Hedge fund managers should be open to investments from all different types of investors including sovereign wealth funds or “SWFs.” Sovereign Wealth Funds are government owned investment entitites. Discussion of SWFs is usually with regard to many of the large oil producing countries, but a SWF can be established by any governmental entity including state entities (both Alaska and Texas have funds). Continue reading
Raising capital is the most vital part of the hedge fund start-up process. If the manager cannot raise sufficient capital to cover the cost of starting up and running the fund, the manager will soon be out of business. Because raising capital is difficult, and because hedge fund managers cannot publicly advertise pursuant to the Regulation D offering rules, third party marketers (3PMs) are an oftentimes invaluable service provider.
Third party marketers are firms which are registered as broker-dealers with the SEC and also registered with the securities commission of the firm’s resident state(s). These firms have contacts within the hedge fund industry and work to raise money for the hedge fund. All of the people who raise money for the third party marketing firms are registered as brokers which will generally mean that they have both the Series 7 license (the General Securities Representative Examination) and the Series 63 license (the Uniform Securities Agent State Law Examination).
Third Party Marketing Fees
Third party marketing fees will be different for each 3PM firm. Most all firms will charge a fee for placing assets which will be calculated as a percentage of the hedge fund manager’s fees – both from the management fee and the performance fee or allocation. For example, one fee structure might be that the manager pays the third party marketer 20% of all the management and performance fees earned on the assets raised by the third party marketer. The percentage stated above will be larger (up to 50% or more) for smaller funds because it is easier (and more lucrative to the third party marketer) to raise money for larger funds.
These groups may also require a monthly retainer. These retainer fees will not typically be paid by the hedge fund but by the management company. In certain circumstances, especially when the fund is very small or just starting out, the third party marketing firm may negotiate for an equity stake in the hedge fund manager.
The Third Party Marketing Agreement
The relationship between a hedge fund manager and the third party marketer is solidified through a third party marketing agreement. These arrangements are typically initiated by the third party marketing firm and should be reviewed by the manager and the manager’s attorney before signing. There may be several back and forth iterations of the agreement and the hedge fund lawyer can help a manager with the drafting of certain parts of the agreement based on the business points agreed to with the third party marketer. A hedge fund manager should never enter into a third party marketing agreement without first having an attorney review the agreement.
Other Asset Raising Considerations
All funds are different and the capital needs of each manager will vary according to a number of factors; however, most all managers are interested in adding assets. Start-up and emerging hedge fund managers may also want to discuss their strategy with a hedge fund seeder which is basically like a third party marketer except that the seeder will usually provide a large capital contribution to the hedge fund and potentially will take an equity stake in the management company. Other groups also, such as prime brokers and mini prime brokers, may offer capital introduction services. While such groups will never commit to raising a certain amount, or any, assets for the fund, it would be worthwhile for the hedge fund manager to discuss this point with the fund’s broker. Additionally, a hedge fund manager may want to submit its performance results to a hedge fund database.
It goes without saying, but start-up hedge fund managers should not take your eye off the ball when trying to raise assets – attractive returns over time is the best way for the manager to raise money over the long run.
As hedge fund managers are limited in their ability to advertise their performance results because of the Regulation D rules, one of the ways which managers have found to market their hedge fund and distribute the performance results is through hedge fund databases.
What is a hedge fund database?
Hedge fund databases are websites which collect information and performance results from a hedge fund and then publish the information for the use of their subscribers. Subscribes to hedge fund databases are typically either high net worth investors or institutional investors like hedge fund of funds. Other service providers such as administration firms may be subscribers as well as students/academics. Subscribers will usually go through a vetting process to ensure that they meet the eligibility requirements for investing in hedge funds.
What information is included in a hedge fund database?
Hedge fund databases will include all of the basic identifying information on the hedge fund (name, manager, addresses, phone numbers, etc) as well as the structure of the hedge fund (i.e. domicile, fees, lock-up, withdrawal provisions) and any pertinent investment strategy information. In addition to these items the database will also post the performance results of the hedge fund. Depending on the database, the reports will be more or less comprehensive – that is, some databases will include information on the fund’s underlying positions and other metrics (alpha, beta, VaR, etc) while some databases will only include the fund’s most recent returns. This helps an institutional investor with some of the initial parts of the hedge fund due diligence process.
How does a hedge fund manager submit information to the databases?
Each database requires different information in order to establish listing. In addition to much of the basic factual information on the hedge fund, some databases may request a copy of the offering documents or evidence that the performance returns have been reviewed by a hedge fund auditor. Once a manager has gathered this information and completed any other items required for listing, the database will include the fund’s most recent information and performance. After the listing is initially established, the hedge fund managers will typically need to upload their performance reports on a monthly or quarterly basis. This process can usually be done by an administrative person within the hedge fund management company.
