Hedge funds have long been perceived as the stealth bombers of the financial world. Equipped with sophisticated weaponry and commanded by top guns, they target market inefficiencies while moving undetected by regulators and the masses -- that is, until one strays off course and crashes. The hedge fund community’s elusiveness is often cited as a tactical advantage, allowing fund managers to operate covertly and ensure their strategies aren’t replicated by competitors. But the real source of hedge funds’ shadowy existence can be traced to federal securities laws dating from the 1930s and 1940s that forbid public offerings of unregistered shares. Beyond the need to protect their strategies, hedge funds stayed out of the press -- not to mention the Yellow Pages -- for fear of attracting the attention of the Securities and Exchange Commission.
That could change if SEC commissioner Roel Campos has his way. He believes lifting the ban on advertising for hedge funds would be enough incentive to entice them to willingly register with the regulator. And he’s planning to float just such a proposal in the near future, based on the strong positive feedback he says his colleagues have given to the idea so far.
“I favor the carrot approach, as opposed to the stick,” says Campos, who knows a little something about the lure of advertising from his pre-SEC days as one of two principal owners of Houston-based radio broadcasting company El Dorado Communications. “Liberalization of advertising rules would let a hedge fund talk about its strategies and its performance and essentially promote itself.”
During the past few years, a handful of blowups have forced hedge funds into the regulatory spotlight, fueling the debate over whether the industry’s secrecy should be allowed to continue -- particularly as pension funds and endowments increasingly gravitate to the vehicles. The SEC’s stick approach to forcing transparency on hedge funds was short-lived, and, despite a lot of noise in the last Congress, nothing has come of the cries for the industry’s reform.
With the 110th Congress off and running, the issue still looms, but managers can rest assured that at least for the foreseeable future, it is unlikely that either the SEC or Congress will make any significant changes to their business. And it doesn’t hurt that the shift of power to Democrats has effectively silenced some of the most vocal critics of hedge funds -- who just happened to be Republicans. Of course, if Campos does proffer his advertising carrot, one thing hedge funds can expect is some noisy opposition, particularly from the mutual fund industry.
In 2004 it looked like the veil of secrecy would finally be lifted when the SEC passed a rule requiring most hedge fund advisers to register with the agency by February 2006. But only five months after the rule took effect, an appellate court threw it out in what has been dubbed the Goldstein decision -- a reference to fund manager Phillip Goldstein, co-founder of Saddle Brook, New Jerseybased Bulldog Investors, who challenged its legality. Since then some hedge funds have fled registration. Of the 2,500 hedge fund advisers who filed with the SEC by February 2006, there has been a net decrease in registration of 150 advisers -- 204 have withdrawn, while 54 have signed up.
As the SEC works to discourage withdrawals, its endorsement of a carrot approach may symbolize a new, more conciliatory attitude toward regulating hedge funds. Two events could rekindle the regulatory ardor of 2006 -- another major hedge fund blowup or the resignation, or death, of Democratic Senator Tim Johnson of South Dakota, who underwent brain surgery in December 2006 after a congenital malformation caused bleeding in his brain. If Johnson were to step down, it could tilt control of the Senate back to the Republicans.
When the SEC passed the registration rule, the commission was headed by William Donaldson, an ardent supporter of hedge fund reform. The two Democratic commissioners and Donaldson saw registration as a critical step in gaining control over the hedge fund industry. The rule -- which allowed the SEC to conduct random inspections of hedge funds’ records, among other things -- bitterly divided the five-person commission but was adopted by a 3-to-2 vote, with the two Republican commissioners strongly opposing it.
By contrast, Donaldson’s successor, Republican Christopher Cox, had earned a reputation as a supporter of deregulation during his nine terms in Congress as a Southern California representative. Tellingly, after the Goldstein decision Cox did not ask Congress for legislation to grant the SEC power to require registration, nor did he direct the SEC to appeal the appellate court ruling. Moreover, he is unlikely to feel any regulatory pressure from the Bush administration as it winds down its final two years.
Hedge funds make for strange political bedfellows. In Congress it was the normally laissez faireminded Republicans in the U.S. Senate who spent 2006 calling for tougher regulations for hedge funds, while the more typically consumer-oriented Democrats were perceived as friendlier to the industry.
Now that the Democrats control Congress, the two strongest advocates of hedge fund reform, Republican Senators Charles Grassley of Iowa and Arlen Specter of Pennsylvania, have been sidelined. In the formerly Republican-controlled Senate, Specter served as chairman of the Senate Judiciary Committee and Grassley sat as chairman of the Senate Finance Committee.
The two cooperated closely last year as the Senate held hearings on insider trading by hedge funds and on allegations that the SEC thwarted an investigation into alleged insider trading at Westport, Connecticutbased Pequot Capital Management. It was Grassley who got the General Accounting Office, Congress’s investigative arm, to undertake a broad review of the SEC’s enforcement and compliance policies. And just two weeks before the 109th Congress adjourned in December, Specter circulated draft legislation to discourage what his bill calls “pervasive” and “insidious” insider trading among hedge funds.
