SEC rules to lock-in hedge funds

Historically US hedge funds have been able to avoid the glare of the Securities and Exchange Commission (SEC), but in 2004 the SEC changed all that, and the deadline is fast approaching. The growth of hedge funds pushed the SEC into making this move. In December 2002 the SEC began an investigation. They found that although the original purpose of hedge funds was to invest in equity securities and use leverage and short selling to “hedge” the portfolio’s exposure to movements of the equity market, this remit had altered. Today, hedge fund advisers use a wide range of investment strategies and techniques to increase investor returns, and many are very active in the trading of securities. Hedge funds are said to represent between 10% and 20% of equity trading volume in the US.

Three points emerged from the investigation. First, that the number and size of hedge funds was rapidly increasing, according to Hedge Fund Research Inc, in 1990 there were 610 hedge funds worldwide with US$39bn under management. In early 2005, there were 8,532 hedge funds with over US$1trn of assets. This has had a significant effect on the securities market. Second, there was also a growing number of enforcement cases in which hedge fund advisers defrauded hedge fund investors, who typically were able to recover few of their assets. Third, the SEC was concerned that the activities of modern-day hedge funds could affect a broader group of people than the relatively few wealthy individuals and families who had historically invested in them.

A report was published in September 2003 and from that the SEC derived its final rule, ‘Registration Under the Advisers Act of Certain Hedge Fund Advisers.’ The report recorded that in the previous five years, the Commission has brought 51 cases in which it has asserted that hedge fund advisers have defrauded hedge fund investors or have used the fund to defraud others in amounts estimated to exceed US$1.1bn. The SEC decided that all US-based hedge funds with more than US$25m of assets and all offshore firms with more than 14 US citizens as investors must register with the SEC unless they impose a two-year lock-up on investors.

The deadline for registering was February 1, 2006, yet according to reports, the hedge fund industry is split over what to do. On the one hand, by registering with the SEC they give up part of their precious secrecy. On the other they are concerned that a two-year lock-in period will discourage investors. Hedge funds’ returns thresholds are slightly above the bond market, currently at 10% to 12%, because investors can get their money out on the same day they decide to withdraw. Private equity return expectations are double this, around 25% with a 10-year lock-in, so hedge funds with a two-year lock-in are going to have to raise their returns to attract investors. As a result, up to half of US-based hedge fund advisers are understood to be moving towards a two-year lock-up, investors told Thomson Merger News recently. Offshore firms are also divided about the need for registering. This move is affecting their strategy, some investors said. A longer lock-up was allowing firms to buy more illiquid assets, such as equity in a takeover, further fuelling investor demand for leveraged buyouts, they added.

Hedge funds are already viewed as a threat to private equity, and this move by the SEC is likely to see an increasing encroachment on territory traditionally regarded as private equity’s sole domain. The buyouts market is already over-crowded in the US (one of the main reasons American buyout funds are fishing in Europe), so if hedge funds decide to make the move, expect this trend to increase, with US hedge funds looking at Europe as well as an increasing number of private equity firms.

The threat posed by hedge funds has been downplayed by a number of industry observers, and to a large extent they were probably correct as the vast majority of hedge funds, when they do involve themselves in the world of private equity, have traditionally been short-term lenders in LBOs. As more money has poured into the industry, hedge funds have broadened their remit to include actually buying companies; although at the moment the examples can be counted on one hand, the fear is that with a lock-in period, the need for higher returns will drive hedge funds into new territory.

UK-based hedge funds already have to register with the SEC equivalent, the Financial Services Authority (FSA), and some have already come out and said they will not be taking on US-based investors so as to avoid having to register with the SEC. The FSA has also increased its attention on hedge funds of late. It published a discussion paper in June of last year, which identified several potential risks but added that it did not see significant risks to UK retail consumers arising in the hedge funds sector. However, this did not stop the FSA in November from announcing it was keeping a close eye on 25 hedge funds headquartered in London.

The threat faced by European private equity, if threat is the right word, is not from European hedge funds, who are busy buying up senior debt, PIK loans and notes, second lien and mezzanine, but from US hedge funds. However, in order to do this, hedge funds are going to have to change how they work. Henry Kravis for one thinks that they are ill-equipped to compete with private equity, their short-term nature makes them ill-equipped to run companies. LPs seem to agree. According to Coller Capital’s latest Global Private Equity Barometer, released in January 2006, 61% of institutional investors expect buyout firms to face stiff competition from hedge funds in the coming year. However, three-quarters of LPs believe hedge funds will be unable to compete in the private equity market in the long term. In an increasingly crowded market, European private equity firms will be hoping this is the case.