NASHVILLE, Tenn.–(BUSINESS WIRE)–Nov. 6, 2003–
A Commentary by George Van,
Chairman of Van Hedge Fund Advisors International, Inc.
This last September, the SEC’s Division of Investment Management released its report, “The Implications of the Growth of Hedge Funds.” This report followed the SEC Staff’s diligent and intensive review of the hedge fund industry which began June 2002 and continues today, according to George Van, Chairman of Van Hedge Fund Advisors International, Inc.
One of the most significant recommendations of the report is that many additional hedge fund advisers should register as investment advisers under the Investment Advisers Act of 1940, as amended.
Two important categories of unregistered hedge fund advisers are, first, those who advise U.S.-domiciled hedge funds; second, those who advise non-U.S. domiciled hedge funds which accept U.S. investors.
Our research indicates that over 50% of advisers to U.S.-domiciled funds currently are registered with the SEC as investment advisers. This means that an additional number of advisers to U.S. funds, about 1,500, would become subject to registration.
In addition, how many advisers to non-U.S. hedge funds would be required to register with the SEC? Our information indicates that the number is likely to be in the hundreds.
Should the recommendation of the SEC Staff regarding additional registration be accepted by the SEC Commissioners? I suggest not, for these reasons:
1. THE NEW LEGISLATION, ARGUABLY, IS NOT NEEDED.
Hedge funds, contrary to general belief, already are subject to regulation. This includes, as a partial list only, certain requirements of the Securities Exchange Act, and certain requirements of the Investment Advisers Act (even if the hedge fund adviser is not registered), and in some jurisdictions, state or other local regulation. In addition, some hedge funds and their managers are required to register (as broker-dealers) under the Securities Exchange Act and (as Commodity Pool Advisers and Commodity Trading Advisers) under the Commodity Exchange Act. To avoid registration of hedge fund interests under the Securities Act of 1933 and to avoid registration of the hedge fund as an investment company under the Investment Company Act of 1940, most hedge fund investors are “accredited investors” and, increasingly, many are “qualified purchasers.” The income, net worth and/or amount of investment assets required of investors to qualify to invest in a hedge fund provides considerable protection to the general public.
Within the existing regulatory environment, it is generally recognized – and was, at the SEC Roundtable – that while there has been some hedge fund fraud, statistically, it has been in a relatively low range. Further, whether or not occasional SEC audits would uncover fraud is debatable. Insider tips appear to have been a more fruitful source, and expeditious prosecutions of high profile cases appear to be a more powerful deterrent.
2. THERE IS UNCERTAINTY ABOUT THE SEC’S FUTURE AUDIT PROCESS FOR INVESTMENT ADVISORS.
Our company has chosen to register three affiliates as investment advisers. In our experience, the SEC’s audit process has been fair and reasonable over the years. Will it now expand greatly? One of the SEC Staff’s recommendations was that the SEC “Encourage the Hedge Fund Industry to Enhance and Further Develop Best Practices.” On its face, this is eminently supportable. The SEC Staff Report goes on to suggest that the current scope of “Best Practices,” as currently outlined by various industry associations, be refined and expanded.
The “Best Practices” are not “one size fits all.” Some procedures that might be feasible for large funds may be impractical for smaller funds.
The Managed Fund Association’s version of Best Practices is 85 pages long and susceptible to expansion. It takes only a small leap of paranoia to go from viewing Best Practices as guidelines, to seeing them incorporated, as written, into SEC audit procedures for investment advisers. This could result in a wide gulf of judgment between hedge fund advisers and SEC auditors, as to Best Practices applicability to a given fund.
3. ADDITIONAL LEGISLATION WILL IMPOSE A BARRIER TO ENTRY TO THE INDUSTRY AND A BURDEN ON MANY HEDGE FUNDS.
The hedge fund industry has grown, in part, because of its historically low barriers to entry, unlike the mutual fund industry. Promulgating myriad regulations would raise the cost of entering the business and stunt the growth of what has been a bright spot in an otherwise dismal economy.
Further, in their early years, many hedge funds are small and entrepreneurial. Their staffs work long hours to produce maximum value for their investors and for themselves. The distractions, for small staffs, imposed by additional regulation would be considerable. They would include registration, filing, setting up systems in compliance with the Advisers Act, the implementation of “Best Practices,” the use of Form ADV and implementation of the SEC Staff’s proposed hedge fund brochure.
4. ADVISERS TO NON-U.S. HEDGE FUNDS MAY CHOOSE TO ESCHEW U.S. INVESTORS RATHER THAN TO REGISTER.
As stated earlier, we believe this number of advisers is in the hundreds. Their investors include U.S. tax-exempt institutions such as universities and hospitals. In the past, many non-U.S. funds have refused to accept U.S. investors in order to avoid any entanglements with the U.S. government. It is anybody’s guess as to how many will elect to register to keep U.S. investors.
The stature of the U.S. as financial capital of the world has been possible in part because of U.S. laws favoring the free flow of capital and the even-handedness of its laws in monitoring such markets. Requiring non-U.S. market participants to register may be seen as a “toll” or unfair “duty” on non-U.S. persons. Already, we have seen articles in the European press suggesting that the U.S. is overreaching in potentially requiring non-U.S. persons to register.
5. THE IMPLIED NEED FOR THE SEC TO REVIEW THE PRACTICES OF THOUSANDS OF ADDITIONAL HEDGE FUNDS WOULD ENCUMBER AN ALREADY BURDENED AGENCY.
As stated frequently elsewhere, the SEC’s responsibility of being the investor’s watchdog is a heavy one, given the size, diversity and complexity of the financial markets. To divert precious resources away from those who invest for small, retail investors, to those who invest for more wealthy individuals and institutions, seems questionable.
Clearly, we believe that, for the reasons stated above, the SEC Staff’s recommendation in favor of additional adviser registration should not be implemented until these issues can be addressed.
In the light of reality, we believe that the recommendation will be implemented, either in its proposed form, or modified somewhat. Anyone who reads the 472-page transcript of the SEC’s two-day Roundtable as well as the subsequent 131-page Report of the SEC Staff will likely reach the same conclusion.
And as always, there are two sides to the story. Adaptation of the SEC Staff recommendations will undoubtedly lead to uniform industry standards and more disclosure. It also will lend more deserved legitimacy to an industry peopled by diligent, highly intelligent and hard-working professionals who have nothing to fear from increased oversight.
The SEC has done an excellent job of publicly gathering the views of interested parties and subsequently producing sensible recommendations. We await the outcome with considerable anticipation.
