WEBMASTER NOTE: This is the unedited transcript of the hedge fund hearings held on May 14-15, 2003, which we received directly from the court reporter. We are posting the transcript in this form to make it available as soon as possible. Staff will review this transcript and will correct any errors that may be contained in it. We will post on our website the corrected transcript, which will also be easier to view and to read, as soon as it is available. -------------------------------------------------------------------------------------- 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 In the Matter of: ) 4 ) File No. 05-007-03 5 HEDGE FUND ROUNDTABLE ) 6 PAGES: 1 through 285 7 PLACE: Securities and Exchange Commission 8 450 Fifth Street, N.W. 9 Washington, D.C. 10 DATE: Wednesday, May 14, 2003 11 12 The above-entitled matter came on for hearing, pursuant 13 to notice, at 9:00 a.m. 14 15 BEFORE: 16 17 WILLIAM H. DONALDSON, Chairman 18 PAUL ATKINS, Commissioner 19 RAUL CAMPOS, Commissioner 20 CYNTHIA GLASSMAN, Commissioner 21 HARVEY GOLDSCHMID, Commissioner 22 23 24 Diversified Reporting Services, Inc. 25 (202) 467-9200 1 C O N T E N T S 2 PAGE 3 4 Welcome and Overview - Chairman Donaldson 8 5 6 PANEL 1 - HEDGE FUNDS - OVERVIEW, ROLE AND STRUCTURE 12 7 8 MODERATOR: 9 PAUL F. ROYE 10 Director, Division of Investment Management 11 12 PANELISTS: 13 DAVID VAUGHAN 14 Partner, Decker, LLP 15 16 RICHARD LINDSEY 17 President, Bear Stearns Securities Corp. 18 19 CHARLES GRANDANTE 20 Managing Principal, Hennessee Hedge Fund 21 Advisory Group 22 23 WILLIAM KEUNEN 24 Director, Citco Fund Services 25 1 GREGORY NEWTON 2 President, Managed Accounts Reports, LLC 3 4 JOEL PRESS 5 Senior Partner, Ernst & Young 6 7 ROBERT SCHULMAN 8 Chairman and CEO, Tremont Investment Management 9 10 MICHAEL NEUS 11 Principal and Chief General Counsel, Andor Capital 12 Management, LLC 13 14 15 PANEL 2 - MARKETING ISSUES - HOW ARE HEDGE FUNDS 16 MARKETED/DISTRIBUTED? 100 17 18 MODERATOR: 19 ELIZABETH G. OSTERMAN 20 Assistant Chief Counsel, Division of Investment 21 Management, Securities and Exchange Commission 22 23 PANELISTS: 24 ALAN BELLER 25 Director, Division of Corporation Fincance, SEC 1 MICHAEL BUTOWSKY 2 Partner, Mayer Brown Rowe & Maw 3 4 LEROY CODY 5 Managing Director, American Express Alternative 6 Investments 7 8 JAMES R. HEDGES 9 Founder, President, and Chief Investment Officer, LJH 10 Global Investments, LLC 11 12 CLARK HOOPER 13 Executive Vice President of Disclosure Policy and 14 Review, NASD 15 16 JUDSON P. REIS 17 Partner, the Sire Group of Partnerships 18 19 CRAIG RUSSELL 20 Managing Director and Global Head of Sales and 21 Marketing, DB Absolute Return Strategies 22 23 MICHAEL TIEDEMANN 24 Chief Operating Officer, Tiedemann Investment Group 25 1 PANEL 3 - ISSUES ASSOCIATED WITH HEDGE FUND DISCLOSURE, 2 TRANSPARENCY AND PAERFORMANCE FEES 100 3 1 MODERATOR: 2 ROBERT E. PLAZE 3 Associate Director, Division of Investment Management, 4 Securities and Exchange Commission 5 6 PANELISTS: 7 8 ROBERT BERNARD 9 Chief of Administration and Finance, RiskMetrics Group 10 11 GEORGE HALL 12 Founder and President, Clinton Group 13 14 DAVID A. HSIEH 15 Professor of Finance, Fuqua School of Business, Duke 16 University 17 18 JEAN KAROUBI 19 President, The LongChamp Group, Inc. 20 21 LARRY SIMON 22 President and CEO, Ivy Asset Management Corp. 1 DAVID SWENSEN 2 Chief Investment Officer, Yale University 3 4 MICHAEL G. TANNENBAUM 5 Director, Hedge Fund Association 6 Partner, Tannenbaum Helpern Syracuse & Hirschtritt, LLP 7 8 9 PANEL 4 - ISSUES ASSOCIATED WITH VALUATION, ALLOCATION, USE 10 OF COMMISSIONS AND PERSONAL TRADING 219 11 12 MODERATOR: 13 DOUGLAS SCHEIDT 14 Associate Director and Chief Counsel, Division of 15 Investment Management, Securities and Exchange 16 Commission 17 18 PANELISTSl 19 ANTHONY ARTABANE 20 Partner, PricewaterhouseCoopers, LLP 21 22 MICHAEL DIESCHBOURG 23 Principal, Silver Creek, LLC 24 25 BING LIANG 1 Assistant Professor of Finance, Weatherhead School of 2 Management, Case Western Reserve University 3 4 ANDREW W. LO 5 Harris & Harris Group Professor of Finance, Sloan School 6 of Management, Massachusetts Institute of Technology 7 8 RICHARD PHILLIPS 9 Partner, Kirkpatrick & Lockhart, LLP 10 11 STEPHEN VINE 12 Partner, Akin Gump Strauss Hauer & Feld, LLP 13 14 15 ROBERT ZACK 16 Senior Vice President and General Counsel, Oppenheimer 17 Funds, Inc. 18 19 CLOSING ARGUMENTS 20 21 PAUL F. ROYE 22 Director, Division of Investment Management, U.S. 23 Securities and Exchange Commission 24 25 1 P R O C E E D I N G S 2 CHAIRMAN DONALDSON: Good morning, ladies and 3 gentlemen. I'm Bill Donaldson, Chairman of the SEC. On 4 behalf of my fellow Commissioners, Paul Atkins, Raul Campos, 5 Cynthia Glassman, Harvey Goldschmid, welcome. It's really a 6 pleasure to have all of you here for our hedge fund 7 roundtable. 8 Although I'm not surprised, I'm pleased to see that 9 we have a large turnout. And I also welcome those of you who 10 are watching by webcast. 11 As you can see by the agenda, we have an impressive 12 group of people, panelists, and a broad range of very timely 13 and engaging issues to explore. 14 As all of you know, this is an exciting and dynamic 15 time for the hedge fund industry. Over the past few years, 16 hedge funds have become more popular and continue to grow in 17 size. It's estimated that there are close to 5,700 hedge 18 funds operating in the United States today, managing 19 approximately $600 billion in assets. 20 By contrast, in 1990, only about $50 billion was 21 under management in hedge funds. And hedge funds play an 22 important role in our markets and have a legitimate place in 23 the array of investment options available to investors. 24 However, while there are frequent reports of high 25 returns for hedge funds, there are also reports just as 1 frequently that highlight possible areas of concern, such as 2 potential conflicts of interest, questionable marketing 3 techniques, valuation concerns, and the market impact of 4 hedge fund strategies. 5 Consequently, since June of last year, SEC staff in 6 the Division of Investment Management and our Office of 7 Compliance, Inspections and Examinations have been engaged in 8 a fact-finding mission aimed at reviewing the operations and 9 practices of hedge funds.] 10 While we still are at the fact-finding stage, and 11 have yet to reach any conclusions, this roundtable is the 12 next stage in the process. With our impressive list of 13 panelists, we hope to have a full and frank discussion of the 14 many issues surrounding hedge funds. 15 The last time the Commission took a good look at 16 hedge funds was in 1998, when the Connecticut-based hedge 17 fund, Long-Term Capital Management, nearly collapsed. 18 After that incident, the Commission, along with the 19 Treasury Department, the Federal Reserve, and the Commodity 20 Futures Trading Commission, as part of the President's 21 Working Group on Financial Markets, issued a report on the 22 risk management and transparency issues raised by LTCM, in 23 particular, and by "highly leveraged institutions," in 24 general. 25 The President's Working Group looked at such issues 1 as firms' adherence to their own stated policy, their margin 2 and collateral requirements, their use of leverage and 3 whether it was excessive, and how well their risk models 4 functioned. 5 The President's Working Group issued a report and 6 recommendations, and the indications are that the industry 7 has taken these recommendations to heart. The President's 8 Working Group continues to function. 9 However, as the markets and the hedge fund industry 10 have continued to evolve, I believe the time has come for us 11 again to advance our review of hedge funds and how they are 12 operated, managed, and regulated. 13 We are looking to ensure investor protection and 14 are focusing on issues such as "retailization" of hedge 15 funds, transparency, risk management, conflicts of interest, 16 and fraud. 17 As part of our fact-finding to date, SEC staff has 18 obtained and reviewed documents and information from 67 19 different hedge fund managers representing more than 650 20 different hedge funds and approximately $162 billion under 21 management. 22 The staff concluded on-site visits to a wide range 23 of hedge funds, large and small, and spoke to employees who 24 are responsible for brokerage, compliance, risk management, 25 legal and other operational issues. The staff also met with 1 a variety of industry experts to get their perspective on 2 these issues. 3 Over the next two days, you will hear from many of 4 these experts, including a host of legal and accounting 5 experts, academics, hedge fund investors, risk managers, 6 prime brokers, representatives from foreign regulators, trade 7 industry representatives, hedge fund consultants and 8 administrators, as well as hedge fund managers and investor 9 advocates. 10 After these two days of discussions, let me assure 11 you that we will continue to listen to all of the various 12 perspectives regarding hedge funds. I encourage you to send 13 us your comments reflecting what you have heard today and 14 tomorrow, because the discussion does not end when we leave 15 here tomorrow. 16 Before I turn the microphone over to Paul Roye, our 17 Director of the Division of Investment Management, I want to 18 thank Paul and the dedicated staff who worked very hard, 19 tirelessly, on the fact-finding mission and roundtable, as 20 well as Lori Richards and her staff in the Office of 21 Compliance, Inspections and Examinations. 22 I also especially want to thank all of our 23 panelists who have been so generous with their time and ideas 24 as we work to bring better understanding to the hedge fund 25 industry. 1 And, finally, I'd like to thank all of you who have 2 taken time out of your busy schedules to be here, whether in 3 person or over the Web, to observe and listen along with us, 4 and I hope we exchange a few ideas as the day progresses. 5 Paul, let me turn the podium over to you. Thanks 6 very much for being here. 7 MR. ROYE: Thank you, Chairman Donaldson, for those 8 welcoming remarks. You've highlighted a number of important 9 issues that we want to explore over the next couple of days. 10 Before I begin, I want to mention a few 11 housekeeping items. As you can see, we have a large audience 12 today, and we won't be able to take questions from the 13 audience. The questions will come from the moderators and, 14 of course, our Commissioners. 15 I'd also ask you to turn off your cell phones. Our 16 agenda does include built-in breaks, where you can turn on 17 your cell phones and make the calls that you have to make, 18 but we ask that you again turn them off at the beginning of 19 each panel. 20 And I would note that if you leave the building, 21 unfortunately, you have to go through our security check once 22 again. 23 Now let's get started with our first panel. And, 24 really, the purpose of our first panel is really to kind of 25 frame the discussion for what follows, for our subsequent 1 panels, really to provide an overview of the industry, to 2 review how hedge funds are structured and operated, the types 3 of services the various service providers provide to hedge 4 funds, and really to give an overview of the current state of 5 the hedge fund industry. 6 We have our Commissioners present, Commissioner 7 Glassman, Commissioner Atkins, Commissioner Campos, and, of 8 course, Chairman Donaldson. Commissioner Goldschmid is going 9 to be joining us later this afternoon. 10 But we do have a distinguished group of panelists, 11 and I'd like to take a quick moment to introduce each of them 12 to you. 13 To my far right is Joel Press. Joe is a senior 14 partner at the accounting firm of Ernst & Young. He's been a 15 contributing author to a number of articles and industry 16 publications in the hedge fund area and is a leader in the 17 field of hedge fund accounting. 