What are the costs?
Generally there are no costs associated with initiating a listing with a hedge fund database. However, many of these databases require investors to pay an initial or periodic fee in order to continue to receive the information within the database. Those databases with the highest fees tend to have the most fund listings and also tend to provide greater searching abilities which provide institutional investors with the metrics used to select potential hedge fund investments.
What are the best databases?
I have not seen any studies on which databases actually place the most assets. Obviously the best database for any individual hedge fund is the database which places the most assets in such fund. With that being said there is no reason why any particular hedge fund should not submit to multiple databases. The only issue with this is the time and costs it takes a hedge fund manager to submit the periodic information to these databases. This would be a cost normally borne by the management company (instead of the hedge fund itself) unless the offering documents specifically allowed for this expense to be incurred at the fund level.
Other related HFLB articles include:
The term “hedge fund” is really a misnomer as most hedge funds are not hedged. A better term would be pooled investment vehicle. Traditional types of pooled investment vehicle structures include hedge funds, private equity funds, venture capital funds, real estate funds, and “hybrid” funds (funds which combine components of the above).
This article is going to discuss other types of non-traditional hedge funds, that is hedge funds which do not fall within the typical types of hedge fund securities trading strategies (long/short equity, multi-strategy, global macro, fixed income, equity market neutral, managed futures, etc). As more people become familiar with hedge funds and become interested in investing in them, managers will begin to create funds to fit specific demographics. The following are interesting projects which can be accomplished through the hedge fund (or pooled investment vehicle) structure:
Green Hedge Funds – in a vein similar to the Vice Fund*, hedge funds can concentrate their investments in any specific hot area. Green companies is currently a hot area and many people are already calling a bubble in “green” companies, at least in the private equity space. According to this article by Richard Wilson, mandates at institutional level to invest in “green” hedge funds are expected to significantly increase in the coming years.
Horse Racing Hedge Funds – there are two ways that a fund like this would work. First, the hedge fund can actually pool investor money and then the manager would place bets on various horses through various betting establishments. With a fund like this the sponsor would need to make sure to disclose the exact nature of the program so that any legal or gambling issues could be vetted before the hedge fund launch. Second, the hedge fund could buy racing horses and then race them for profit. There are already these types of pooled vehicles out there and they are usually have a private equity structure with capital calls.
Gambling or Online Gambling Hedge Funds – with the rise in popularity of Texas Hold-em on television and the proliferation of online gambling there has been discussion of hedge funds devoted to making money from this phenomenon. Basically this would be done through pooling money and then allocating to traders (live or online) who would then play with money. With a fund like this there are many issues, not the least of which is the illegality of gambling in much of the US and online. It is likely that a gambling attorney would need to be brought in to opine on the issue of the legality of such a fund.
Sports Betting Hedge Fund – like the gambling hedge fund, sports betting presents a very attractive opportunity for potential hedge fund managers. A couple of years back Mark Cuban discussed the idea of a sports betting hedge fund on his blog (blog post). While his fund never got off the ground, I have heard of other potential hedge fund sponsors trying to get a fund like this launched. I have not yet heard of a successful fund like this, but I think it is just a matter of time.
Lottery Hedge Fund – about a year and a half ago I had the idea of starting a lottery hedge fund which would pool money to buy a large amount (or all possible number combinations) of number combinations at one of the very large lottery drawings. While it is feasible to create a fund to do this, there are many technical issues which would need to be resolved if a fund like this was to launch.
Charitable Hedge Funds – while not necessarily having a different strategy from traditional hedge funds, these charitable hedge funds would take a portion of their profits and devote them to charitable causes. Presumably the sponsor of a charitable hedge fund would create such a fund for his network of friends and family, all of whom would have similar views on the nature of the charitable donation.
Shariah Compliant Hedge Funds – such funds have become more over the past couple of years and are expected to continue such growth in the future.
Other Issues – in general, establishing a non-traditional hedge fund or pooled investment vehicle will involve the same basic steps as forming a hedge fund (see Start Up Hedge Fund Timeline). The key issue is what type of assets the fund will buy and sell. The nature of the assets will necessarily drive the structure. These are they types of issues you would discuss with your attorney, include whether the manager will need to be registered as an investment advisor. Other articles of interest may include:
* The Vice Fund is a mutal fund which invests in domestic and foreign companies engaged in the aerospace and defense industries, owners and operators, gaming facilities as well as manufacturers of gaming equipment, manufactures of tobacco products and producers of alcoholic beverages. The website can be found here.
