Hedge funds have long been dampened by the perpetual rain cloud of suspicion looming overhead, but several in the industry see regulators' proposals last week requiring advisors to register as investment advisors with the Securities and Exchange Commission as a welcome ray of sunshine. Some even likened the proposals to a symbolic "Good Housekeeping Seal of Approval."
Hedge fund managers knew increased oversight was on the horizon. It was just a matter of when it would take place. While that time isn't quite here yet, the SEC took a first step in that process last week by laying groundwork that would permit it to regularly inspect hedge funds. The SEC said it was particularly interested in regular exams that would allow it to detect, in the early stages, problems that have led to well-publicized blow-ups in the past. It could help to deter fraud and would "encourage a culture of compliance and controls," the SEC said.
Daniel J. Barnett, chairman and CEO of Broadmark Asset Management, a hedge fund advisor, is "totally in favor" of the new proposal. Barnett, who runs two funds, said that when Broadmark opened shop for business four years ago, he and his partners decided to get registered from the get-go.
"If this industry truly wants to grow and become a legitimate part of asset allocation, it has to move to the registered investment advisor-type of status simply to build the confidence of the investor," Barnett said.
"Firms that are already registered probably will welcome this because they will consider this as a leveling of the playing field," said Mark Goshko, a partner at Kirkpatrick & Lockhart. However, Goshko said he expects a lot of initial resistance from firms that are unregistered.
"I think it's just part of the hedge fund industry growing up," said John Trammell, chief executive officer of fund-of-hedge funds Investor Select Advisors. "There's sort of a collective groan in the industry about the proposal, but I think people realize it is part of the business, and as they find out it's not an onerous part of the industry, they will be more accustomed to this.
"I think you would find there are many more SEC-registered hedge funds than many people believe.
The industry has been shifting over the past few years to include more institutional investors, such as pension plans and foundations, many of which want to invest in a fund that is registered with the government. This has led many in the industry to voluntarily become registered in order to attract the big institutions and their wad of assets.
Under the proposal, the SEC would be allowed to collect basic and meaningful information about hedge fund advisors and the funds themselves. Hedge fund advisors would be required to disclose conflicts of interests coming from side-by-side management of hedge funds and mutual funds. They would also be required to disclose other pieces of information about relationships that would help investors when making decisions regarding a fund.
Additionally, the direct investment minimum would likely be boosted by the SEC's proposed measure in some hedge funds. Currently, advisors are generally not allowed to charge performance fees unless an investor has $750,000 invested with the advisor or a net worth of $1.5 million.
After reviewing documents from 65 hedge fund advisors managing more than 650 funds with a combined $160 billion in assets under management, the staff became increasingly aware that it is severely limited in its ability to prevent major problems within the industry. Regulators are currently in a position to prosecute offenders only after they have committed their misdeeds and investors' money is already lost.
Growing Retail Interest
"The industry has grown, and it is playing an important part in the equities and bond markets," said Charles Gradante, managing principal of Hennessee Group. "It's become an important player with the retail investor in that most investors have money in pension plans that invest in hedge funds, and many investors invest in funds-of-funds." Gradante said the positive aspect of the proposal is that it makes hedge funds available to more people, both retail and institutional, who would not ordinarily invest unless hedge funds were regulated.
"I think the move will shine a light on hedge funds and let the public find out that 99.99% of the managers are hard-working managers trying to do the best thing for their investors - not a bunch of rich cowboys," Barnett said. "I think this is a great step for us in the sense of legitimizing and validating and bringing us up to speed over time with any other established asset class.
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