Subject: File No. S7-25-06
From: Amit Chokshi
Affiliation: CFA

January 26, 2007

This is a very bad and economically discriminatory ruling...

This week the SEC will take a look at revising the accredited investor rule, seeking to raise the minimum net worth standards and annual income levels that individuals must meet to qualify for the accredited investor definition. The current standard set in 1982 defines an accredited investor as a person with a net worth of $1 million or annual income of $200,000 in each of the previous two years with a reasonable expectation of making $200,000 in the current year. These standards have been criticized as being stale since the figures are not adjusted to keep pace with inflation.

Over the past year hedge funds have become easy targets, shouldering the blame for alleged manipulation of energy prices to taking criticism for purchasing certain classes of distressed mortgages in an attempt to make money off struggling homeowners. Hedge funds have been such an easy target its a wonder that natural disasters and global terrorism havent been pinned on them as well. The combination of recent hedge fund scandals and implosions over recent years along with general underperformance relative to the broader market has led to SEC Chairman Christopher Cox initiating a misguided crusade against hedge funds in order to protect the little guy. Notwithstanding fund of funds and institutional investors including bulge bracket investment banks and pension funds were significant investors in many funds which imploded due to either poor risk controls or simple fraud, Mr. Cox and many of his supporters latest proposed fix is the conclusion that an individual with a net worth of $3 million must have a much higher financial I.Q. relative to one with a net worth of just $1 million and is therefore more qualified to invest in a hedge fund.

In either case, many of the frauds involving hedge funds with hundreds of millions of dollars under management probably had far more money from institutional investors than the little guy. Whether one has $1 million in total net worth or $2 million in liquid net worth will not make a significant difference in the capability of either of those individuals to cut a check for the minimum investment in many of the established hedge funds. Established hedge funds in certain cases are closed to new investors and in many cases have minimum investments that are multiples of the net worth of defined accredited investors.

What the new changes will do, however, is stifle creativity and new blood in the hedge fund industry. These new rules, if they take affect, will squarely and unequally impact hedge funds structured as 3c1s which can take just 99 accredited investors. Hedge funds structured as 3c7s can have as many as 500 investors that are defined as qualified purchasers which are individuals with at least $5 million in investments or institutional investors with at least $25 million in investments. Its just a guess but most of the big ticket funds and the $100+ million fraud funds are probably structured as 3c7s so the little guy Mr. Cox is so intent on protecting has far limited direct participation in these funds except through institutional money invested on his behalf i.e. pension funds.

Raising the bar to a subjective new level will just make it that much more difficult for honest managers to successfully launch start up hedge funds and crimp the ability for emerging managers to strike out on their own. For every Eric Mindich and Dinakar Singh that can raise billions, there are other investors and traders with impressive pedigrees and track records that still must work incredibly hard to raise capital and in many cases depend on their initial network of friends and family for seed capital. Despite being unregulated, hedge funds face a litany of restrictions such as the inability to advertise so the initial capital is limited to a select group of people a fund manager can reach out to. As the manager of a small fund, I can attest that that seed capital from friends and family is critical and subjectively raising the accredited investor bar can have profound implications on the ability of start up funds to survive.

Of course, the main point isnt feeling sorry for the small fry fund manager. Mr. Cox would suggest that protecting investors from themselves is his paramount concern. Given Mr. Coxs proposed solutions, the end result of this protection will come in the form of increased economic discrimination. While those that pass the accredited investor definition will have direct access to alternative investments, the unsophisticated millionaire will likely be bombarded with beaten down, systematic returns offered from the Morgan Stanleys (MS), Merrill Lynches (MER), and other big houses peddling packaged funds modeled off of various hedge fund strategies that will be pumped through the brokerage firms network of brokers and affiliates. In addition, the new rules will just result in more money funneled to the largest investment firms which will further reduce returns. With fewer original investment fund opportunities available, retail investors will simply place more money in the consistently underperforming asset aggregators like Fidelity Management and Research.

The most attractive aspect of the hedge fund industry is its entrepreneurial nature and what Mr. Cox and many other hedge fund critics would like people to believe is that its this very nature that attracts a high level of fraud and predatory practices. While one can concede that fraud will be present in this industry, the fact is with 8,000 hedge funds in existence, there is bound to be a certain level of fraud and nearly every facet of investing has its share of frauds and predatory practices. How many spam emails does one receive discussing new stock opportunities, mortgage refinancing opportunities, and real estate investing ideas on a weekly basis? Id take an admittedly biased guess and believe more small investors are swindled through investing or falling prey to these schemes as opposed to hedge funds.

In contrast to criminal activity with hedge funds, the biggest frauds have occurred in highly regulated and visible areas. Just turn back about 4-5 years to the accounting frauds related to Enron, Worldcom, and Healthsouth (HLS) or just look back a year to the Refco fraud that duped Thomas H. Lee Partners TH Lee and auditor Grant Thornton. As a leading LBO firm, TH Lee can be considered one of the smartest of the smart money investors and probably spent close to $10 million in the due diligence of Refco. Yet somehow the consultants, auditors, and smart money investors in Refco were still duped.

What is typically lost on critics of hedge funds is the benefit of the entrepreneurial nature of the industry. The industry is entrepreneurial in the sense that hungry managers do not need to play office politics and wait for their turn and generally spend time running reports and performing tedious tasks that have little to do with generating strong returns. If learning the institutionalized process for analyzing stocks made a difference, gray haired fund managers at firms like Fidelity and T Rowe Price should have learned how to produce consistently market beating returns. Although marketers and fund consultants love and prefer these investment process handbook gimmicks, the investment process is not something that can be modeled after a GE manufacturing facility with Six Sigma certification.

This is not to say that hedge fund managers are not organized and have no processes in place in which to analyze investments either. Despite the image of hedge funds operating akin to gunslingers, investment processes are in place and more importantly, unlike a fund manager making $500,000 at a Fidelity, a hedge fund manager will often times have his entire net worth invested in the fund.

If Mr. Cox is intent on protecting the smaller investors he should spend most of his time focused on pension funds ramping up their allocations to alternative investments. Nobody has blinked as buyout funds have purchased company after company and what people fail to understand is the end risk lays with the limited partners, not the general partner.

Limited partners are increasing both their concentration in the asset class as well as company specific risk. The biggest deals are the LBO gangbangs where three to four financial sponsors take down a sizeable company. The end owner is really the institutional limited partner like CalPERS. CalPERS may have $50-$200 million each allocated to a KKR, Blackstone, TPG, etc. and if a few of these funds team up to buy HCA, the MGM film library, Hertz, etc. and one of those club deals goes bad, its bad for the financial sponsor but disastrous for CalPERS since its exposure to a certain company is magnified due to its investment in each financial sponsors fund.

Of course, none of the deals will go bad and CalPERS has excellent risk management practices in place. Investors probably believed the same thing when Forstmann Little acquired XO Communications and McLeodUSA (MCLD). Forstmann Little was a top flight sponsor and one of the original buyout kings and was essentially done in by its foray into XO Communications and McLeodUSA. The XO bankruptcy resulted in a lawsuit by the state of Connecticut which lost just $122 million on this bankruptcy. Irrespective of the legal issues surrounding the case concentration issues for the fund, the scale of the loss should be compared to what current pension funds could face if the new wave of mega-deals turn south.

The SECs attention on accredited investor standards is a gross waste of its resources when the scale of loss on the pension side and its very real implication for small investors is far more pronounced. Of course, if there is one thing government bodies have been consistent on over recent years, its been political grandstanding and wasting resources.