The biggest issue for start up hedge funds (and also established hedge fund managers) is how to grow assets under management. Growing a hedge fund’s capital base is very important because increased AUM mean both increased management fees and performance fees (assuming the fund has positive performance returns). This article focuses on traditional avenues of raising capital for a hedge fund.
Raising Hedge Fund Capital – Friends and Family
Most hedge funds raise capital to start up through their friends and families. Often this can be a significant sum, other times it can be relatively small. I have seen some hedge funds start with as little as $500,000 and sometimes less. Often, after a hedge fund has a few months of performance (assuming again positive performance) these friends and family members will invest more money. Other friends and family members, who did not originally invest, may also decided to invest. Family members of investors may also be persuaded to invest in the hedge fund.
Generally investments from friends and family are completed fairly quickly and through less formal conversations than from other types of investors. However, the hedge fund manager must always make sure that the friends and family have the fund’s offering documents and have made the appropriate representations in the subscription documents.
After an initial investment from friends and family, it is important for a start up manager to focus on the trading as it is most important to have a good 6-12 month track record that you will be able to market to other potential investors.
Raising Hedge Fund Capital – High Net Worth Individual Investors
High net worth investors (generally qualified purchasers as well as some qualified clients and accredited investors) often invest in hedge funds. High net worth investors will usually have legal and investing teams which will vet the managers and the strategy. Usually there will at least be a minimum amount of due diligence requests on the manager and the fund. Managers can be introduced to high net worth investors through their own networks or through other channels such as hedge fund conferences, hedge fund databases or through other means.
Raising Hedge Fund Capital – Institutional Investors
Institutional investors will occasionally invest in hedge funds with a track record shorter than one year. Generally in these cases the hedge fund sticks out to them for various reasons. Such reasons might be that the hedge fund performance was just spectacular, or the institutional investor likes the way the particular investment strategy fits within the institution’s allocation design, or the hedge fund manager may have a strong pedigree which appeals to the institutional investor.
Whatever the reason, getting an investment from an institutional investors is usually a longer and more in depth process than receiving money from friends and family or from a high net worth investor. The hedge fund manager will need to first establish a meeting with the institutional investor. Generally the meeting will be at the office of the institution and the manager will have a certain amount of time to give his pitch, usually through a pitchbook presentation. Some managers of the institution will look carefully at these presentations; others will not even open the cover. However, the hedge fund manager should be ready to answer any number of different questions from the institution regarding the program. Such questions will likely cover the following topics: risk management procedures, expected performance in down markets, performance analytics, etc. The hedge fund manager should act composed and answer each question directly and completely – this is the time for the manager to show his knowledge of the investment strategy and sell the strategy to others.
Either before or after the meeting with the institution, the hedge fund manager will likely be asked to complete some basic due diligence. I’ve outlined a sample request in this article: Institutional Hedge Fund Due Diligence. After the institution has interviewed and vetted a manager it may take some time before the institution actually invests in the fund. This happens for a variety of reasons and the hedge fund manager is urged to stay patient during the process.
Non-tradtional forms of raising hedge fund capital
I will be discussing other ways to raise capital in subsequent articles. Such non-traditional ways include: utilizing the services of a third party marketer, capital introduction services, hedge fund conferences, and hedge fund databases.
Legal Implications of Raising Capital for a Hedge Fund
As most hedge fund managers know, under the Regulation D offering rules managers cannot raise capital through any type of general advertising or solicitation. This means that they cannot: buy advertising in any financial publications, advertise generally on the internet (but please see article on Hedge Fund Websites), cold call potential investors and or engage in other similar activities. Additionally, hedge fund managers, and others raising money for hedge funds, must be aware of and abide by all broker-dealer regulations. This is a very important issue, so please discuss it with your hedge fund attorney (please see Guide to Broker-Dealer Registration).
Please contact us if you have a story on raising capital for you hedge fund – we would like to hear your story and potentially profile your fund on our blog. Other articles which are related to items in this article include:
We hear about the “web 2.0” and today’s San Francisco Chronicle used the term “Wall Street 2.0” which made me wonder what the hedge fund industry will look like after this mess clears itself over the next couple of months. First, it is obvious that there is going to be government regulation of some sort over the hedge fund industry which I will be detailing over the coming weeks and months. Additionally, investors are going to need to take proactive steps to protect their investments and hedge fund due diligence will become a greater part of the hedge fund industry – I’m dubbing this “Hedge Fund Due Diligence 2.0”.
