The Securities and Exchange Commission today voted to propose requiring hedge fund advisors to register as investment advisors, ending a long period of speculation and anticipation within the alternative investment industry.
The proposal was adopted in an unusual vote that saw two commissioners dissenting.
The proposed rules apply to managers of what the SEC calls ‘private funds,’ defined as funds that otherwise would be exempt from registering but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940; and to funds that allow liquidity within two years.
Many hedge funds allow monthly, quarterly or yearly redemptions, while most private equity funds have decade-long capital lock-up provisions.
Section 3(c)(1) allows an exemption from registration if a fund has fewer than 100 investors. Section 3(c)(7) allows an exemption from registration if all investors are ‘qualified purchasers’ – a person or company with more than $5 million in assets.
The Investment Company Act of 1940 regulates the funds themselves and applies to most mutual funds. The Investment Advisors Act of 1940 applies only to the managers of funds. The new SEC proposals would require many hedge fund advisors to register, but not their underlying funds.
The proposed rules also change the definition of the term ‘client’ for an investment advisor. Now, according to an SEC statement, advisors to ‘private funds’ must “register with the Commission by requiring the advisers to ‘look through’ the funds and to count the number of investors (rather than the fund) when determining whether the advisers are eligible for the Adviser Act's exemption for advisers with 14 or fewer clients.”
Most alternative investment advisors have until now been exempt from registering because they manage fewer than 14 funds, regardless of how many LPs they have.
'It puts a spotlight on the rather fluid or overlapping boundaries amongst various private equity funds, hedge funds, venture capital funds,' said Michael Collins, a partner at Boston-based law firm Testa, Hurwitz & Thibeault. 'You can see here that the distinguishing feature to which they point is somewhat of a slim reed to separate to separate various private funds.'
Hedge fund advisors with less than $25 million in total assets need not register.
The SEC said it wants hedge funds to register as investment advisors so the commission can better “collect and provide to the public basic information about hedge funds and hedge fund advisers, including the number of hedge funds operating in the United States, the amount of assets, and the identity of their advisers.”
Registration will allow the SEC to conduct surprise audits of hedge funds. It would also impose basic compliance procedures on advisors.
'The important thing to note is that hedge funds are being viewed in a much larger context,' said Collins. 'They are being associated with a lot of unsavory mutual fund activiteis that are not really at the core of what hedge fudns are all about.'
The SEC appears to have taken to heart concerns expressed by overseas asset managers. Today’s announcement reads: “The proposed rule would contain special provisions for advisers located outside the United States designed to limit the extraterritorial application of the Advisers Act to offshore advisers to offshore funds that have U.S. investors.”
Comments on the proposed provisions should be submitted to the Commission by September 15, 2004.
Far from uncovering rampant abuse in the hedge fund industry, many SEC staffers were impressed with the controls and systems that most hedge funds have in place. Said Collins: 'It is notable that the SEC staff came away with a predominant impression that hedge funds were very well run. This is important, because that's what private equity needs to do to maintain a high standard of operations and integrity.'