18 Next to Joel is Robert Schulman. Bob is the 19 Chairman and CEO of Tremont Investment Management, and he's 20 co-chief executive officer of Tremont Advisers, a hedge fund 21 consulting firm that focuses on advising individuals and 22 institutions investing in hedge funds. 23 Next to Bob is William Keunen. William is the 24 Director of Citco Fund Services. It's a firm that provides 25 custodial and fund administration services for the 1 international fund industry, including hedge funds, and 2 they've been in this business for over 30 years. 3 On my immediate right is Mike Neus. Michael is a 4 principal and the chief general counsel of Andor Capital 5 Management. They manage hedge funds. Mike oversees all of 6 the legal and regulatory matters and is also Andor's chief 7 compliance officer. 8 On my immediate left is Charles Gradante. Charles 9 is the managing principal of The Hennessy Group, LLC, a hedge 10 fund consulting firm that he co-founded with Lee Hennessy in 11 1997 after 11 years in the business division of several major 12 financial institutions. They're in the business of advising 13 individuals and institutions regarding hedge fund investing. 14 Next to Charles is David Vaughan. David's a 15 partner in the financial services group of the law firm of 16 Deckert, LLP, in Washington, where his law practice focuses 17 principally on advising hedge funds. 18 Next to David is Dr. Richard Lindsey. Richards is 19 president of Bear Stearns Securities Corporation. They 20 provide prime brokerage, broker-dealer, and registered 21 investment adviser clearing services. And prior to joining 22 Bear Stearns, he served at the SEC as the director of the 23 Division of Market Regulation, and also as the SEC's chief 24 economist. 25 And then next to Richard is Greg Newton. Greg is 1 the president of Managed Accounts Reports, LLC, known in the 2 industry as MAR, a New York-based publisher of several 3 newsletters covering the alternative investment marketplace. 4 It seems appropriate that to begin our discussion, 5 we ought to really try to understand, when you use the term 6 "hedge fund," what we're really talking about. 7 David, could you maybe define "hedge fund" for us, 8 or what people typically view as a hedge fund, and maybe how 9 a hedge fund is distinguished from other types of private 10 investment vehicles. 11 MR. VAUGHAN: Sure, I'd be happy to. I heard some 12 people in the audience kind of laughing to themselves as they 13 heard that I was going to try to define hedge funds, because 14 I think most people in the audience and everyone on the panel 15 knows there is no precise definition of "hedge fund." 16 It's a term used in the industry, people seem to 17 know one when they see one, but there is no legal definition. 18 Usually we're referring to an unregistered fund, 19 not registered with the Commission, typically relying on 20 Sections 3(c)(1) or 3(c)(7) for that exception from 21 investment company regulation. 22 They're usually characterized by the ability to do 23 short selling or leverage or other types of more or less 24 exotic strategies, nontraditional strategies. They often 25 have performance-based compensation. And the thing that 1 makes it a little difficult to know where to draw the line 2 is, there are lots of other funds that may have some of these 3 characteristics, or even all of them, that do not consider 4 themselves hedge funds for one reason or another or not 5 considered by the industry hedge funds. 6 Some of the more obvious examples are private 7 equity and venture capital funds, which are really 8 distinguished more by the level of liquidity of the fund, and 9 that they don't mark their assets to market typically, 10 although, again, that's not a bright line. They are hedge 11 funds that have some crossover aspects to them. 12 And so that's about the best we can do in 13 describing what a hedge fund is from a legal or even a 14 business perspective. I'd be interested in anyone else's 15 views as far as other views as what are essential 16 characteristics of hedge funds. 17 MR. LINDSEY: I think from a business perspective, 18 it can be described somewhat -- a little differently, and 19 that is, that hedge funds are actually nothing very much 20 different than the proprietary trading activities that exist, 21 and have existed for a very long time within street firms. 22 So if you take a proprietary trading desk from one 23 of the major houses of a street and you privatize that 24 operation, that's really what a hedge fund is. And many 25 times, of course, that's where hedge funds even come from, 1 are those traders that step out of the proprietary -- or step 2 out of the houses and form their proprietary interest. 3 Of course, the way that they have to do business 4 is, they have to have capital, they have to have a way to do 5 that. So, typically, they go about with a Reg D offering, 6 they raise capital, and then they invest that capital in the 7 fairly typical proprietary trade strategies. 8 CHAIRMAN DONALDSON: I'd like to comment on that. 9 There's been a reduction in proprietary trading on Wall 10 Street in the last decade. As investment banking firms have 11 gone public, seeking earnings that are stable and more 12 predictable, they've cut back on proprietary trading. 13 It's not a figure I can quote, but it's a feeling 14 that I get from talking to fellow compatriots on the street. 15 And those people leaving proprietary trading desks have gone 16 into the hedge fund industry. Quite simply, the compensation 17 factors are quite similar to what they were receiving on Wall 18 Street to what they would be receiving as a hedge fund. 19 MR. SCHULMAN: And just to amplify for one second, 20 if I could. What we're hearing from managers as they come 21 out of proprietary training desks, of course, is, they're 22 embedded in brokerage firms that have gone through a 23 relatively difficult earning cycle, which means that their 24 earnings are down. 25 So we're at a time now where there's significant 1 inducement for a lot of these people to come out of the 2 marketplace -- come off the trading desks and out on their 3 own. There's little to lose, because their pay scale is down 4 simply because the firm has not done well. 5 But it's not fair to categorize everything as -- 6 every hedge fund as something that would otherwise exist on a 7 trading desk in a brokerage firm. A lot of them are 8 research-driven and not execution-driven. And I think you 9 really have to look at the market in those two ways. 10 Some of them are brilliance of execution and 11 brilliance of trading. Probably more of them are driven by 12 some kind of internal information edge, research edge, or 13 asset allocation edge, not just trading skills. 14 MR. PRESS: I think also you have to look at hedge 15 funds as entrepreneurs. It really is a business of people 16 wanting to create their own culture, their own environment, 17 instead of working either in a large organization, but 18 creating their way of earning dollars in a way that's unique 19 to them, in their own strategy, their own people, their own 20 compensation environment, and allowing them to exist in 21 today's technology wherever they choose to set up their 22 organization and just work and trade and do their research. 23 It's a very unique entrepreneur. No different than 24 any other business in America, but it really is a group of 25 very successful entrepreneurs. 1 MR. ROYE: When you talk about hedge funds, I know 2 there are, you know, just a variety of different types of 3 hedge fund strategies. I guess either Charles or Bob, could 4 you kind of maybe outline the types of various strategies out 5 there in the hedge fund world and how you sort of categorize 6 them generally? 7 CHAIRMAN DONALDSON: Well, we have categorized -- 8 or located 23 different strategies. Lee Hennessy, our 9 founder, saw the need in order to benchmark our consulting 10 practice, the managers we were investing in on behalf of our 11 clients, to put managers into categories, and fundamentally 12 we started using the categories we found in the traditional 13 world, growth, value, and other categories like that. There 14 are 23. 15 And in arbitrage, there are convertible arbitrage 16 and merger arbitrage, and I can -- I don't think we need to 17 list the 23 strategies. 18 But I think what's important is that the need to 19 categorize hedge funds in order to benchmark their 20 performance against their peer group is something that 21 consultants find the need to do. 22 MR. NEUS: I think that one way to look at it is, 23 if you group those various strategies, and because it's an 24 entrepreneurial industry, there are a tremendous number of 25 variations within each strategy and crossover strategy. 1 I think one useful way is to bucket them in three 2 basic groups: market neutral strategies, event-driven 3 strategies, and directional strategies. And that's linking 4 it from the least risky or volatile to the most risky. 5 And it's useful to do that, because then you can do 6 the comparisons between private investment funds, on the one 7 hand, mutual funds, private equity, or other alternative 8 investment asset classes on the other side. 9 MR. SCHULMAN: Another way to look at it is, 10 understanding there are a few strategies that dominate from 11 Charles's list, or even from the list that we just talked 12 about. 13 Long short equity is 35 to 40 percent of all of the 14 money, so it is by far the largest strategy. The other big 15 strategies are the global macro strategies. Recently 16 convertible arbitrage and distressed have become big 17 strategies. 18 Although there may be lots of sub-strategies, 19 contained in that first list of seven or so you're going to 20 find the vast majority of the money. 21 MR. PRESS: But, again, hedge fund people, when you 22 talk to them, the reason there's 5,000 and maybe growing is 23 because each of them feel they bring a uniqueness to what 24 they do, and each has a slightly different way to approach 25 the market, and each will tell you that in general for their 1 strategy, there is a limit to the amount of capital they 2 would want to trade and will work with. 3 And most will find that there is a level that 4 they're comfortable with, and it may take years to grow into 5 in building up a staff and credibility to take on more 6 capital, and it's a very organized, coordinated process in 7 growing their business. 8 MR. KEUNEN: Now, one of the trends that we've seen 9 in terms of capital flows is that capital has flowed out of 10 long short equity funds over the last couple of years into 11 some of the other strategies that were mentioned, in 12 particular, macro arbitrage and fixed income strategies. 13 CHAIRMAN DONALDSON: Paul, I wonder if I could ask 14 a question. And I understand that the Commissioners are 15 allowed to ask questions -- 16 MR. ROYE: Of course. 17 CHAIRMAN DONALDSON: -- without anything being 18 attributed to -- behind that. 19 But what's been the experience of the panel on 20 people who have set out a strategy in some sort of an 21 offering circular and then change it? What happens when that 22 happens? 23 MR. SCHULMAN: As the funds get larger, it is much 24 more difficult for them to do that without it becoming -- 25 without bells going off. 1 In cases of small funds, especially in long short 2 equity, we've seen some of that, not as much as you would 3 think. Typically, these are very small organizations run by 4 a few entrepreneurs that have a particular area of expertise. 5 It becomes pretty good news and it spreads pretty 6 rapidly through the industry if somebody really abandons 7 their knitting. 8 I don't know about anybody else on this panel, but 9 we don't want to pay 1 in 20 for anybody to learn anything. 10 We're paying 1 in 20 or 2 in 20 for people who are already 11 experts in it. So -- 12 MR. PRESS: If I might -- and hedge funds really 13 adhere to their offering document which defines their 14 strategy and the partnership agreement that also sets in 15 stone effectively their strategy. And most stay within that 16 strategy in my 35 years working in that industry. 