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Roye Says Extended Lock-Ups May Raise Red Flags

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KEY BISCAYNE, Fla. (–Hedge fund managers who extend their funds’ lock-up periods beyond two years risk raising the suspicions of investors and the U.S. Securities and Exchange Commission, Paul Roye, director of the SEC’s Division of Investment Management, told attendees at a Managed Funds Association seminar on hedge fund regulation.

In prepared remarks, Mr. Roye said the SEC had taken care not to make its new rules, which will require most hedge fund managers with U.S. clients to register with the Commission as investment advisers, too burdensome. He said managers with nothing to hide should have nothing to fear from greater regulatory oversight.

Mr. Roye also hinted that if enough managers seek to evade SEC registration by extending lock-up periods beyond two years, the SEC would consider changing the rules and bringing those managers into the registration fold anyway. Currently, new SEC rules requiring hedge fund managers to register exempt managers with lock-up provisions longer than two years. The idea was to exclude private equity and venture capital managers from the mandatory registration requirement, since they tend to have longer lock-up provisions than hedge fund managers.

However, shortly after the SEC voted to approve the new hedge fund rules, speculation grew that managers might simply exploit the lock-up loophole.

Mr. Roye tried to throw cold water on that idea. “?? 1/2 [F]or a hedge fund adviser to avoid registration because of the two-year redemption provision, the adviser’s clients must agree to forgo the ability to gain access to every dollar invested for a period of two years from the date of each investment,” he said. “It is our expectation that few investors will agree to leave their money tied up for so long and that the ‘market’ will therefore prevent circumvention of the rule.”

Mr. Roye encouraged hedge fund investors to take a close look at managers with long lock-up periods and consider whether they may be trying to avoid SEC oversight. He said such long redemption periods should serve as a “red flag.”

“Investors must ask themselves whether they are comfortable handing a multi-million dollar investment to an investment adviser that may be trying to avoid SEC registration,” Mr. Roye said. “My guess is that, in most cases, the answer will be no.”

Nonetheless, Mr. Roye said the SEC will monitor the issue and will not hesitate to propose further rule changes extending SEC oversight, via mandatory registration, to managers who extended their lock-up periods.

Mr. Roye also sought in his speech to ease concerns that the SEC had passed the rules without consideration of the costs and burdens compliance would impose on smaller hedge fund managers, that new SEC rules overlap unnecessarily with oversight of some managers by the Commodity Futures Trading Commission and that the new rules could constrain trading activity.

“?? 1/2 [T]he commission was acutely aware of the benefits that hedge funds provide to our financial markets by contributing to market efficiency and enhancing liquidity,” Mr. Roye said. “Registration of hedge fund advisers under the Investment Advisers Act represented the least intrusive form of regulation available to address the concerns of the commission in the hedge fund sector of the investment management industry.”

He said small hedge funds should have no problem registering and complying with the new requirements. Half of all investment advisers registered with the SEC have five or fewer employees, Mr. Roye said, and almost 70% have 10 or fewer employees. Moreover, he added, most of those advisers don’t charge the management or performance fees that hedge funds charge, implying that they manage to absorb the costs of compliance with less revenue than the typical hedge fund.

Mr. Roye also attempted to sell the compliance provisions of the new SEC rules–managers must develop compliance policies and procedures, adopt a code of ethics and name a chief compliance officer–as an opportunity to do a little operations housekeeping.

“I also encourage you to use the updating or preparation of your compliance policies and procedures and code of ethics as an opportunity to perform a risk-based assessment on the operations of your firms so that you can establish policies and procedures that are best designed to ensure that conflicts are managed and your clients are protected,” Mr. Roye said. “In essence, these requirements impose no more than your clients already expect of you as their fiduciary.”

He said the SEC planned to work with the CFTC to minimize registration duplication, but that provisions already existed that exempted from SEC registration firms that have registered with the CFTC as commodity trading advisers and whose primary business is not acting as an investment adviser.

Mr. Roye encouraged hedge fund managers to embrace, not fight, oversight. “While no one enjoys having someone look over their shoulder, it can impose a healthy and constructive discipline,” Mr. Roye said.

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Contact Bob Keane with questions or comments at: [email protected].


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