November 27, 2011
To whom it may concern,
Thank you for allowing me to comment on this matter. I wish to discuss the issue raised by Question 222, regarding the legitimacy of the unified definition of hedge fund and private equity fund as a covered fund. After reading the intentions of Article 13 of the Dodd-Frank act, I feel it is extremely necessary to separate conceptually hedge funds and private equity funds. The unified definition used in the article on creates ambiguity and attributes false assumptions on each of the two separate entities.
Let me explain. Hedge funds and private equity funds serve very different functionalities in the market. There is so much diversity within the realm of a hedge fund that even that word on its own may not represent with any totality all the entities which it aims to describe, especially with regard to the social productivity of hedge funds that this Act so clearly wishes to distinguish. The same reasoning can be applied to private equity funds.
I assume the creation of the unified definition in this article is attributable primarily to the notion held by the masses that pools of money, when used with the freedom that is bestowed to organizations such as hedge funds and private equity funds, can become dangerous to the economy. The definition is thus created due to the notion that these funds have the power to be destructive, and therefore must be all the same and should all face similarly harsh legislation. It is easy to see the flaws with this reasoning. Such a definition ignores the complexity of the reality of each of these hedge funds and private equity firms. By trying to apply such a blanket legislation to an industry with as much diversity and complexity as this is simply ignorant.
Let me, for the sake of clarification, delineate a few of the functional roles hedge funds take and a few of the functional roles private equity firms take.
Hedge funds have far greater legal freedoms than mutual funds do. They are permitted to invest in a diverse array of investment vehicles with strategies that allow them great flexibility. There is no legal definition for a hedge fund as of yet, but those that carry the title of hedge fund may carry common characteristics. They normally have an incentive fee based on performance and a management fee set at a certain percentage, with the industry standard holding a 20% incentive and 2% management fee structure. Private equity funds have similar fee structures. Hedge funds are able to hedge their risks by both shortselling and going long on stocks in the market, though not all may choose to do so. They have potential for great diversification, in strategy and in operation, and allow them to have smaller risks. Hedge funds are not required to be monitored by the Securities and Exchange Commission. Hedge funds can invest in equities, fixed income, and cash in different ways- through money market mutual funds, bank deposits, US treasury bills, government bonds, corporate bonds. They can also invest in nearly anything that can hold investment value, ranging from innovative derivatives such as options and futures, as well as currencies, commodities, real estate, oil gas, art, and even other hedge funds and other private equity funds. Traditionally, hedge funds invest in market inefficiencies to make profits, thereby making markets more efficient by point out its flaws. They can have a number of strategies, from various forms of arbitrage, short selling, long and short term purchases of debt, of energy, of political options, of global trends, of mortgage backed securities, of collectibles, to name a few. They can use good amounts of leverage, can invest in illiquid securities, are not required to diversify, and have a limited number of accredited investors that must know the risk they are taking before investing in the fund. Investors in hedge funds are assumed to be sophisticated, and mainly include pension plans, institutional endowments, charities and foundations, insurance companies, and high net worth individuals. Regarding general effects to society, hedge funds create more liquidity in markets, reduce volatility, are among the leaders in innovation in the financial industry, absorb shocks that the market takes in times of high volatility thereby stabilizing the markets, find loopholes in the market for them to exploit and by doing so close that gap, and so ultimately make markets efficient.
The sheer number of functional forms a hedge fund can take puts light on how difficult it would be to apply uniform legislation upon these diverse entities.
Private equity funds often have very different strategies from hedge funds. While both are pools of money that are invested and that have similar fee structures, the method of investment taken my private equity firms is very different. Private equity firms do not hold publicly held securities. They normally seek partial ownership in private companies or private placements of securities from public companies. Venture capital is included under the branch of private equity, and it often specializes in funding startup operations. Private equity firms tend to have much longer obligations to their investments than funds that hold publicly traded securities. They often make highly illiquid investments in those private companies. They often assume the role of an active investor, helping manage the company they invest in to grow. Private equity firms also execute leveraged buyouts, purchasing a mature company with leverage, optimizing the companys performance, making it grow in value, and selling it again at a higher price. Sometimes they buy distressed companies, real estate, infrastructure, energy and power, merchant banking, and funds of funds. Private equity firms traditionally take part n a limited partnership and act as the general partner that has unlimited liability, while the investors are made the limited partners. While a hedge fund would have investor money in its possession, investors in private equity commit their capital to the operations of a private equity firm, so when the firm makes a decision, the investors would invest their money. The money normally stays illiquid and is realized after the firm is satisfied by the position of its company and decides to let go of its investment though an initial public offering, through mergers and acquisitions, or through recapitalization.
There is quite a bit of variation in the private equity industry as well. One can see by these characterizations that private equity and hedge funds are extremely different from each other and from their generic definitions.