17 Where they change or may go differently is, they'll 18 form a new product that allows them to work in a new area, 19 and they have a new offering document, a new partnership 20 agreement that defines the scope, services, leverage issues, 21 and how that strategy operates relative to that performance. 22 But they're very careful. There's always those 23 exceptions, but in my experience it's really very rare, and 24 they don't have what we call "style drift." 25 CHAIRMAN DONALDSON: Just as a follow-on, would 1 your experience indicate that they would communicate with 2 their investors if they've changed the strategy or -- 3 MR. PRESS: In my experience, any time they would 4 go for a style change, they would need to go, per the 5 offering document and the partnership agreement and get 6 permission to go outside. 7 For example, if someone said they could not go 8 short in their offering document, and then decided to go 9 short, they'd have to ask for permission from their 10 investors, and then would about going through a partnership 11 amendment offering document change. 12 So where there are changes, they do go back to 13 their investors and get permission to make those changes. 14 MR. SCHULMAN: And most funds have become pretty 15 good now. And I would say, again, there are exceptions that 16 can demonstrate every concern that this panel might have. 17 But the vast majority of funds do write quarterly 18 letters, and they are quite forthcoming, more forthcoming 19 than the mutual fund industry might be about what their 20 strategy is, what's working, and what their approach is. 21 Perhaps not down to the security level, but certainly down to 22 the type of security, the sector in the industry, and the 23 exposures to the market. 24 There's very good information in those quarterly 25 letters. They have conference calls, they have web sites in 1 many cases, and they're pretty good at communicating that, 2 much better than they were a few years ago. 3 MR. ROYE: Regarding the comments from Joel and 4 Bob, I've seen very little style drift, and managers tend to 5 stick to what their offering documents say, and if they 6 don't, they're advised by legal, by counsel, to notify the 7 limited partners of any movement or any style drift that they 8 feel necessary to fulfill the objectives of the partnership. 9 MR. VAUGHAN: I think one thing in recent years, 10 too, is many of the documents have become more detailed in 11 what exactly the strategy is, and more detailed in what the 12 investment guidelines are; and, as those guidelines need to 13 be adjusted as a style evolves, people do go back to their 14 investors and get permission and give them notice of what the 15 changes are going to be, even if it's a relative -- what 16 would be viewed as a relatively minor change, because the 17 investors are looking for somewhat more detail on these 18 documents, so that it can be triggered if there is style 19 drift. 20 MR. NEUS: I think lastly is -- there's been an 21 increasing tendency for investors to be more activist and 22 investors know a lot more and are much more willing to 23 actively engage the managers. And so I think that the time 24 period is compressed by which changes in the past may not 25 have been communicated as quickly. 1 MR. ROYE: I just want to push back a little bit on 2 this point because in the course of our review, you know, we 3 saw a number of private placement memoranda that did indeed 4 set out a strategy that was going to be employed by the hedge 5 fund manager. But we saw tremendous flexibility to deviate 6 from those strategies in the document, a lot of flexibility, 7 and a lot more flexibility than we typically see in mutual 8 fund registrations. 9 So, I guess, my question is is it a matter of 10 practice that they don't deviate, even though I think in a 11 lot of the documents that at least we saw, there was a lot of 12 flexibility for the manager to really move into another style 13 if circumstances dictated. 14 MR. GRADANTE: I think there is a lot of 15 flexibility in the offering docs when you compare them to, 16 you know, a mutual fund placement; but I think that is the 17 nature of the hedge fund industry. We're entrepreneurial and 18 so it's not, you know, not to give the impression that hedge 19 funds are a bunch of cowboys out there winging it, they do 20 have a defined offering doc, but is very broad to give them 21 and allow entrepreneurial, you know, spirit in investing. 22 MR. SCHULMAN: Just to amplify for another second. 23 These are absolute return vehicles. They come with very 24 broad mandates. They typically have a clientele, a 25 traditional clientele, which is a very high net worth, U.S. 1 and European clientele, that is premised on the idea of not 2 losing money in most cases. They are not mutual funds. They 3 don't have mutual fund kind of narrow mandates. 4 And, as a practical matter, if we looked at what's 5 happened in the mutual fund industry in the last three years, 6 if you have a narrow mandate and you have to be fully 7 invested, you don't actually get to avoid the catastrophic 8 impacts of the market. 9 The hedge fund industry has avoided, in large 10 measure, the catastrophic impacts of the market by having 11 enough flexibility in the document and using it to react to 12 what you would call different market conditions. It's hard 13 for a technology mutual fund that says it's going to be 100 14 percent invested to not have a very bad run when technology 15 has a very bad run. 16 MR. PRESS: It's also critical -- it's not style 17 drift. When they raise the capital through the offering 18 document and the partnership agreement, they're very careful 19 to define the scope of what they're allowed to trade and how 20 they'll use those instruments. 21 And the investors know very well that -- in some 22 cases you might say they're opportunistic reacting to the 23 market, either on a daily, trade-by-trade, or on a 24 philosophical strategy basis on a much longer term, but they 25 stay within that category. 1 MR. ROYE: You see articles about hedge funds being 2 risky, more risky than mutual funds. Any comment on that in 3 terms of various strategies and whether or not there's any 4 truth or merit to that? 5 MR. SCHULMAN: I think you only have to go back 6 to -- well, you can go back as far as you'd like or as short 7 as you'd like. You can go back to any period of real 8 dislocation and look at how hedge funds have performed, or 9 especially fund-to-funds have performed, which is a 10 diversified approach to hedge funds relative to mutual funds. 11 The typical mutual fund in the last really, really, 12 really bad month, which I guess would be August or September 13 of '98, with the Russian crisis -- the typical mutual fund 14 was down in the mid-20's. The average hedge fund was down 15 less than 5. The average fund-to-fund was down less than 3. 16 When you look at the volatility studies of the 17 hedge fund industry, whether it be individual hedge funds, or 18 whether it be fund-to-funds, virtually any metric that you 19 would take to measure how they've done -- if performance is a 20 fair measure of volatility -- suggests that diversified hedge 21 fund investing is much less volatile than diversified stock 22 market investing. And probably approaches the volatility of 23 domestic mid-maturity bond investing in terms of the actual 24 risks. And long term, the risks of the hedge fund industry 25 in aggregate, and now I'm just using our own index, is 1 less -- slightly less than half of that of the S&P. 2 MR. PRESS: Again, here's where the strategies make 3 a big difference. If you look -- you can't look at absolute 4 return. You have to really look at what that hedge fund 5 manager says they're trading, how they're trading it, what 6 they will do within market parameters -- because if you look 7 at the S&P or the Dow, most hedge funds do not look at those 8 as relative to their own styles. 9 So when you're making that investment, they define 10 their risk, they define what they'll call a draw down -- what 11 they think the maximum loss is in a month or in a quarter. 12 And by and large, hedge funds pretty well stick to those 13 numbers; and if the market may be up 40 percent, a hedge 14 fund, for its style, may be up only 18 percent. 15 And people are investing knowing those strategies 16 and knowing those risk parameters, because the managers are 17 very careful to disclose them. 18 MR. GRADANTE: I'd like to make several points. 19 You know, many feel that assuming risk creates a risky 20 investment. We believe that hedge funds expose themselves to 21 risk in an intelligent way. Is shorting necessarily a 22 risking strategy? We believe intelligent use of shorting and 23 derivatives by hedge funds can reduce risk. 24 Leverage doesn't always mean you're taking on more 25 risk. In fact, banks -- of which I was a CEO of one -- and, 1 as Mr. Lindsey mentioned earlier, proprietary trading desk at 2 investment banks are also using leverage. 3 Hedge fund managers add risk with respect to the 4 portfolio as a whole and the prudence of the strategy. 5 Making an investment, which in and of itself assumes greater 6 risk, does not necessarily increase the risk of the overall 7 pool. 8 You know, risk often is measured in terms of 9 volatility risk, leverage risk, and portfolio risk. With 10 respect to volatility risk, which is often measured by 11 standard deviation, as Joel and Bob reported, I think Bob 12 mentioned that the S&P 500 is about double the hedge fund 13 universe. And we see the same thing. And we have indices 14 that go back to '87. 15 Since 1987, the S&P 500 has averaged 18 percent in 16 standard deviation -- I'll drop the decimal points -- and the 17 Hennessey Hedge Fund Index has an average standard deviation 18 of 11 percent. 19 Leverage used by hedge funds is often exaggerated. 20 Our surveys show that 84 percent of hedge funds never use 21 more than Reg T. For the majority of the industry, 22 long/short equity, the average gross exposure will range from 23 a high of 159 percent in 1999 -- that's a average -- to a low 24 of 117 percent in 2001. 25 Only 2 percent of hedge funds we've surveyed -- and 1 our survey was 193 management companies, 763 hedge funds, 2 and, I believe, $137 billion, or about 23 percent of the 3 industry -- only 2 percent used leverage over 500 percent. 4 So -- and in our survey, we exclude CTAs. Since 5 they're registered, we don't include them in the world of 6 hedge funds. But CTA leverage is a whole different matter. 7 Portfolio risk management has greatly improved in 8 the industry as the industry is involved. You know, we're 9 seeing a lot greater use of value-at-risk position limits and 10 stop losses. 11 And, as we mentioned earlier, the performance in 12 this bear market has been another measure of risk. Hedge 13 funds, during this bear market, have out performed 14 traditionally managed, long only, vehicles -- which is a 15 positive, not a negative. And approximately 8 to 9 out of 10 16 hedge fund managers, whether they be arbitrage or long/short 17 equity, have out performed the S&P 500, which represents a 18 diversified portfolio of securities. 19 MR. LINDSEY: I'd like to add a couple of things to 20 what Charles just said. 21 I think that if you look at the averages, hedge 22 funds are somewhere on the order of 4 to 1 maximum leverage. 23 If you look at banks, they're probably in the range of 6 to 8 24 to 1. If you look at broker dealers, they're probably in the 25 range of about 15 to 20 to 1. 1 So in terms of just that pure business, it hearkens 2 back a little bit to what Robert was saying -- is that a 3 large part of the investor base for hedge funds are 4 interested in capital preservation; therefore, the hedge fund 5 managers are interested in capital preservation. 