With Financial Bill Looming, What is Impact for Hedge Funds?

The largest financial reform bill in more than 70 years is expected to pass this week and many are asking what impact the bill will have on hedge funds. The impact of the Dodd-Frank bill—named on the hedge fund industry, remains an open question. The legislation is more than 2300 pages, and even a thorough reading won't reveal the ultimate impact of such a bill on hedge funds.

As the current bill reads, hedge funds would face some greater oversight. Hedge funds with more than $150 million in AUM would have to register with the SEC, though more than half of hedge funds are already registered.

One also has to wonder how the SEC, which so miserably failed to oversee the hedge funds and financial institutions it already regulates, will be able to provide competent oversight of even more firms. If the SEC couldn't devote the resources to police banks with trillions in assets, how can we expect them to competently oversee $200 million hedge funds?

The new bill would also introduce a water-down Volker rule which will permit bank holding companies to invest up to 3% of their assets in hedge funds and other alternative investments.

US Proposal to Regulate Private Equity and VC, Not Just Hedge Funds

Senator Jack Reed (D) is proposing an amendment targeting virtually all private investment pools to a proposed Wall Street reform bill. While the current senate bill would require hedge funds with assets under management in excess of $100 million to register and report to the SEC, it doesn't cover Private Equity and Venture Capital, nor funds with less than $100 million AUM. Senator Reed's amendment would target all pooled investment vehicles, including PE and VC funds, with lighter restrictions on smaller funds on $100 million.

According to Reed, "The financial crisis is a stark reminder that transparency and disclosure are essential in today’s marketplace. Improving oversight of hedge funds and other private funds is vital to their sustainability and to our economy’s stability."

It remains to be seen how effective US hedge fund regulation will be at preventing systemic risks. Insiders widely believe $100 million hedge funds may pose a risk to their investors and some counter parties, but do not threaten the entire system like some multi-billion dollar funds.

The Future of Hedge Fund Regulation - US

The Future of Hedge Fund Regulation - US

Summary
Over the last couple of years there has been a lot of political discourse about the need for greater regulation of the financial industry, including hedge funds. Much of the information (and rumors) about possible hedge fund regulation is somewhat contradictory. We will wade through the debate and provide a summary of current proposals for hedge fund regulation in the US and discuss hedge fund regulation in the EU and other countries.

Though it was highly regulated financial institutions that are widely believed to be the cause of the recent financial crisis and subsequent economic malaise, there is talk of regulating hedge funds and private equity firms as well. There have been a huge number of proposals for regulating hedge funds ranging from registration requirements for just the largest to funds, to almost authoritarian regulation for all private money managers. However, the current proposals with the most support appear to be hedge fund registration requirements, without significant additional oversight.

Current Hedge Fund Regulations
Under the existing system hedge funds and private equity firms are far less regulated than mutual funds and other investment vehicles open to the public. Though some hedge funds are registered with the SEC, a couple clauses in the Investment Company Act of 1940 allow must hedge funds to operate without registering with the SEC or any other government agency. Probably fewer than half of all hedge funds are currently registered as investment advisors with the SEC. For funds that are registered, the SEC requires certain filings, but does not provide operational oversight.

The Need for Hedge Fund Regulation
Hedge funds were clearly not the major players in the current financial crisis. However, the $50 billion fraud perpetrated by Bernard Madoff sparked plenty of public outrage and there have been a couple of multi billion dollar hedge fund failures since 2007. Additionally, many politicians still fear another hedge fund collapse ala Long Term Capital Management, the giant hedge fund that collapsed in 1998 and necessitated a Federal Reserve orchestrated bailout.

Treasury Secretary Timothy Geithner voiced his concern in April, "Today, the consequences of (hedge funds') failure is greater. They need to be subject to a higher set of standards.”

Proposals for Regulating Hedge Funds and Recent Developments (2009)
In January 2009, Senators Charles Grassley (R-Iowa) and Carl Levin (D-Mich.) introduced the Hedge Fund Transparency Act of 2009. The Act would affect funds with more than $50 million in assets (“large firms”). All funds in excess of $50 million would be required to register with the SEC and maintain books and records according to SEC requirements. It would also require disclosure of including information regarding the identity (including addresses) of the fund’s “beneficial owners,” the amount of the fund’s assets, the fund’s equity structure, affiliations the fund may have with other financial institutions, the minimum investment commitment required of investors, and the total number of investors. The bill did not get to a vote.

In March of 2009, Larry Summers , Director of the National Economic Council for Barack Obama, said the U.S. wants large hedge funds and private-equity firms to be subjected to "rigorous public scrutiny," compared with the minimal oversight they now face. Before joining the Obama Administration, Summers was a Managing Director with one of the worlds largest hedge funds, D.E. Shaw Group.

Then in late April, President Obama lashed out at hedge funds refusing to accept a government offer for Chrysler debt. "A group of investment firms and hedge funds decided to hold out for the prospect of an unjustified taxpayer-funded bailout," Obama said, "They were hoping that everybody else would make sacrifices, and they would have to make none. Some demanded twice the return that other lenders were getting. I don't stand with them."