Hedge Fund Due Diligence 2.0 is likely to include more questions on the hedge fund manager’s business acumen and operations. The current crisis has showed us, in numerous circumstances, that hedge fund managers were simply not prepared to handle a complete market crisis. Hedge fund managers already have to answer in depth questions relating to risk management policies and procedures, but these questions will likely become more in depth. Specifically, Hedge Fund Due Diligence 2.0 will likely inquire into a manager’s specific cash management policies. While this might be viewed as digging into the manager’s operational business (as opposed to just the managers performance results), it is necessary to protect an investor’s investment in the event that a high watermark provision is implicated.
More to come on this topic …
Earlier this year the SEC approved the formation of an automated filing system for Form D. As noted in this article on Form D, the filing must be made with the SEC 15 days after the first sale of hedge fund interests. While the launch of the new online system was supposed to make it easier for small companies (including hedge funds) to make the filing, in implementation it is a two-step, potentially cumbersome process. In the next few weeks after we make some of these filings, I will be able to rate the new SEC Form D online filing system. The press release below announcing the new system can be found here.
SEC Launches Voluntary Online Filing System for Form D to Reduce Burden on Smaller Companies
Securities and Exchange Commission today began accepting filings of Form D through the Internet as part of the agency’s overall efforts to reduce unnecessary paper filings and regulatory burdens, particularly for smaller companies.
The new rules providing for online filing and simplification of Form D notices were approved by Commission at the end of last year. Form D filings are made mostly by smaller companies, and notify the SEC of sales of securities in private and certain other non-registered offerings of securities. Many states also require Form D notice filings.
“With electronic filing, the information available in Form D filings will now be far more accessible to all users,” said John White, Director of the Division of Corporation Finance. “We look forward to hearing from voluntary filers over the next six months about their experiences as we prepare to move to the mandatory system next spring.”
The SEC’s new Form D online filing system features simplified and updated information requirements and is voluntary until March 16, 2009. Companies and funds required to file Form D notices may continue to file them on paper until that date, following either the old or new information requirements. Guidance on the Form D filing process with the new system as well as more information about filing and amending a Form D notice are available on the SEC Web site.
Form D filers are encouraged to use the voluntary system and inform SEC staff about their experiences. The SEC staff expects adjustments will be made to the system to increase its utility and user-friendliness before the online filing of Form D becomes mandatory. Filers can report their experiences to the SEC’s Office of Small Business Policy in its Division of Corporation Finance at (202) 551-3460 or [email protected].
The SEC staff is continuing to work with the North American Securities Administrators Association (NASAA) to link its Form D filing system with a system built by state securities regulators that would accept state Form D filings. No timetable has been adopted for linking the two systems. (Press Rel. 2008-199)
Performance results are the ribbons of the hedge fund industry. In order to raise institutional money for your hedge fund, you will need good performance results. Even hedge fund managers who will not be focusing on raising money from institutional investors will need to have performance results in order to market the hedge fund. Performance results are usually displayed in a hedge fund pitchbook format, a tearsheet format and/or with monthly or quarterly performance reports to investors. Whenever performance results are included, the manager must make sure that the proper performance disclosures accompany the results. As a routine matter, all hedge fund performance results and advertisements should be reviewed by a hedge fund attorney.
SEC Guidance – Clover Capital No-Action Letter
The SEC has authority under the anti-fraud provisions of the investment adviser’s act (which apply to both registered and unregistered hedge fund managers) to police the performance results of hedge fund managers. [HFLB note: please see “Basis of SEC authority” below for explanation.] Under this authority, the SEC has provided some guidance on this subject through the Clover Capital no-action letter. Clover Capital is not famous because of the position of the staff with regard to a certain party, but because the staff went further and provided guidelines for all managers in how performance results should be disclaimed.
The Clover Capital letter is notable for a few reasons including that (i) it provides guidance on both model results (sometimes referred to as “backtested”) and actual results and (ii) it requires that performance results be present “net of fees.” While some aspects of the Clover Capital requirements have been softened in certain specific fact circumstances, through subsequent no-action letters, Clover Capital remains the central source of guidance for performance reporting requirements. These requirements (with footnotes omitted) are broken down below.
Model and Actual Results
With regard to model and actual results, the staff believes that a hedge fund manager is prohibited from publishing an advertisement that:
Actual Results
Additionally, with regard to actual results, the staff believes that a hedge fund manager is prohibited from publishing an advertisement that fails to disclose prominently, if applicable, that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material.
Closing
The SEC staff closed the Clover Capital letter with the following statement that should be given great weight by all hedge fund managers:
We wish to emphasize that: (1) it is the responsibility of every adviser using model or actual results to ensure that the advertisement is not false or misleading; (2) the list set forth above of advertising practices the staff believes are prohibited by Rule 206(4)-1(a)(5) is not intended to be all-inclusive or to provide a safe harbor; and (3) the staff, as a matter of policy, will not review specific advertisements.
