Staff Hedge Fund Report Fact Sheet
Implications of the Growth of Hedge Funds
Report of the Staff of the U.S. Securities and Exchange Comission
The Commission is releasing today a report on hedge funds, "The Implications of the Growth of Hedge Funds."
Culmination of Staff Efforts. The Report, which contains the views of the staff and not necessarily those of the Commission or any individual Commissioner, represents a culmination of the staff's efforts over several months. As part of that study, the staff reviewed documents from 65 hedge fund advisers managing more than 650 different hedge funds with more than $160 billion of assets. The staff also visited hedge fund advisers and prime brokers and conducted a series of examinations of registered funds of hedge funds. In addition, the staff met with hedge fund advisers, investors, fellow regulators and industry observers willing to share information about hedge funds. Finally, the staff and the Commission benefited from views expressed at a highly successful two-day Hedge Fund Roundtable in May, during which a variety of experts discussed key aspects of hedge fund operations, and from insights contained in the approximately 80 public letters received by the Commission commenting on matters raised in the roundtable discussions and related hedge fund issues.
The Report was prepared by the Division of Investment Management, with the assistance of the Divisions of Corporation Finance, Enforcement and Market Regulation, and the Offices of Compliance Inspections and Examinations, Economic Analysis, International Affairs and Investor Education and Assistance. The Report outlines the staff's factual findings, identifies concerns and recommends that the Commission consider certain regulatory and other modifications to improve the current system of hedge fund regulation and oversight.
Growth of the Hedge Fund Industry. The Commission's decision to study the hedge fund industry was based, in large part, on the growth of hedge fund assets coupled with the Commission's lack of information about these investment pools. The hedge fund industry recently has experienced significant growth in both the number of hedge funds and in the amount of assets under management. Based on current estimates, 6,000 to 7,000 hedge funds operate in the United States managing approximately $600 to $650 billion in assets. In the next five to ten years, hedge fund assets are predicted to exceed $1 trillion.
Concerns Identified in Study and Report. The Report notes that one of the staff's primary concerns is that the Commission lacks information about hedge fund advisers that are not registered under the Investment Advisers Act of 1940 (the "Advisers Act") and the hedge funds that they manage. Although hedge fund investment advisers are subject to the antifraud provisions of the federal securities laws, they are not subject to any reporting or standardized disclosure requirements, nor are they subject to Commission examination. Consequently, the Commission has only indirect information about these entities and their trading practices, thereby hampering the Commission's ability to develop regulatory policy.
The staff is concerned that the Commission's inability to examine hedge fund advisers makes it difficult to uncover fraud and other misconduct. The Commission typically is able to take action with respect to fraud and other misconduct only after it receives relevant information from third parties, and frequently only after significant losses have occurred.
Another of the staff's key concerns relates to the manner by which hedge fund advisers value hedge fund assets. The broad discretion that these advisers have to value assets and the lack of any independent review over that activity gives rise to questions about whether some hedge funds' portfolio holdings are accurately valued.
During the course of its study, the staff observed various uses of the Internet by hedge fund advisers to communicate with investors. The staff, in its Report, reiterates the Commission's statement that the analysis historically applied to determine whether an offering is part of a general solicitation or public offering has not changed in the context of offerings made through electronic sources.
In its report, the staff makes a number of recommendations to address the concerns it identified. The staff's most significant recommendations include the following:
The Commission should consider requiring hedge fund advisers to register as investment advisers under the Advisers Act, taking into account whether the benefits outweigh the burdens of registration. The staff recommends that the Commission consider revising its rules under the Advisers Act to require hedge fund advisers to register as investment advisers. The staff further recommends that the Commission consider amending its rules to require that registered hedge fund advisers file with the Commission, and deliver to investors, a disclosure statement specifically designed for hedge fund investors.
Registration of hedge fund advisers would have several benefits:
- registered hedge fund advisers would become subject to the Commission's regular inspections and examinations program. Effective Commission oversight could lead to earlier detection of actual and potential misconduct, help to deter fraud and encourage a culture of compliance and controls.
- the Commission would be authorized to collect basic and meaningful information about the activities of hedge fund advisers and hedge funds, which are becoming increasingly influential participants in the U.S. financial markets.
- Advisers Act registration would enable the Commission to require hedge fund advisers to disclose information about issues important to investors, such as conflicts arising from side-by-side management of hedge funds and other client accounts and hedge funds' relationships with their prime brokers.
- registration of hedge fund advisers under the Advisers Act also would effectively increase the minimum investment requirement for direct investments in some hedge funds because registered advisers are generally prohibited from charging performance fees unless investors have $750,000 invested with the adviser or have a net worth of $1.5 million.
In the Report, the staff notes that Advisers Act registration would not impede the manner in which a hedge fund adviser invests or operates a hedge fund. Registration would not place restrictions on a hedge fund adviser's ability to trade securities, use leverage, sell securities short or enter into derivative transactions. Registration also would not require the disclosure of hedge fund trading strategies and portfolio positions, nor would it result in the identification of the hedge fund's investors.
The Commission and its staff should address certain valuation and fee disclosure issues relating to registered funds of hedge funds ("FOHFs"). The staff also recommends that the Commission consider requiring, through rulemaking, that all registered investment companies that invest their assets in hedge funds, including registered FOHFs, have policies and procedures designed to ensure that funds and their boards value their interests in hedge funds in a manner consistent with the requirements of the Investment Company Act. To address concerns that registered FOHF investors do not understand the impact of multiple layers of fees, the staff recommends that the Commission adopt its proposed rulemaking to require all registered investment companies, including registered FOHFs, to disclose in their prospectus fee tables the estimated expenses of the company's underlying fund interests.
The Commission should consider permitting general solicitation in fund offerings limited to qualified purchasers. The staff recommends that the Commission consider eliminating the prohibition on general solicitation or advertising in offerings by hedge funds that rely on the exclusion from the definition of an investment company for hedge funds that permit investments only by highly sophisticated investors. Permitting pooled investment vehicles, including hedge funds, which limit their investors to this higher standard to engage in a general solicitation could assist funds in identifying such qualified purchasers, without raising significant investor protection concerns.
Other recommendations. The staff also recommended that:
- the staffs of the Commission and the NASD monitor closely capital introduction services provided by broker-dealers and watch closely for violations of broker-dealer suitability obligations with respect to the sale of FOHFs;
- the Commission encourage the hedge fund industry to embrace and further develop best practices;
- the Commission continue its efforts to improve investor education regarding hedge funds; and
- the Commission consider issuing a concept release to examine the wider use of hedge fund investment strategies in registered funds.