Speech by SEC Commissioner:
Remarks Before the Hedge Fund Institutional Forum Corporate Funds Roundtable
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
March 5, 2007
Good morning. I'd like to thank Institutional Investor and, in particular, Robin Coffey, for inviting me to speak before representatives of some of the most prominent and influential hedge funds and fund of funds today. I think it goes without saying that we currently are in a golden age for alternative investments. Hedge funds are an increasingly dominant force in all parts of the market. I've read that 18-22% of all trading on the NYSE is done by hedge funds and, as we all know, 1/3 of the London Stock Exchange is currently owned by hedge funds.
Moreover, it seems that you can't turn on the television or go to a store without seeing widespread evidence of the new "hedge fund" culture. For example, you've already been honored with the publication of a book that attests to your relevance to mainstream America…your own "Hedge Funds for Dummies" book. But perhaps one of the greatest testaments to your newfound "cultural icon" status is that you recently joined the ranks of famous professional athletes and movie stars when you received your very own…shoe. Kenneth Cole last year debuted the sleek "Hedge Fund" loafer for $120 retail. In what I hope is not an ominous sign for hedge fund performance in 2007, however, I've recently seen this very same shoe now being sold on Bluefly.com for $96.00 — a 20% loss!
All humor aside, I know we have a very short time together and that you'd probably like to spend some time this morning asking me a few questions, so I'll move immediately to my response to the recent articulation by the President's Working Group of principles and guidelines for private pools of capital. I'll also cover a couple of additional topics that are likely to be of particular interest to the hedge fund industry today. Before I begin, however, I must I must give the standard disclaimer that, as a matter of policy, the SEC disclaims responsibility for any private statement and my remarks are my own opinions and do not necessarily reflect those of the Commission, my fellow Commissioners, or members of the staff.
President's Working Group Paper on Private Pools of Capital
I know that the topic du jour today in the hedge fund world is the President's Working Group paper on private pools of capital, which was issued just last Thursday. Now, I have already heard the paper described by the press as advocating for or supporting many different things — a "call to inaction," a "light touch regime," even a "rejection" of more oversight of hedge funds. However, as we all know, media depictions of policy developments are often skewed in favor of the sensational one-liner or sound-bite, and I think it is fair to say that this is no exception.
These press blurbs have grossly oversimplified the non-binding principles and guidelines that were issued by this group, and have morphed these general, aspirational statements into crystal-ball predictions of what we can expect regulators to do or not do in the near future. All of this, of course, is simply not accurate. The President's Working Group is comprised of the current heads of four different financial regulators and departments — it does not comprise the final policy or regulatory agenda of any one of those regulators. Those types of decisions must be decided and acted upon by the relevant Commissions, Board of Governors, or Department heads that bear responsibility and authority for satisfying their policy missions and meeting their statutory mandates.
I do, however, feel that I must share my own views in this area because my reading of the paper, and frankly, my understanding of the SEC's regulatory oversight role over hedge funds do not comport with the media's descriptions. Simply put, I do not read the President's Working Group paper as either deferring all responsibility to general "market discipline" or rejecting any further role for regulators in the monitoring and regulation of hedge funds. The paper specifically states that investor protection concerns are most effectively addressed by a combination of multiple parties and policies, including regulators and regulatory policies. While the paper makes it clear that market discipline effectively addresses systemic risks posed by hedge fund activities, it also makes it clear that regulators have and should use their authority to foster vital and stable capital markets. I would hardly characterize this as "inaction."
Rather, I see the paper's generally positive tone as a reflection of the many strong regulatory policies that currently are in place, and are currently being considered, to protect hedge fund investors. We currently have an accredited investor standard, along with proposed revisions to that standard and a proposed anti-fraud rule. Moreover, we have a detailed regulatory regime that oversees and monitors market participants like broker-dealers and investment banks that interact with hedge funds. That being said, I read nothing in the paper as precluding or discouraging consideration of further regulatory action if the circumstances were to warrant it.
I do not mean to imply by this last statement that I believe that we should be looking for new and intrusive ways to regulate or monitor hedge funds. I do not believe in regulation for the sake of regulation. Overregulation has its own problems and costs, and my almost 5 years experience at the Commission has taught me that we need to exercise the particularly powerful tool of regulation with great caution and sensitivity. Rather, all I am saying is that — far from precluding or requiring future regulatory action — we simply need to be prepared to regulate when the circumstances necessitate it, and to exercise restraint when they don't. For example, as I noted at the Commission open meeting, I would have gone further on the hedge fund antifraud rule and would have supported a tougher regulatory stance. However, the many, many comments that we've received on the revised accredited investor proposal since we published it for notice and comment have me re-analyzing what the correct threshold should be for our accredited investors and whether the proposed threshold will capture the appropriate level of investor sophistication.
