Hedge Fund Registration

Implications for small and unregistered funds

Originally published in the October 2010 issue

The stiffening regulatory environment isimposing changes on the US hedge fund industry. The key change is that mandatory registration may lead to further consolidation in the industry. This holds implications for smaller, unregistered funds and what they face. With capital raising still difficult, except for the very largest funds, consolidation has been the trend. Consolidation would make economic sense even without the additional compliance costs associated with registration. Take two large firms: Man Group and GLG Partners. With upfront registration costs of some $100,000 to $300,000 and ongoing incremental costs, including the cost of a chief compliance officer, the barriers to entry are steeper than ever before.

Regulation and registration
The Dodd-Frank Wall Street Reform and Consumer Protection Act generally requires registration of private investment funds with assets under management in excess of $150 million and for funds with assets between $25-$150 million to be registered in their state. Readers will recall that in February 2006, many funds were required to register their investment advisors with the SEC. Subsequently, litigation overturned the mandate and many fund managers de-registered their advisors. Even so, current industry statistics indicate that 50% of hedge funds are currently registered and that this group manages approximately 70% of US hedge fund AUM.

A disproportionate amount of the hedge fund assets are with the largest funds. For instance, in 2010, $8.8 billion of the $9.5 billion total net inflow was allocated to firms exceeding $5 billion AUM. These firms manage approximately 60% of total industry capital. Many of these are affiliated with large banks and investment companies so changes placed in effect by the ‘Volcker Rule’ may put limitations on the amount of permitted bank proprietary investing. At the very least it will significantly alter their ability to invest in or seed hedge fund managers. The most notable transaction to date illustrating the impact the ‘Volcker Rule’ may have is Skybridge’s acquisition of Citigroup’s alternative investments. I am certain that a number of new funds will be formed to fill the void that will be created by the new rule. With capital remaining scarce, this trend should gain momentum. It is also probable that these new funds will not be nearly as large as bank controlled ones because capital remains such a scarce commodity.

Institutional investors exhibit a strong bias toward investing with managers who have registered. For some it is an absolute requirement, as when the fund is maintained as a quasi-governmental entity or is established for the benefit of an institution such as a pension fund. The internal debates focus on the benefits afforded by registration versus the added costs and additional compliance burdens. Clearly, marketing and investor relations executives will tout the competitive advantage of registration.

With capital investing being more international than ever before, it is worth noting that in some European Union countries there are various proposals that require disclosure, transparency and liquidity levels to be present before residents of these countries can be solicited.

These provisions are more extensive than any current requirements in the US and it will be interesting to see if US firms will be willing to comply with the EU rules, and whether the US will ultimately move toward these more intrusive investor protective provisions. It should also be noted that the EU provisions did not have unanimous acceptance from member countries.

Best practices continue to evolve in this post-Madoff world. In the past, many of the large hedge fund groups would have internal personnel provide administration services to the fund. Today, most of these funds have also hired skilled independent administrators to perform at least some portion of the tasks involving valuation and custody to provide a higher comfort level to investors. The costs are not trivial but the perceptionof care in administering assets offsets the added expense. For smaller funds, confirmation from third party service providers to fund managers that the funds are in fact performing their tasks (i.e. audit, administration, and custody functions) is now routine. A good example is where administration firms have SAS-70 reviews performed on their own internal controls. Smaller funds have generally found it cost effective to outsource their administration, trade execution and back office functions. These services can offer a competitive advantage and independent daily reconciliations of both cash and positions have become a must. Investors have also shown quite a bit of interest in UCITS compliant funds and managed accounts. Certainly statistics show them gaining a significant percentage of capital inflows.

Opportunities for smaller funds
Emerging managers continue to be sought by investors including funds of funds. Typically, due to their size, these funds may have more concentrated portfolios and represent the managers’ best ideas. These funds, which generally have less than $100 million in AUM, often outperform their benchmarks in the early years. Unlike the larger funds whose investor base is dominated by institutional investors, a significant portion of the investor base for the smaller funds consists of high net worth individuals. These funds typically have minimum investment levels of $250,000 up to $1 million, and can attract investors who cannot afford minimums of $5 million or more. The non-registered funds will primarily continue to attract this class of investor. Given the size of these emerging funds, many of the managers will not be required to register with the SEC yet they may be required to seek a state registration. Managers of these funds will need to weigh the costs and benefits of added expenses against the possibility that some investors are more attracted to registered funds. Others, indeed, will opt to put in place the practices and procedures that would be required with SEC registration.

Larger registered funds are dominating the inflow of new capital coming into funds. Much of this is due to the infrastructure, research, analytics and global capabilities that they possess. In addition to these resources, the registration of larger funds provides an additional degree of legitimacy and comfort to the investor base. Smaller funds have been facing scale issues for several years. The imposition of registration requirements have served to raise the ante. It may be that with the trend toward consolidation, coupled with the marketing advantages inherent in registration, there is a likelihood that smaller funds will continue to develop best practices that mirror those of larger, registered funds.