Grassley and Specter’s successors, Max Baucus of Montana, the new chairman of the Senate Finance Committee, and Patrick Leahy of Vermont, who now chairs the Senate Judiciary Committee, are not likely to pursue hedge fund reform with the same zeal as their predecessors, if at all.
Unlike Specter, Leahy doesn’t think hedge fund reform is the Judiciary Committee’s business. He is a liberal Democrat with a proconsumer reputation, but as the new Congress was convening, he quickly assured Connecticut Senator Christopher Dodd, the new chairman of the powerful Senate Committee on Banking, Housing and Urban Affairs, that he would not take up Specter’s legislation.
As chairman of the Senate Finance Committee, Baucus is expected to focus on reforming the Alternative Minimum Tax -- which was introduced to ensure that wealthy individuals can’t use special tax benefits to pay minimal tax but now affects many in the middle class -- and on finding ways to close the gap between taxes assessed and those actually collected, two issues in which he has a strong interest.
The outlook for regulatory reform in the House of Representatives is a bit clearer. Massachusetts Democrat Barney Frank is the new chairman of the House Financial Services Committee. When the SEC lost its case for registration, it was Frank who came to the rescue with a new law that required it. But he later withdrew his bill, and his office says he has no plans to reintroduce it.
The degree of regulatory zeal that Congress will aim at hedge funds will be primarily determined by Senator Dodd and the Senate Banking Committee, which has jurisdiction over banking and financial institutions, including the SEC. As committee chairman, Dodd not only sets the legislative agenda, he also appoints the next chairmen of the two subcommittees important to hedge funds -- the Subcommittee on Financial Institutions and the Subcommittee on Securities and Investment.
Senator Johnson of South Dakota is next in line to become chairman of the Subcommittee on Financial Institutions, but because he faces months of recovery following surgery, Dodd will likely appoint an acting chairman in Johnson’s absence. (U.S. senators cannot be declared disabled or removed from office by anyone but themselves.)
By virtue of seniority and expertise, Delaware Senator Thomas Carper is the likely choice. A moderate with a reputation for consensus building, Carper has a strong financial background, having served three terms as Delaware’s treasurer (plus five terms as its congressman and two as governor). He holds an undergraduate degree in economics from Ohio State University and an MBA from the University of Delaware.
Dodd’s pick to lead the Subcommittee on Securities and Investment has yet to be made, according to one of his aides. “It’s very, very premature. The makeup of the subcommittees has not been determined,” says the aide. Johnson is also next in line to become chairman of Securities and Investment, but the aide says it is unlikely that a senator would be appointed chairman of two subcommittees. Rhode Island Democratic Senator Jack Reed would be the obvious next choice, but will most likely take over as chairman of the Subcommittee on Housing and Transportation.
But this speculation is moot if Johnson dies or resigns. Johnson’s successor would be chosen by South Dakota Governor Mike Rounds, a Republican. Rounds would choose a fellow Republican, the Democrats would lose their two-vote majority, and it’s likely that the two leading hedge fund critics, Specter and Grassley, would return to power.
In a December speech Dodd gave in anticipation of becoming the new chairman of the Senate Banking Committee, he briefly mentioned hedge funds. But his remarks hardly sounded like a war cry. “We will examine hedge funds and the role this trillion-dollar industry has in our economy,” he said, later adding that though he was worried about unsophisticated investors investing in them, he didn’t foresee a return to registration requirements.
Dodd must tread carefully. He represents Connecticut, where hordes of hedge funds are based. With billions of dollars under management and its own state association, the hedge fund industry is an important constituency.
At the same time, two Connecticut-based hedge funds -- Long Term Capital Management and Amaranth Advisors -- have been responsible for some of the most harrowing failures in the industry.
Although Dodd hasn’t taken the lead on hedge fund reform, Connecticut’s attorney general -- and fellow Democrat -- Richard Blumenthal has been one of the industry’s most vocal critics (Alpha, July/August 2006). In December, Blumenthal testified at a hearing on hedge funds before Specter’s Senate Judiciary Committee. He argued that to protect investors the SEC needs stronger tools “to promote sound hedge fund management and disclosure of critical information” and warned that federal inaction could force individual states to step in as early as 2007.
Blumenthal isn’t too concerned that Dodd is not pushing for registration requirements. “There may be ways to provide greater disclosure without mandatory registration across the board,” he says, adding that his office is continuing to study the issue before it decides how to proceed at the state level. He expects to make a proposal of his own sometime this year.
Commissioner Campos says the idea of states issuing individual hedge fund regulations may be the one thing to prompt the industry to welcome more SEC oversight. Following the Goldstein decision, Campos met with the heads of several major hedge funds and says they all agreed that dealing with 50 different state regulatory regimes would be their worst nightmare.
