HEDGE FUND SUMMARY AND TRENDS

EDITED AND PREPARED BY: PROF. MENTZ

There is no statutory or regulatory definition of the term "hedge fund. " They are generally characterized by their common structure and investment strategies, both of which are directly related to their lack of regulation. Like mutual funds, hedge funds pool investors' money to be invested by portfolio managers. However, they are typically organized as limited partnerships, with the portfolio manager/general partner investing a significant amount of capital in the fund.  Hedge funds typically require substantial minimum investments and require individual investors to be wealthy and financially sophisticated in order to invest.

With the exception of anti-fraud regulations, hedge funds are generally exempt from regulation by the Securities and Exchange Commission (SEC) or any other entity. Specifically, hedge funds are not required to register with the SEC as investment companies under the Investment Company Act of 1940. Hedge funds are also not required to register their securities offerings under the Securities Act of 1933. In the past, hedge fund advisers were not required to register under the Investment Advisers Act of 1940. However, in December of 2004, the SEC issued a final rule and rule amendments requiring certain hedge fund managers to register as investment advisers under the act.

 

This lack of regulation allows hedge funds to employ a wide range of investment strategies. Hedge funds, in contrast to mutual funds, may purchase derivative investments and use "financial leverage" and "short positions," although they are not limited to these methods. However, the type and number of investors are limited in order for the hedge funds to remain exempt from the regulations. Although the SEC notes that there has been a growth in the hedge fund market in recent years, it is difficult to produce an exact figure as the funds are not required to be registered (although some do so voluntarily). However, a recent American Bar Association article estimates that there are currently more than 8000 hedge funds that manage up to $ 1 trillion in capital.

INVESTMENT STRATEGIES

According to the SEC, hedge funds were originally designed to invest in equity securities and use leverage and short-selling to "hedge" the portfolio's exposure to movements of the equity market. However, hedge fund advisers presently utilize a wide variety of investment strategies. The term "hedge fund" is more reflective of the fact that the funds, unlike other investment products like mutual funds, have the ability to utilize these strategies.

HEDGE FUND STRUCTURE

Organization

Most hedge funds are set up as limited partnerships, with the portfolio manager acting as a general partner and the investors acting as limited partners. The managers cannot raise funds through public offerings of securities. Instead, they offer securities in private offerings to limited partners who provide the necessary additional capital. Investors must usually contribute a significant minimum investment. (Portfolio managers usually have a significant personal investment in hedge funds as well. ) Hedge funds typically charge an asset management fee of 1-2%, plus a "performance fee" of 20% of the profits.

Type and Number of Investors

In order for hedge funds to be free from federal regulation, the number and types of investors must be limited to comply with exemptions to existing securities laws. A hedge fund will not have to register its interests under the 1933 Securities Act, register as an investment company under the Investment Company Act of 1940, or comply with reporting requirements of the Securities Act of 1934, if it limits the number and types of investors.  

Since hedge fund interests are considered securities under the Securities Act of 1933, they would ordinarily be subject to SEC registration requirements. However, the 1993 Act provides an exception to the registration requirements if the interests are not sold in a "public offering. " Pursuant to Regulation D under the 1933 Act, offers and sales of securities by an issuer that satisfy certain conditions are deemed to be transactions not involving any public offering (and therefore, exempt from registration requirements. ) To meet the commonly used "safe harbor" in Regulation D, hedge funds may sell their interests to an unlimited number of "accredited investors. " This term includes a number of entities and (1) a natural person who has individual net worth, or joint net worth with the person's spouse, that exceeds $ 1 million at the time of the purchase; (2) a natural person with income exceeding $ 200,000 in each of the two most recent years or joint income with a spouse exceeding $ 300,000 for those years and a reasonable expectation of the same income level in the current year; and (3) an officer of the company selling the securities. It should be noted that Regulation D allows an issuer to sell its interests to a limited number of non-accredited investors (35) if they have sufficient financial knowledge. However, most funds choose to accept only accredited investors.

Under the Investment Company Act, an issuer (1) whose outstanding securities are beneficially owned by 100 or fewer persons and (2) who does not plan to make public offerings is not required to register as an investment company. There is also a "sophisticated investor" exclusion from the Investment Company Act registration requirements. Issuers are exempt from registering under the act if (1) their outstanding securities are owned by "qualified purchasers" and (2) they do not make a public offering of securities. A qualified purchaser is also known as a "super-accredited investor" and is defined as an individual who owns $ 5 million worth of investments and certain entities that own $ 25 million of investments.

As a result of all of these rules, hedge funds are typically arranged as a partnership of 100 "accredited investors" or a partnership of up to 500 "qualified purchasers" (or "super-accredited investors").  

FUNDS OF HEDGE FUNDS

Hedge funds should be distinguished from "funds of hedge funds". A fund of hedge funds is an investment company that invests in hedge funds rather than investing in individual securities. Some funds of hedge funds register their securities with the SEC. These funds must provide investors with a prospectus and file certain reports with the SEC.

Many  of these funds have lower investment minimums than typical hedge funds. It should be noted that investors in a fund of funds will have to pay the fees of the underlying hedge funds, as well as the fees of the fund of funds.

General Description of Hedge Funds and Growth of its Use.

The term "hedge fund" is commonly used to describe a variety of different types of investment vehicles that share some similar characteristics. Although it is not statutorily defined, the term encompasses any pooled investment vehicle that is privately organized, administered by professional investment managers, and not widely available to the public.

The primary investors in hedge funds are wealthy individuals and institutional investors. In addition, hedge fund managers frequently have a stake in the funds they manage. Entities classified as hedge funds are commonly organized as limited partnerships or limited liability companies, and in many cases are domiciled outside the United States.

