February 5, 2007
February 5, 2007
To the Securities and Exchange Commission:
My comments do not come from a vacuum as Ive read every response posted to your website up through Kim Azizy, Aventura, FL on February 3, 2007.
There is no cost in telling the truth, so if the anti-fraud provisions in the Commissions' proposal deter one bad apple from entering the industry, without keeping honest professionals away, it will be a good thing.
However, it appears that, overall, you've missed the mark with your proposed rule S7-25-06. The changes surrounding who is and who is not eligible to invest in private investment partnerships, as currently proposed, will have serious negative impact on the investing public, the economy and the trajectory of the investment management community.
First, as has been widely discussed by others, this proposal will markedly restrict the investment options available to the investing public in ways that reek of "wealth discrimination."
Second, the proposed changes will constrict certain positive benefits currently enjoyed by the US (and global) economy.
Third, entrepreneurial investment professionals will pull back from starting their own firms. Steven Cohen started SAC Capital with $25 million under management; Warren Buffet started his career with investments made by friends and family in a few investment partnerships he managed. Does the Commission really wish to keep the next generation of Cohen's and Buffett's on the sideline and away from investors? Does it want to deter future industry participants in this manner?
The following issues, concerns and questions came to me as I read through your proposals. Some concerns have been widely expressed, and other ideas less so. I have organized my thoughts into three main areas: (i) definitions and regulatory philosophy, (ii) the economic impact of "hedge funds" and "private equity funds," (iii) risk characteristics of investments available to the general public and (iv) potential solutions. Thank you for providing a forum to express my ideas.
Definitions and Regulatory Philosophy
1) Why is the Commission attempting to create yet another defined term, yet more regulations, yet more hurdles for the investor and the investment manager? Specifically, why, instead of creating the Accredited Natural Person, didnt the Commission simply consolidate the thinking behind Qualified Client and Accredited Investor to come up with a single definition that would fit both objectives? These two ideas are close enough in substance that there is no reason to have different standards for these two classes of investor. If you must keep these sorts of hurdles in place, make it is simpler for the investor, the investment manager and the regulator.
2) Why did the Commission elect to eliminate real estate holdings from the definition of "net worth"? This seems to be a bit misguided given the ease of moving equity from a personal residence into the markets via a home-equity loan, second mortgage or a refinancing. Because of this, I do not see a mechanism for the Commission to eliminate real estate from the net worth equation and to not simultaneously regulate the mortgage market.
3) I have wondered if the Commission doesn't have an unwritten desire to put all small investment management firms out of business via ever expanding regulatory requirements. Consider that to comply with the new "accredited natural person" proposal will eliminate nearly 6 of 7 of the potential investors generally open to smaller firms and therefore it will be 7X as hard to build and grow their companies under the proposed rules as compared to the current rules and regulations. Further, this proposed rule will not impact the big firms in any meaningful way as they rely nearly exclusively on QP investors for their private investment funds, whereas it will destroy hundreds of small firms who currently rely on the existing investor definitions to pay our bills and hire our employees.
4) What percentage of Commission staff members meet the new "accredited natural person" standard? I expect the percentage to be very low, possibly lower than the general public. And, what expertise do who are not "accredited natural persons" themselves bring to the table in determining who is and who is not savvy enough to invest in certain things? This particularly smacks of bureaucratic arrogance where the Commission is essentially telling the investing public that, "We know how to take care of your business affairs better than you, despite the fact that our personal wealth would not indicate as much."
Economic Impact of "Hedge Funds" and "Private Equity Funds"
1) Has the Commission considered the economic impact to job creation in the investment management industry if analysts, brokers, consultants and traders at large firms are meaningfully less able to leave to start their own firms with friends, family members and close associates as their initial clients? One of the attributes that has made America different from all other countries is that anyone has the ability to use a big idea to make a place for themselves however, it would appear that the Commission has decided that entrepreneurship is fine in all it's forms (as evidenced by the preferential treatment to pools of venture capital over all other private investment funds), as long as it doesn't show up in the investment management industry. Speaking of which, how would the Commission rule on a private equity fund that only held investments in operating companies that managed hedge funds? The more I consider this bifurcation, the sillier it seems.
