SEC yesterday approved final rules implementing one of the most important changes to securities regulation and offering practices in decades, as mandated by Congress in the Jumpstart Our Business Startups (“JOBS”) Act: to lift the ban on general solicitation or advertising in offerings to accredited investors that are exempt from registration under Rule 506 of Regulation D under the Securities Act of 1933. The implications of this rule change for the private fund industry could be substantial. However, readers who are expecting to see Beyoncé laud XYZ fund’s risk-adjusted returns in TV-ads, on busses etc. are likely to be disappointed. Private funds are still bound by an existing ban on using celebrity endorsements and other gimmicks to sell financial products.

Although the SEC lifted the ban on general solicitation, it appears to desire a counterbalancing of possible effects in the private fund industry. The SEC approved for publication a series of proposed rules to enhance its ability to monitor offerings in the aftermath of these unprecedented rule changes. The proposed amendments to the private offering rules are designed to reduce the risk of fraud and would require issuers to notify the SEC fifteen days before any offering and provide information on the use of proceeds and the type of general solicitation used.

It will take some time until private fund advisers and their attorneys understand exactly how the combination of new rules works, and it will be interesting to see if the enhanced anti fraud requirements will indeed discourage private fund managers from using general solicitations. Given this significant discontinuity, it will be fun to evaluate the effects of the new sets of rules.

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Lifting the Ban on General Solicitation for Private Funds

I previously commented on the bright future for the hedge fund industry. More good news for the industry it seems: private funds could find the ban on general solicitation lifted very soon under SEC rules implementing the provisions of the JOBS Act. Europe’s pending new AIFM regime for alternative investments is stricter but still has lots of loopholes.
Long consigned to silence, hedge fund advisers are starting to practise their sales pitches. Private funds piggybacked on the JOBS Act reforms in the hope of widening the pool of investors they can pitch to. The SEC is busy writing the rules that would put the bill into practice. That process has been bedevilled by delays but it seems inevitable it will overturn the Depression-era ban on “general solicitation”.

Summary of Recent Study on Hedge Fund Manager Registration under Title IV of the Dodd-Frank Act

Read the article at Cayman Financial Review

Read the full study

This article summarises the results of a recent survey of private fund managers.*

The study identifies the possible effects of hedge fund adviser registration under the Dodd-Frank Act and is intended to support policy makers in implementing new rules pertaining to the hedge fund industry. 

The study suggests that the registration and disclosure requirements under the Dodd-Frank Act and the SEC’s implementation of these requirements created several areas of concern for the hedge fund industry. Overall, however, the hedge fund industry appears to be adapting well to the regulatory environment after the enactment of the Dodd-Frank Act.

The Dodd-Frank Act marks the ending of the era of light-touch regulation and unsupervised hedge fund activities. Before the enactment of the Dodd-Frank Act, hedge fund managers were able to operate in financial markets with minimal regulatory supervision. 

The growth and importance of the hedge fund industry in worldwide financial markets may be attributable, at least in part, to the lack of regulatory oversight for more than half a century. The hedge fund industry thrived without regulatory supervision, generating higher returns and attracting an increasingly larger investor base. 

Given the success of the hedge fund industry in a light-touch regulatory environment, it is not surprising that the industry resisted the SEC’s past attempts to register hedge fund managers. When the SEC in December 2004 issued a final rule requiring hedge fund advisers to register under the Advisers Act1, the hedge fund industry strongly opposed the rule2. 

Two years later, in 2006, the United States District Court of Appeals for the District of Columbia in Goldstein v. SEC vacated the rule requiring registration of hedge fund managers as arbitrary3. 

Most registered hedge fund managers deregistered after the court issued its ruling in the Goldstein decision.

Title IV of the Dodd-Frank Act, entitled the Private Fund Investment Advisers Registration Act of 2010 (PFIARA), and SEC rules implementing the Act changed the regulatory landscape for the private fund industry. First and foremost, PFIARA authorised the SEC to promulgate rules requiring registration of private funds. The Act mandates hedge fund adviser registration so as to increase recordkeeping and disclosure4. 

Hedge fund manager registration under PFIARA, applies to any fund with more than $150 million assets under Management (AUM)5. 

Once registered, private fund managers are subject to enhanced disclosure requirements. Hedge fund managers are required to maintain records to avoid systemic risk6 and provide confidential reports related to systemic risk7. 

Information about the fund and the managers’ portfolio includes: the amount of AUM, the use of leverage, including off-balance sheet leverage, counterparty credit risk exposures, trading practices, trading and investment positions, valuation policies, side letters and other information deemed necessary8.


In order to identify the possible impact of hedge fund adviser registration requirements under the Dodd-Frank Act, the study draws inferences based on a sample of investment advisers from a population of investment advisers registered in the United States. The author and four research assistants collected data by approaching 1264 private fund managers with a survey questionnaire. 