Hedge funds are not a recent invention, as the founding of the first hedge fund is conventionally dated to 1949.  A 1968 survey by the Securities and Exchange Commission ("SEC") identified 140 funds operating at that time. During the last two decades, however, the hedge fund industry has grown substantially. Although it is difficult to estimate precisely the size of the industry, a number of estimates indicate that as of mid-1998 there were between 2,500 and 3,500 hedge funds managing between $200 billion and $300 billion in capital, with approximately $800 billion to $1 trillion in total assets.

Collectively, hedge funds remain relatively small when compared to other sectors of the U.S. financial markets. At the end of 1998, for instance, commercial banks had $4.1 trillion in total assets; mutual funds had assets of approximately $5trillion; private pension funds had $4.3 trillion; state and local retirement funds had $2.3 trillion; and insurance companies had assets of $3.7 trillion.

 

Growth of Hedge Funds

Since 1993, the estimated assets in U.S. hedge funds have increased fifteenfold to at least $795 billion, and the number of hedge funds has increased more than fivefold to 7,000. Although hedge funds remain a relatively small portion of the U.S. financial markets, the rate of growth of hedge funds has been substantially greater than that of other sectors, and hedge fund assets have been projected to grow to over a trillion dollars by the end of 2004. In addition, hedge funds play a growing role in our securities markets as large and frequent traders of securities. One recent article portrayed a single hedge fund manager as responsible for an average of five percent of the daily trading volume of the New York Stock Exchange. Another reported hedge funds dominate the market for convertible bonds.

Federal Reserve Chairman Alan Greenspan warned of the likelihood of substantive regulation following registration. See Greenspan Testimony, supra note 11. ("I grant you that registering advisers in and of itself is not a problem. The question is: What is the purpose of that unless you're going to go further? And therefore I feel uncomfortable about that issue."). The majority argues that all investors, regardless of their wealth, deserve the protection of the Investment Advisers Act. See Proposing Release at nn. 15-17. Wealthy investors might not want or need the same level of protection. They often employ well-trained professionals to select investments appropriate for them. If they desire the comfort afforded by a more rigorous regulatory regime, they may select mutual funds or other investments managed by advisers registered with the Commission or rely on a registered investment adviser to invest their money for them. Thus, the majority should view the benefit of enhanced protection for wealthy investors against the costs, including limitations on their investment options and potentially higher fees. See , Erik J. Greupner, Comment, Hedge Funds Are Headed Down-market: A Call for Increased Regulation?, 40 San Diego L. Rev. 1555, 1578 (2003) ("[R]egulatory action aimed at eliminating every vestige of fraud in a given market would place such a heavy and costly burden of compliance upon issuers that investors would be safe but unable to achieve any meaningful return on their investments. The regulatory agency would also incur a high cost of enforcement. Carried to its logical end, investor protection as a sole reason for regulation, without also granting markets the freedom to reward those who take risk, ironically keeps investors safe and yet fails to fully protect the investors' sole interest in investing in the first instance: to achieve the highest return commensurate with their individual tolerance for risk.").The majority contends that hedge fund advisers fall within our traditional jurisdiction, but for the safe harbor provision in rule 203(b)(3)-1 [17 CFR 275.203(b)(3)-1 ("A limited partnership is a client of any general partner or other person acting as investment adviser to the partnership")]. See Proposing Release at text accompanying n. 119. We disagree with the majority's suggestion that rule 203(b)(3)-1 conflicts with the spirit of section 208(d) of the Act, which prohibits a person from doing indirectly or through another person something that would be unlawful for the person to do directly. See Definition of "Client" of Investment Adviser for Certain Purposes Relating to Limited Partnerships, Investment Advisers Act Release No. 956 (Feb 22, 1985) (when the Commission proposed rule 203(b)(3)-1, it explained that the rule's availability is limited "to situations where the general partner advises the partnership based on the investment objectives of the limited partners as a group" to "prevent a general partner, in contravention of section 208(d) of the Advisers Act, from using the partnership to do what it could not do directly itself, namely, provide individualized investment advice to 15 or more clients without registering as an investment adviser"). Hedge fund advisers provide advice to hedge fund investors as a group, not individually, and, therefore, they should not be deemed to be managing the assets of more than 14 persons in contravention of the Act.Absent clearly identified red flags, we are concerned that high performance will likely invite extra Commission scrutiny.Systemic risk issues are properly addressed jointly with the Treasury and the Federal Reserve. As Federal Reserve Chairman Alan Greenspan has stated, hedge funds have "been very helpful to the liquidity and hence the international flexibility of our financial system." Greenspan testimony, supra note 11. If well-meaning, but ineffective regulation inhibits hedge funds from performing their important function of lubricating our financial system, it could have a negative effect on our economy. The Chairman of the CFTC has expressed a desire for cooperation across agencies. See CFTC Chairman James Newsome, Financial Times, 5 April 2004 ("But my concern is that before any regulatory agency drives specific rules, you have to remember that hedge funds run across multiple jurisdictions. So I would suggest that the [President's] working group is the appropriate mechanism because that group takes the broader context.").See Anti-Money Laundering Programs for Unregistered Investment Companies, 67 FR 60617 (Sept. 26, 2002) (proposing to require, among other things, that unregistered investment companies file a notice containing certain basic information with the Department of Treasury's Financial Crimes Enforcement Network).Proponents tend to paint the proposed approach as little more than a notice filing approach. We suspect that many advisers already regulated under the Advisers Act would not share that view.