On January 29, Senators Grassley and Levin introduced The Hedge Fund Transparency Act, a revision to Grassley’s previously proposed legislation – Hedge Fund Registration Act of 2007 (S.1402). The 2009 Act calls for an amendment to the Investment Company Act of 1940. While titled a ‘transparency’ act, the proposed bill effectively broadens the regulatory authority of the SEC. The Act of 1940 defines an investment company and details the regulation set forth by U.S. Securities and Exchange Commission (SEC), primarily overseeing traditional mutual funds and closed-end funds. The act as currently written allows hedge funds to avoid being listed as investment companies because they are not open to the general public and often via pooled entities have fewer than 15 investors. Hedge Funds are only open to “qualified purchasers” or sophisticated investors (pension funds, endowments, wealthy individuals, etc) and thus are allowed to engage in higher risk, higher reward investments without the regulatory burden of the SEC.
As mentioned, hedge funds are currently not “investment companies” and are thus not subject to SEC oversight. Under the proposed bill, hedge funds would qualify as investment companies, but with special qualifications reducing the required level of disclosure and amount regulation. The availability of mutual funds to retail investors warrants the high degree of regulation and disclosure. The act would require all hedge funds to disclose the following:
(a) List the companies and natural individuals who are the beneficial owners of the fund
(b) Explain the ownership structure
(c) List of affiliated financial institutions
(d) Minimum investment commitment required from an investor
(e) Total number of investors in the fund
(f) Name of the fund’s primary accountant and broker
(g) Current value of the fund’s assets and assets under management (AUM) – effectively disclosing returns
Grassley and Levin provide three arguments for amendment, two of which have some merit. First, hedge funds have exploded by number of firms (10,000) and assets under management ($1.8 trillion), thus hedge funds play a significant role in the financial markets. Second, pension plans, endowments and charities invest in hedge funds leaving working class Americans and all sector of the economy susceptible to hedge fund activity. Last and most importantly, hedge funds have become commingled with the regulated financial sectors; many financial services holding companies of federally insured banks and insurance companies are also owners of hedge fund affiliates. As the funds encroach on the regulated and insured sectors, the ripple effects become severe, as exhibited in 2008. Levin highlighted in his speech on the Senate Floor such effects: Bear Sterns two affiliated hedge funds failed, Merrill Lynch’s investments in Bear Stern’s funds contributed to ML’s failure, with ML’s demise imminent, Bank of America (a FDIC insured depository institution) acquired ML. Bank of America, which received TARP funds, is now further susceptible the volatile and secretive hedge fund world. It is murky how the proposed disclosure would have prevented our current financial meltdown. Listing affiliated financial institutions would provide retail investors with some information regarding the potential risk to public listed firms; however, assessing the magnitude of losses would likely prove difficult.
It is important to note that hedge funds are not completely without regulation. Institutional investment managers, hedge funds qualify, with over $100 million in capital invested in exchange traded securities are required to report via Form 13F a listing of security holdings within 45 days of quarter-end. Said listings are available to the public via EDGAR.
The proposed regulatory requirement do not appear to onerous for the funds, nor is the mild disclosure likely to materially impact the funds ability to quietly build positions – often a key to ‘generating alpha’. Levin concluded his speech with the following remarks “The ‘Hedge Fund Transparency Act’ will protect investors, and it will help protect our financial system.” In analyzing the proposed legislation, it is unclear how the small amount of transparency will protect investors. Hedge funds will be subject some oversight by the understaffed SEC, but it is difficult to ascertain if the proposed level of disclosure would have reduced the carnage in the markets in 2008. Levin further noted that “It is time to bring hedge funds under the federal regulatory umbrella”, which indeed this entry-level regulation will open up hedge funds to further regulation in the future. Restrictions on holdings and leverage would be particularly negative for fund managers. Hedge funds are at the top of a slippery slope of regulation which will hopefully not continue the US march toward less competitive capital markets.
As mentioned, hedge funds are currently not “investment companies” and are thus not subject to SEC oversight. Under the proposed bill, hedge funds would qualify as investment companies, but with special qualifications reducing the required level of disclosure and amount regulation. The availability of mutual funds to retail investors warrants the high degree of regulation and disclosure. The act would require all hedge funds to disclose the following:
(a) List the companies and natural individuals who are the beneficial owners of the fund
(b) Explain the ownership structure
(c) List of affiliated financial institutions
(d) Minimum investment commitment required from an investor
(e) Total number of investors in the fund
(f) Name of the fund’s primary accountant and broker
(g) Current value of the fund’s assets and assets under management (AUM) – effectively disclosing returns
Grassley and Levin provide three arguments for amendment, two of which have some merit. First, hedge funds have exploded by number of firms (10,000) and assets under management ($1.8 trillion), thus hedge funds play a significant role in the financial markets. Second, pension plans, endowments and charities invest in hedge funds leaving working class Americans and all sector of the economy susceptible to hedge fund activity. Last and most importantly, hedge funds have become commingled with the regulated financial sectors; many financial services holding companies of federally insured banks and insurance companies are also owners of hedge fund affiliates. As the funds encroach on the regulated and insured sectors, the ripple effects become severe, as exhibited in 2008. Levin highlighted in his speech on the Senate Floor such effects: Bear Sterns two affiliated hedge funds failed, Merrill Lynch’s investments in Bear Stern’s funds contributed to ML’s failure, with ML’s demise imminent, Bank of America (a FDIC insured depository institution) acquired ML. Bank of America, which received TARP funds, is now further susceptible the volatile and secretive hedge fund world. It is murky how the proposed disclosure would have prevented our current financial meltdown. Listing affiliated financial institutions would provide retail investors with some information regarding the potential risk to public listed firms; however, assessing the magnitude of losses would likely prove difficult.
It is important to note that hedge funds are not completely without regulation. Institutional investment managers, hedge funds qualify, with over $100 million in capital invested in exchange traded securities are required to report via Form 13F a listing of security holdings within 45 days of quarter-end. Said listings are available to the public via EDGAR.
The proposed regulatory requirement do not appear to onerous for the funds, nor is the mild disclosure likely to materially impact the funds ability to quietly build positions – often a key to ‘generating alpha’. Levin concluded his speech with the following remarks “The ‘Hedge Fund Transparency Act’ will protect investors, and it will help protect our financial system.” In analyzing the proposed legislation, it is unclear how the small amount of transparency will protect investors. Hedge funds will be subject some oversight by the understaffed SEC, but it is difficult to ascertain if the proposed level of disclosure would have reduced the carnage in the markets in 2008. Levin further noted that “It is time to bring hedge funds under the federal regulatory umbrella”, which indeed this entry-level regulation will open up hedge funds to further regulation in the future. Restrictions on holdings and leverage would be particularly negative for fund managers. Hedge funds are at the top of a slippery slope of regulation which will hopefully not continue the US march toward less competitive capital markets.
Posts
1 comment:
There are a couple of clarifications with regard to this article I would like to make. First, not all hedge funds require investors to be "qualified purchasers." Section 3(c)(1) funds can be sold to "accredited investors" (generally a lower net worth requirement) and in some cases to non-"accredited investors."
Second, the Transparency Act will additionally require hedge fund management companies to register with the SEC as investment advisors under the Investment Advisers Act of 1940. Presumably hedge fund registration will provide hedge fund investors with another level of protection, in addition to the information gathering aspects of the Act.
Post a Comment