Is a Hedge Fund the Way Out of the Regulatory Nightmare?
One of my personal market indicators is what I call the “Hedge Fund Indicator”, and is based on the number of inquiries I receive from non-financial professionals who want to start a hedge fund – because they have “proven” themselves to be an excellent trader. When the numbers start increasing on a monthly basis, the indicator is usually signaling a market top.
That was the case earlier this year, but now my Hedge Fund Indicator is indicating another trend – a trend in brokers who are looking for another way to earn a living, one, in theory, that is free of regulatory nonsense and expense, and who are turning to the hedge.
First, lets get our definitions down, since a hedge fund doesn’t necessarily have to hedge anything. In its most expansive definition, a hedge fund is a private investment fund, usually structured as limited partnership, managed by the general partner who makes the investment decisions and collects a management and incentive fee. The fund is only open to accredited investors with a level of sophistication. The manager is not restricted in his investment approach and strategy, and can typically employ every financial tool known to the investment community, including selling short, engaging in arbitrage transactions, trading options and derivatives, and high margin trading.
However, no matter how one defines a hedge fund, the common factor is that a hedge fund is not registered in any way with any securities agency – at least not on the federal level. A hedge fund is not a broker or a dealer since it does not buy or sell securities for others and receive a commission. Technically, it is an Investment Company, but pursuant to exemptions contained in the Investment Company Act, it is exempt from the registration requirements under that Act.
The creation and establishment of a hedge fund involves two separate concepts – the creation of a limited partnership (in order to provide the investment vehicle for the investments by the investors) and the creation of a Regulation D offering – while a the hedge fund itself is not subject to registration, its solicitation of investments is subject to the securities laws. Once again however, a properly created hedge fund is exempt from the registration requirements of the Securities Act of 1933, so long as the offering is accomplished pursuant to an exemption, typically pursuant to Regulation D.
And therein lies the lure of the hedge fund – it does not have to register as a broker-dealer, it does not have to register with the NASD, and it is not under the jurisdiction of the SEC.
The freedom from the regulatory burden of a broker-dealer registration, or registration as a mutual fund, or even as a registered investment advisor is a tempting lure into the world of hedge funds for many investment professionals. However, before jumping, be warned – there is a price to the regulatory freedom.
Many hedge funds are operating without compliance with the applicable exemptions from the regulations, and in violation of those regulations. In fact, I suspect that many investment clubs – which do not have to be registered since all of the club members participate in the investment decisions, are actually hedge funds, operating in violation of the applicable securities laws.
Hedge funds are private. The exemption from the Investment Company Act requires that the funds cannot make a public offering of there securities, Further, since the investments are made pursuant to a Regulation D offering, hedge funds cannot advertise, and cannot make general solicitations to the public. However, a recent SEC no action letter has permitted the use of the Internet in some limited circumstances by hedge funds, as an earlier letter did for the Regulation D offerings.
Second, the fund can only have a maximum of 99 investors. While this is not a significant hurdle, the limitation can become a problem when one delves into the world of counting investors, but the reality is that most hedge funds are well below the limits of 99 investors.
Third, only “accredited investors” can become limited partners in the underlying limited partnership – the SEC assumes that if you are an “accredited investor,” then you are a sophisticated investor and can look out for yourself, without their help.
An accredited investor, generally speaking, must have a net worth of $1 million or more; or an annual income of $200,000 or more in each of the most two recent years and has a reasonable expectation of reaching the same income level in the current year.
In 1996 Congress changed the limits on investors by allowing a hedge fund to have an unlimited number of investors who are “qualified purchasers.” A qualified purchaser is generally accepted as one or more of the following: an individual with $5 million or more in investments, including investments held jointly with a spouse; a family held business that owns $5 million or more in investments; a business that has discretion over $25 million or more in investments; or a trust sponsored by qualified purchasers.
Obviously, these investor limitations leave the vast majority of the investing public out of the running, although it has been estimated that at year end 1997, over 3 million people in the US had a net worth in excess of $1 million. Add to that group those whose salaries have climbed above $200,000 in 1998, and those investors whose portfolios rose during 1998, and there is a sizable pool of investors.
Insuring compliance with the exemptions is an important consideration – not only for the manager of the hedge fund who is the general partner of the limited partnership, but for the investors themselves, as a properly created and maintained limited partnership has serious tax implications for the individual investor. Therefore, strict compliance with the securities offering side of the hedge fund and compliance with the limited partnership laws, are required. Additionally, while a true hedge fund is exempt from SEC registration, the applicability of the state securities laws must also be addressed when creating a hedge fund.
Creating and maintaining the regulatory side of a hedge fund is not a simple task, but apparently the managers of the 4,000 or so hedge funds operating in this country have found that compliance with the exemptions is well worth the effort. There is an advantage in allowing a manager to manage money, rather than comply with day to day compliance and regulatory issues, which far outweighs the initial exemption hurdles.
This article originally appeared in the October 1998 edition of Research Magazine.
Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article.