Given these differences, I strongly urge the Dodd-Frank Act to not simply classify these two categories under the same definition of a covered fund to be subject to the stipulations of the act. Section 619 of the Dodd-Frank Act aims to add a section 13 to the Bank Holding Company Act of 1956, amending it to place a general ban on banking entities from investing in the covered funds- defined collectively as hedge funds and private equity funds. It allow for certain exceptions:
(Quoted from http://sec.gov/rules/proposed/2011/34-65545.pdf)
Trading in certain government obligations
Underwriting and market making-related activities
Risk-mitigating hedging activity
Trading on behalf of customers
Investments in Small Business Investment Companies (SBICs) and public interest investments
Trading for the general account of insurance companies
Organizing and offering a covered fund (including limited investments in such funds)
Foreign trading by non-U.S. banking entities and
Foreign covered fund activities by non-U.S. banking entities
My first issue is that it is very hard to determine whether a hedge fund fits the criteria set forth here, of market making activities or trading toward government obligations or not. Hedge funds strategies are normally not very easy to discern as complete visibility of their strategy would normally hurt the hedge fund itself in the competitive market. In addition, it is very difficult to define what would properly constitute a proper market making activity. There are many hedge funds that would invest in government bonds, etc. and directly fit into the criteria of trading in favour of government obligations and there are many hedge funds that would take only long strategies on securities, but there are more factors to making the market than we would normally take into account. Many hedge funds provide necessary liquidity where there would otherwise have been high transaction costs. But these wouldnt be so directly classified as market-making institutions.
Once the fund is classified as a market making institution, it is held under certain stipulations to ensure in the eyes of the Dodd-Frank act that it is benefitting the market. Some of the stipulations requires are ildefined and may hurt the market more than help. To clarify, the act doesnt allow banks to invest in high risk assets. Without defining what high risk means, the act effectively could imply that in high stress situations like that which occurred in 2008, the market making institutions would have had to exit out of the majority of their positions in the mortgage market and in other markets as an incredible rate, extremely decreasing liquidity when it is needed the most. This would carry terrible implications upon the economy. The act also urges the market making institutions to have perfect hedging. Without realizing that there is no such thing as perfect hedging, especially in areas of income markets and OTC markets where hedges dont exist, the act encourages institutions to exit out of positions in many of those areas. The act creates compliance costs associate with detailed recordkeeping of each trade, burdening the institutions with onerous tasks that could, at the end, be subject to hindsight misinterpretations that fail to capture the reasoning behind the trade when it was made. The act makes exceptions for government bonds but fails to realize the negative effects it will have upon corporate fixed income assets due to reduced liquidity in areas that these institutions dont intend to create markets in.
The act would ultimately take billions of dollars out of the sectors that were, before its application, very liquid. It would force the banks to make money in other ways that their current investments, possibly charging extra fees to the consumers. Reducing money in investment, especially at this time post recession, could further harm the economy.
These are, of course, general concerns about the act. When we look at these concerns in light of the mixed definition, we can see more issues. The transaction costs and the lower volatility and the raised compliance costs would only hurt these institutions. Even if we were to accept the goals of the Dodd-Frank Act, it would be much more sensible to tailor policies to hedge funds and private equity funds separately. Some of the stipulations involved- such as the high risk clause would be more sensible to apply to certain kinds of hedge funds and certain kinds of private equity funds. To the rest, it would just be extra paperwork and needless regulation. It could also be harmful toward those funds that depend on investing without too much hedging, with high risk potential, with little interest for furtherment of US government, but with still a good business.
Grouping them together in definition also creates cross implications and extra office work that is not necessary. Venture capital funds would be put to the same restrictions as hedge funds- and they would have to fill out the same paperwork. For instance, think about a venture capital firm ambitiously trying to create companies in the health sector- if it has great risk, it would be similarly to a hedge fund trading in ultra-risky assets. One could argue that the venture capital firm, with its direct necessity to help the society to generate profits, would be put under unfair comparison to a hedge fund that wishes to toss around securities.
I think it is necessary to understand the complexity of the reality in each of these two institutions- in hedge funds and in private equity funds- and to tailor policies accordingly to avoid hurting one at the expense of implications carried from a specifically notorious category of the other. It is important not to lay a blanket rule so blinded by and so motivated by the fear of the masses to invest in risky areas onto institutions that are necessary to create liquidity and competitiveness in the markets. It is important to realize the reality of the situation and make sure the transition to the newly structured regulations is still competitive, efficient, and liquid. Or else this may just be a case of governmental overregulation that ends up harming the productivity of the markets and in efforts to make a better, safer market, just makes the market more volatile and less liquid.
Thank you for considering my commentary on this issue.