6 And hedge fund managers also have some additional 7 incentives that are built in -- both in terms of the way 8 they're compensated, and the way they're not compensated if 9 they don't meet certain hurdle rates. So if they haven't 10 exceeded a hurdle rate, indeed, their compensation may be 11 dramatically different. 12 So they have an incentive to preserve the 13 performance and preserve the capital. 14 The second point that I'd like to make is if you 15 take a look at sharp ratios associated with hedge funds, 16 you'll find that they actually have very good sharp ratios 17 compared to most standard indices -- meaning, of course, that 18 the return-per-unit risk is actually very good. 19 And finally, I think it's important not to under 20 estimate the value of a portfolio. I don't think anybody in 21 this room would ever advise that you put all of your money 22 into any one investment period. And that's the reason for 23 diversification; and that's the reason for the portfolio 24 effect. 25 When you look at hedge funds as a asset class, if 1 you want to think about it that way -- and there's plenty of 2 academic quirk that can demonstrate that hedge funds look 3 very different than mutual funds, look very different than 4 stock returns, look very different than anything else -- it 5 looks like a very different asset class, both in terms of the 6 mean return, standard deviations, skewness, kurtosis -- 7 whatever metrics you want to apply. 8 And when you look at that, they're fairly 9 uncorrelated with the market, or relatively less correlated 10 with the market. So when you include hedge funds as part of 11 an overall portfolio, you actually increase return and 12 decrease risk. So it's more a matter of what's that 13 diversification effect worth, rather than the idea that any 14 individual investment is or is not risky. 15 COMMISSIONER GLASSMAN: Can I ask a question, Paul? 16 To any of you. What's the failure rate of hedge funds and 17 how does that compare to any relevant benchmark? 18 MR. SCHULMAN: We have some numbers on that which 19 we have published. Last year it was an all-time high. It 20 was at about 14 percent. There was about -- we estimate 21 about 700 funds closed. And I'd like to distinguish closed 22 from failed. 23 Seven hundred ninety-six of the funds that closed 24 closed up, sent the investors their money back, and said I'm 25 going to the beach, thank you. Most of those closed because 1 they had performed poorly for two years, and were in danger 2 of losing the bulk of their investors, and it did not make 3 economic sense for them to continue. 4 Nobody lost money they shouldn't have lost. Nobody 5 dealt with a failed situation. These companies didn't go 6 bankrupt; they went through an orderly close down, which 7 happens in the mutual fund business and in the asset 8 management business all the time. 9 While 700 funds were closing last year -- I know 10 Greg may have different numbers than this -- we think about 11 1300 new funds started. And we have found closing rates to 12 vary between 8 and 15 percent, depending upon market 13 conditions. 14 A lot of very small long/short equity managers 15 closed because they were reaching their second year of bad 16 performance, their clients or their limited partners were 17 withdrawing, they effectively did not have a business. So 18 they, on an orderly basis, just closed the business. 19 And Joel's finishing up the audits on those as we 20 speak. So he can probably speak to what a typical close down 21 might look like. 22 MR. PRESS: I also think we missed the point here. 23 A hedge fund is very different than mutual funds -- again, in 24 the risk area. All really have their own capital invested. 25 And in setting up the hedge funds, especially start-up hedge 1 funds, the key for raising capital is the fact that they're 2 putting in most of their liquid net worth and they keep that 3 money there. 4 So when it comes to risk and managing risk, that's 5 a real part of the capital. And in some cases, it can be as 6 much as 20 percent of the capital; and, in the larger hedge 7 funds, the staff, the employees, have their money and they 8 effectively are eating their own lunch. 9 Very different than other investments where there 10 is a proprietary trading desk -- unless you own stock in the 11 company -- but it's not a direct relationship and in the 12 mutual fund industry. 13 And here's where there's a huge difference in 14 capital and how people approach risk because it's really 15 their own money also. And it does have an impact. 16 MR. NEUS: I'd like to ask you one more thing and 17 that's to pick up with something that Chairman Donaldson 18 asked before. When speaking about hedge funds, if the 19 average hedge fund is less risky or more risky, I think that 20 misses the point. It's not a monolithic institution. Hedge 21 funds, by and large, are incredibly entrepreneurial; are 22 constantly innovating and mutating. 23 So if you look at the 7,000 hedge funds, there's a 24 continuum for much less risky, on a volatility basis, to a 25 mutual fund, say, in the arbitrage area, to going through the 1 continuum to manage futures or macro-funds, which have 2 largely exhibited a greater volatility. 3 And if you look at a portfolio basis of -- as an 4 investor -- an investor may want to hire risk-reward ratio; 5 and so that's why it's important to make sure that they're 6 selecting the right hedge fund to the right strategy for 7 them. I don't think it's necessarily a fair comparison to 8 say, "Is a mutual fund more or less risky than a hedge 9 fund?," because it varies widely. 10 MR. NEWTON: I could just make one quick point that 11 hasn't been mentioned so far. There is a pretty substantial 12 pile these days of academic research on hedge funds, managed 13 futures, and various other bits and pieces, and I'm not aware 14 of any of it which indicates that adding hedge funds to a 15 portfolio, hedge funds as a class -- if they are such a 16 thing -- are inherently riskier, more volatile, than 17 traditional investments. 18 In fact, you know, the over-whelming evidence that 19 I'm aware of is that adding these things to a portfolio 20 almost always reduces their volatility and enhances their 21 performance. And I think that academic research is out there 22 at the moment and it's very important. 23 MR. SCHULMAN: And I would suggest that there are 24 people around the stable who would be happy to supply the 25 Commission with whatever -- if the Commission is not 1 convinced that diversified hedge fund investing reduces the 2 risk of equity investing by the addition, I think there are 3 people around this table who would be happy to do the 4 research in as an exhaustive fashion as they would like, or 5 supply them with the research that's been done. 6 That is not something that I think is in dispute 7 any more. 8 MR. VAUGHAN: I'd just like to comment that sort of 9 ties the two questions together. We're saying hedge funds 10 are not inherently risky, but the press and the offering 11 documents tend to talk about risk and speculation. I think 12 the reason behind that is sort of two-fold. 13 One is because these hedge funds tend to be 14 entrepreneurial. There's a risk that the entrepreneurial 15 enterprise simply won't make it, that the fund will go out of 16 business in a couple of years not having achieved what they 17 really thought they could; and, therefore, there's that risk. 18 And one of the reasons, coming from the legal 19 side -- that the offering documents may seem to be pretty 20 vigorous in their description of risk -- is that often these 21 risks are risks with which at least some investors are just 22 not familiar. Most investors, all investors, ought to be 23 familiar with general market risks. 24 But some of the risks that they're incurring in 25 hedge funds, even if they're not inherently more risky than 1 other investments, are simply novel to the investors; and one 2 wants to be sure that they understand that these risks are 3 different and not be lulled into thinking, because the fund 4 is less volatile, that it is therefore not at all risky. 5 MR. PRESS: Also, hedge funds, because they're 6 entrepreneurial, embrace new strategies, embrace different 7 ways to approach risk -- and on the cutting edge of those 8 strategies. And because of that, they approach risk from a 9 very technical, academic, modeling point of view. Especially 10 as credit derivatives develop, they'll be the first to look 11 at them and try and figure out how they operate, whether it's 12 within their style, and how it will make their strategy safer 13 within the volatility of their strategy. 14 MR. GRADANTE: And in this bear market, Morningstar 15 has reported -- and I believe I'm quoting correctly -- that 16 mutual funds have failed at a rate of about 5 percent per 17 year. There was mention earlier about an 8 to 15 percent 18 failure rate among hedge funds. I'd like to expand that a 19 little bit because it could be misinterpreted. 20 We see four kinds of closures that can be lumped 21 together and interpreted incorrectly. One is the out-right 22 failure -- liquidation through the fund not being able to 23 perform. 24 The second is a voluntary liquidation due to the 25 fact that that's the only way a hedge fund manager can exit a 1 career. He decides to retire and he liquidates his fund. 2 Thirdly, funds that are functioning but are closed 3 to new capital is a large portion of the closures that fall 4 off databases and get counted as terminations. 5 And then the fourth one is -- although it's a small 6 part of it, but it is a part of it -- there are time hedge 7 funds. There are hedge funds out there that have a time 8 limit to them. They will close down after five years, or 9 after ten years. 10 All in all, we see the failure rate -- actual out- 11 right failure rate -- at 5 percent; and then the remaining 10 12 percent is voluntary closures. 13 I might just add -- and speaking here and to the 14 Webcast out there -- that we would love to see any of that 15 academic research that's out there. We would welcome that 16 being sent into the Commission. 17 MR. ROYE: Let me just follow up on Commissioner 18 Glassman's question about the closures. And to what extent 19 do you see hedge fund managers, where they have not 20 performed, shut down the fund, resurfaced elsewhere? Either 21 affiliating with somebody else, starting another hedge fund. 22 Does that go on? And what happens to their track record and 23 are any potential new investors in a new fund aware of that 24 typically? 25 MR. PRESS: My experience has been when a hedge 1 fund manager shuts down, again, there's all these reasons 2 that we just talked about -- when they decide to retire and 3 come back into the business, they will come back in, it will 4 be disclosed in their offering document that they took a 5 period of time off. And in fact, if the strategy is the 6 same, they will tell what their strategy was for that period 7 of time and so forth. 8 Many that come back that have maybe lost money. 9 Very often, in my experience, they will continue to offer to 10 their old investors the concept of what's called the high 11 water mark. Hedge fund managers do not get compensated until 12 they make money, so if you put a dollar in and it went up to 13 a dollar fifty, the hedge fund manager would be compensated. 14 But if it lost money, the hedge fund manager doesn't get an 15 incentive fee; they would get a management fee. 16 Until they go back to the dollar fifty, they cannot 17 make more money on the incentive side. And very, very often 18 the managers, because of integrity issues, will put back the 19 high water mark for their old investors. 20 So in terms of the integrity of the process -- now 21 there are others that have surfaced. If they joined another 22 hedge fund, and they're not part of management and so 23 forth -- they're just part of the participants -- there's no 24 issue. It is disclosed, usually in the letters to partners 25 and -- limited partners, about changes in management and 1 additional traders and so forth. 