“The ‘90s: Rom-coms, the Spice Girls, & MFA:” Remarks Before the Managed Funds Association

Thank you Bryan. As is customary, I’d like to note that my views are my own as SEC Chair, and I’m not speaking on behalf of my fellow Commissioners or the SEC staff.

The 1990s

The 1990s was the decade of Michael Jordan and the Chicago Bulls. The Cold War was over. It was the dawn of the internet and the Spice Girls. Seinfeld was on TV. Bill Clinton brought blue jeans and Domino’s delivery to the White House.

The 1990s also was pretty relevant for the private fund field. The Managed Funds Association was founded in 1991.

Congress passed amendments in 1996 to the securities laws that included a new exception from registration allowing private funds to have an unlimited number of qualified investors.[1]

That same 1996 law included an important provision that SEC rulemaking had to consider efficiency and competition as well as capital formation, in addition to investor protection and the public interest.

The 1990s was when I became the father of three wonderful daughters and watched great Meg Ryan and Julia Roberts rom-coms. I also had a career shift that took me to Greenwich, Conn., that fateful weekend in 1998 prior to Long-Term Capital Management’s failure.

Private Funds and the American Economy

Let’s fast forward to the 2020s. I’m not talking about Biden versus Clinton or generative AI versus the internet or Taylor Swift versus the Spice Girls. Though there may be some things on which Taylor and I agree. Instead, I’m going to focus on private funds.

Advisers now report more than $25 trillion in private fund gross asset value[2] amongst tens of thousands of funds.[3] The reported assets surpass the size of the total $23 trillion banking sector.[4] In 1998, the industry had $800 billion to $1 trillion in assets with only a few thousand funds.[5] This represented 20-25 percent of the then $4-plus trillion banking sector.[6]

The private fund industry plays an important role in each sector of the capital markets, whether it’s equity, treasury, corporate bond, mortgage, municipal, loan origination, or many other markets. It’s intertwined with the derivatives and funding markets, such as the repo and reverse repo markets. It participates in capital formation for startups to late-stage companies.

It also plays an important role for investors, such as retirement funds and endowments. Standing behind those entities are a diverse array of teachers, firefighters, municipal workers, students, and professors.

Subsequent to the 1990s, as you know, we had the 2008 financial crisis. In response, Congress gave the SEC important new authorities, including with regard to private funds.

First, Congress repealed the exception that most private fund advisers previously relied on to avoid registration, causing private fund advisers, with some narrow exceptions, to register with the SEC.[7]

Second, Congress also directed the SEC to collect information from private funds “as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the FSOC.”[8]

We take congressional mandates seriously in the context of our three-part mission: to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. The markets should work for the benefit of investors and issuers—not the other way around. I recognize we may have different clients. The MFA’s clients are your members, largely investment advisers to private funds. The SEC’s clients, though, are the American public, investors and issuers alike.

Much of the SEC’s work in updating rules is to keep up with today’s ever-changing technology and business models. We are focused on promoting fair, orderly, and efficient markets, which helps protect investors and facilitate capital formation. In that context, I’ll speak to our work to enhance market efficiency, integrity, and resiliency.

Efficiency

You probably are familiar with Alfred Winslow Jones, the father of hedge funds, who started the first fund strategy in 1949. He created the 20 percent performance fee structure. It’s said that he modeled it on Phoenician sea captains who took the same in profits.[9] By my time on Wall Street, this had led to the traditional “2 and 20” model.

Today, private fund advisers receive multiple levels and types of fees—from management to performance to portfolio company fees. That’s not to mention consulting, advisory, monitoring, servicing, transaction, and director’s fees, among others.

Average private equity fees[10] were estimated to be 1.76 percent (annual management fee) and 20.3 percent (performance fee) in 2018 and 2019. For the largest private equity firms, those fees might even be higher.[11] Average hedge fund[12] fees were estimated to be 1.4 percent (annual management fee) and 16.4 percent (performance fee) in 2020.

Taken together, those fees might add up to 3-4 percent in private equity and 2-3 percent in hedge funds per year. Fees and expenses range well into the hundreds of billions of dollars each year.

We have a number of projects across the capital markets around efficiency. Most important to this group is the private fund adviser proposal.[13]

This proposal uses the tools of transparency and market integrity to promote competition and efficiency. This ties to those 1996 reforms, in which Congress said we had a role to consider efficiency and competition in the capital markets. Congress didn’t cabin those 1996 reforms only to retail investors or one segment of our markets. They didn’t leave out so-called sophisticated investors.

The proposal’s new transparency would relate to fees, expenses, performance, and side letters.

As to market integrity, annual audits would be required. The proposal also would prohibit certain activities, such as seeking reimbursement, indemnification, exculpation, or limitation of its liability, including a breach of fiduciary duty in providing services.