Clover Capital – Basis for SEC authority
The following comes from the Clover Capital no-action letter and states the SEC staff’s basis for their authority to produce guidance on performance advertising requirements.
Section 206 of the Act prohibits certain transactions by any investment adviser, whether registered or exempt from registration pursuant to Section 203(b) of the Act. Under paragraph (4) of Section 206, the Commission has authority to adopt rules defining acts, practices, and courses of business that are fraudulent, deceptive, or manipulative. Pursuant to this authority, the Commission adopted Rule 206(4)-1, which defines the use of certain specific types of advertisements by advisers as fraudulent, deceptive, or manipulative.* Although the rule does not specifically prohibit an adviser from using model or actual results, or prescribe the manner of advertising these results, paragraph (5) of the rule makes it a fraudulent, deceptive, or manipulative act for any investment adviser to distribute, directly or indirectly, any advertisement that contains any untrue statement of a material fact or that is otherwise false or misleading.** Accordingly, the applicable legal standard governing the advertising of model or actual results is that contained in paragraph (5) of the rule, i.e., whether the particular advertisement is false or misleading.***
* For example, Rule 206(4)-1 prohibits an adviser from using advertisements that include testimonials (paragraph (a)) or that refer to past specific recommendations unless certain information is provided (paragraph (b)). The staff is currently reviewing Rule 206(4)-1 to determine whether it needs to be revised or updated. See Investment Advisers Act Rel. No. 1033 (Aug. 6, 1986).
** As a general matter, whether any advertisement is false or misleading will depend on the particular facts and circumstances surrounding its use, including (1) the form as well as the content of the advertisement, (2) the implications or inferences arising out of the advertisement in its total context, and (3) the sophistication of the prospective client. See, e.g., Covato/ Lipsitz, Inc. (pub. avail. Oct. 23, 1981)(“Covato”); Edward F. O’Keefe (pub. avail. Apr. 13, 1978)(“O’Keefe”); Anametrics Investment Management (pub. avail. May 5, 1977)(“Anametrics”).
*** Of course, if an advertisement containing model or actual results also includes any of the specific advertising practices addressed by paragraphs (a)(1)-(a)(4) of the Rule 206(4)-1, the advertisement would have to comply with the requirements of these paragraphs.
If you have any questions on this article or would like to discuss your hedge fund performance results, please contact us.
A common question from start-up hedge fund managers is what kind of a website can I have and how do I go about getting investors through an internet solicitation? The unfortunate answer is that hedge fund managers must be very careful when they are designing their website. In general, websites for a hedge fund or a hedge fund manager need to be very low key and potentially password protected. This is especially important in the current regulatory enviornment because securities officials, at both the federal and state level, are becoming more and more vigilant about enforcing the website solicitation rules. This article will briefly detail the legal background and some website best practices.
Regulation D – no “public offering”
Most hedge funds are offered to investors through a Regulation D private placement offering. One of the requirements of the Reg. D offering is that the sale of securities (interests in the hedge fund) is not done through a “public offering.” While there is no exact definition of “public offering,” it will generally mean that the hedge fund is not allowed to offer or sell interests through general solicitation or general advertising. According to the SEC, the analysis can be broken down into two main questions: (i) is a communication a general solicitation or advertisement, and, if so, (ii) is it being used to offer or sell securities? If the answer to either of these questions is negative, the fund is not in violation of public offering rules.
Regulation D – the “pre-existing” relationship
If a private placement is offered to potential investors with whom the hedge fund manager has no pre-existing relationship, the SEC may conclude that there was a general solicitation in violation of the Reg D rules.
Frequently, an issuer can satisfy the pre-existing relationship requirement through prior investment or other business dealings with the potential purchaser. The pre-existing relationship generally involves at least some degree of contact between the issuer and the prospective purchaser prior to the offering – generally 30 days from a “first contact.”
[HFLB note: there are a couple of very important no-action letters on this subject. I will be posting these in the next couple of days.]
Website Best Practices
We will generally recommend that all web presence be minimized. The two most important principles with regard to web presence and web communications are (1) do not name the hedge fund and (2) do not personally, or by fiat, write that you manage a hedge fund. Besides those two overriding items, we recommend that the web presence is minimal at all times. However, we are aware that from a business standpoint, the manager would like to have a web presence.
There are five important parts to a hedge fund website:
The Splash Page
The hedge fund manager should have an initial “splash page” which might include the name of the management company (do not say you are an “investment advisor” unless registered as such in your state of residence or with the SEC). The splash page should include very minimal information.
