Read the article in the Cayman Financial Review Magazine
This article summarises the results of a recent survey of private fund managers.*
The study identifies the possible effects of hedge fund adviser registration under the Dodd-Frank Act and is intended to support policy makers in implementing new rules pertaining to the hedge fund industry.
The study suggests that the registration and disclosure requirements under the Dodd-Frank Act and the SEC’s implementation of these requirements created several areas of concern for the hedge fund industry. Overall, however, the hedge fund industry appears to be adapting well to the regulatory environment after the enactment of the Dodd-Frank Act.
The Dodd-Frank Act marks the ending of the era of light-touch regulation and unsupervised hedge fund activities. Before the enactment of the Dodd-Frank Act, hedge fund managers were able to operate in financial markets with minimal regulatory supervision.
The growth and importance of the hedge fund industry in worldwide financial markets may be attributable, at least in part, to the lack of regulatory oversight for more than half a century. The hedge fund industry thrived without regulatory supervision, generating higher returns and attracting an increasingly larger investor base.
Given the success of the hedge fund industry in a light-touch regulatory environment, it is not surprising that the industry resisted the SEC’s past attempts to register hedge fund managers. When the SEC in December 2004 issued a final rule requiring hedge fund advisers to register under the Advisers Act1, the hedge fund industry strongly opposed the rule2.
Two years later, in 2006, the United States District Court of Appeals for the District of Columbia in Goldstein v. SEC vacated the rule requiring registration of hedge fund managers as arbitrary3.
Most registered hedge fund managers deregistered after the court issued its ruling in the Goldstein decision.
Title IV of the Dodd-Frank Act, entitled the Private Fund Investment Advisers Registration Act of 2010 (PFIARA), and SEC rules implementing the Act changed the regulatory landscape for the private fund industry. First and foremost, PFIARA authorised the SEC to promulgate rules requiring registration of private funds. The Act mandates hedge fund adviser registration so as to increase recordkeeping and disclosure4.
Hedge fund manager registration under PFIARA, applies to any fund with more than $150 million assets under Management (AUM)5.
Once registered, private fund managers are subject to enhanced disclosure requirements. Hedge fund managers are required to maintain records to avoid systemic risk6 and provide confidential reports related to systemic risk7.
Information about the fund and the managers’ portfolio includes: the amount of AUM, the use of leverage, including off-balance sheet leverage, counterparty credit risk exposures, trading practices, trading and investment positions, valuation policies, side letters and other information deemed necessary8.
In order to identify the possible impact of hedge fund adviser registration requirements under the Dodd-Frank Act, the study draws inferences based on a sample of investment advisers from a population of investment advisers registered in the United States. The author and four research assistants collected data by approaching 1264 private fund managers with a survey questionnaire.
The survey asked private fund managers to describe the possible effects of hedge fund manager registration requirements under the Dodd-Frank Act. Respondents (n=94) answered questions in several categories, including: strategic responses to the Dodd-Frank Act requirements, cost of compliance, long-term effect of reporting and disclosure rules on the private fund industry, compliance measures, long-term effect of reporting and disclosure rules on private funds, effect of the regulatory regime on assets under management, and effect of the regulatory regime on profitability.
The results summarised below are the major findings of the first observational study conducted after the SEC’s registration effective date for hedge fund advisers, 30 March, 2012. The study will help support hedge fund advisers in the administrative management of their funds because it quantifies compliance costs, it evaluates compliance measures and it assesses fund managers’ strategic responses to the implementation of the Dodd-Frank Act.
Other important findings of the study pertain to the implications of the private fund disclosure requirements under the Dodd-Frank Act and the possible long-term effects of hedge fund manager registration, including the effect on assets under management and profitability.
Strategic responses to Dodd-Frank
Hedge fund managers can implement a broad array of legal and strategic responses to address perceived concerns of new regulations. For instance, managers can change the legal structure of their funds and management companies, they can lower or increase the assets under management, or they can change the strategy pertaining to their funds.
As Figure 1.1 shows, a minority of respondents in the survey has planned a strategic response to the Dodd-Frank Act requirements. This suggests that the requirements in Dodd-Frank and the SEC regulations implementing these requirements are not perceived as materially changing the existing business and compliance model.