2 MR. SCHULMAN: The typical advisory firms are now 3 doing background checks and full reviews of what the 4 background has been. Although people have come back into the 5 business, it's relatively unusual. 6 Lots of people their funds -- in some cases -- and 7 I agree with Charles about a third of those cases are from 8 people who decided they just didn't want to do it any more. 9 "I wanted to take some time off." Those people have come 10 back; they've gone back to their old clients; they typically 11 have gotten the money back from the old clients, if they've 12 done well. 13 It's relatively unusual to have somebody burn up in 14 the atmosphere. A real flame-out in terms of a closed down, 15 really did very poorly; and successfully come back into the 16 business alone as a stand alone entity. It doesn't happen. 17 Memories are quite long. People like me, and 18 Charles, and Joel, are around to remind people. 19 COMMISSIONER ATKINS: Yes, I'll show you. That's 20 one thing I wanted to ask about. It's a relatively small 21 society, this; and so I was going to ask you if someone could 22 speak to the reputational aspect of this and how those 23 memories are? 24 MR. NEWTON: Those memories are great because I 25 know that we, as a newsletter in this business -- when we 1 hear that someone who has perhaps closed a fund or something, 2 we're all over that like a rash. You know, when someone's 3 coming back into business after perhaps shutting down because 4 he was so far under his high water mark that he, you know -- 5 the bubbles weren't getting to the surface -- that happens. 6 But it's covered very widely and fully. 7 And I guess, you know, you're not around a hedge 8 fund any time for very long before the subject of long-term 9 capital management comes up. And the fact of the matter is 10 that people who have been associated with substantial 11 failures still have sufficient credibility in the marketplace 12 to be able to reappear in the business. It happens. 13 But it's no secret. Their past is no secret. 14 COMMISSIONER GLASSMAN: Presumably, the funds of 15 funds then obviously have the same information and you would 16 avoid those funds as well? Is that a logical conclusion? 17 MR NEUS: But speaking as somebody who is on the 18 other end of filling out those due diligence 19 questionnaires -- field that one -- I think what happened in 20 the last -- I've been in hedge funds -- in-house counsel for 21 10 years, and before that, outside counsel -- and I think 22 what's happened is that the investors have become much more 23 activist, much more interested. The use of consultants has 24 expanded. 25 The investor base has changed from a largely high 1 net worth, both on shore and off shore, to a more 2 institutional investor base. And the institutions, whether 3 they're fund-to-funds, or pensions, or insurance companies -- 4 the institutions tend to have a much more rigorous process. 5 Whether they do it internally of whether they hire a 6 consultant, they do more than kick the tires. They audit. 7 Sometimes they audit results, they do background checks, they 8 do a huge amount of legal work internally, as well as 9 externally -- talking to other investors. 10 And so that the entire process of investing into 11 hedge funds has changed dramatically from a time when it was 12 a cocktail party chatter -- "Which of your investments have 13 done better?" I think the industry as a whole has changed 14 dramatically. 15 The fund-to-funds business, in particular -- 16 because the fund-to-funds has to be generally a registered 17 investment advisor, the fund-to-funds, when they're choosing 18 the hedge funds in which they're going to invest, have a 19 higher due diligence level in disclosure information. And 20 that is, I think, raising the bar across the board on the way 21 hedge funds are operated and the level of disclosure that's 22 out there. 23 MR. PRESS: One of the reasons fund-to-funds have 24 become so important is the complexity of these strategies for 25 people to understand. Fund-to-funds have a tremendous 1 infrastructure dealing with risk strategy and have a great 2 understanding of what those hedge funds are. 3 So in going through the people they want to invest 4 with, it's an incredible process. Takes months, sometime 5 years, for them to make a decision to make that investment. 6 And then they have a whole monitoring, due diligence process 7 to make sure that it's on track, doing what they say they're 8 doing. And very difficult to get through a fund-to-funds to 9 be able to make a bad investment in terms of style or people 10 that don't belong in the industry. 11 MR. KEUNEN: And the due diligence exercises that 12 fund-to-funds perform aren't just of the investment advisors. 13 They're far more. They're for all the accounts -- including 14 administrators. So we experience due diligence exercises 15 just like the investment advisors. 16 MR. SCHULMAN: I would suggest we have times -- as 17 many people doing that today as we did two years ago, as a 18 big fund-to-funds operator; and the chances of us hiring 19 somebody that has something in their background that we don't 20 know about, at a senior level in the organization, I think is 21 quite small. 22 We have the full financial story of somebody going 23 back to when they came into the business. 24 MR. GRADANTE: I think we're all using third party 25 investigative companies; and, insofar as they can determine 1 prior regulatory infractions and impairments, you know, we're 2 aware of it. 3 But the old Wall Street culture, and I go back to 4 the Wall Street in the '80s, when you had a rogue trader and 5 the whole street knew about it. That has carried into the 6 hedge fund industry. 7 So even though it appears to be a small industry, I 8 think that culture will maintain itself as it did on Wall 9 Street, as Wall Street grew; and that people talk, and we 10 know who are the people who've gotten into problems in the 11 past. 12 So you either get it from a third party 13 investigative company, or you hear about it from the Street. 14 The Street's a small place -- whether it's hedge-fund world, 15 or whether it's the real Wall Street. 16 MR. SCHULMAN: And to Charles' point, everybody 17 around this table understands that it's not in anyone's 18 interest to ever hire someone who's going to do something 19 untoward, so even competitors are pretty good at 20 communicating where they think there's a real problem. 21 So I don't think it happens very much. The rogues, 22 if you look at them, the people who have really been 23 dysfunctional or dishonest, are people who basically raised 24 the money in their country club, typically out of one of 25 the -- not in New York City, or San Francisco, or Chicago -- 1 from a bunch of people who knew absolutely nothing, and had 2 no protection, and never got any of the vetting that we're 3 talking about around this table. 4 MR. LINDSEY: I think it also should be noted that 5 this upsurge in due diligence isn't necessarily a function of 6 some of the headlines we've seen in the last few years. I 7 think it's also a function of the kind of financial 8 institutions, the state pension funds, and that sort of 9 thing, that because of their returns in the traditional 10 sectors, they['re suddenly realizing that they need to be 11 looking at alternative investment vehicles. 12 And, of course, those institutions with their ERISA 13 restrains, and various other things, are inclined to -- and 14 also obvious, you know, at some -- to some level, political 15 exposure -- are also inclined to look much more closely at 16 where they're putting their money in these things because, 17 you know, because of the perceptions that might be out there. 18 COMMISSIONER CAMPOS: Well, what -- if I take 19 everything this panel is saying just at face value, then it 20 appears that hedge funds are safer, they're diversified, they 21 have -- they use prudent leverage, they use prudent 22 strategies, they're involved in maintaining principal, you 23 know, absolute returns. So why shouldn't all of this -- all 24 of these good things be made available to the public, instead 25 of just, you know, privileged people who are qualified 1 investors? 2 MR. GRADANTE: I'd like to comment on that. Now 3 since retail investors already have access to shorting Reg T; 4 options; futures; distressed debt; illiquid stocks: 5 unregistered limited partnerships; oil, gas, real estate, you 6 name it, the core of the issue you're addressing is not the 7 regulatory differences between mutual funds and hedge funds, 8 but how can we protect the retail investor without inhibiting 9 the free determination of hedge fund investment objectives 10 and their uses of investment strategies. 11 We need diversified market choices and capital 12 formation, not homogenized choices. 13 COMMISSIONER CAMPOS: I don't follow what you're 14 saying. 15 MR. GRADANTE: I think what you're saying is why 16 shouldn't -- why should we offer hedge funds to the retail 17 public. And those hedge funds that want to go retail, fine; 18 but then there are hedge funds that want to maintain the 19 entrepreneurial spirit and not be registered as a mutual 20 fund -- and they should be allowed the entrepreneurial 21 freedom to do that. 22 COMMISSIONER CAMPOS; I didn't know the two 23 different issues. 24 MR. SCHULMAN: Let me try to answer it. I'm not 25 sure if my answer will be any better than Charles'. I don't 1 see -- if the Commission is willing to recognize and 2 distinguish between the idea of having more risk from 3 understanding the risk, then there is no reason why you 4 shouldn't want to go as retail with these products if you 5 can. 6 Being involved in retail distribution of hedge fund 7 products, I will tell you it is very difficult to communicate 8 and the less financially sophisticated that an investor is, 9 the more pains you must go to to properly communicate what 10 these complex and very different kinds of risks -- not more 11 risk, but very different kinds of risks -- are. 12 We think this is a wonderful asset class. Everyone 13 sitting here around this room is in this business, makes a 14 living at it, has been successful, and done pretty well, and 15 watched investors do pretty well. So we conceptually think 16 that it is a business that other people would profit from. 17 The question is, is it articulatable and is it worth putting 18 up with the inconveniences that come with it? 19 And that's really a decision for the Commission. 20 We're talking about complex tax filings; we're talking about 21 K-1's; we're talking about, in many cases, delayed or filed- 22 at-the-last-minute tax returns; we're talking about a set of 23 risks that are not necessarily explainable in easy terms to 24 an unsophisticated investor. Which is why there's a 25 sophisticated investor rule associated with these products to 1 start with. 2 If you're asking is the actual outcome worth having 3 available for retail, the answer is yes. Is there a way to 4 easily surmount some of the issues that have been raised 5 associated with it, as in "Can we give enough disclosure?" 6 That's an answer that the Commission has to -- it's a trade 7 off that the Commission has to accept because -- and, by the 8 way, no one is trying, no one has a product out there that is 9 trying to bring this to retail. 10 Everyone is a qualified investor, even when they 11 buy registered products. So we're not talking about 12 unsophisticated investors. If your question is "Should this 13 go further down the line to unsophisticated investors?," that 14 is "How willing are you to have them make a leap of faith?" 15 If they really need to understand the strategies, that's 16 going to be hard in the size commitments you're talking 17 about. 18 COMMISSIONER CAMPOS: Do you really believe that 19 your investors, because they necessarily have a higher net 20 worth, understand what you're talking about? 