Note: you should not include your phone number or contact information on this splash page.
Registration Page
This page should have questions to determine if a viewer is qualified to be viewing the fund’s information over the internet. Generally this will include the accredited investor qualifications; it may also mean that the qualified client qualifications are also included.
Login Page (may be on the splash page)
This page will be for viewers who are either currently invested in your fund or who have met the qualifications of registration.
Password protected content
All identifying information of the fund and management company should be password protected. You should never post the fund’s offering documents on the internet unless there are stringent controls in place to make sure that the offering documents can only be viewed by the one investor they are intended for – even if there are these stringent controls, we would normally recommend against this practice.
General disclaimer
The site should have a general disclaimer which should be prepared by an attorney. Additionally, all performance information within the password protected portion of your website should have all appropriate disclaimers.
Note: it is recommended that once you have an almost final draft of the website, you should have your lawyer review before it goes live.
Legal Developments and Conclusion
The regulators are very sensitve about website solicitations. For example,the State of Massachusetts is trying to fine activist hedge fund manager Phillip Goldstein, of Bulldog Investors, because of how he designed his fund’s website. The famed investment adviser is under prosecution by Massachusetts for allowing potential investors unrestricted access to Bulldog’s website. [HFLB to insert the complaint.]
Because of this and other activity it is extremely important that you have your hedge fund attorney discuss the website rules with you. Please contact us if you have further questions or if you would like help launching your hedge fund website.
On Wednesday the U.S. Government Accountability Office (“GAO”) released a report examining investments by defined benefit pension plans into hedge funds. The report is titled: Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity. To produce the report, the GAO talked with hedge fund instry associations, government administrative entities and both private and public pension funds. Some of the private pensions interviewed include: American Airlines, Boeing, Exxon Mobil, John Deere, Macy’s and Target. Some of the public pensions included: CalPERS, New York State Common Retirement Fund and the Washington State Investment Board.
I had a chance to read through the 65 page report and found it to be very well written and researched. The report also accurately and succinctly summarizes the applicable laws and regulations which apply to pensions investing in hedge fund and private equity funds. Overall I think that the report contains a good deal of very useful information. For start up hedge fund managers looking to eventually raise money from institutional investors, the report should be required reading. Some of the more salient points raised in the report include:
Below I have produced (what I view are) the most useful or intersting parts of the report. The headings and the emphasis in the text below, along with all information in brackets, are my own. Any footnotes have been omitted. The entire report can be found here.
Background and purpose of the report
Millions of retired Americans rely on defined benefit pension plans for their financial well-being. Recent reports have noted that some plans are investing in ‘alternative’ investments such as hedge funds and private equity funds. This has raised concerns, given that these two types of investments have qualified for exemptions from federal regulations, and could present more risk to retirement assets than traditional investments.
To better understand this trend and its implications, GAO was asked to examine (1) the extent to which plans invest in hedge funds and private equity; (2) the potential benefits and challenges of hedge fund investments; (3) the potential benefits and challenges of private equity investments; and (4) what mechanisms regulate and monitor pension plan investments in hedge funds and private equity.
GAO recommends that the Secretary of Labor provide guidance on investing in hedge funds and private equity that describes steps plans should take to address the challenges and risks of these investments. Labor generally agreed with our findings and recommendation.
Hedge fund definition
While there is no statutory definition of hedge funds, the phrase “hedge fund” is commonly used to refer to a pooled investment vehicle that is privately organized and administered by professional managers, and that often engages in active trading of various types of securities and commodity futures and options contracts. Similarly, private equity funds are not statutorily defined, but are generally considered privately managed investment pools administered by professional managers, who typically make long-term investments in private companies, taking a controlling interest with the aim of increasing the value of these companies through such strategies as improved operations or developing new products. Both hedge funds and private equity funds may be managed so as to be exempt from certain aspects of federal securities law and regulation that apply to other investment pools such as mutual funds.
Description of pension plan investment into hedge funds
Pension plans invest in hedge funds to obtain various benefits, but some characteristics of hedge funds also pose challenges that demand greater expertise and effort than more traditional investments, which some plans may not be able to fully address. Pension plans told us that they invest in hedge funds in order to achieve one or more of several goals, including steadier, less volatile returns, obtaining returns greater than those expected in the stock market, or diversification of portfolio investments. Pension plan officials we spoke with about hedge fund investments all said these investments had generally met or exceeded expectations. However, at the time of our contact in 2007, several plan officials noted that their hedge fund investments had not yet been tested under stressful economic conditions, such as a significant stock market decline. Further, some indicated mixed experiences with hedge fund investments. At the time of our discussions, however, officials of each plan interviewed indicated that they expected to maintain or increase the share of assets invested in hedge funds.