Plan a Strategic Response to Dodd-Frank
This finding is confirmed by Figure 1.2: a clear majority of respondents did not plan to change their assets under management in response to the new regulatory environment even though lowering the AUM below a certain threshold could exempt hedge fund advisers from the Dodd-Frank Act requirements.
Consider Current Regulations to Determine AUM Size
Figure 1.3 illustrates hedge fund managers’ most common strategic responses in reaction to the registration and disclosure requirements under the Dodd-Frank Act. Most respondents indicated that they are addressing the requirements through compliance measures. By contrast, Figure 1.4 shows that a change of the funds’ legal structure, lowering the AUM, and other changes to escape the application of the Dodd-Frank Act do not constitute common strategic responses.
Most Common Actions Taken
Least Common Actions Taken
Figure 1.5 shows that 25 per cent of respondents plan on decreasing the AUM size of their funds to avoid the regulatory hassle. Others will increase current AUM size to cover expenses.
Take Regulatory Regime into Account for AUM by
Figure 1.6 suggests that the ideal AUM size for most respondents is somewhere between $150 million and $1.5 billion. However, existing regulation does not appear to have influenced funds’ choice regarding the size of their AUM. Rather, figure 1.7 suggests that choosing a particular AUM size is based on a fund’s strategy and its existing size.
Desired AUM After Dodd-Frank
Factors Influencing AUM Preference
Private fund profitability after the enactment of the Dodd-Frank Act
A major concern of the hedge fund industry prior to the enactment of the Dodd-Frank Act pertained to the possible effect of new rules and regulations on privacy, proprietary trading positions, and profitability. Managers were concerned that a leak of sensitive data managers report to the SEC could affect their profitability, result in possible reverse-engineering of a fund’s strategy, and the detection of weaknesses that rival firms could exploit.
Figure 2.1 illustrates managers’ responses pertaining to the profitability of their hedge funds and the effects of the Dodd-Frank Act on investors. While the new requirements do not appear to have affected the earnings of hedge funds, Figure 2.2 suggests that the profitability of the management company will be affected. Future research examining hedge fund performance after the enactment of the Dodd-Frank Act may help clarify if the tectonic shift in hedge fund regulation through the Dodd-Frank Act had a latent or delayed effect on hedge fund earnings9.
Dodd-Frank Affect Fund’s Earnings?
Dodd-Frank Affect Management Compnay Porfits?
Another major concern of the hedge fund industry revolved around the possible cost of compliance. The industry and regulators have not addressed the possible consequences of compliance costs. A high level of compliance costs could make it more difficult for new hedge fund start-ups to enter the market and result in consolidation of larger funds. If the consolidation of hedge funds should increase systemic risk, Title IV of the Dodd-Frank Act could result in the exact opposite of Congress’s intent10.
Figure 2.3 indicates that the cost of compliance for the hedge fund industry is somewhat moderate. 48 per cent of respondents did not incur more than $100,000.00 in compliance costs per year after the enactment of the Dodd-Frank Act.
Cost Required to Comply with Dodd-Frank
Conclusion and future research
Despite initial industry grumbling, the results of this study suggest that hedge fund advisers are taking the new regulatory burdens under the Dodd-Frank Act in stride. Most hedge fund managers are not altering the size of their funds to avoid Dodd-Frank Act requirements. Managers are also not altering their investing styles. Most of the new registration and disclosure requirements have not affected the returns for hedge fund investors.
Very few managers have changed their funds’ legal structure in response to Dodd-Frank Act requirements. Rather, hedge funds are adapting to the new requirements by outsourcing compliance work, hiring additional counsel, establishing new record-keeping policies, hiring additional staff, and changing marketing materials and investor communication.
Hedge funds should easily absorb the cost of these measures. There is some evidence, however, that smaller investment advisers could be disproportionally affected by the registration and disclosure requirements in the Dodd-Frank Act. Future research may help policy makers appreciate the effects of the regulatory regime on smaller fund advisers11.
There is also some anecdotal evidence that ambiguities in the SEC forms may enable fund managers to report data in disparate ways. Disparate data reporting could make it more difficult for the newly created Financial Stability Oversight Council (FSOC) to conduct a comparative and comprehensive assessment of systemic risk. The FSOC’s work could be further complicated by funds’ use of estimates and educated guesses in disclosing the required data to the SEC. Future research could help clarify whether FSOC and SEC d12.