He believes the SEC’s experience shows that hedge fund registration can be effective. The agency’s primary focus is to register advisers who accept money from pension funds and are thereby believed to expose the unsophisticated investors they invest for to risk. At the registration peak last spring, the 2,500 hedge fund advisers who were registered with the SEC managed 80 to 85 percent of the industry’s assets, now an estimated $1.3 trillion. Campos hopes advertising can reverse the withdrawal trend and bring other hedge funds under the SEC’s regulatory umbrella.
“The hedge fund industry is in an interesting position,” says Campos. “It’s gathering assets at an astronomical rate, and the ones that are doing very well have something more valuable than their assets -- their brand or reputation.”
Nothing would transform the image of hedge funds as secretive, clubby investment pools for the rich faster than advertisements in newspapers, magazines and on Web sites touting absolute returns. And as it becomes clear that Campos is gaining SEC support, and that his advertising proposal could actually come to fruition, the powerful Investment Company Institute, the Washington-based trade group representing the mutual fund industry, is likely to become a vociferous opponent. The ICI has vigorously opposed legislation to lift restrictions on hedge funds, including a proposal a decade ago that would have made hedge funds available to a broader array of investors. The ICI declines to comment.
Because most of his SEC colleagues have been behind the advertising idea so far, Campos says, his plan could be put into action early this year. But it remains to be seen whether it will be enough of a carrot to entice hedge funds to register.
In December the SEC proposed two new rules governing hedge funds: a provision to hold hedge fund managers accountable for fraud against individual hedge fund investors and an amendment restricting hedge fund investments by individuals to those with a minimum of $2.5 million in investable assets -- excluding their principal residences. Both measures have been criticized as harmful to the industry. Robert Leonard, a New Yorkbased partner at Boston-based law firm Bingham McCutchen who represents more than 100 hedge funds, predicts strong opposition to the higher-asset requirement and questions why the same investor suitability standards are not applied to venture capital, private equity and real estate funds.
“This rule could knock out a whole segment of the hedge fund industry,” says Leonard. “Entrepreneurs rely on their friends and family who don’t have $2.5 million to invest but can contribute $250,000 to get a new fund started. The SEC is responding to the political climate, and that never makes for good law.”
But Campos, a former federal prosecutor appointed by President George W. Bush to a second term in 2005, argues that registration serves the interest of hedge funds by protecting the industry’s reputation: “The SEC, with a moderate regulatory structure -- and I underscore moderate -- ends up assuring the public that we at least have a framework through which we can move if we see bad behavior.”
A Fresh View on Hedge Funds
As the 110th Congress gets under way, two of its new members have taken seats on key financial committees. Fortunately for hedge funds, both are supportive of the business and bring a strong knowledge of alternative investments to Capitol Hill.
Democrat Tim Mahoney of Florida, a member of the House Financial Services Committee, is the one freshman most likely to rally behind the hedge fund industry. Mahoney, who took the seat of Republican Mark Foley -- whose embroilment in an e-mail sex scandal forced his resignation in September 2006 -- not only enters his new position with a prohedge fund bent, he already has specific plans aimed at the industry.
He says he would like to pass legislation that would grant favorable long-term capital gains tax treatment to investors in initial public offerings -- even if they divest their shares within a year. He believes such legislation would encourage hedge funds to maintain their traditional investment focus on corporate securities and deter them from acting as merchant banks or getting into M&A.
His concern is that even sophisticated investors may not be familiar enough with the intricacies of nontraditional strategies to really understand the risks. “It’s important that a hedge fund’s investors understand its investment methodology,” says Mahoney, who has an MBA from Washington, D.C.'s George Washington University. If hedge funds continue broadening their investment mechanisms, he cautions, there could be a need to regulate them as registered investment advisers.
Mahoney’s primary focus is on small businesses and early-stage companies, likely a reflection of his own business experience. In 1995 he and friend Leonard Sokolow co-founded Miami-based venture capital firm Union Atlantic. Three years later, after the pair was unable to get its firm listed on vFinance.com -- an online matchmaking Web site for venture capitalists and entrepreneurs -- they bought the business. Until his election to Congress, Mahoney was chairman and CEO of Boca Raton, Floridabased vFinance, the Web site’s parent company, whose broker-dealer subsidiary, vFinance Investments, provides hedge fund incubator services, among its other offerings. Congressional rules required that Mahoney resign his post at the company.
Having run his own online business, Mahoney says one of his biggest calls is to foster technological innovations that will spur industrial growth.
Hedge fund managers could also have a friend on the other side of the Capitol building in first-term Democratic Senator Robert Casey Jr. of Pennsylvania, a new addition to the Senate Banking Committee. Casey, who holds a JD from the Catholic University of America and is the son of Pennsylvania’s 42nd governor -- Robert P. Casey -- brings with him extensive hedge fund experience. He served two terms as Auditor General for Pennsylvania, where his responsibilities included oversight of the Pennsylvania State Employees’ Retirement System -- one of the biggest public investors in hedge funds. -- William Freedman
