January 9, 2007
The anti-fraud provisions are terrific:
As an Advisor to a hedge fund with less than $2m in assets, I am not required to register. Nonetheless, it seems obvious that the SEC ought to hold me accountable if I deceive, mislead, or defraud my clients. Furthermore, I agree with the comments under the Cost/Benefit analysis that it generally doesnt cost anything to be honest. One shouldnt even need to check with an attorney, as alluded to in your analysis, if one sticks to factual material and resists forward looking statement or promises.
On the other hand, the creation of an accredited natural person is a terrible provision:
The worthy intent of this provision is to protect individuals from financial harm. Creating an accredited natural person does not achieve this goal because it is based on the false assumption that wealth equates to financial savvy. What we have seen in the past few years is the opposite: Very smart, well informed individuals are capable of colossal mistakes. Amaranth was being recommended by many well heeled, well informed hedge fund gurus, and was invested in by many funds of hedge funds. All their money and access made them no more able to contain, nor apparently understand, their risk at Amaranth.
To go back a little bit further, apparently even the Nobel Prize winners inside LTCM did not quite understand the risks they were taking. Surely if they did not understand, then merely having $2.5m to invest is unlikely to help much.
There is one and only one way to mitigate risk: diversification. My suggestion is that the SEC maintain the current Accredited Investor standard with the following critical addition: Just as the investor must represent to the hedge fund manager that he or she has sufficient assets and/or income, insist that the investor also represent that the proposed investment in the managers fund represents no more than 10% of the investors net worth.
This proposal has many advantages over the one put forth by the SEC. First and foremost is that it would necessarily create the result the SEC intends: No investor would be severely hurt even by the total collapse of one hedge fund because they would not have too much of their net worth invested in it. This is far better protection then, for example, an individual with $2.5m of investable assets being able to place $1m or $2m in Amaranth or LTCM or Bayou or KL Group or ...
Second, for the purpose of determining who may invest, the SEC would no longer have to struggle to distinguish between hedge funds and venture capital or other types of private investment funds. Apply this rule to all of them. Surely, one should not place more than 10% of their net worth into a single VC fund, or private equity fund or other generally illiquid investment vehicle relying on Reg D.
(All these rules, in my view, should be suspended for member/employees of the fund. I have far more than 10% of my assets in my fund to demonstrate clearly that I believe in it. No doubt, many other hedge fund or VC fund managers do the same.)
Third, no inflation adjustment would ever be necessary.
Fourth, the arbitrariness of the $2.5m standard disappears, solving a concern of the SEC stated on p. 22. One million dollars is also arbitrary, but at least more and more people are no longer restricted by it.
Fifth, by not restricting insufficiently wealthy people, but insisting that one keep any single investment relatively small compared to total wealth, this rule would allow the SEC to keep more investment choices available to a wider audience. This enhances, as essentially zero cost, the true wealth of more individuals as it allows them greater latitude in creating portfolios tailored to their specific risk/reward tastes. For example, a person with $1m in investable assets could purchase interests in 10 different hedge funds. This person will be far more diversified, and thus safer, than a person with the $2.5m contemplated by this rule who happens to choose only two funds because they have $1m minimum investments.
Sixth, your comments noted concern that hedge funds might avoid your proposed rule by increasing their lock up period so as to avoid looking like a hedge fund. Under my proposed solution, this and any other avoidance technique is rendered useless.
Comments on grandfathering were also solicited. If the SEC pushes ahead with the rule as proposed and does not grandfather, the following silly situation could obtain: The up to 35 exception to the Accredited Investor rule could remain in the fund, while all those with between $1m and $2.5m would be thrown out. At the very least, existing investors should be allowed to remain members of a fund. Perhaps such investors would be unable to add to their positions in the fund.
Thank you for the opportunity to comment.