2) It would seem to me that allowing employees to invest in "hedge funds" would be a strong desire of the Commission. Why would it seek to eliminate the opportunity? If the Commission is fine with publicly traded companies making employer matches into 401(k) plans with company stock where the employee is required to become a shareholder (occasionally for an extended period with no chance to sell), why would it have a problem with an employee voluntarily wanting to invest in the fund he or she was working on and to size it appropriately for their own investment portfolio? It is a good thing for investors if they know their investment manager is invested in the same things they are in. In fact, a hypothesis of mine states that if more investment advisors only invested alongside their clients, there would be less fraud, not more.
3) Has the Commission considered the tangential economic benefits that all businesses and investors enjoy because hedge funds exist? For example:
Because there are more funds going both long and short in all the markets around the world, market volatility is at or near historic lows partly because there are so many investment funds that are active on both the long and short side of the markets. If prices get too far away from where they should be, they will correct through the actions of the invisible hand of capitalism and the profit motive of private investment fund managers.
PIPE ('private investments in public equities') funds have become an integral component in the capital formation process for small publicly traded businesses with inconsistent access to the capital markets.
All of the various types of arbitrage funds (statistical, merger, convertible, relative value, market neutral, etc) flatten the bid/ask spread for various assets making it more efficient for traditional buyers and sellers to get executions at reasonable prices.
Through simultaneously holding positions in privately held companies and publicly held companies, some hybrid hedge/private-equity funds bridge gaps in the capital markets and the economy that are not otherwise bridged.
If the amount of capital in these sorts of funds diminishes, these direct benefits to the economy may be halted or reversed. Be aware of the law of unintended consequences
Risk Characteristics of Investments Available to the General Public
1) Why is the Commission even attempting to delineate between a "hedge fund" and a "private equity fund"? Is investing in my neighbor's auto body shop or a college friends' biotech startup somehow less risky for the investor, than investing in my new long/short equity fund? No it's not; an investment in a startup operating company inherently carries more risk, as it's outcome is almost guaranteed to be binary (big success or big failure), whereas owning a piece of a diversified pool of investments is substantially more likely to deliver an outcome that is meaningfully less variable.
2) When considering the method the Commission chose to delineate between what is and what is not a "private equity fund" and what is and what is not a "hedge fund," the Commission seems to assert that a highly levered commodity pool or arbitrage fund (fixed income, merger, convertible, etc) presents the same risk to an investor as a fund pursuing asset backed lending with low loan-to-values? The Commission seems to lump all "funds that charge performance fees" or "funds that have lockups of less than five years" or "funds that use leverage" in the same category, regardless of what they do or how they do it, to the detriment of both the investor and the investment manager, especially those that are entrepreneurially inclined.
3) Does the Commission believe it better for investors with net worth of less than $2.5 million (absent their residence) to buy puts to protect the value of their IBM shares than it is for them to hire a professional, via a private investment fund, to do this for them? Surely each staff member at the Commission goes to their personal dentist rather than drilling holes in their head at home...
4) Is it less risky for an investor to invest 100% of their assets in any of the thousands of publicly traded companies than it is to invest 100% of their assets in a private investment fund? If the answer is "yes, it is more risky to invest in a single operating company than to invest in a single private investment fund," is the Commission going to mandate certain minimum diversification levels for investors, too? If so, how exactly is this going to happen? Be careful, this is a slippery slope. Pretty soon, the Commission may be trying to regulate how much I spend on my car or my vacation, too. It is still asset allocation, after all.
However, if the Commission holds that the answer is "no, its more risky to invest in a single private investment fund than it would be to invest in a single operating company," could the Commission consider how to explain this with investors who owned securities issued by WorldCom and Orange County, CA?
If the answer is, "it depends," then either this piece of proposed regulation really doesnt go far enough in trying to constrain investors from various choices, or it goes way overboard.
5) Theoretically speaking, how different is a "hedge fund" from a manufacturing company? While its easy to dismiss the question out of hand, consider that each entity has its own raw materials (say, "powders, bottles, caps, labels and cardboard boxes" vs. "all publicly traded stocks") and production processes ("assembly line" vs. "mathematical formulae and phone calls to management") in order to generate profits for the firm owners. How would the Commission determine that one is a more risky proposition than the other?
Relatedly, how different is a "hedge fund" from, say, GE Capital, Ford Motor Credit, Sears, Berkshire Hathaway or Fannie Mae? Who is to say that one of these traditional stalwarts isnt going to follow Global Crossing or any of the thousands of other operating businesses that declare bankruptcy each year. When Enron died, it was one of the shining stars on Wall Street, afterall.