Perhaps a better way describing this type of regulatory philosophy is to call it the familiar "Goldilocks" approach — not too much regulation, not too little, but "just right." Given our short time today, I'll finish up by giving just a few examples of how this Goldilocks-regulatory approach can work in a way that benefits both the hedge fund industry and its investors, before moving on to questions.
Hedge Fund Advertising
As some of you may know, I am very interested in exploring the option of providing limited relief from the prohibition against general solicitations for hedge funds whose advisers are registered with the SEC. While it may not be appropriate to modify the limitations on all types of general solicitation, including those resulting from the use of electronic media, it may be worthwhile to consider the need for such limitations for private offerings or hedge funds whose owners are limited to investors that clearly meet a higher standard or may be presumed to be able to "fend for themselves" such as, for example, the "qualified purchaser" standard of Section 3(c)(7).
I believe that this type of a carrot-and-stick regulatory approach could provide the perfect "goldilocks" blend of effective regulation coupled with enhanced capital access. On the business end, this approach would provide enhanced flexibility for hedge funds to target and provide information to eligible investors without running afoul of the general solicitation or advertising prohibitions. On the regulatory end, making this relief available only to funds that are managed by registered hedge fund advisers would provide the SEC with the necessary transparency and regulatory oversight to comfortably permit enhanced solicitation and marketing activities in a manner that is consistent with our investor protection mission.
Now, I want to emphasize that all of this is still in a very brainstorming and formative stage, and the agency has not taken a policy position on how or whether it will provide such advertising relief to hedge funds. However, I look forward to analyzing this possible approach with our Division of Investment Management and with the industry. I'm also quite aware that if this approach were to go forward that we would have to think very carefully about how to craft the relief in a way that it effectuates our policy goals without resulting in unintended or negative consequences. For example, I've already become aware of certain private funds that are not technically hedge funds — but that operate in the same business sphere as hedge funds — that could be affected by an SEC rule that would provide limited solicitation relief to certain funds managed by registered hedge fund advisers. I am continuing to explore these intricacies, but I would just note off-hand, that I could not possibly imagine a rule that would preclude the advisers of such private funds from registering with the SEC, should they wish to rely on similar advertising relief.
I would be very interested in hearing your views on this potential approach, and I encourage you to contact both myself and our Division of Investment Management staff with your own views and comments on hedge fund advertising issues.
Fund of Hedge Funds
I believe that another intriguing "goldilocks" possibility for coupling effective regulation with enhanced capital access is in listed "funds of hedge funds" — registered closed-ended mutual funds that would be listed and made available to investors on a public exchange. I have often asked the question, "If hedge funds are so good for sophisticated and wealthy investors, why shouldn't these benefits be available for all investors?" To me, listed funds of hedge funds would be one way to provide all investors with access to the benefits of hedge fund strategies and diversification, while simultaneously providing investors with an important layer of investment protection and oversight. I also raise the question as to whether the current pool of unlisted registered funds of hedge funds that voluntarily limit investments to accredited investors should consider accessing a broader retail base by making their products available to all investors, particularly since this limitation is not required by law.
Now, I want to first clarify exactly why I believe that funds of hedge funds should be made available to all investors, whereas, I have supported limiting investments in hedge funds to investors that meet certain sophistication and financial criterion. In short, funds of hedge funds are not hedge funds. Hedge funds are highly complex products and involve risks not generally associated with many other issuers of securities. Not only do hedge funds use complicated investment strategies, but there is minimal information available about them in the public domain. Accordingly, investors may not have access to or be in a position to negotiate for the kind of information necessary to understand the full nature of their investment, and may find it difficult to appreciate the unique risks of these pools, including conflicts of interest and complex fee structures.
Funds of hedge funds, in contrast, give investors access to a diversified group of hedge funds that are selected for them by a professional money manager who is in a position to obtain and evaluate information from the hedge funds. Indeed, managers of funds of funds owe the funds a legal duty to act in their best interest and, in that regard, to ensure that the fund's investment decisions are prudent and sound. The professional intermediaries that manage fund of hedge funds provide a crucial and meaningful layer of investor protection.