In July, the Obama Administration, released TG-214, a fact sheet with the Administration’s proposals for regulating hedge funds. Funds with more than $30 million would be required to register with the SEC. Once registered funds would be subject to:
• Substantial regulatory reporting requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised private funds
• Disclosure requirements to investors, creditors, and counterparties of their advised private funds
• Strong conflict-of-interest and anti-fraud prohibitions
• Robust SEC examination and enforcement authority and recordkeeping requirements
• Requirements to establish a comprehensive compliance program
The main rationale for the above requirements is to “protect the financial system from systemic risk”

The most recent House of Representatives proposal for hedge fund regulation, from Aug 6, 2009, seems to have lost some of the initial enthusiasm and would regulate hedge funds under less-stringent conditions than banks and lenders. According to House Financial Services Chairman, Barney Frank, “How can you regulate a hedge fund like a mortgage? It doesn’t make any sense. It will be a form appropriate to them.” In apparent moment of bipartisanship, both Democrats and Republicans seem to be in agreement that hedge fund and private equity firms should be more lightly regulated than other traditional financial firms. It should also be noted that hedge fund industry groups spent almost $4 million in lobbying in the first half of 2009.

Hedge Fund Regulation in Europe
Europe has been quicker to attempt hedge fund regulation and proposals there have generally been more severe than in the US. Likewise, hedge funds and private equity firms in the EU have been more vocal in their opposition to regulation than their US counterparts. The most contentious issue in EU hedge fund regulation appears to be an attempt to limit or place caps on the amount of leverage funds can employ. Because of the possibility of regulatory arbitrage, look for the EU and US to finalize regulations that are relatively consistent.

When Will We Get New Hedge Fund Regulations?
Though there are ongoing talks, there is currently no bill for hedge fund regulation in Congress that is likely to pass. It is unlikely any new regulation will be finalized until 2010. Because compliance with new rules could be costly and time consuming, it is conceivable that new hedge fund regulations might not be enforceable until 2011.

SEC Wants Greater Hedge Fund Authority

Schapiro Seeks Larger Staff, Greater Regulatory Control, for Hedge Funds
SEC Chairman Mary Schapiro said today that the SEC "needs" the authority to require hedge funds to register with the agency. Additionally, Schapiro wants the SEC to have the power to examine hedge funds' book. Schapiro also noted that registration without significant oversight and authority "would not be sufficient". "It would be good to have rulemaking authority," she said. "It's good to have flexibility to respond to crises as they emerge."

Schapiro also wants additional funding to provide adequate hedge fund oversight. "With over 30,000 regulated entities and a staff of 3,600 people, we cannot add a couple thousand more hedge funds and get the job done under any circumstance," she said.

European Union Imposes Hedge Fund Regulations

EU Imposes New Hedge Fund Regulations
The European Union is proposing new rules extending oversight for the European hedge fund industry which has close to $1 trillion in assets by some estimates. The European Commission Wednesday proposed new disclosure requirements for hedge funds and private equity firms managing more than EUR100 million in assets. Many had expected, upon release of an early draft, that the AUM cutoff for firms would be as high as EUR250 million. This cutoff means only 3% of funds (accounting for 10% of assets), will be regulated under the proposal.

Germany and France in recent years have railed against hedge funds while the U.K., home to Europe's largest financial center has taken the opposite position. Germany and France, for example, believe certain derivatives and other aspects of financial markets have evolved to become beyond regulators' understanding and oversight. The U.K. for their part, believes stricter regulations will only push hedge funds and other alternative managers to locales with less stringent requirements.

Under the plan, firms exceeding the cutoff will have to register with regulators and provide information on their holdings, fees and the amount of money they borrow to boost their potential returns.

The commission's proposal still needs approval from E.U. governments and the European Parliament. Officials expect continued argument about how to manage the sector.

Hedge Funds to Face Greater Regulation From SEC

Mary Schapiro, Chairman of the SEC, is expected to tell Congress today that the SEC is seeking greater regulation for hedge funds, according to the WSJ.

Though many hedge funds managers already register with the SEC, the new proposal would bring all or must funds under the SEC umbrella. They will also seek to regulate individual hedge funds, as opposed to current regulations on the greater fund company. Regulating individual funds would presumably provide greater transparency into the systemic risk posed by larger funds.

Of course, regulation by the SEC is very contentious. How well has the SEC been able to regulate any of the institutions it has primary oversight of? Given that there are several thousand hedge funds in the US, and the SEC's inability to effectively regulate in the past, couldn't greater oversight just be another disaster in waiting?

One of the dangers of SEC oversight is that it would seem to legitimize hedge funds for the typical investor, when in fact, many hedge fund strategies are inappropriate for all but institutions and select individuals. Though the SEC will disclaim having "approved" the fund or its accounting, it will imply this to less sophisticated investors. Will any of them read the 250 page prospectus each fund will be forced to issue?

Paul Volcker Urges Congress to Restrict Hedge Funds

Former Federal Reserve Chairman and current Obama economic advisor, Paul Volker, urged Congress today to place "strong restrictions" on hedge funds and private equity firms to ensure market stability.

Below are some quotes from Volker's testimony:

“We must not again leave the markets so vulnerable that a breakdown will again threaten the national and world economies"
Volker and Obama, July 28, 2008

We need "strong restrictions on risk-prone capital market activities -- hedge funds, equity funds, proprietary trading and the like"

"We are living in a difficult time for the economy, with unprecedented complexities, complications and risks for financial markets and financial institutions."

"There are problems with the present international monetary system that have not received sufficient attention,"

It remains to be seen, what, if any, restrictions or registration requirements Congress will impose on hedge funds, but there current economic and political climate will certainly make it tough for private capital to remain as opaque as it once was.

Hedge Fund Registration Discussed in Senate

The US Senate again began discussing the possibility of greater hedge fund regulations including broader registration requirements. Sen. Chuck Grassley, R-Iowa argued that hedge fund clients include pensions and other retirement funds, not just "fat cat" investors.

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