From the October 2006 issue of Investment Advisor • Subscribe!

A Boon For Hedge Funds?

Pension Act makes it easier for pension funds to invest in hedge funds

More On Legal & Compliance

from The Advisor's Professional Library
  • The Custody Rule and its Ramifications When an RIA takes custody of a client’s funds or securities, risk to that individual increases dramatically. Rule 206(4)-2 under the Investment Advisers Act (better known as the Custody Rule), was passed to protect clients from unscrupulous investors.
  • Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIA’s failure to stay within the scope of the Section 28(e) safe harbor may violate the advisor’s fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients’ transactions.

Hailed as the most sweeping overhaul of the pension system in decades, the Pension Protection Act of 2006 is touching all facets of the financial services community--including hedge funds. The Act modifies the Department of Labor's (DOL) plan asset regulation by allowing hedge fund advisors to accept more money from pension programs.

In essence, what the pension law does is enable hedge fund advisors to pull in more pension fund money "in terms of the percentage of the [hedge fund's assets] before tripping DOL rules," explains Michael Tannenbaum, a partner at New York law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP. Once a fund has more than 25% of its money in pension plan assets, it becomes subject to DOL rules. However, under the new pension law, when a hedge fund computes the 25%, it would be required to include those plans that are subject to ERISA, individual retirement accounts, and Keogh plans, but the fund "no longer has to consider government or non-U.S. pension plans," he explains. As a result, "it will take a longer time to get up to that 25% [threshold], which is favorable."

Tannenbaum believes that the Act's modification to the plan asset rule is just another sign of the trend toward more hedge funds seeking pension investor assets. More and more hedge fund advisors are voluntarily registering with the SEC so they become more attractive to pension funds. "Pension trustees are fiduciaries and they have certain responsibilities, one of which is to be prudent in selecting managers," Tannenbaum says. "So you'd want to choose a manager that's registered with the SEC."

On the issue of registration, in response to the D.C. Circuit Court of Appeals' decision in Goldstein v. SEC, which struck down the SEC's hedge fund manager registration rule, the SEC decided not to challenge the ruling and instead issued a no-action letter in August announcing that hedge fund advisors may withdraw their registrations if they do so by February 1, 2007. As of mid-September, 84 hedge fund advisors had de-registered, according to an SEC spokesman.

In testimony before the DOL Advisory Council in August, John Gaine, president of the Managed Funds Association, said that while the plan asset rules within the pension Act are "a good first step" to encouraging more pension funds to invest in hedge funds, he believes the plan asset rules should be modified further in order to "enhance the investment opportunities available to plans," and to eliminate confusion in some areas. The current lack of guidance, he said, "Causes hedge fund managers to incur unnecessary compliance costs, which are ultimately passed on to all investors in a fund." Gaine said there are currently more than 8,000 hedge funds with $1.2 trillion in assets under management.

For instance, Gaine said hedge funds need clarity regarding how the plan asset rules apply to them, which would help "minimize the administrative burdens and expenses that hedge funds face when they choose to accept ERISA investors." Gaine also said that changes that would treat hedge funds like venture capital funds and real estate funds--which are generally not subject to ERISA-- and "would provide ERISA plans greater flexibility with respect to their investment options."

Mainstreaming = Regulation

While the plan asset rules within the Act are a definite loosening of the pension rules as they apply to hedge funds, John Rekenthaler, VP of research at Morningstar, says that the fact that hedge funds are seeking more money from public, private, and government pension funds is a sign that hedge funds are going more "mainstream." This is precisely why regulators are zeroing in on hedge funds, he says, warning that further regulatory changes reining in the industry may be inevitable. "Where there is a loosening [of regulation] there will also be a tightening," he says.

The new plan asset rules are mainly good news for large single funds as well as funds of funds--not the mid-sized single funds that Morningstar interacts with, Rekenthaler notes. Indeed, Gaine said in his testimony that while pension plans may invest directly with a hedge fund, most plans gain access through a fund of funds arrangement because it gives the plans "a chance to learn about hedge fund before investing in them directly, access to individual hedge funds that are closed to the broader community, and a tailored investment strategy."

Gaine noted in his testimony that as it stands now, investors in hedge funds are mainly public pension plans, university endowments, or other large institutions, and wealthy individuals. However, some large pension funds, including those of General Electric, General Motors, and Verizon, include hedge funds in their portfolios, he said. Defined benefit pension plans, too, have become increasingly interested in hedge funds, he said, "due to the diversity of the investment styles available to help such plans meet their benefit obligations." But statistics show that only about $71 billion in pension fund assets (both corporate and public) were invested directly in hedge funds as of January 2005, he pointed out, compared to the more than $1.8 trillion held by corporate defined benefit pension plans at the end of 2004.

Corporate and public pension plans are expected to invest even more capital in hedge funds in the future, Gaine predicted. Corporate defined benefit pension plans' interest in hedge funds peaked when the equity markets took a nosedive from 2000 to 2002, he said. During that time, institutions like endowments, which had significant hedge fund exposure, experienced the best risk-adjusted returns, he noted, while many pension funds that were invested in traditional stocks and bonds didn't do as well.

Tannenbaum also notes some other pension-related modifications included in the Act.

The Act would provide an exemption from ERISA's prohibited transaction requirements for block trades of at least 10,000 shares or $200,000, he notes. "This exemption would not be available in respect of any ERISA plan more than 10% of the block trade," he explains in his GlobalNote newsletter. For example, "an ERISA plan having more than 10% interest in a plan asset fund involved in a block trade," he says. The Act would also generally exempt cross-trades if several criteria are met, Tannenbaum says, "including a requirement that plans have $100 million in assets and that no brokerage commission or fee (other than previously disclosed transfer fees) be paid by either party to the transaction."

In addition, Tannenbaum says the Act would "exempt from ERISA's prohibited tranactions rules most transactions between an ERISA plan and an entity that is a 'party in interest' to the plan solely by reason of providing services to the plan."

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

Help From the Government, Really, for Small Businesses

As small businesses, independent advisors know that compliance can be one of their most time-consuming chores. But more help on complying with the Feds is on the way this month, as the Small Business Administration (SBA) relaunches its Business.gov Web site. The new site heeds small business owners' call for assistance by searching for compliance news and information, providing federal forms from close to 100 government Web sites, and compiling government contact information from all branches of the federal government--from the Department of Labor to the Environmental Protection Agency.

Such help is good news, since according to the U.S. Small Business Administration's Office of Advocacy, the average small business owner spends $7,647 per employee to stay compliant with government regulations--which is 45% more per employee than larger firms. (A Securities Industry Association report earlier this year estimated that the securities industry as a whole spent $25 billion on compliance in 2005, up from $13 billion in 2003; see www.sia.com/research for the report.) Small businesses make up more than 99.7% of all U.S. employers, SBA says, and create more than 65% of America's net new jobs.

The Business.gov site was originally launched in 2004, and contains information on starting, managing, growing, and exiting a business. However, since the SBA received an overwhelming number of requests from small businesses for compliance help, it decided to add compliance information. Business.gov is a great resource for any small business owner, as it provides advice and information on a range of topics including business laws, the best procedures to use when hiring or firing employees, how to find the right employees, taxes, international trade, and finances. It also contains keyword, industry, and topic-specific compliance searches, and includes all federal forms from Forms.gov.

Also available is research on business statistics, employment data, and market research.

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