The Hedge Fund Association’s position on Hedge Fund Regulation

Date: Wednesday, June 3, 2009
Author: Hedge Fund Association

The Hedge Fund Association ("HFA") is a not-for-profit organization made up of hedge funds (both large and small), hedge fund investors (including funds of funds, family offices and high net worth individuals) and service providers (including law firms, administrators, brokers, accountants, marketers and technology firms). Unlike some of the other trade organizations in the industry, our membership is not made up exclusively of the largest funds in the industry.

Given the loss of confidence in the financial system, the HFA realizes that any broad based increase in regulation is going to include the hedge fund industry. However, given the extremely important benefits hedge funds provide, the Government must be careful not to implement broad, sweeping regulations that will make the barrier to entry for newer, smaller hedge funds too large to overcome. Furthermore, any new regulation should not increase the cost burden of existing smaller funds, which will further exacerbate the contraction that is currently occurring within the industry. Given the fact that 2008 was the worst year on record in the hedge fund industry, a large percentage of hedge funds are already teetering on the edge, struggling to survive and are likely considering whether it is still worth the cost to remain in business. Increased regulation that becomes a financial burden for smaller funds may just be what pushes them over the edge.

It appears from media reports and discussions that the HFA has had with members of Congress to date, that the two key concerns with regard to the hedge fund industry are as follows:

1. Systemic Risk – we clearly want to avoid another Long Term Capital event. The Government no doubt wants to understand what assets are the industry invests in, and try to understand what potential risks those assets provide; and

2. Indirect Access to Hedge Funds – that non-accredited investors are exposed to unregulated hedge funds through their pension fund investments.

We believe that both of these objectives can be met without over-reaching, broad regulation that makes it costly for small funds to operate.

Based on industry data provided by Hedge Fund Research, Inc., a leading industry data provider, at the end of 2008, there were over 6,800 hedge funds and over 2,300 funds of funds, managing $1.4 trillion. Those figures have further been reduced in the first few months of 2009. What is most interesting to this discussion, however, is to look at the number of funds that have more than $250 million, and what percentage of the $1.4 trillion is controlled by those firms with more than $250 million.

Out of the 9,100 hedge funds and funds of funds, 31.3% have more than $250 million. That means 2,850 hedge funds and funds of funds have over $250 million. It also means that over 68% of firms have less than $250 million, i.e. there are 6,250 firms with less than $250 million.

Looking at the assets controlled by those with over $250 million, a whopping 95% of the $1.4 trillion is managed and controlled by firms with more than $250 million. Thus, $1.33 trillion is controlled by 2,850 firms, and only $67 billion is controlled by 6,250 firms.

The operations and profits of a fund managing less than $250 million are vastly different from a firm managing $2 billion of assets. Any potential industry regulation of hedge funds must take that into account to achieve fair and balanced regulation. Typically firms with more than $250 million have a much larger internal staff than firms managing smaller funds. The larger firms can take on the burden of increased registration/reporting requirements and an internal compliance officer in a much more economical fashion. Smaller firms may only have 3 or 4 employees and the burden of additional registration and compliance will have a greater impact on their operations.

Based on these figures, and the disparity in the industry between larger funds (over $250 million) and smaller funds (less than $250 million), in order to achieve its objective of monitoring systemic risk in the industry, those objectives can be achieved by focusing regulation on larger funds.

As for pension fund access, pension funds, due to their large asset size, have historically only invested with large tier firms with assets in excess of $500 million. Hedge Funds want to limit ERISA capital to 25% of their asset base and given the large size of pension fund allocations, funds with less than $250 million are usually excluded from consideration. One solution would be to regulate this at the pension fund level and require that pension funds only invest in hedge funds that are regulated/registered. This would also serve to encourage smaller firms who want to attempt to attract pension money to voluntarily register.

