Bruce Karpati, head of the SEC’s Asset Management Unit, housed within the agency’s Enforcement Division, told compliance officers Tuesday that overseeing hedge funds’ compliance will continue to be a priority for the agency next year.
Speaking at the Regulatory Compliance Association’s conference in New York, Karpati said that from 2010 to present, the SEC’s Enforcement Division has brought more than 100 cases against hedge fund managers, “a significant majority of which involved conflicts of interest, valuation, performance, and compliance and controls.”
He told conference attendees that the Asset Management Unit is particularly concerned about four developments in the hedge fund space.
First, he said, the retailization of hedge funds, which has “made it easier for unsophisticated investors to invest directly in hedge funds.” Looking ahead, he said, the elimination of the prohibition on general solicitation and general advertising as a result of the JOBS Act “could have an immediate impact because, what were formerly private offerings, can now in some form be broadcast to a much wider audience.” While, he added, the SEC “understands that this may facilitate capital formation, one of our concerns is that these retail-oriented hedge funds may be offered to investors that may have the financial wherewithal to meet accredited investor standards but are otherwise financially unsophisticated.”
Second, Karpati said is the “emerging retail orientation” of hedge funds that increasingly exposes ordinary investors to such funds either directly or indirectly through pensions, endowments, foundations, and other retirement plans.
For instance, Karpati cited data that has found that private sector pension funds currently seek to allocate on average about 10% of their assets to hedge funds, and public sector pensions target an 8% allocation on average. “Adding in private equity and real estate, these numbers get even bigger,” he said. “According to these sources, larger pensions with more than $1 billion in assets have increased their stakes in alternative investments to almost 20%, nearly double the percentage from five years ago.”
The third area of concern, Karpati continued, is the fact that alternative investment vehicles “often involve complex, illiquid or opaque investments.” This lack of transparency into their investment strategies and operations, he said, “may occur for legitimate business reasons, but, at the same time, the potential for fraud is substantial. Even sophisticated investors can be defrauded through alternative investment vehicles, especially when their practices are not transparent to investors or regulators.”
Fourth, the Asset Management Unit is “particularly aware of the risks posed by private funds advised by unregistered advisers,” Karpati said. “Smaller private fund advisers, typically those with less than $150 million in assets under management, pose a risk because they may be exempt from SEC registration.”