The Law of Unintended Opportunities

Dodd-Frank act redraws rules of money management

Originally published in the July/August 2010 issue

The United States Congress seems poised to enact The Dodd-Frank Wall Street Reform and Consumer Protection Act, the regulatory reform act which will fundamentally change the way banks and broker-dealers approach their money management and lending businesses. The press has repeatedly trumpeted the Act as “sweeping,” an “overhaul” of the system, and as “dramatically changing” how Wall Street does business. As with any post-crisis legislation, the Act does indeed create significant changes and challenges to market participants – primarily banks and brokers. The changes were a given; in the current highly charged political environment, increased regulation of financial institutions was unavoidable. Rather than bemoan the inevitable, however, we are encouraging our managers to stay several steps ahead of the game, and instead, to think strategically, i.e. to consider what business opportunities the Act creates, and how these changes might work to their advantage.

Summary of key provisions
The Act, as approved by the joint congressional conference committee, is more than 2,000 pages long and addresses a host of issues relating to consumer protection, predatory lending, bank capital requirements, systemic risk determinations, investment adviser registration and swap regulation. Among other changes, especially pertinent to the money management community are:

• a prohibition against banks or “nonbank financial companies” from engaging in certain trading activities;
• a prohibition against certain broker transactions which merely “involve” a “material” conflict of interest;
• the possible imposition of a fiduciary duty standard on brokers who make investment recommendations; and,
• a requirement that all private equity and hedge fund managers with in excess of $150 million in assets register with the Securities and Exchange Commission (SEC) as investment advisers.

Much of the bill is written in broad general terms, satisfying the currently rabid political appetite for a Wall Street smack-down. Although undoubtedly accomplishing that goal, as always, the devil will be in the details: much of the bill leaves the SEC with the unenviable task of defining the undefined terms, deciding whether to actually implement the bill’s policy provisions, and overseeing the hundreds and hundreds of new registrants.

Lying low, below the noise and pontificating, however, is a host of traders and money managers who aren’t waiting for the dust to settle, but who instead are already strategising and putting into place operations to exploit the many market opportunities – and very real risk – the Act will create.

What are the opportunities?
We tell mid-sized hedge fund managers and well-funded start-ups that, in a very real sense, this bill is their big break. Once you cut through the 2,000-page legislative thicket, the opportunities become more readily apparent. Consider:

The Act creates significant barriers to entry
The Act requires all private fund managers with more than $150 million in assets under management to register with the SEC as investment advisers. This registration requirement alone creates a real, almost insurmountable, barrier to entry for smaller managers. The days of the proverbial two guys with a Bloomberg terminal are gone. Taking into account the cost of office space, staff and prime broker and administrator arrangements, it will be virtually impossible for a $150 million fund to assume the cost of registration, maintenance of a compliance program and a periodic, disruptive and time consuming SEC inspection. Consequently, mid-sized managers and well-funded start-ups are looking at a market that that will see fewer launches over the next several years, and which will become less competitive. Is this good for investors? No. Is it good for hedge fund managers? Very.

Bank brokers are still not fiduciaries
After much debate and hullabaloo about the lack of any fiduciary duty owed by banks and brokers to investors, Congress surprisingly chose not to immediately impose any such duty. Instead, it punted that issue to the SEC, leaving it to that agency to determine to what extent brokers should be fiduciaries to their retail investors. In contrast, fund managers and investment advisers have always been fiduciaries and have always had an obligation to put investor interests first – not simply to recommend “suitable” investments. It’s hard to imagine that investors who’ve been burned by broker-recommended investments (e.g. Goldman recommended the Abacus investments as broker, not adviser) will be inclined to continue to do so. This is especially true sincenot even Congress seems fully convinced the duty of care should change, and any change will likely only apply to retail investors. Consequently, we see the market wide open for fiduciary investment professionals like hedge fund managers. Again, is it good for investors to give them fewer choices? No. Is it good for hedge fund managers to have investors funneled their way? Yes.

Conflicts and independence
The Act also prohibits brokers who have placed investments in asset-backed securities (such as an underwriter or placement agent) from engaging in any transaction posing a “material conflict of interest” within one year of the placement. “Material conflict of interest” is not yet defined. This ambiguity also works to the advantage of private funds. Rather than face the struggle of determining what may or may not “involve” a “material conflict of interest” (and potentially guessing wrong when the SEC reviews it in hindsight), most brokers will avoid engaging in sales of these interests altogether – or at least until some guidelines have been established. Hedge fund managers could easily fill the void in ABS offerings with some effective strategies and savvy marketing. In any event, it is hard to imagine many institutional investors would be comfortable participating in such transactions if they can’t be sure of the broker’s loyalty. A manager offering the option of investing with an independent, conflict-free entity surely has the advantage.

Growing burden on non-bank financial companies
Furthermore, over the past 10 years, hedge fund managers faced strong competition from affiliates of banks engaging in money management activities. Marketing these funds was easy and effective as they typically had the use of the valuable institutional rolodex of the bank’s brokerage affiliate, and the bank’s brand behind them. These “non-bank” financial companies may still be able to engage in money management activities, but the proposed restrictions will make it significantly more expensive and onerous. Specifically, they may be subject to supervision by the Federal Reserve, increased capital requirements and as yet unspecified quantitative limits on its investment activities. Sustaining such a business – although it may ultimately be lawful – will likely prove so expensive and burdensome so as not to be worth the resources required. The resulting abdication of this market by a previously formidable competitor, again, creates market opportunity to funds properly situated and marketed.

In our view, many in the private fund community view the Act in entirely the wrong way. Every market crisis, meltdown, failure and resulting legislative initiative contains both burden and opportunity. The next wave of wildly successful financial market participants will be not those who see increased market regulation simply as a shield, but those who instead recognise its incredibly potent value as a sword.

Rosemary Fanelli is co-founder of CounselWorks, a firm providing strategic business advice, regulatory and compliance consulting services to private equity and hedge funds, investment advisers and broker-dealers.