January 15, 2007
I run a small hedge fund that is very negatively affected by the proposed new rule that raises investor's minimum investable assets to $2.5 million. This rule is incredibly anti-small business as it is small firms like ours that will likely have to go out of business while the large hedge funds with most of the assets and revenues won't even care as the majority of the larger funds manage money for institutions and very high net-worth individuals. This new rule would not likely have prevented some of the more notable recent blow-ups (Amaranth, Bayou and International Management Associates) or the largest (Long-term Capital Management). Further, this new rule would not have saved many smaller investors as these firms had mostly investors who would still qualify under the new rule. I understand the need to protect investors in hedge funds; however, keep in mind that while the majority of sophisticated institutional investors see the merits of having investments in hedge funds, this eliminates almost 99% of the population from being able to benefit from having some money invested in hedge funds. The proposed rule also is inconsistent with protecting the small investor given that venture capital funds, a far more risky investment than most hedge funds, can still raise money from the same individuals you would now exclude from hedge funds. Hedge funds already operate at several disadvantages relative to mutual funds: hedge funds cannot deduct fund expenses against the funds earned income (unless it exceeds 2% of AGI), they cannot do normal marketing, they have limits of 100 investors, and they cannot invest in IPOs without breaking the fund into two with restricted and non-restricted investors.
Moving back to the impact on small businesses, I left a large firm (SSgA) with a high paying position to travel less and be closer to home to have more time and flexibility to see my family and attend my kids events after spending many years often away from home much more than I would have liked. This actually involved taking a sizeable pay cut despite the perception that all hedge fund managers are making enormous amounts of money. As noted, the rule changes are not really affecting those hedge fund managers making millions as they have large funds with mostly institutional or very high net worth clients. The proposed rule would nearly eliminate the new business opportunities of most hedge funds that are funded by individual investors; 85% of my existing potential marketplace would be eliminated using the SEC statistics. Had I known this new rule would be coming into effect, I doubt I would have left my position at SSgA. My business plan when I started three years ago was based on what I knew about my individual contacts and this rule nearly obliterates my ability to generate the revenues I expected from the hedge fund I manage. In addition, the rule that doesnt allow existing investors to contribute additional money unless they meet the new stringent guidelines further damages my business; at SSgA, approximately 75% of new assets came from existing investors. The vast majority of my existing investors would no longer qualify to invest. Thus, you are seriously reducing the ability for people in this business to have one part of the American dream: having ones own business. It is likely there will be far fewer new firms starting up given the proposed rule. This seems likely to be a negative for employment since it is small business that creates the majority of new jobs these days.
Finally, where is the evidence that there is a high correlation between the size of ones investable assets and their investment knowledge? Many of the people with $2.5 million in assets have inherited their wealth making them no more a sophisticated investor than somebody with a college degree would make them a sophisticated investor. One of the few investors I have who I believe would still qualify, built a business and then sold most of it. Upon the sale, he went from non-qualified to qualified. Yet, he probably has less investment sophistication than my average investor. I would suggest that the SEC consider some other measure of sophistication such as education. To suggest an idea, maybe those without a college degree would need to have the proposed $2.5 million, but those with a college degree would still qualify under the old rule ($1 million in net worth). I know it is unlikely you will go along with this approach, but think about this: who is likely to have more investment knowledge- a person with $2.5 million and no college education or a person with $1 million and a college degree? I think most people would say the latter.
I have some other ideas on how to make any rule changes more effective in protecting small investors while still allowing more than just 1% of the investing public. First, those who are already invested in hedge funds should be allowed to add (and subtract) investments. Not allowing them to move money in and out creates an incentive to keep it in since they can never add it back in. The rule, as written, will make their allocations inefficient and tie their hands somewhat in making changes.
I suggest you consider changing the rule only for those hedge funds that are not registered with the SEC or equivalent state agency. If a hedge fund firm is registered, then this provides better protection than any artificial rule on the size of an investors assets. Assuming the previous ideas are not adopted, at least consider lowering the bar as well as including all assets- not just investable. Using the data provided by the SEC, the idea of adjusting the limits to reflect inflation makes more sense than the arbitrary limits set in the proposed rule. This would suggest using $1.9 million for all assets, or $400,000 in terms of income (or $600,000 joint). In addition, I suggest doing this on a phased basis so it doesnt eliminate so much of the individual marketplace in one fell swoop. Perhaps moving to $1.5 million now (and $300,000 or $500,000 joint now) and then $2 million in 3 years would give small hedge fund firms like mine time to adjust to the changes.
Thank you for your consideration.