The survey asked private fund managers to describe the possible effects of hedge fund manager registration requirements under the Dodd-Frank Act. Respondents (n=94) answered questions in several categories, including: strategic responses to the Dodd-Frank Act requirements, cost of compliance, long-term effect of reporting and disclosure rules on the private fund industry, compliance measures, long-term effect of reporting and disclosure rules on private funds, effect of the regulatory regime on assets under management, and effect of the regulatory regime on profitability.

Executive summary

The results summarised below are the major findings of the first observational study conducted after the SEC’s registration effective date for hedge fund advisers, 30 March, 2012. The study will help support hedge fund advisers in the administrative management of their funds because it quantifies compliance costs, it evaluates compliance measures and it assesses fund managers’ strategic responses to the implementation of the Dodd-Frank Act. 

Other important findings of the study pertain to the implications of the private fund disclosure requirements under the Dodd-Frank Act and the possible long-term effects of hedge fund manager registration, including the effect on assets under management and profitability.

Strategic responses to Dodd-Frank

Hedge fund managers can implement a broad array of legal and strategic responses to address perceived concerns of new regulations. For instance, managers can change the legal structure of their funds and management companies, they can lower or increase the assets under management, or they can change the strategy pertaining to their funds.

As Figure 1.1 shows, a minority of respondents in the survey has planned a strategic response to the Dodd-Frank Act requirements. This suggests that the requirements in Dodd-Frank and the SEC regulations implementing these requirements are not perceived as materially changing the existing business and compliance model.

Plan a Strategic Response to Dodd-Frank
Figure 1.1

This finding is confirmed by Figure 1.2: a clear majority of respondents did not plan to change their assets under management in response to the new regulatory environment even though lowering the AUM below a certain threshold could exempt hedge fund advisers from the Dodd-Frank Act requirements.

Consider Current Regulations to Determine AUM Size
Figure 1.2

Figure 1.3 illustrates hedge fund managers’ most common strategic responses in reaction to the registration and disclosure requirements under the Dodd-Frank Act. Most respondents indicated that they are addressing the requirements through compliance measures. By contrast, Figure 1.4 shows that a change of the funds’ legal structure, lowering the AUM, and other changes to escape the application of the Dodd-Frank Act do not constitute common strategic responses.

Most Common Actions Taken
Figure 1.3

Least Common Actions Taken
Figure 1.4

Figure 1.5 shows that 25 per cent of respondents plan on decreasing the AUM size of their funds to avoid the regulatory hassle. Others will increase current AUM size to cover expenses.

Take Regulatory Regime into Account for AUM by
Figure 1.5

Figure 1.6 suggests that the ideal AUM size for most respondents is somewhere between $150 million and $1.5 billion. However, existing regulation does not appear to have influenced funds’ choice regarding the size of their AUM. Rather, figure 1.7 suggests that choosing a particular AUM size is based on a fund’s strategy and its existing size.

Desired AUM After Dodd-Frank
Figure 1.6

Factors Influencing AUM Preference
Figure 1.7

Private fund profitability after the enactment of the Dodd-Frank Act

A major concern of the hedge fund industry prior to the enactment of the Dodd-Frank Act pertained to the possible effect of new rules and regulations on privacy, proprietary trading positions, and profitability. Managers were concerned that a leak of sensitive data managers report to the SEC could affect their profitability, result in possible reverse-engineering of a fund’s strategy, and the detection of weaknesses that rival firms could exploit. 

Figure 2.1 illustrates managers’ responses pertaining to the profitability of their hedge funds and the effects of the Dodd-Frank Act on investors. While the new requirements do not appear to have affected the earnings of hedge funds, Figure 2.2 suggests that the profitability of the management company will be affected. Future research examining hedge fund performance after the enactment of the Dodd-Frank Act may help clarify if the tectonic shift in hedge fund regulation through the Dodd-Frank Act had a latent or delayed effect on hedge fund earnings9.

Dodd-Frank Affect Fund’s Earnings?
Figure 2.1

Dodd-Frank Affect Management Compnay Porfits?
 Figure 2.2

Another major concern of the hedge fund industry revolved around the possible cost of compliance. The industry and regulators have not addressed the possible consequences of compliance costs. A high level of compliance costs could make it more difficult for new hedge fund start-ups to enter the market and result in consolidation of larger funds. If the consolidation of hedge funds should increase systemic risk, Title IV of the Dodd-Frank Act could result in the exact opposite of Congress’s intent10.  

Figure 2.3 indicates that the cost of compliance for the hedge fund industry is somewhat moderate. 48 per cent of respondents did not incur more than $100,000.00 in compliance costs per year after the enactment of the Dodd-Frank Act.

Cost Required to Comply with Dodd-Frank
Figure 2.3

Conclusion and future research

Despite initial industry grumbling, the results of this study suggest that hedge fund advisers are taking the new regulatory burdens under the Dodd-Frank Act in stride. Most hedge fund managers are not altering the size of their funds to avoid Dodd-Frank Act requirements. Managers are also not altering their investing styles. Most of the new registration and disclosure requirements have not affected the returns for hedge fund investors. 