Further, how is exactly is Amaranth going bust different than Enron going bust? Other than, of course, Enron going bankrupt was far more damaging to both the global capital markets and individual investors than the largest melt-down in the history of hedge funds. That and Enron was a case of fraud whereas the implosion at Amaranth was, essentially, the net result of a poorly sized investment in natural gas. In light of this, if the Commission goes forward with these changes to the suitability standards, it may be reasonable for the Commission to start placing limits on who can and who cannot own shares in certain risky operating companies. The logic is the same.
And, if the Commission decides to not place such limits, surely its not going to be because the "hedge funds" are more difficult to understand, is it? "Hedge Funds" (generally) distribute interim financials each month (generally accompanied by with a manager letter) one to three weeks after the end of the month. Public companies, on the other hand, issue quarterly financials one to two months after the end of the quarter and an annual shareholder letter. Which entity has transparency issues? Besides, do you know exactly how Intel makes its computer chips, or what The Coca-Cola Corporation mixes together to get their concentrate? And yet, these are not so scary as to require the Commission to restrict investors from owning shares.
Potential Solutions
1) Continue to allow knowledgeable employees to invest in the products they work on, whether or not they are accredited. It is a valuable benefit to talented (but not yet wealthy) staffers and it provides some assurance to the clients / limited partners that the staff has the same objectives as the clients / limited partners. This is a very important aspect of the existing regulatory environment that the Commission should to maintain.
2) Allow all aspects of net worth to be included when determining eligibility, including real estate holdings. Its simply too easy to convert real estate equity to real estate debt and market equity. To hold any other view is disingenuous and requires investors to bear an unnecessary burden to effect their desired investment strategies.
3) Combine the definition of Qualified Client and Accredited Investor into a single set of rules where an investor would meet the definition of Qualified Accredited Investor with $200,000 / $300,000 income levels, $1,000,000 net worth or $750,000 invested with the investment manager. This simplifies things for everyone involved.
4) Allow investors who do not meet the definition of Qualified Accredited Investor (#3 above) to make the definition of Qualified Sophisticated Investor by fulfilling either (i) have a CFP, CFA, CPA or lawyer advise the investor whether or not they should invest in any particular private fund, regardless of the type of private fund, (ii) have earned an undergraduate or graduate degree in finance, accounting or economics from an accredited college or university, (iii) hold a CFP, CFA or CPA designation, (iv) as an attorney, be a member of any states' bar, or (v) pass a written test administered by the SEC to certify they understand the unique nature of private partnerships.
5) Require all private investment partnerships to have an audit performed by an unaffiliated third party on an every-other-year basis, at a minimum. Require the most recent audit to be given to potential investors at the same time as the private placement memorandum and other documents pertaining to the investment fund. Leave it up to the potential investors, or their advisors, to contact the auditors to verify they are real and there is true separation between the auditor and the investment manager.
6) Do not distinguish between "private equity" and "hedge funds." Besides there being a meaningful overlap between these types of funds today, each distinct type of fund serves an important role in our economy.
Through the combination of #3, #4 and #5, the Commission could pretty closely guarantee that (i) investors in private funds are of sufficient means to lose capital in a speculative venture, (ii) have appropriate levels of education, (iii) are advised by someone who is looking out for their interests, and/or (iv) have proven their sophistication to a satisfactory level to the Commission. This will allow all investors a chance to invest in a private fund, if it is in their best personal interests to do so, regardless of net worth. And, this will democratize the world of alternative investments among all investors, while providing an additional level of checks and balances to make sure the Commission is holding up its mandate to protect the investing public from unscrupulous investment managers / shysters.
Summary
If consultants and advisors are told to apply the Prudent Man Rule when working with their clients, I would encourage the Commission to apply a Cognizant Regulator Rule prior to impacting, potentially radically, (i) the livelihood of thousands of people employed at smaller investment management firms, (ii) the capital formation process in numerous industries across the country, and (iii) the important capital markets benefits that flow to each of us simply because hedge funds are active and prevalent.
Simply said, the proposed changes are decidedly anti-capitalistic and flatly un-American. With this sort of approach to dealing with the investing public and the investment managers that serve it, is it any wonder that New York (and therefore America) is at risk for losing its preeminence as the worlds financial center? Please scrap the current proposal and please consider implementing at least a few of the suggestions immediately above instead.
Thank you, again, for this opportunity to share my ideas.
Sincerely,
Darren Unruh
President
Watchmaker Capital Management, LLC