It is precisely for this reason why registered funds of hedge funds were not included in our recent December accredited investor proposal. The Commission expressly stated its belief that the safeguards provided by the proposed accredited investor threshold would not be necessary for pools that are managed by experienced investment professionals with explicit fiduciary obligations to the investor. The importance of this fiduciary layer was also reiterated by the President's Working Group who emphasized that concerns regarding indirect hedge fund exposure through fund of funds or pension funds were best addressed through "sound practices on the part of the fiduciaries."
Moreover, investors in funds of hedge funds also would receive the benefits and transparency that would come with investing in products that are registered with the SEC. In contrast to the opacity that is generally associated with unregistered hedge funds, registered funds of hedge funds would be subject to all of the registration and regulatory obligations under the Investment Company Act. Investors in these products would have transparency regarding the nature of their investments and the principals managing those investments, disclosure regarding the fees involved, as well as specific protections against certain conflicts-of-interest and self dealing activities.
Lastly, I would like to address the comment that fund of hedge funds may be too risky or unsuitable for the average investor by noting that this comment simply misses the mark. The SEC has never been, and is not in the business of eliminating investment risk. Rather, we protect investors and their investments by regulating fund disclosures, conflicts-of-interest, and governance. We have always held that the determination of appropriate investment risk and investment suitability with respect to a particular product is to be made by the market and professionals and investors that operate in that space, not by the SEC. This is why we currently can purchase products in the marketplace today that are, by all metrics, extremely volatile and "risky" — for example, commodity funds or volatile sector funds that available for purchase by any investor. More specifically, look at all of these new mutual fund products — the long/short equity products — that are essentially adopting hedge fund strategies under the wrapper of a registered, open-ended mutual fund.
Now, I recognize that registered funds of hedge funds are not currently available to the public, and are currently under review by the SEC's Division of Investment Management. Thus, while I can't speak to the particulars of any specific pending application, all of the evidence I have seen to date points towards making these products available to the investing public.
Hedge Fund IPOs
A final example of a successful "goldilocks" approach is one that is not even being driven by the regulators, but rather, the industry itself! Yes, I'm talking about hedge fund IPOs and the recent unprecedented actions by several hedge fund and private equity players to access the public markets. Although I have been tracking with interest the several fund managers that went public on foreign exchanges last year, I watched with particular satisfaction the US market's reaction to its first hedge fund IPO — the Fortress IPO — on February 9, 2007. In particular, the fact that Fortress chose to list on the NYSE — notably, with an incredible 68% rise on the first day of trading alone — seemed to validate my long-held belief that, notwithstanding all the nay-sayers who have criticized the US markets as being less attractive to issuers than other foreign markets, there remains a significant and dramatic premium for listing and raising capital on our domestic shores.
What is particularly astonishing about this particular IPO was that it showed that even those entities that have historically prized privacy and minimal regulation above all else are now modifying their calculus. Fortress voluntarily chose to register its shares with the SEC and to list on the NYSE — and, in doing so, to comply with all of the attendant regulatory responsibilities — in order to better raise capital. Fortress did the cost-benefit analysis of costs of regulation vs. enhanced capital, and clearly the capital side won.
I would not be surprised if 2007 witnessed the advent of several other hedge fund managers entering our public markets, and I would welcome such a development. If hedge fund managers are willing to provide the transparency required of all public companies to its investors, I have no objections to them tapping the deepest and most liquid capital markets in the world. Moreover, these public offerings can also benefit investors by offering them yet a different way of getting a piece of the "hedge fund action." Investors who wish to share in some of the gains (as well as losses) of publicly offered hedge fund managers would be able to do so without the high minimums, fees, and long lock-up periods that would typically be required to invest in the manager's hedge funds. While I recognize that investments in publicly offered shares of hedge funds pose unique types of investment risks — volatility and earnings fluctuations are just a few — risk is not per se bad. So long as risk is appropriately disclosed and the market accounts for and prices in that risk — exactly what our registration process is designed to do — both investors and the hedge fund industry can benefit.
There are so many other topics that I would like to discuss with you — the growing retailization and institutionalization of hedge funds, hedge fund activism, and our current rulemaking proposals, to name a few. But perhaps in light of our short time together today, it would be best for me to end my remarks open the floor to questions.