07/07/2010 Author: Tony Griffiths and Shannon Hawthorne

The new deal

The US Government's response to the financial crisis has been a long time coming, with the hard-line adopted in Europe and tough talk from the Obama administration fuelling speculation of a legislative crack-down. With new measures passed through the House last week, HFMWeek provides an impact assessment for hedge funds

America’s hedge fund managers have spent much of 2010 bracing themselves for what they had been warned would be the biggest financial reforms since the Great Depression. The build-up has been gradual but palpable, and this week, after months of being overshadowed by Europe’s headline-grabbing regulatory sideshow, the US legislative focus has finally turned inwards.

Last Wednesday, following an emergency redraft, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed by the US House of Representatives, 237 votes to 192. Approval in the Senate is still required – since pushed back to after the 4 July recess – but the final direction was out in the open. Having held their breath through talk of tax levies and propriety desk restrictions, US hedge fund managers found themselves exhaling a sigh of relief. Gone was the controversial hedge fund tax, which would have seen larger managers help pay for the bill’s estimated $19bn cost, while the Volcker rule, seeking to ban banks investing directly in hedge funds, was watered-down, much to its namesake’s frustration.    

The immediate sense of reprieve has quickly given way to a more practical analysis of the bill’s implications. Few within the US hedge fund industry have argued with the bill’s sentiment – that of mandatory registration and increased reporting. The Alternative Investment Management Association (Aima) welcomed the bill upon its initial, pre-emergency redraft release, but admitted it was “concerned” with certain sections. Aima’s chief fear, the tax levy, has since been drafted out, but questions remain surrounding the wording and application of many of the bill’s provisions. Speaking to HFMWeek, law firm Schulte, Roth & Zabel distanced itself from any industry back-slapping over the diluted Volcker rule as its team makes sense of “the ambiguity in the language”, while there is still uncertainty surrounding reporting requirements and the SEC’s as-yet-unspecified new powers.

That said, though much work remains to be done before Capitol Hill’s plan for the hedge fund industry achieves clarity, the main areas of affect are identifiable. With the help of a several regulatory experts, HFMWeek outlines the bill’s impact on US managers.

SEC REGISTRATION

WHAT IT IS
Under the Private Fund Investment Advisers Registration Act of 2010, all advisers of hedge fund and private equity firms with assets under management of $150m or more will be required to register with the Securities and Exchange Commission (SEC) as of July 2011.
The legislation effectively eliminates the ‘private investment adviser exemption’ contained in the previous Act (the Investment Adviser Act of 1940) which stated that any adviser who had had fewer than 15 clients over the preceding year would not be required to register, deeming a private fund, such as a hedge fund, as one ‘client’.
The SEC will further be authorised to require hedge fund and private equity firms to provide regular reports to investors, counterparties and creditors as well as the regulatory body itself.

WHAT IT MEANS
While the prospect of increase compliance costs are clearly a concern to many managers, with a number of advisers already voluntarily registering with the SEC, the impact of the Act may not be as dramatic as some anticipate.
Nevertheless, for those hedge funds who don’t currently register, compliance will now have to appear much higher on their list of priorities. “Often at a hedge fund, the chief compliance officer and the chief financial officer or even the chief executive officer might be one and the same,” says AnnMarie Croswell, director of regulatory compliance and due diligence at Kinetic Partners. “Whereas in the past, they may have viewed compliance as a secondary concern, going forward, it will very much need to be a primary aspect of their business.”
According to industry estimates, complying with registration rules may cost the hedge fund industry as much as $500m in the first year.

EXEMPTIONS

WHAT IT IS
Though the bill has eliminated the private adviser exemption, a series of fresh exemptions have been included for funds of a certain size, nature and origin. Non-US funds will be exempt unless they: hold themselves out to be an investment adviser to the public in the US; have more than 15 US clients that are funds or US investors; have a place of business in the US; or have more than $25m of AuM attributable to US persons.
Other exemptions have been included for family offices and venture capital funds, as well as several based on size. Funds under $25m in AuM are prohibited from registering under the act and subject to individual state registration. Between $25m and $100m, funds are subject to state legislation unless they are required to register with more than 15 individual states, then they are permitted to register with the SEC. Lastly, there is an exemption for those managers that “solely manage private funds” and have less than $150m AuM in the US.

WHAT IT MEANS
The flipside of mandatory registration, the bill’s exemptions throw up some unexpected complications, particularly for foreigner advisers. The low cap – more than 15 investor or $25m in US money – means that a significant number of non-US funds will be snared in the bill’s net. This potentially gives rise to dual-registration requirements – a fear Aima raised when the exemption first appeared in an earlier draft.
Elsewhere, the exemptions for family offices and venture capital funds are undefined, state regulation is not a level playing field (see New York’s plans for carried interest), while the exemption for advisors who solely manage private funds with less than $150m is “poorly worded”, as Josh Dambacher of Schulte Roth and Zabel explains. “The term ‘AuM in the US’ is not used anywhere else in the act, so you don’t know if that means $150m of US investor money, US-domiciled fund money or just managed from an office in the US,” he says. “The second funny part about that language is that it’s solely managing private funds, which suggests that if you’re a manager that has a couple of traditional managed accounts and a private fund, you’re not going to be able to live under that exemption.”

