Hedge Fund Registration Exemption 'Value Judgment'

NEW YORK - The hoopla about hedge funds stems from regulators' basic distrust of the industry managers, according to Paul N. Roth, a lead attorney with Schulte Roth & Zabel in New York.

"If you look at the figures between 1998 and 2005, you will see growth in the industry unlike anything before it," said Roth, the keynote speaker at the National Investment Company Service Association Hedge Fund Conference, held here last week. "That is, in my judgment, the major reason you have regulation," he said.

With approximately 2,150 hedge fund advisors managing about 9,500 funds, Roth said, these products have increasingly become the alternative investment vehicle of choice. Most recently, pension funds and other large institutional investors have turned to the $1.5 trillion industry--once reserved only for high-net-worth individuals--as part of their portfolio strategies.

Although institutional investors are more sophisticated than retail clients, the Securities and Exchange Commission's worries that the fast movement of money that made hedge funds famous, will impact the overall market, causing swings too big for many small investors to stomach, he said.  Furthermore, federal regulators have argued, hedge fund registration is in the best interest of investors.

While it is true that investors must meet certain requirements in order to participate in the hedge fund market, regulators argue that qualifying investors is not enough to protect them from giving their money to someone who will close shop and run, or take advantage of them through unjust fees and commissions. "At what point do investors no longer require the SEC's protection?" he asked. "In some way, it's pejorative."

"It's a value judgment from the SEC on people in the hedge fund industry," Roth said. "Off the record, not attributable, what they are saying is that there are a lot of bad people in the hedge fund industry," Roth told the room of  about 200 industry representatives.

And that perception of fly-by-night managers out to plunder is why funds that impose two-year lock-ups are exempted, and allowed to continue operating without registering. "They don't want to register venture capital  or private equity," Roth said. "They're not the bad guys."

Registration, he said, not only represents an unfair characterization of the industry but is, ultimately, ineffective, Roth argued.

"Registration will deter some minor fraud," he said.  Major frauds will only be detected as they have in the past, after whistle-blowers draw attention, he said.

But regulation poses problems for fund-of-fund managers, for example, who may have to think twice when considering including a non-registered fund in their portfolios.

The industry lobbied to simply raise the minimum asset and income requirements needed to qualify, but regulators argued that the "realization of the industry" made regulation the only means of protecting the masses. Roth dismissed the idea of hedge funds becoming a retail market.

In reality, most managers are upstanding, and that is only proven by the fact that about 85% of advisors registered in accordance with the Feb. 1 deadline, he said.

What increased regulation really accomplishes is running up costs for companies and regulators alike.

"Expect exams," Roth continued. The SEC have a vested interest in making sure registered hedge funds abide by the rules to prove the new regulations are well-founded, especially since two of the five SEC commissioners strongly opposed the rule, said Roth.

In the end, the only thing regulation has accomplished is to strip hedge fund managers of some of the tools that made them successful in the first place, including side letters and top-secret portfolios.

 "At some point, there is a higher cost of regulating these, than there is benefit," he said.