21 That, to me, the communication issue is the same 22 regardless. If it's something that's complicated, it's 23 complicated. You know, if you're rich, it doesn't mean you 24 understand it any better. So essentially they've taken a 25 leap of faith, you know, in the particular style, the 1 particular situation that's going on. 2 So if communication is the problem, isn't that 3 something that solvable? I mean, you know, we've got all the 4 great communicators in the world in the industry. Moreover, 5 if you balance the risk that the general public is taking by 6 going long, without any protection, in a bad market, I mean, 7 is that their fate that they're supposed to be able to just, 8 you know -- because it's too complicated for you, sorry, you 9 know, there's nothing available. 10 MR. SCHULMAN: The communication issue is the same. 11 You have to communicate what hedge funds are about, whether 12 it's a retail investor or not; but the experience base is 13 different. A sophisticated investor typically has obtained 14 their wealth and experience in manners that make it easier 15 for them to understand what hedge funds are about. 16 COMMISSIONER CAMPOS: I don't necessarily agree 17 with that, but that's -- 18 MR. NEUS: Let me take a different tact. When we 19 talk about the average returns and average volatility for 20 hedge funds, you're doing it over a period of time. And the 21 traditional hedge fund has a lock-up period, a period of time 22 where investors cannot remove their money. 23 It's not an open-end fund like a mutual fund, and 24 the liquidity requirements of the ordinary investor are well 25 suited for mutual funds -- less well suited for a hedge fund 1 that needs the staying power of making sure that they have a 2 stable capital base when some of them are illiquid 3 investments, or areas where they can't necessarily liquidate 4 and realize investments to cover redemptions on a daily 5 basis. 6 Where the retail investor has been involved, and 7 has had a tremendously increased exposure to hedge funds, is 8 through the indirect way of insurance companies, pension 9 funds, charitable endowments. Those organizations where they 10 are professionally managed can take the risk, and can blend 11 the benefits, of a hedge fund as hedging the risk of mutual 12 funds, and other asset classes, on an aggregated basis for 13 the benefit of retail investors. 14 MR. ROYE: We're going to have to move on. There's 15 been references to the size of the industry, that the 16 Chairman in his remarks talked about a $600 billion dollar 17 industry. Is that about right, you guys who observe and 18 track the industry, and others? This notion that there's 19 been a lot of growth in the industry? Has there been growth, 20 and if there has been growth, where's it coming from? 21 Michael, you alluded to the fact that you have more 22 institutional investors, endowments, that are looking at 23 hedge fund investments. What's driving this growth, if there 24 is growth? Because, you know, they're not registered with 25 us. We're not -- we read the press. We've got the $600 1 billion number from simply reading articles. 2 MR. SCHULMAN: Well, I think people like Charles 3 and I gave it to the press, so -- 4 MR. GRADANTE: We have the institutional investors 5 at 30 percent of the industry. The growth is from $53 6 billion in 1998 -- this is all based upon surveys. We're 7 surveying about 25 percent or more of the capital industry. 8 $53 billion in 1998 to $175 billion in 2002. So that's a 230 9 percent increase, or 30 percent. And by institutions, we're 10 including, you know, ERISA, and corporations, endowments, 11 foundations, in that category. 12 MR. SCHULMAN: You know, we think -- Charles and I 13 think the $600 billion is about correct. We think the 6,000 14 hedge funds is approximately correct. That's our polling 15 from the TAS database that we operate. We think those are 16 reasonable numbers, but I think it's important to realize 17 that this explosive growth that has been talked about, we 18 estimate as $32 billion in 2001, and $16-odd billion in 2002; 19 with the fourth quarter of 2002 being negative. 20 And the first quarter numbers are in, by the way. 21 We think assets grew -- and, again, this is not appreciation; 22 this is just the grown of new assets -- by about $6 billion 23 in the first quarter. 24 So you have a business arguably over the last two 25 years that is growing at $25 billion or so a year. That is a 1 rapidly growing, but not an explosively growing business on a 2 $600 billion base. 3 MR. GRADANTE: And just of the growth that has 4 happened since January 2000, or roughly when the bear market 5 began, where the hedge fund industry was around $300 billion 6 in size. So it's at $600 billion. 7 So prior to that point in time, when the S&P was 8 doing 20 - 25 percent, you know, people said, "Why should I 9 invest in a hedge fund and pay one and twenty when I can 10 invest in an S&P 500 fund and get 25 percent?" So a lot of 11 this phenomenon we're seeing lately is the bear market and 12 the performance of hedge funds relative to traditional 13 managed funds. 14 MR. PRESS: I think also this is a global, 15 international market. When you go to England, Australia, 16 Hong King, Singapore, there's a vibrant hedge fund market. 17 That's all part of this industry. So it's not just an 18 American market by far, but truly is an international market. 19 MR. KEUNEN: That's an interesting point because of 20 that $600 billion, a very substantial portion of it is out of 21 Europe. And a very substantial proportion of that -- 22 although Europe's hedge fund management sector is growing, 23 you know, much more rapidly than it is here, in fact, because 24 it's starting from such a small base -- a very large 25 proportion of those European assets are invested with U.S. 1 domicile managers, if not necessarily U.S. domicile money. 2 MR. GRADANTE: We show 55 percent of the money is 3 off shore and 45 percent on shore. 4 MR. NEUS: Of the off shore, Charles, does that 5 include U.S. non-taxable? 6 MR. GRADANTE: Yes, it would include ERISA money 7 and other U.S. non-taxable. 8 MR. ROYE: That's kind of a nice segue. Bob, did 9 you have a comment? 10 MR. SCHULMAN: Yes. I just want to comment one 11 more point here. The vast majority of this growth -- and 12 this would be echoed by these small fund-to-fund operators 13 and the people we've talked to -- the vast majority of this 14 growth is coming institutionally. 15 So although there's been a lot of talk about the 16 retailization of the business, and all of these retail 17 products, the reality is it is large commitments from big 18 public plans and part leaders, like CALPERS and Texas 19 Teachers, that is leading the way towards the growth in this 20 asset. It is not a massive flow of money from retail or high 21 net worth investors using registered products. That's not 22 what's fueled the growth here to date. It may come to be 23 that, but that's not what it's been today. 24 COMMISSIONER CAMPOS: But isn't that diverting 25 institutional monies from the product they normally would be 1 if they're going into hedge funds? Isn't there some -- 2 MR. SCHULMAN: Yes. 3 MR. GRADANTE: I mean, diverting it from what? 4 COMMISSIONER CAMPOS: From operative investments. 5 MR. GRADANTE: No, could be diverting it from 6 venture capital, from private equity. 7 MR. SCHULMAN: Or from -- banks. 8 COMMISSIONER CAMPOS: Yes, I understand. 9 MR. GRADANTE: Okay. Let's move a little bit to 10 structure. You know, we talked about the off shore funds. I 11 guess, we observed that a number of hedge fund managers have 12 both domestic and off shore funds. Can we go into -- maybe, 13 David -- the reason for that, and maybe outline sort of the 14 typical hedge fund structure and how the funds are managed? 15 MR. VAUGHAN: Sure, be happy to. The classic hedge 16 fund structure here in the United States was a limited 17 partnership, with the manager, and potentially management 18 affiliates, providing the management of the partnership, and 19 the investors being the limited partners. The idea being 20 it's the most tax-efficient vehicle domestically in an 21 unregistered form. 22 In recent years, limited liability companies have 23 become popular because they provide the same tax benefits and 24 slightly more liability shield for the manager. 25 The other type of vehicle you typically see is an 1 off-shore corporation, which looks very much like the U.S. 2 corporation. Has a board of directors, typically; has an 3 investment advisor that has a contract with the corporation; 4 and shareholders are the investors. 5 Now this is all simplifying it quite a bit. There 6 are a number of structures I'm sure the staff has seen as we 7 go through -- of different structures, different combinations 8 of this, off shore partnerships, things like that, that can 9 be used in different structures, depending on the tax 10 aspects, the types of investors you have, and where the 11 manager is located. 12 We talked about the itnernationalization. There 13 are certain tax aspects for a manager based in the United 14 States which are different if you're based in the U.K.; and 15 you may want, depending on your investor base -- you've got a 16 taxable U.S. investor base -- they'll typically go into a 17 partnership vehicle. 18 Non-taxable U.S. investors often want to have a 19 corporate vehicle; and the non-U.S. investors typically will 20 prefer the corporate vehicle. And so you often have a 21 combination of these vehicles really designed to appeal to 22 the investors and provide a way, with other benefits that 23 they see to being in off shore funds, for the investors to be 24 comfortable and make it attractive to them. 25 MR. PRESS: Hedge funds also have a very complex 1 compensation structure. They're different than mutual funds 2 where it's one sum of money for all investors at one moment 3 in time. Hedge funds actually track the investment returns 4 by investor domestically; and off shore, which makes it even 5 more complicated because the off shore fund, as David has 6 said, is a corporation -- we actually have separate share 7 classes by kinds of investors so that you can track each 8 investor's return separately. 9 And it becomes very complex. The administrators do 10 an incredible job of doing that accounting for the off shore 11 fund. 12 But it is very different than mutual funds because 13 it's an investor-by-investor performance. 14 MR. GRADANTE: David, you alluded to the fact that 15 off shore, it's a corporation. It would be a board of 16 directors. I guess, typically an administrator. Is that 17 driven by the regulatory framework of the jurisdiction where 18 the hedge fund is organized? 19 MR. VAUGHAN: It's typically, primarily driven by 20 the tax aspects of the fund, plus the off shore investors are 21 often more comfortable in a fund that's administered off 22 shore. And part of the off-shore administration business 23 grew up before a tax law change, which is no longer very 24 recent; but basically required the off shore funds to be 25 administered off shore if they were going to be managed in 1 the Unites States. 2 It was really a tax benefit to encourage investment 3 in the United States, I think, going back to the 1960s. And 4 that was liberalized to allow some of those administrative 5 services to come on shore; but partly out of investor comfort 6 and partly out of just where the infrastructure is, a lot of 7 the administration has remained off shore. 8 MR. KEUNEN: Yes, I'd just like to add to that. 9 Many of the off shore domiciles actually require 10 administration to be performed off shore. But as you were 11 saying, David, the -- when the ten commandments were 12 repealed, we expected many of the functions to move back on 13 shore. And mainly because of investor-driven initiatives, 14 most of those services did not move on shore because the 15 investors remained comfortable with the process the way it 16 was, the way there was an independent administrator, the way 17 that certain functions were performed independently. 