Hedge Funds Enter the Daylight

August 2012

IN THIS ISSUE

— Secretive No More: The Pros and Cons of Marketing Hedge Funds to a Broader Public
— Risks to Hedge Funds of Broader Appeal

Welcome to the August edition of our newsletter! In this issue, we’ll examine how the SEC’s recently proposed regulation concerning the marketing of hedge funds could affect that industry and its disclosure practices.

SECRETIVE NO MORE: THE PROS AND CONS OF MARKETING HEDGE FUNDS TO A BROADER PUBLIC

Hedge funds have often been portrayed as financial tools largely inaccessible to the broader public – a perception which has been bolstered by prohibitions against their marketing to individual investors in the same way mutual funds do, a rule set in place by the 1933 Securities Act. But a provision in the recently enacted JOBS Act would allow hedge funds to discuss their investment strategy and past performance in marketing materials with investors directly. This presents an opportunity for the hedge fund — a pool of heretofore uninvolved investors — but also risks for both the funds and their would-be clients.

The risks are not equal, in theory, but are equally important: for an investor who thinks investing a $2 million inheritance with a hedge fund is a good idea, information is available but it is limited relative to information available on mutual funds or broker-dealers. The SEC’s Investment Adviser Public Disclosure System and the National Futures Association’s BASIC system each provide information on hedge funds or their managers, and both sources include references to any arbitration awards against the firm or other regulatory actions. But neither can be used to independently verify claims of past performance, so for a new customer the burden of due diligence can be daunting, and a full spectrum of litigation searches, reputational interviews and other methods is warranted before making an investment decision.

RISKS TO HEDGE FUNDS OF BROADER APPEAL

While the new proposal, if enacted, would create a level of due diligence for any investor who previously had not dealt with hedge funds, there is a defensive incentive for hedge funds to do their homework as well. The guilt by association of being a conduit for the next Bernard Madoff or other schemers of his ilk can have lasting negative effects — especially damaging in a time when a fund that was not previously able to market to “everyday” investors had just begun to do so. The current system necessitates go-betweens who solicit clients for hedge funds and, to some degree, also vet those potential clients for the funds. If that layer of protection is removed, it would become the fund’s responsibility to make sure — to the fullest extent possible — that it would not suddenly become an unwitting accessory to fraud simply by accepting a client’s funds.

The proposed rule would create opportunities for both parties involved in an investment transaction, and could add liquidity and capital into funds that hadn’t existed previously. But it will also undoubtedly create the need for more attorneys and fraud examiners to thoroughly ascertain the risks posed by and for each side of the transaction. This could ultimately increase compliance costs, but may prove beneficial if the broader investment community gains exposure to, and benefits from, access to pooled fund operators like hedge funds.