Nonetheless, hedge fund investments pose investment challenges beyond those posed by traditional investments in stocks and bonds. These additional challenges include: (1) the inherent risks of relying on the skill and techniques of the hedge fund manager; (2) limited information on a hedge fund’s underlying assets and valuation (limited transparency); (3) contract provisions which limit an investor’s ability to redeem an investment in a hedge fund for a defined period of time (limited liquidity); and 4) the possibility that a hedge fund’s active or risky trading activity will result in losses due to operational failure such as trading errors or outright fraud (operational risk). Although there are challenges of hedge fund investing, plan officials and others described steps to address these and other challenges. For example, plan officials and others told us that it is important to negotiate key investment terms and conduct a thorough “due diligence” review of prospective hedge funds, including review of a hedge fund’s operational structure. Further, pension plans can invest in funds of hedge funds, which charge additional fees but provide diversification and the additional skill of the fund of funds manager. According to plan officials and others, some of these steps require considerably greater effort and expertise from fiduciaries than is required for more traditional investments, and such steps may be beyond the capabilities of some pension plans, particularly smaller ones.
ERISA considerations
Under the Employee Retirement and Income Security Act (ERISA), plan fiduciaries are expected to meet general standards of prudent investing and no specific restrictions on investments in hedge funds or private equity have been established. Labor [the DOL] is tasked with helping to ensure plan sponsors meet their fiduciary duties; however, it does not currently provide any guidance specific to pension plan investments in hedge funds or private equity. Conversely, some states do specifically regulate and monitor public sector pension investment in hedge funds and private equity, but these approaches vary from state to state. While states generally have adopted a “prudent man” standard similar to that in ERISA, some states also explicitly restrict or prohibit pension plan investment in hedge funds or private equity. For instance, in Massachusetts, the agency overseeing public plans will not permit plans with less than $250 million in total assets to invest directly in hedge funds. Some states have detailed lists of authorized investments that exclude hedge funds and/or private equity. Other states may limit investment in certain investment vehicles or trading strategies employed by hedge fund or private equity fund managers. While some guidance exists for hedge fund investors, specific guidance aimed at pension plans could serve as an additional tool for plan fiduciaries when assessing whether and to what degree hedge funds would be a prudent investment.
… all [the pension plans] said that their hedge fund investments had generally met or exceeded expectations, although some noted mixed experiences. For example, one plan explained that it had dropped some hedge fund investments because they had not performed at or above the S&P 500 benchmark. Also, this plan redeemed its investment from other funds because they began to deviate from their initial trading strategy.
Challenges and risks of hedge fund investments
While any plan investment may fail to deliver expected returns over time, hedge fund investments pose investment challenges beyond those posed by traditional investments. These include (1) reliance on the skill of hedge fund managers, who often have broad latitude to engage in complex investment techniques that can involve various financial instruments in various financial markets; (2) use of leverage, which amplifies both potential gains and losses; and (3) higher fees, which require a plan to earn a higher gross return to achieve a higher net return.
Hedge Fund Fees
Several pension plans cited the costly fee structure fees as a major drawback to hedge fund investing. For example, representatives of one plan that had not invested in hedge funds said that they are focused on minimizing transaction costs of their investment program, and the hedge fund fee structure would likely not be worth the expense. On the other hand, an official of another plan noted that, as long as hedge funds add value net of fees, they found the higher fees acceptable.
Operational Risk
Pension plans investing in hedge funds are also exposed to operational risk—that is, the risk of investment loss due not to a faulty investment strategy, but from inadequate or failed internal processes, people, and systems, or problems with external service providers. Operational problems can arise from a number of sources, including inexperienced operations personnel, inadequate internal controls, lack of compliance standards and enforcement, errors in analyzing, trading, or recording positions, or outright fraud. According to a report by an investment consulting firm, because many hedge funds engage in active, complex, and sometimes heavily leveraged trading, a failure of operational functions such as processing or clearing one or more trades may have grave consequences for the overall position of the hedge fund. Concerns about some operational issues were noted by SEC in a 2003 report on the implications of the growth of hedge funds. For example, the 2003 report noted that SEC had instituted a significant and growing number of enforcement actions involving hedge fund fraud in the preceding 5 years. Further, SEC noted that while some hedge funds had adopted sound internal controls and compliance practices, in many other cases, controls may be very informal, and may not be adequate for the amount of assets under management. Similarly, a recent Bank of New York paper noted that the type and quality of operational environments can vary widely among hedge funds, and investors cannot simply assume that a hedge fund has an operational infrastructure sufficient to protect shareholder assets.