18 COMMISSIONER CAMPOS: Well, since everybody's got 19 statistics here, what percent of hedge fund managers are 20 registered investment advisors and what's the difference in 21 performance for their funds, if any? If there's any 22 statistics kept? 23 MR. GRADANTE: I have numbers on that. From our 24 last survey, we asked managers if they were registered 25 investment advisors, CPOs, or broker dealers. And, once 1 again, that's 173 management companies; 793 hedge funds, or 2 14 percent of what we think is the industry; and 20 percent 3 of the capital in the industry. And 75 percent of those 4 surveyed were either an IRA, and/or CPO, and or broker 5 dealer. 6 So they're registered with one of the agencies, one 7 or more of the agencies, on that sample. So to the extent 8 that sample is representative, it is increasing. And that 9 IRA number, by the way, the 75 percent, of that 54 percent 10 were registered investment advisors, up from 38 percent in a 11 prior survey. So there is a movement. 12 MR. SCHULMAN: We have almost identical numbers, by 13 the way. 14 COMMISSIONER CAMPOS: Do you have stats as to 15 who -- which of those managers also managed mutual funds? 16 MR. GRADANTE: No, I don't at this time. But the 17 other question is, well, you know, why this increase? And I 18 think the market is segmenting, or the hedge funds are 19 segmenting themselves into those that need registration to 20 address a client base that requires it, like ERISA money. 21 And then the hedge funds that are not registered 22 are basically saying we don't want to address that 23 marketplace. We will stay with high net worth individuals, 24 and other entities that don't require it. So there are three 25 C-7's being segmented and -- so as money -- as Bob mentioned 1 earlier -- money is moving in from the institutional world, 2 much of which require registrations in order to place the 3 investment, hedge fund managers have been stepping up to that 4 to receive that capital formation. 5 COMMISSIONER CAMPOS: Is there any difference in 6 performance? Registered in some fashion versus not? 7 MR. GRADANTE: I don't have that answer. 8 MR. NEWTON: I was going to say I was pretty sure 9 that if there was a difference in performance if getting 10 registered was going to increase your performance by 5 11 percent. 12 COMMISSIONER CAMPOS: I was thinking -- maybe tell 13 me -- 14 MR. NEWTON: No, they would all be rich -- 15 MR. GRADANTE: I mean, there is -- I think we all 16 have seen a reversion to the mean sometimes. Not for 17 everyone, but some managers, if they get too big, they can 18 revert to some sort of mean; but that's a generalization, 19 that's not true of everybody. 20 MR. VAUGHAN: We don't have statistics on it, but I 21 think anecdotally we do see more registered hedge fund 22 managers, mostly because institutions have gotten into the 23 hedge fund management business and, therefore, have other 24 businesses which drive them to be registered investment 25 advisors. 1 Traditionally, going back 10 years, it was mostly 2 CFTC registration in the industry. Now they're registered 3 advisors, as the institutions have gotten into it, for two 4 reasons: 5 One, to keep talent in the mutual fund organization 6 by offering the ability to do other types of products that 7 the manager finds interesting and challenging; and also 8 because of the interest of investors in hedge funds, being 9 able to offer a full menu of investment products to their end 10 investors by having their own in-house, or proprietary, hedge 11 funds. 12 MR. PRESS: And the Commission has looked at least 13 at almost every organization that I'm aware of where they 14 have mutual funds, hedge funds, or other kinds of investment 15 product, and had extensive examinations on trading, 16 allocations, commissions, and so forth. And, to my 17 knowledge, it's shown to be an incredibly clean examination 18 with great compliance, great procedures being put in place, 19 and some of the conflicts that the press has reported have 20 not come up on those kinds of examinations. 21 MR. SCHULMAN: We have about 100 funds in our 22 database where the manager is also involved, either directly 23 or indirectly, in a mutual fund company. 24 We have also -- a survey -- we also have a study in 25 the TAS database that says a little more than half the 1 managers are RAA's, and I think there's a subsetting: People 2 who are out there building businesses and raising money are 3 registering because it's one of the things you need to do. 4 It's one of the ways that you can raise money. It would 5 involve being registered, whether it's retailization or 6 institutionalization. 7 A lot of the bigger funds that have been around for 8 a long period of time and have operated very successfully, or 9 who are closed to new investors, but have not yet thrown out 10 the existing investors, are not registering because they have 11 no purpose associated with doing it. 12 MR. KEUNEN: Many of the funds that we service also 13 have stock exchange listings. So there obviously there are 14 requirements associated with that. 15 MR. VAUGHAN: One thing to keep in mind, too, the 16 managers that are not based in the United States are often 17 registered in their home jurisdiction. So while the 18 institutionalization -- there may be a few clients who want 19 them to be registered with the Commission if they're trying 20 to give them a mandate, many are comfortable if they're 21 registered with the U.K. regulatory authorities, that that, 22 if they're based in London, is substantial equivalent from 23 their due diligence standpoint. 24 MR. GRADANTE: Did want to move on to just the 25 roles that various service providers play in the hedge fund 1 industry. 2 And since we talked about the domestic off shore 3 fund distinction, William, maybe you could go into an outline 4 of really what off-shore administrators do, the types of 5 services they provide to hedge funds. 6 MR. KEUNEN: Yes, sure. I mean, the first thing to 7 say is that the services that we perform are defined in an 8 administration agreement that is between the fund and the 9 administrator. So that's the first thing; and, obviously, 10 that varies fund by fund. 11 Also, hopefully, the disclosure in the offering 12 documentation properly outlines what the functions and 13 responsibilities of the administrator are. But we tend to 14 split our services between cost services and added-value 15 services. 16 The cost services include accounting, which 17 basically comprises maintaining the books and records of the 18 fund, typically, independently; taking the activities of the 19 fund on a day-to-day basis from the accounts -- to the fund, 20 the prime brokers; reconciling positions and cash balances -- 21 typically, daily; and then, you know, producing a portfolio 22 in cash balances; pricing the portfolio, again, subject to 23 the rules of the fund; calculating fees and accruals; and 24 then, you know, preparing -- calculating the net asset value; 25 and producing financial statements. 1 Typically, the cycles for that are at the very 2 least, you know, at intervals whenever investors can either 3 come or go out of the fund. But they can also be daily, 4 weekly, or monthly. 5 Other services are investor-related services. We 6 typically verify investors in accordance with applicable 7 anti-money laundering rules. We process capital flows. We 8 process subscriptions, redemptions, and other transactions 9 such as dividends, and distributions, and transfers; we 10 communicate with investors on a periodic basis -- typically, 11 monthly, with standard information about the fund and the 12 investor's holdings in the fund. 13 So those are sort of cost services. 14 Added-value services include corporate and legal 15 services; possibly tax reporting, typically in the U.S.; 16 compliance with investment restrictions; compliance 17 monitoring with investment restrictions; and other 18 administrative services. 19 So those are the primary services. 20 And again, over the last few years, we've seen a 21 trend towards out sourcing more of the operational work that 22 hedge funds would have historically and typically 23 traditionally done. And that, you know, that could include 24 operational support such as trade rate reporting, cash 25 exposure reporting, currency exposure reporting, on a daily 1 basis. 2 But again, the parameters are covered fund-by-fund, 3 with the funds that we service, by virtue of the agreement 4 that we have. 5 MR. GRADANTE: Now William, you've outlined some 6 very key functions in terms of accounting, valuation, 7 pricing -- typically occurring by you as the independent 8 third party for what we refer to as off shore funds. 9 Who does that in a domestic fund context and 10 where's the independence? Or is there any independence in 11 terms of those functions in the domestic hedge fund arena? 12 MR. KEUNEN: I think, again, for domestic funds, it 13 tends to vary and it depends on the fund and the nature of 14 the fund. But, you know, I guess there are a number of 15 different parties who perform this. For some funds, it's 16 done in house by the investment advisor. For other funds, 17 it's done by the administration. 18 We see a trend towards more independent 19 administration for domestic funds. And for other funds, it's 20 done by sometimes the accountant. 21 MR. NEUS: I think also the prime brokerage plays 22 an increasing function on both the off-shore and domestic, 23 but specifically with regard to reconciliation, valuations, 24 and the other issues. 25 MR. PRESS: There are numerous checks and balances 1 within the hedge fund organization; but again, it also 2 depends -- as an entrepreneurial organization, some hedge 3 funds can just be the manager. That doesn't require lots of 4 technology, if he's trading long/short. Call your broker to 5 execute the trade. It goes right through on a bookkeeping 6 service, or you can do it yourself. Not a lot of checks and 7 balances to very large organizations that have no different 8 than a mutual fund complex, or broker dealer complex -- a 9 very elaborate compliance, accounting, risk, technology, 10 analytics, and so forth and so on. 11 And each organization really has to structure it, 12 but the administrators have the -- driving force, and the 13 bookkeeping, and accounting part. To my knowledge, no big 14 four accounting firm does bookkeeping for -- as a part of its 15 business. It's just not something that we do. It's also a 16 conflict in our minds; so bookkeeping is not done by the 17 accounting -- large accounting firms. 18 There may be some medium-sized firms that do it 19 within the context of the AICPA rules and regulations; and 20 it's perfectly acceptable under certain specific guidelines. 21 But the administrators have really picked it up. 22 There is a shortage of CFOs in this industry. It's 23 hard to learn and train. It takes years of knowledge. 24 Legal, compliance, hard-to-get operations people. The prime 25 brokers are a large source of operations people that work in 1 the hedge fund industry and there's not enough of those. 2 COMMISSIONER CAMPOS: What are the statistics, if 3 you have any, about the valuation of assets and how regular 4 reports are produced for investors and hedge funds? 5 MR. PRESS: In general, hedge funds value their 6 securities on a daily basis. No different than any 7 proprietary trading. And they go through elaborate steps. 8 On reporting to investors, it depends on what the 9 offering document or partnership agreement has said. Most 10 report on a minimum of a quarterly basis and the investors 11 have accepted that. Or monthly. Some will report more 12 often; others have elaborate Web sites, with secure 13 identification procedures to get in, to give daily 14 information. 