Integrity and Disclosure

Congress also gave the SEC an important role promoting market integrity and disclosure to help investors, facilitate capital formation, and build trust. This lowers the cost of capital for issuers, raises returns for investors, and helps increase participation. Integrity and disclosure facilitate what can be the best of capital markets and guard against the worst.

At the SEC, we have a number of projects focused on market integrity and disclosure. I’m going to focus on five, all of which relate to Dodd-Frank mandates and authorities.

Dodd-Frank mandated two rulemakings to bring greater transparency around securities lending[14] and short positions.[15] Thus, we have proposals that would reduce information asymmetries between borrowers and sellers in the securities-lending market[16] and make aggregate data about large short positions available to the public.[17]

Further, we have three outstanding proposals authorized in Dodd-Frank related to investment advisers’ custody of client assets, beneficial ownership, and large positions in security-based swaps.

In the wake of Bernie Madoff, Congress gave the SEC updated authorities that investment advisers should safeguard client assets over which they have custody.[18] Thus, we proposed a safeguarding rule, updating our prior custody rule.[19] In particular, Congress gave us authority to expand the advisers’ custody rule to apply to all assets, not just funds or securities. Further, investors would benefit from the proposal’s changes to enhance the protections that qualified custodians provide, which helps protect assets should the adviser or custodian go bankrupt.

In 1968, Congress mandated that large shareholders of public companies disclose information that helps the public understand their ability to influence or control that company. Beneficial owners of more than 5 percent of a public company’s equity securities who have control intent have 10 days to report ownership.[20] Today, markets move dramatically faster. Congress in Dodd-Frank gave the SEC authority to shorten this deadline;[21] thus, we proposed to cut it in half to five days.[22]

Lastly, after the 2008 crisis, Congress granted the SEC broad authority with regard to security-based swaps, including credit default swaps, which played a leading role in that crisis.[23] A critical part of Long-Term Capital Management’s risk-taking was in total return swaps, another form of security-based swaps. Given this history, Dodd-Frank authorities, and not to mention what happened in Archegos, I supported the Commission’s proposed rules to a) require prompt disclosure of large security-based swap positions and b) strengthen investor protection in security-based swaps.[24]

Resiliency

Let’s turn back to the 1990s for a moment. With my youngest daughter, Isabel, then a year old, on my lap, Secretary Rubin was calling.[25] He had just been discussing Long-Term Capital Management with Federal Reserve Chair Alan Greenspan.

After visiting the fund that weekend, I told Secretary Rubin it would be unlikely the fund would last past the upcoming Wednesday.

Though I shared with him estimates of the first-order losses of direct counterparties, I said at best it only would be a guess as to the possible systemic effect across the financial markets and into the economy. The fund had about $1.2 trillion in derivatives, booked in the Cayman Islands, on a $100-plus billion balance sheet, with only about $4-$5 billion of net asset value.[26]

Subsequently, I was asked to staff the President’s Working Group review. We found the event “highlighted the risks of excessive leverage, and the possibility that problems at one financial institution could potentially pose risks to the financial system as a whole.”[27]

History is replete with times when tremors in one corner of the financial system or at one financial institution spill out into the broader economy. When this happens, the American public—bystanders to the highways of finance—inevitably gets hurt. Investors and issuers inevitably get hurt.

Lest we forget that 10 years later, eight million Americans lost their jobs, millions of families lost their homes, and small businesses across the country folded as a result of the financial crisis of 2008.

In Dodd-Frank, Congress put in place new requirements regarding registration and reporting of private fund advisers.

Since the SEC put in place Form PF 12 years ago, a lot has changed. We have two proposals to update it. One is related to current reporting, and tomorrow we have calendared to consider its adoption.[28] Working with the Commodity Futures Trading Commission, the second proposal, among other things, would expand the reporting requirements for large hedge fund advisers on their large funds.[29]

Lastly, I’ll note we have important projects about the efficiency and resiliency of the Treasury market. Private funds have significant investments in this $24 trillion market.[30] These projects include registering and regulating Treasury dealers[31] and platforms,[32] as well as facilitating greater clearing of treasuries in both cash and funding markets.[33]

These projects are important, in part, because hedge funds can create risks for financial stability through the use of leverage and through counterparty exposures.[34] Hedge fund exposures to repurchase agreements, reverse repurchase agreements, and Treasury securities have increased in recent years. Moreover, in the last few years, many hedge funds are receiving repo financing in the non-centrally cleared bilateral market, where haircuts or initial margin requirements are not necessarily applied.[35]

Conclusion

So much has changed since the 1990s. My daughters are grown up. The technology of today makes the technology of that time seem quaint. Though I still do enjoy Sleepless in Seattle and Notting Hill.

The projects I have discussed are designed to update the rules of the road for private funds to meet today’s times and ensure these intermediaries, too, work for investors and issuers alike.