REPORTING
WHAT IT IS

Under the act, the books and records of those funds registered with the SEC will be deemed those of the advisers and subject to regulatory scrutiny. Information previously held by the fund, and now also the adviser, includes assets under management, the use of side letters, counterparty exposure and trading positions.
The reporting of short positions is now mandatory and required “no less frequent than monthly”. Short-sale reporting is expected to be introduced via an amendment to form 13F, a publicly available report.
The 2,500-page bill also includes a section on derivatives, or more specifically swaps. All swaps will be required to be traded over-the-counter, affecting registered and unregistered hedge funds alike. “For those that can’t be traded on a formal exchange, because they’re sufficiently common, there will be reporting of those derivative positions,” says David Guin, partner at law firm Withers.

WHAT IT MEANS
Increased reporting requirements were neither unexpected nor criticised by the industry. “The good thing is that if you report to the SEC, the statute specifically says it’s not a public disclosure and it’s exempt from the Freedom of Information Act,” says Dambacher. 
The filing cost is only around $100 but funds will have to have a lawyer, which, depending on the size of the firm, could cost anywhere from $20,000 to $75,000, he estimates.
Short-sale reporting, however, looks set to be publicly disclosed – “not the most welcome news for managers,” notes Dambacher. Potentially of bigger concern is the SEC’s power to increase the frequency of short-sale reporting. In the aftermath of the Lehman collapse, short positions were temporarily required to be reported to the regulator on a weekly basis, which was “very costly”, he adds. 
The changes to the swaps industry will also take some getting used to.
“It’ll add another administrative expense,” adds Withers’ Guin. “But unless a manager decides to exit certain types of derivatives that they might be otherwise trading because they don’t want to report them it shouldn’t impact their bottom line too much.”  

VOLCKER RULE
WHAT IT IS
Named after White House special adviser Paul Volcker, the ‘Volcker rule’ originally sought to ban US banks from owning, sponsoring or investing in hedge fund or private equity firms.
Much to the chagrin of the former Federal Reserve chairman (or so it’s claimed), the final version of the rule now allows banks to invest up to 3% of their Tier 1 capital into such funds, and limits their investment into any single fund to 3% of said fund’s capital.
Banks may also have until 2022 to apply these limitations. According to the bill, the Volcker rule will only come into effect 15-24 months after the law is passed, after which banks have a further two years to comply and the potential to apply for another three one-year extensions. They could then seek a further five years to withdraw money from ‘illiquid’ funds.

WHAT IT MEANS
With the wording of the Volcker rule still frustratingly ambiguous, many fund managers are still unclear about exactly how hard they will be hit by the changes. Recent bold moves by JPMorgan and Citigroup, both of which are continuing to invest in the space, seem to indicate that they, at least, are confident the impact will be moderate at best.
The limitations are, however, still expected to significantly impact start-up hedge funds; namely those relying on banks as a source of seeding capital.
“Often, a start-up hedge fund has been launched by an individual who has spun out from a bank – which then becomes the seeding investor,” says Kinetic’s Croswell. “This is certainly something I expect to see less of as a result of the Volcker Rule.”

...AND THE REST
‘Pay-to-play’
The SEC has voted in favour of a new rule banning hedge fund and private equity investment advisers from managing public pension investments for two years if they make political contributions to elected officials with influence over awarding investment contracts.
“Pay-to-play distorts municipal investment priorities, as well as the process by which managers are selected,” said SEC Chairman Mary Schapiro at a meeting in Washington.
Funds will still be permitted to donate up to $350 to officials that they are entitled to vote for and up to $150 for those they cannot vote for, such as out of state politicians.

Carried interest
Last month, the House of Representatives voted in favour of taxing ‘carried interest’ – in the case of hedge funds, performance fees – as income (at 35%), as opposed to capital gains (at 15%) – raising an estimated $24.6bn over ten years. However, the tax has been shelved after the Senate failed to pass the bill for the third time.
But for New York-based fund managers, the coast may not be clear quite yet. A legislative plan to raise revenue has proposed taxing carried interest as income for those who work in the state, but live elsewhere, costing said managers an estimated $50m a year.

increased SEC powers
As well as creating the Consumer Financial Protection Bureau (CFPB), the bill also grants a small increase in power to the SEC itself; not just nominal obligations to clarify certain terms, but broader powers to define any other information it deems systemically relevant and therefore wants retained or reported.
“One of the things that we’re concerned about is that the SEC is likely to impose fiduciary obligations on investment advisors that currently don’t exist,” says David Guin, partner at law firm Withers. “I think there will be a natural inclination to over-regulate in an attempt not to be caught unawares again, and only when those things prove unworkable will they be unwound.”
The SEC’s recent reinvention – its no-nonsense approach to market abuse and increased appetite for information – has been characterised by its recruitment drive. The extra manpower will be needed to monitor a larger client base. Estimates suggest that only 6% of funds will be visited in 2010, meaning, on current numbers, a mere 0.1% will be examined post-enactment. Managers can expect an increase in the number of mandatory surveys they receive as a substitute for visitations.