Several pension plans we contacted also expressed concerns about operational risk. For example, one plan official noted that the consequences of operational failure are larger in hedge fund investing than in conventional investing. For example, the official said a failed long trade in conventional investing has relatively limited consequences, but a failed trade that is leveraged five times is much more consequential. Representatives of another plan noted that back office and operational issues became deal breakers in some cases. For example, they said one fund of funds looked like a very good investment, but concerns were raised during the due diligence process. These officials noted, for example, the importance of a clear separation of the investment functions and the operations and compliance functions of the fund. One official added that some hedge funds and funds of funds are focused on investment ideas at the expense of important operations components of the fund.
Importance of hedge fund due diligence
Pension plans take steps to mitigate the challenges of hedge fund investing through an in-depth due diligence and ongoing monitoring process. While plans conduct due diligence reviews of other investments as well, such reviews are especially important when making hedge fund investments, because of hedge funds’ complex investment strategies, the often small size of hedge funds, and their more lightly regulated nature, among other reasons. Due diligence can be a wide-ranging process that includes a review and study of the hedge fund’s investment process, valuation, and risk management. The due diligence process can also include a review of back office operations, including a review of key staff roles and responsibilities, the background of operations staff, the adequacy of computer and telecommunications systems, and a review of compliance policies and procedures.
Smaller pension plans are not as active hedge fund investors
Available data indicate that pension plans have increasingly invested in hedge funds and have continued to invest in private equity to complement their traditional investments in stocks and bonds. Further, these data indicate that individual plans’ hedge fund or private equity investments typically comprise a small share of total plan assets. However, data are generally not available on the extent to which smaller pension plans have made such investments. Because such investments require a degree of fiduciary effort well beyond that required by more traditional investments, this can be a difficult challenge for plans, especially smaller plans. Smaller plans may not have the expertise or financial resources to be fully aware of these challenges, or have the ability to address them through negotiations, due diligence, and monitoring. In light of this, such investments may not be appropriate for some pension plans.
Conclusions
The importance of educating investors [pension plans] about the special challenges presented by hedge funds has been recognized by a number of organizations. For example, in 2006, the ERISA Advisory Council recommended that Labor publish guidance about the unique features of hedge funds and matters for consideration in their use by qualified plans. To date, EBSA [Employee Benefits Security Administration] has not acted on this recommendation. More recently, in April 2008, the Investors’ Committee formed by the President’s Working Group on Financial Markets published draft best practices for investors in hedge funds. This guidance will be applicable to a broad range of investors, such as public and private pension plans, endowments, foundations, and wealthy individuals. EBSA can further enhance the usefulness of this document by ensuring that the guidance is interpreted in
Available data indicate that pension plans have increasingly invested in hedge funds and have continued to invest in private equity to complement their traditional investments in stocks and bonds. Further, these data indicate that individual plans’ hedge fund or private equity investments typically comprise a small share of total plan assets. However, data are generally not available on the extent to which smaller pension plans have made such investments. Because such investments require a degree of fiduciary effort well beyond that required by more traditional investments, this can be a difficult challenge for plans, especially smaller plans. Smaller plans may not have the expertise or financial resources to be fully aware of these challenges, or have the ability to address them through negotiations, due diligence, and monitoring. In light of this, such investments may not be appropriate for some pension plans.
GAO Recommendation
To ensure that all plan fiduciaries can better assess their ability to invest in hedge funds and private equity, and to ensure that those that choose to make such investments are better prepared to meet these challenges, we recommend that the Secretary of Labor provide guidance specifically designed for qualified plans under ERISA. This guidance should include such things as (1) an outline of the unique challenges of investing in hedge funds and private equity; (2) a description of steps that plans should take to address these challenges and help meet ERISA requirements; and (3) an explanation of the implications of these challenges and steps for smaller plans. In doing so, the Secretary may be able to draw extensively from existing sources, such as the finalized best practices document that will be published in 2008 by the Investors’ Committee formed by the President’s Working Group on Financial Markets.
DOL Response to GAO Recommendation
With regard to our recommendation, Labor stated that providing more specific guidance on investments in hedge funds and private equity may present challenges. Specifically, Labor noted that given the lack of uniformity among hedge funds, private equity funds, and their underlying investments, it may prove difficult to develop comprehensive and useful guidance for plan fiduciaries. Nonetheless, Labor agreed to consider the feasibility of developing such guidance.
GAO’s Response to the DOL’s Response
Indeed, the lack of uniformity among hedge funds and private equity funds is itself an important issue to convey to fiduciaries, and highlights the need for an extensive due diligence process preceding any investment.