Managers Mull Alternatives to Private Funds
Three months after SEC registration became mandatory for most hedge fund managers, industry lawyers say they see a silver lining to the Dodd-Frank edict.
Until now, the majority of fund operators had no choice but to structure their vehicles as private funds, which can be offered only to a limited number of wealthy individuals and institutions. To launch a so-called registered investment company such as a mutual fund — which can be marketed to anyone — a manager has to be an SEC-registered investment advisor.
Under Dodd-Frank, any fund operator with more than $150 million of U.S. regulatory assets, including leverage, had to register as an investment advisor by March 30. In other words, most managers of private funds are now in a position to consider other fund structures — and there's evidence that an increasing number are doing just that.
"There are obviously managers out there, including large managers, who weren't SEC-registered a year ago," said Kenneth Gerstein, a Schulte Roth lawyer who specializes in registered funds. "The fact that they had to register took them one step closer to being in a position to sponsor and manage a registered fund. However, it's a big bridge to cross. It's changing the nature of your business, and a manager needs to consider all of the regulatory, business and operations implications, as well as the potential benefits."
Some blue-chip fund operators, including AQR Capital and Blackstone, had already recognized the potential of registered funds to attract a broader mix of clients — including smaller investors who can't meet the higher minimum-investment requirements of hedge funds, as well as institutions that feel more comfortable with mutual funds. Both of those firms added registered vehicles to their offerings in the wake of the financial crisis. They could do that because both were registered investment advisors before it became mandatory under the Dodd-Frank Act of 2010.
Industry lawyers now expect an increasing number of smaller hedge fund firms will consider offering versions of their strategies through vehicles registered under the Investment Company Act of 1940. So-called '40 Act funds can accept unlimited numbers of investors, and those that pursue public share offerings, including mutual funds, can be sold through retail brokerages.
The flip side, of course, is that registered vehicles — especially mutual funds — face stricter regulatory oversight than private funds, including limits on everything from the use of leverage to charging performance fees (see table on Page 5). They are typically more expensive to manage than private funds and less profitable. But at a time when most managers are struggling to attract traditional hedge fund investors, registering a vehicle could open doors to fresh sources of capital.
"Everyone thinks launching a '40 Act fund is so cost-prohibitive," said Aisha Hunter, a partner at Cole-Frieman Mallon. "But hedge funds are so regulated now, I think it's less onerous to launch a mutual fund, depending on the circumstances. It's a pretty complex Chinese menu, but managers have two main questions to answer: How liquid is your investment strategy? And how often do you want to provide liquidity? Those two questions drive whether you look at registering the fund under the '40 Act as a closed-end fund or an open-end mutual fund."
Traditionally, hedge fund operators set up their vehicles under exemptions in the '40 Act that allow funds to avoid registration if they're limited to a relatively few large investors. Under one private-fund exemption, Section 3(c)1, a vehicle can admit no more than 100 "accredited" investors, which for individuals is defined as having a net worth of at least $1 million. A separate exemption, Section 3(c)7, permits funds to accept up to 2,000 "qualified purchases," which for an individual means having an investment portfolio of at least $5 million. Funds can exceed that limit if they're willing to file financial statements with the SEC, but most aren't.
Some or all of these constraints disappear when a fund is set up as a registered investment company, commonly called an RIC. That's the main reason firms including AllianceBernstein, Arden Asset Management, BlackRock, Legg Mason and Northern Trust plan to launch registered funds of funds. All of those managers contemplate vehicles that would offer shares privately, and therefore could only be marketed to accredited or qualified clients.
Other alternative-investment managers have gone even further and structured vehicles as mutual funds, which make public offerings that can be widely marketed. The most recent example: Russell Investments is crafting a fund of hedge funds called Russell Multi-Strategy Alternative Fund in the form of a mutual fund. It is expected to launch in August with more than $500 million.
Many managers will continue to steer clear of '40 Act funds for fear that it may harm their credibility among sophisticated investors or, worse, dilute the value of their existing vehicles. After all, why would investors in a hedge fund continue to pay incentive fees when they could get similar performance through a registered vehicle run by the same manager?
Strictly speaking, mutual funds and other registered vehicles aren't barred from charging performance fees. There are provisions allowing them to charge a so-called "fulcrum fee" that's tied to performance. In practice, however, registered funds rarely take a cut of investors' profits — another reason the structure won't appeal to everyone.
"I think it's very difficult for a hedge fund manager who currently earns 2 and 20 and provides quarterly liquidity to take a 70% pay cut and earn 1% with no carry and provide daily liquidity," said Bradley Alford, chief investment officer at wealth-management shop Alpha Capital.