Hedge Fund Registration:The Shortcomings Of The U.S. Securities And Exchange CommissionS-Private Fund- Definition

• Author: Jonathan P. Straub, Esq.
• Pages: 03

Page 15

Introduction

OVER THE LAST TEN YEARS, institutional and high net-worth investors embraced "hedge funds" as high-return investment

vehicles and as a means of reducing the market risk of their overall investment portfolios. The hedge fund industry has experienced exponential growth in the number of funds available, in the variations of the underlying investment strategies and particularly in assets under management. The increasing prominence and flow of dollars into this asset class coincided, as expected, with heightened governmental scrutiny.

Ultimately, this scrutiny culminated in the U.S. Securities and Exchange Commission's ("SEC") much-disputed rules and amendments1 mandating that by February ¹, 2006, hedge fund managers had to register as investment advisers under the Investment Advisers Act of 1940.² However, under the new rules, many private investment funds can escape the registration requirements because the SEC failed to make an important definitional distinction between a "hedge fund" and other similarly structured investment vehicles. Specifically, these other funds fall outside the scope of registration because their partnership language extends the fund's redemption period beyond two years, the threshold of a "hedge fund" as defined by the SEC. As a corollary to longer lockup periods, this new rule serves to decrease liquidity terms to the detriment of the individual investor.

By eliminating this two-year lockup distinction and elucidating a definition grounded in investment characteristics, the SEC can achieve full hedge fund registration and develop appropriate insight into the dynamics of the industry without placing undue burdens on the funds or their investors. Without comprehensive industry data, policy makers are inadequately informed to determine whether additional regulation is warranted and ill-equipped, if necessary, to implement an appropriate regulatory framework.

Defining a hedge fund

The memory of Long Term Capital Management's ("LTCM") infamous collapse in September 1998 serves as an example of the threat hedge funds pose as a source of systematic risk to the capital markets. However, the industry has developed a great deal since the implosion of LTCM and the Federal Reserve-brokered bailout of the funds.

The popular misconception of hedge funds is that they are all inherently volatile investment vehicles-relying heavily on global macro strategies and significant leverage to make large directional bets on stocks. In reality, less than 5% of hedge funds are global macro funds, and these alternative investment strategies may or may not use leverage and short selling to "hedge" the portfolio's exposure to market movements.

In tracing the etymology of the phrase "hedge fund," one sees the difficulty the SEC faces in defining what it is they seekPage 16to regulate. The hedge fund concept originated from the work of

Alfred Winslow Jones, who created a single-strategy fund in 1949 that utilized short selling and leverage to hedge exposure to movements in the equity markets.³ Today, the amorphous term encompasses a multitude of techniques, with investment return, volatility, and risk varying greatly among the different approaches.⁴ These strategies have branched out from their roots in equity trading into futures contracts, commodities, derivatives, and currencies, among others, all of which attempt to generate positive returns in a variety of market environments.Defining the term itself is not a new problem, as it has historically meant different things to different people.⁵

Broadly defined, a "hedge fund" has three characteristics: (a) a pooled investment vehicle (b) that is privately organized and (c) not widely available to the public.⁶ These funds are formed as separate accounts or commingled investment vehicles administered by a professional investment management firm. Most frequently, hedge funds are organized as limited partnerships or limited liability corporations having a significant position in securities. While these characteristics should normally trigger registration with the SEC as an "investment company" under the Investment Company Act of 1940,⁷ hedge funds typically avoid the "investment company" classification by limiting the number of underlying investors.⁸

Hedge funds are also defined by their structure rather than any distinct investment methodology. Just as investment strategies vary from fund to fund, the risk and return characteristics vary greatly as well. Nevertheless, risk aversion is inherently prevalent among large fund managers because of the management fee structure and the fear of mass redemptions as a result of exorbitant losses. Unlike registered investment companies, which tend to favor a "relative" return approach by seeking to exceed the performance of a benchmark, such as the S&P 500 Index, most hedge funds strive for an "absolute" return. This absolute approach attempts to achieve positive returns in all market conditions, with little exposure to the systematic movements of the capital markets.

The use of hedge funds is an attractive mechanism for portfolio diversification because the lack of correlation to a traditional performance benchmark can dampen the volatility of the overall investment portfolio. Since varying market conditions require a fund to have flexibility in its investment style to achieve consistently positive returns, a hedge fund partnership agreement will usually authorize the manager to partake in multiple strategies. This flexibility is necessary because it is unlikely that successful strategies in a bull market will also provide positive returns during downturns in the market.⁹

Recent Growth as Impetus for Registration

Although hedge funds have been around since 1949, the industry experienced its most explosive growth over the past decade. The bull market run of the 1990's led to tremendous growth in investable assets. But, the subsequent market decline, and expectations of a lower return environment, spurred investors to search for alternative means of achieving higher returns, while also warding off correlation to broad market performance. Hedge funds met both objectives because they had at their disposal a wide array of investment strategies, many of which traditional registered funds were prohibited from employing.¹⁰

Accordingly, sources estimate that the hedge fund industry has grown to approximately 7,000 funds managing almost $1 trillion in assets, an amount that has increased at a rate of 260% over the past five years.¹¹ The SEC estimates that this $1 trillion represents a fifteen-fold increase in...