Tuesday, 20 July 2010

The Hedge Fund Registration Act Ensnares Non-US Funds

Up to now overseas-based investment advisors to offshore hedge funds did not have to register with the SEC. It used to be that the American system of fund regulation was based on regulating the products that were sold, rather than the firms carrying out the business. The old form of regulation was about mitigating mis-selling of products to individual investors. So a form of investment that did not allow unqualified investors in a fund regulated in another country (offshore hedge funds) was not covered by domestic US regulation. John Doe of Main Street was not allowed into hedge funds, and the funds were not allowed to be marketed to retail investors in the United States. So there was no need for protection of the little man.

Today, offshore hedge funds are still not allowed to be marketed to retail investors in the United States, and unqualified investors still may not buy hedge funds. However, first there was the enforced registration of all (domestic) hedge fund advisory firms, and now the the US legislators have gone a step further by seeking to regulate non-US entities with hedge fund clients in the United States.

In the first week of this month the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Bill"), which contains The Private Fund Investment Advisers Registration Act of 2010 (the "Act"). The Act requires all private fund investment advisors to register with the SEC, whether they are US-based or overseas-based.

It is a curiosity, at the least, that the SEC has this role. Speaking to a House Financial Services subcommittee this week, SEC Chairman Mary Schapiro said “it’s really not clear” what (systemic) risk, if any, the hedge fund industry presents. Even if she is not clear, I am: it is quite feasible, given the scale and activity scope of hedge funds that in combination hedge funds can have systemic impacts. In the UK this addressed through the FSA monitoring exposures of the largest hedge fund groups operating in its jurisdiction. The hedge fund industry assets are not managed by many groups, so this focus on the bigger groups is very sensible and practically readily achievable. The SEC should follow suit and limit the number of hedge fund groups it (or another regulator if it doesn't want or see the need for such a responsibility) tracks. However that is not enacted by the new US hedge fund legislation, and the scope is broad, too broad.

That written, there is, I should point out, a Foreign Private Adviser Exemption, but the criteria are set at a level that all non-US hedge fund groups would have a business aspiration to exceed. The Act provides a limited exemption from registration for a "foreign private adviser", which is defined as an investment adviser that: (i) has no place of business in the U.S.; (ii) has in total fewer than 15 clients in the U.S. and investors in the U.S. in private funds that it advises; (iii) has less than $25 million (or such higher amount to be determined by the SEC) in assets under management attributable to clients in the U.S. and investors in the U.S. in private funds that it advises; and (iv) does not hold itself out to the public in the U.S. as an investment adviser, or advise an investment company registered under the Investment Company Act of 1940, as amended (the "Investment Company Act") or a business development company. 

It might take a few marketing trips to bring in 15 US clients to a European or Asian hedge fund, but it is certainly do-able for a Billion Dollar Club member (or a fund with a track record of more than two years) to have that number already. And $25m of US-sourced capital as a threshold will exclude few commercially-sized hedge funds

And what is a "business development company"? Does this include an offshore marketing company that an overseas hedge fund group might have in place to mitigate tax payments within the hedge fund management company?

Also, who is this regulation for, who is it protecting? The likes of CalPERS and other giant state pension plans, sophisticated family offices like the Rockerfeller Foundation, the Endowments of Harvard and Yale, all invest in hedge funds, but given they are qualified investors and large in their own right shouldn't they operate under a "buyer beware" philosophy?  To repeat, the man in the street in the United States cannot buy a domestic hedge fund, still less an offshore hedge fund. 

A few consequences of the implementation of this Advisers Registration Act are: that the costs of being in the hedge fund business have gone up again, reinforcing the tendency for the industry to concentrate; non-US funds will find it more difficult to obtain seed capital from US-based incubators and early stage backers; the Gucci tasseled loafers/Bass Weejun penny loafers division within the hedge fund industry will be reinforced. Across the Atlantic we are being forced apart from our American cousins in hedge funds, by the EU Commission and the US Congress.

Addition of 22nd July: a comment from Andrew Shrimpton, Member at Kinetic Partners: “The expanded authority of the SEC will have a far reaching effect on the alternative investment industry, both in the US and in Europe. Not only will asset managers who handle significant assets in the US now be required to register, they will also be faced with more onerous compliance and monitoring obligations. Therefore, managers in the UK and Europe need to consider whether they are obliged to register with the SEC and respond appropriately to the heightened scrutiny and new demands.”

According to Kinetic Partners SEC registration will have the following bring with it the following requirements of managers: 
  •  comply with applicable SEC filings such as the Form ADV I, Part II and accompanying Schedule F;
  • develop a compliance manual, code of ethics, employee investment policy (personal account dealing policy) and a compliance monitoring programme that meet with SEC requirements and industry best practices;
  • undertake an annual review and testing of the compliance programme; and
  • undertake annual compliance training.
Where applicable, firms should also consider their global group structure and how the Bill may affect non US managers within their group. For example, many managers operating in the UK also have an offshore, non US, manager which delegates to the UK. 

This posting used information made publicly available by law firm Seward & Kissel LLP and a press release from Kinetic Partners.

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