15 It really depends on the hedge fund, investor needs 16 or desires; but at a minimum, quarterly. Some with a one- 17 page letter: "Here's how we've done." Others with -- 18 there's one particular hedge fund that produces a 20-page 19 thesis on the market and their philosophies; and it's quite 20 elaborate. And it's really very different by hedge fund. 21 COMMISSIONER CAMPOS: Well, you're saying that -- 22 do you have statistics for how many actually have a net asset 23 value per day -- daily? You're saying most of them do? 24 MR. PRESS: Most value the positions. They don't 25 necessarily go to an NAV-type of calculation. Some do, some 1 don't. They don't need to report "I've done a daily NAV." 2 Remember, in the hedge fund industry in general, 3 you cannot get out on a daily basis. 4 COMMISSIONER CAMPOS: I understand. I'm just 5 wondering what the practice is. Secondly, is GAAP being 6 used, or other standards being used for evaluation? 7 MR. PRESS: For the audit that we perform on the 8 clients we service, all the opinions are within GAAP unless 9 there's some form of qualification required, but in general, 10 the offering documents require GAAP or valuations in 11 accordance with GAAP, and GAAP is dominant in the industry on 12 a very small percentage. 13 I don't have statistics for you on international 14 GAAP. U.S. GAAP dominates the hedge fund industry nb is 15 followed rigorously. 16 CHAIRMAN DONALDSON: What goes on within the hedge 17 fund is very much like getting back to Mr. Lindsey's point, 18 proprietary trading. 19 If you have a hedge fund manager that is long on 20 short equities that he can mark his portfolio off the screen, 21 typically that's the way it's done, and they have realtime, 22 on-line P&L systems. 23 As you deviate from that and get into more 24 illiquid, less tradeable, on the proprietary desk of an 25 investment bank, you would call an independent company to 1 value that asset. We see that being done more often. You 2 know, some do it monthly, where they call in an independent 3 firm to value assets that they cannot value off the screen 4 properly. 5 MR. PRESS: Hedge funds also have another 6 uniqueness, depending on their documents, where they, what we 7 call a side pocket, where literally they take illiquid 8 investments and say there are no valuations -- I'm going to 9 leave out the financial statement for the moment. There are 10 no valuations. 11 Once you invest and you know you're investing, 10 12 percent of your capital may go into this pocket, and you 13 can't get out. 14 Even if you take your liquid money out, that stays 15 forever until there's a disposition on those assets, and they 16 track those assets very rigorously by investor, and it 17 usually is a year-by-year, in some cases it's a quarterly by 18 quarterly investment, so they're tracking to that, because 19 they know the difficulty in trying to value those illiquid 20 assets in terms of someone getting in and out, and their own 21 performance. 22 So that's another part of the industry that's, 23 again, a little bit different than in the mutual fund 24 industry. 25 From the GAAP perspective, we're required to go 1 through, and the clients are required to go through a 2 valuation/fair value, and they go through rigorous steps 3 trying to get to those valuations, and we review those steps. 4 MR. ROYE: Am I better off, as an investor in a 5 hedge fund, from an investor protection standpoint, being in 6 the offshore fund versus the domestic fund because of the 7 presence of the offshore administrator providing a lot of 8 these independent checks, accounting, valuation, where you 9 don't necessarily have that, and I guess our understanding is 10 largely you don't have that, the third party administrator in 11 the domestic fund context? 12 MR. PRESS: I would say that investing onshore or 13 offshore, any investment manager would be the same. Checks 14 and balances exist between the prime broker and the trading 15 desk, the internal people, offshore administrators and 16 onshore administrators. 17 MR. ROYE: But the onshore administrators, I mean, 18 that is not typical -- 19 MR. PRESS: It's no different than any major 20 brokerage house, has its own internal people determining its 21 earnings per share and publishing it. 22 The requirements and the recordkeeping are as 23 strong as they are in any hedge fund organization, as they 24 are in other organizations, and people comply with proper 25 bookkeeping and accounting procedures wherever possible. If 1 it's a very small entrepreneurial, then that's a different 2 issue. 3 MR. ROYE: I guess the only thing that I'm -- the 4 point I'm making is that, you know, there's an independent 5 party in the offshore context providing a lot of these 6 functions. Within a domestic context, the party is not 7 necessarily independent, and we know from experience that 8 from time to time people stray, and there are incentives to 9 stray. 10 But I guess what I'm saying is that, I mean, maybe 11 the answer is that Rich Lindsey and the prime brokers are 12 doing part of this, and they're part of the independent 13 check, but I mean, it is a fact that in the offshore fund 14 arena, you have an independent third party providing a lot of 15 these critical functions, and you don't have that 16 independence in a domestic context. 17 MR. PRESS: You do in many, in large organizations 18 that have their own internal controls. 19 MR. ROYE: But those are inside folks doing it. 20 MR. PRESS: No different than a mutual fund complex 21 in the same capacity. It has not changed, and any other -- 22 MR. ROYE: You have different directors in a mutual 23 fund context. You sometimes have third party administrators 24 in a mutual fund context. 25 MR. PRESS: And you sometimes have third party 1 administrators in domestic hedge funds, also, and in business 2 today -- 3 MR. ROYE: What percentage of domestic funds have a 4 third party administrator? 5 MR. PRESS: Today more than ever on startups I 6 would tell you that at least 75 to 90 percent go with a third 7 party administrator for onshore and offshore startups, 8 because there are not enough internal people, and the 9 technology costs for the accounting systems that are out 10 there are significant, and you have to be a larger hedge fund 11 to be able to support it, so the small hedge funds have 12 onshore and offshore administrators doing the ascertaining 13 values, also. 14 MR. KEUNAN: I would say there's definitely a trend 15 there. I mean, I think that administrators now have a U.S. 16 presence. 17 They've demonstrated that they have the expertise 18 with specific U.S. requirements such as tax reporting and 19 partnership allocations in the accounting for that, so the 20 trend is there, definitely, as Joel says, towards using 21 administrators on domestic funds. 22 MR. NEWTON: A lot of the players in this business 23 are tuning into the same people who are processing mutual 24 fund transactions. 25 They're all standing on the sidelines, you know -- 1 well, not standing on the sidelines anymore. 2 They're in there, you know, some very big names in 3 the securities processing business, and they are fulfilling 4 these, and they are competing for these functions onshore 5 since the repeal of Tinker-Monmouth. 6 MR. NEUS: Paul, I think the other aspect to this 7 is disclosure documents of hedge funds and increasingly, the 8 due diligence by the gatekeepers and the significant 9 institutional investors are going into great depth of the 10 reconciliation process, when you get independent valuations, 11 when they're reported, and that has increasingly been for 12 firms that do it in-house. There is a vetting process that 13 has emerged within the market. 14 MR. LINDSEY: Since you raised it, I should be very 15 clear though, that a prime broker actually does not have the 16 capability to value a hedge fund. 17 They could not compete an NAV on any basis, because 18 they neither see the cash accounts, bank accounts that might 19 be held by a hedge fund when they do not see any of the off- 20 balance-sheet activity that a hedge fund may be engaged in. 21 That's even if you're the sole prime broker, and of 22 course, typically, hedge funds, at least if we're talking 23 about hedge funds of any size, you know, if you're in the, 24 say, 50 to 150 or $200 million range, they probably have on 25 average one-and-a-half prime brokers, and as you start to get 1 larger, the number of prime brokers increases. 2 MR. ROYE: How about, can you just outline for us 3 the roles that a prime broker would play in the hedge fund? 4 MR. LINDSEY: Well, the prime broker plays a 5 relatively simple role, which, you know, I think a lot of 6 people have had confusion about what a prime broker does over 7 the years, and that is, you know, traditionally, of course, 8 if you wanted to trade with six different houses on the 9 street, and you were a proprietary trading desk, a hedge fund 10 type of operation, you would have to open up six brokerage 11 accounts around the street to do that, and you'd have to have 12 assets held at each one of those accounts. 13 What a prime broker does is essentially allow the 14 hedge fund to give up the name of a prime broker that may 15 hold a substantial portion or at least some sizable portion 16 of their assets, and let them trade anywhere on the street. 17 So the prime broker becomes responsible for the 18 clearance and settlement of the trading activity. 19 The prime broker may or may not trade on any given 20 trade or even at all with the hedge fund, so they may or may 21 not be a counter-party to the hedge fund in some cases, but 22 basically, it provides basic clearance and settlement 23 services. 24 There are some additional services that prime 25 brokers provide to try to facilitate a client relationship 1 with the hedge fund, and those, you know, range from simple 2 things like perhaps the facilitation of them obtaining office 3 space in certain locations to helping them sometimes find a 4 CFO if we know that people are looking to, unfortunately, 5 sometimes, taking personnel from the prime broker to help 6 augment their back office, but it's a wide variety of what 7 I'll call services that are only meant to maintain 8 relationships. 9 MR. ROYE: And the compensation flows essentially 10 from the trading activity that -- 11 MR. LINDSEY: Well, compensation for a prime broker 12 can come from essentially three -- four areas. 13 One could be execution, commission type of flow, 14 if, indeed, the prime broker is associated with the 15 executions. 16 And the other would be essentially -- I've 17 classified them as three separate ones, but that's 18 essentially income derived from margin balances, short 19 balances, and credit balances -- so debits, credits, and 20 shorts. 21 There may, in many cases, also be a processing or 22 transaction fee associated with processing a trade, 23 particularly if that trade is done someplace else. 24 MR. ROYE: How about in promoting the hedge funds, 25 roles prime brokers -- 1 MR. LINDSEY: I don't know of any prime broker that 2 promoted hedge funds. 3 MR. ROYE: Okay. Capital introduction services? 4 MR. LINDSEY: Capital introduction services are 5 services that amount to essentially, you have a clientele 6 that may be interested in meeting institutions. All of our 7 capital introduction is involved with institutional. 8 And you have institutions that are qualified 9 investors that indicate that they are interested in hedge 10 funds, and what we do is, we provide a venue where they may 11 meet, so those venues typically consist of what I'll call 12 conferences, so -- where you have a number of hedge fund 13 managers that may talk, a number of investors that have come 14 into the room, and do that type of thing. 15 As Robert, I think, said earlier, the investing 16 process today is a very long process, particularly with more 17 institutionalization of the marketplace. 18 Those investors may look at hedge fund managers for 19 anywhere between, you know, nine months to a year-and-a-half 20 to two years. They'll see them at a number of different 21 prime brokers' capital introductions meetings. They'll see 22 them at a number of outside conferences. They'll see them 23 perhaps one-on-one in their offices. 24 But they go through a very long and detailed and 25 rather slow process of de