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February 17, 2005 at 07:00 PM
Traditionally, hedge fund advisers have been accustomed to investing pursuant to vaguely drafted investment guidelines that permit a wide range of possible investment options. A typical hedge fund private placement memorandum might include language stating:
To accomplish this objective, the Fund will employ its research-driven investment process, balance longs and shorts in the portfolio based on market conditions, use options to hedge risk and produce income, and selectively invest in corporate debt securities when the risk/reward is better than that of the underlying equity. The Fund does not have fixed guidelines for diversification and may concentrate investments in specific industries or companies.
Many hedge fund advisers have interpreted broadly their obligation to to follow these investment guidelines. As one hedge fund manager put it, “I can even bet assets on whether the Knicks are going to win on any given night.” As of Feb. 1, 2006, however, many advisers will register for the first time as investment advisers under the Investment Advisers Act of 1940 and, as a consequence, will become subject to routine but comprehensive Securities and Exchange Commission inspections. During these inspections, look for the SEC to determine whether advisers are abiding by the delineated investment strategies in their fund prospectuses, PPMs and forms ADV. Why? Because an adviser’s failure to do so may constitute a violation of the antifraud provisions of the federal securities laws.
For example, if a PPM calls for a fund to invest “at least 80% of its assets in securities of companies with small market capitalizations that are listed in the Russell 2000 Index or the S&P SmallCap 600,” the SEC may seek to confirm that the fund is actually following this mandate and not, for example, investing 40% of the fund’s assets in mortgage-backed securities. Advisers that are used to “bending the rules” in an effort to achieve greater returns may find themselves constrained for the first time.
