New regulatory requirements under the Dodd-Frank Act and the attendant infrastructure build-out are forcing emerging hedge fund managers to decide at the outset whether to attract institutional investors or remain exempt from SEC registration by committing to manage less than $150 million during their first few years.
Under the new rules, managers have to commit to building out their infrastructure to support an SEC-registered fund if they want to attract institutional capital, according to Ellen Schubert (left), chief advisor to Deloitte’s hedge fund practice. “This requires the manager to commit to a specific strategy as well as a major financial outlay before the first trade.”
In the past, fledgling hedge fund managers had the flexibility to move fairly quickly from managing the money of their friends and family to institutional capital as soon as the time was right—generally, a three-year track record and a certain level of assets under management.
Someone could hang out a shingle and call himself a hedge fund, Schubert said in an interview with AdvisorOne. “That’s no longer the case. It’s difficult anyway to get money these days as a startup because institutional investors are very wary of somebody without a track record, someone who isn’t registered and whose pedigree is unclear. And in any case, Madoff changed the whole industry.”
The increasing barriers to entry have dramatically altered the dynamic for hedge fund startups, Schubert said. “You need to have seed capital, and the seeders are in the driver’s seat right now. They can attract new portfolio managers to their platforms much more easily than they have in the past because they can afford to set them up with an infrastructure that is compliant out of the gate. But that means they get more ownership of the fund.”
The SFO Carve-Out
Schubert, who advises hedge fund clients on operations, product structuring and regulation issues,sees a potential trend among startup managers resulting from the new regulations. “Since single family offices (SFOs) are not subject to the same regulations as hedge funds, managers may decide to forgo institutional capital altogether and stay the course with ‘friends and family’ money rather than commit to a infrastructure strategy before their investment strategy is proven.”
Under Dodd-Frank, SFOs (and venture capital firms) are exempt from registration as investment advisors—even if they are managing more than $150 million—if they meet three conditions for which the SEC has proposed rules: that they adhere to a specific definition of who are family members; that they not hold themselves out to the public as investment advisors; and that they manage the assets only of family members and certain key employees and directors of the firm.
“I’m thinking there may be an opportunity for portfolio managers to establish themselves as SFOs, manage their own money and that of key employees or directors of their SFO,” Schubert said. “Key employees or directors can be high-net-worth individuals who give them money to manage and are listed as a directors without having any controlling interest in the company. From my reading of it so far, [regulators] haven’t defined a number of key employees or directors, they haven’t explicitly said there has to be any job qualification or job description for those director of key employees.”
Going this route would give the emerging hedge fund manager the same leeway a traditional startup had in terms of trying out a strategy and developing a track record, she said. “And if you have more than $150 million and haven’t had to register yet, hopefully over the three-year period, you have developed a compliance framework such that you’re already prepared to take institutional money.”
Schubert has not yet seen any startup hedge funds establish themselves as SFOs, but these are early days. She does wonder whether some large institutional managers may also find the SFO scenario an attractive alternative—an unintended consequence of the new regulatory environment. These managers would effectively reverse course, giving back institutional money and managing only their employees’ and their own family money. Deregistration would follow because “there’s no reason to be registered if you’re managing only your own money.”
Although the new regulations have tamped down the enthusiasm of young portfolio managers to set up their own hedge funds, Schubert does not think the changes are bad for the industry overall. “There are pluses and minuses in this equation. One of the positive things that will come out of registration is that the institutional community will feel more comfortable investing a higher percentage of their portfolios into the alternative space once they have a regulator saying that we’ve looked at these funds and these funds are okay to invest in.
“It could be the next phase of growth for the hedge fund industry comes as a result of regulation.”