We believe the cost versus benefit of any regulation/registration requirement for firms with less than $250 million is dramatically increased. The SEC's task of monitoring over 9,000 firms as opposed to 2,850 firms would be enormous. But by limiting the regulation/registration requirement to those with more than $250 million, regulation would capture over 95% of the assets in the industry. Furthermore, the financial burden of registration/reporting can be much more easily and economically absorbed by larger firms, than by smaller firms.

In today’s landscape, all hedge funds are already subject to certain rules and regulations – Regulation D is applicable to all hedge funds, as well as the requirement to make Blue Sky filings in various states and at the SEC level. In addition, any fund that holds more than 5% of a single issuer stock is required to file. Of course, all funds also fall under the SEC anti-fraud provisions.

In addition to the existing regulations in place, the HFA believes that the industry is sufficiently self-policed, especially in regards to funds with assets under $250 million. All investors are required to have a minimum net worth, and are generally sophisticated investors. The high minimum investment of most hedge funds also demands that investors are sophisticated and wealthy. Funds of funds act as gatekeepers in the industry, performing extensive due diligence on hedge funds, particularly on the smaller funds in the industry. Small funds are usually anxious to increase their assets, and investors who vote with their dollars can require funds to disclose positions to them, and to be transparent and frank in their discussions. Furthermore, investors can require funds to register etc. which would encourage additional firms to do so if they want to attract additional money from a certain investor.

The HFA would be open to working with Congress to ensure that any regulation is cost effective and achieves objectives that both Congress and the industry desire. Some form of registration requirement
and reporting requirement for firms with more than $250 million would seem to make the most sense. Firms with less than $250 million should be encouraged to register and report, but should not be required to do so.

The HFA is not opposed to additional regulation and registration/reporting requirements, but the HFA would be against regulation and registration/reporting requirements that result in smaller hedge funds being forced to close their doors. This will result in a loss of jobs not only within those hedge fund firms, but also at the administrators, law firms, auditors, banks and brokers who rely so heavily on smaller/startup funds for much of their business.

We are in the middle of a global recession, exacerbated by a complete loss of confidence in the financial system, particularly in the U.S. The difference with this financial debacle is that blaming hedge funds seems a little far-fetched. In this instance, highly regulated entities like banks, investment banks, and registered brokers seem to be the ones at fault. The already low level of confidence in the financial system was exacerbated by the widely acclaimed frauds perpetrated by Bernie Madoff, a securities dealer, and Stanford Financial. The irony is that neither were hedge funds, and both were regulated entities. The hedge fund industry was no doubt hugely affected by both. Many hedge fund groups set up feeder funds to take advantage of Madoff’s supposed trading strategy, and the fallout has led to a further loss of confidence in the hedge fund industry.

In times like this, it is appropriate to discuss some of the benefits hedge funds provide to the financial system. Hedge funds, with their ability to invest long and short, and invest in opaque and illiquid securities, provide much needed liquidity to both our stock markets and other markets that trade illiquid and opaque securities. Hedge funds provide a useful source for setting market prices for distressed and illiquid securities, something that will be greatly needed as the Government looks for banks to sell off and dispose of their toxic assets. As banks have essentially ceased providing credit to the economy, hedge funds have stepped in to fill the void. Hedge funds provide debt and equity capital to real estate developers, small business owners and others that are essential to kick-starting the economy. Many of these benefits were also provided by the proprietary trading desks of the large investment banks. Unfortunately, the proprietary trading desks of the large investment banks have essentially closed down or have been greatly reduced. As a result, the benefits listed above are now solely in the hands of hedge funds.

Hedge funds have also led to the sprouting of other businesses that benefit from the hedge fund industry. These other businesses include law firms, administrators, auditors, brokers, marketers, technology firms and banks. In 2008 alone, over 20,000 jobs in the industry were lost, and in this current climate, the Government must be careful not to implement policies that may lead to further job losses.

The Hedge Fund Association is available to discuss these issues further with members of Congress, and would welcome the opportunity of being a useful resource to Government in this endeavor.