Very few managers have changed their funds’ legal structure in response to Dodd-Frank Act requirements. Rather, hedge funds are adapting to the new requirements by outsourcing compliance work, hiring additional counsel, establishing new record-keeping policies, hiring additional staff, and changing marketing materials and investor communication. 

Hedge funds should easily absorb the cost of these measures. There is some evidence, however, that smaller investment advisers could be disproportionally affected by the registration and disclosure requirements in the Dodd-Frank Act. Future research may help policy makers appreciate the effects of the regulatory regime on smaller fund advisers11.

There is also some anecdotal evidence that ambiguities in the SEC forms may enable fund managers to report data in disparate ways. Disparate data reporting could make it more difficult for the newly created Financial Stability Oversight Council (FSOC) to conduct a comparative and comprehensive assessment of systemic risk. The FSOC’s work could be further complicated by funds’ use of estimates and educated guesses in disclosing the required data to the SEC. Future research could help clarify whether FSOC and SEC d12.

Wall Street Does Not Fear the Dodd-Frank Act

Should Wall Street be afraid of the new rules established by the Dodd-Frank Act? For more than thirty years until the enactment of the Dodd-Frank Act, the hedge fund industry had resisted attempts by the SEC to register hedge fund managers. The SEC’s last attempted to register hedge fund managers failed in 2006 when the United States District Court of Appeals for the District of Columbia in Goldstein v. SEC vacated the registration of hedge fund managers by the SEC as arbitrary. All hedge funds managers that had registered with the SEC under the invalidated rule deregistered after the Goldstein decision.

The industry’s opposition to regulatory oversight can be traced back to several factors. Since the inception of the hedge fund industry, hedge fund managers considered regulatory oversight an infringement on their ability to generate absolute returns. Hedge funds evolved in a regulatory environment that allowed them through so-called safe harbors to stay exempt from regulatory oversight.  Hedge funds’ ability to operate without regulatory oversight facilitated successful hedge fund launches, generated higher returns, and attracted investors.

The Dodd-Frank Act appears to be the last chapter in the debate on hedge fund adviser registration and disclosure. Title IV of the Dodd–Frank Act authorized the SEC to register hedge fund managers and demand enhanced disclosure. The SEC now requires the disclosure of financing information, risks metrics, strategies and products used by hedge fund managers, performance and changes in performance, positions held by the investment adviser, percentage counterparties and credit exposure, of assets traded using algorithms, and the percentage of equity and debt, among others.

The new rules are controversial and precipitated vehement industry complaints. Industry representatives allege the Dodd-Frank rules result in lower profits and undermine managers’ competitiveness. Given its limited resources, it is unclear how the SEC will evaluate the new information it collects.[1] Industry representatives also voiced concern about the confidentiality of disclosure and the impact on the industry if information should be leaked to the market or to hedge funds’ competitors. There is also a concern that the new Dodd-Frank Act requirements could push new market entrants out of the market because of higher startup costs.

Despite these concerns and industry grumbling, the hedge fund industry is taking the new regulatory environment under the Dodd-Frank Act in stride.[2]  Hedge fund investors’ rate of return was not affected by the registration and disclosure requirements. The new regulatory regime has not affected the asset size of hedge funds. Hedge fund managers are not planning changes in their portfolio structure or operations, nor are they planning any other strategic responses. Fund managers are also not changing the size of the assets they hold to avoid the application of Dodd-Frank Act regulations.

Although compliance with Dodd-Frank Act requirements has increased costs for the hedge fund industry, the industry is adjusting well to the new cost structure. Costs have increased because of outsourced compliance work, hiring of additional counsel, new record-keeping policies, the hiring of additional staff, as well as new investor communications and marketing materials.  For most hedge fund managers the cost of compliance ranges from $50,000 to $200,000 and most hedge fund managers spent less than 500 hours per year to comply with the new registration and reporting requirements. These additional costs seem manageable for most hedge funds. It is too early to tell if additional burdens stemming from the Dodd-Frank Act will slow down hedge fund activity and reduce investor returns.

So far, the hedge fund industry has no reason to fear the Dodd-Frank Act.  However, there is one caveat, the SEC and the newly founded Financial Stability Oversight Council (FSOC) have the authority to further increase the regulatory oversight to address systemic concerns posed by the private fund industry. Unless both regulators substantially increase the regulatory oversight, the hedge fund industry should be well prepared to adjust to the new regulatory environment under the Dodd-Frank Act.

[1] Wulf Kaal, Hedge Fund Regulation via Basel III, 44 Vand. J. Transnat’l L. 389 (2011).

[2] Wulf A. Kaal, Hedge Fund Manager Registration under the Dodd-Frank Act – An Empirical Study, 50 San Diego L. Rev. (2013).


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