Loyola University Chicago School of Law, JD 2023
Private equity firms and hedge funds, typically utilized by more knowledgeable and sophisticated parties, have not seen much governmental scrutiny in the past. However, the Securities and Exchange Commission (“SEC”) recently passed a proposal that would force these funds to furnish basic disclosures to their investors and guard against conflicts. These changes stem primarily from the 2020 “meme stock” controversy that put a spotlight on vaguely policed private equity and hedge funds.
A brief history of hedge funds
Alfred W. Jones is believed to have started the first hedge fund in 1949 with the goal of buying stocks and hedging the position with short sales. Unlike private equity funds, which invest directly in companies, hedge funds use pooled money to earn returns for their investors. These funds are largely unregulated and use an asymmetrical compensation structure, allowing the managing partner to keep twenty percent of the fund returns exceeding a predetermined benchmark and includes a small (one or two percent) management fee. This structure allows for extremely high compensation. Since 1994, hedge funds have seen returns comparable to S&P 500 Index returns without the volatility.
At face value, hedge funds do not appear to be an attractive investment route. Due to the high minimum investment requirement, due diligence can end up being as high as $50,000 for investors. Given the high rate of investment, “funds of funds” are utilized, which allow investors to share the costs. Some risks of investing in hedge funds include risks to financial institutions, liquidity, volatility, and investor protection. Moreover, the industry has grown to a point that compensation is eroding. Yet, as of 2020, these funds manage over $11 trillion.
New regulations proposed
Following the financial crisis of 2007-2009, the SEC introduced Form PF, a regulatory filing requirement. It was used as the primary means for private funds to disclose purchases and sales of securities to the SEC. As of now, hedge funds need file their equity holdings to the SEC quarterly, but merely overviews.
However, in a meeting in early February of 2022 month, the SEC passed a 341-page proposal that would amend the Investment Advisers Act of 1940. The new regulations would require hedge funds and private equity funds to provide certain disclosures to their investors. These disclosures include quarterly statements with far more detail, describing fund performance, manager compensation, and fees and expenses. The funds would also have to undergo annual audits, requiring the auditor to notify the SEC of certain events. This proposal was approved by a 3-1 vote, making it likely to pass once the agency seeks public comments.
According to the SEC, these measures would not require public disclosure of this new data, but would aid regulators in spotting signs of trouble, significant margin and counterparty default events, and other implications associated with redemptions and withdrawals. SEC Chairman Gary Gensler notes that private fund investors impact so much of the economy, and it is worthwhile to create regulations that promote more transparency in this field.
The drive for new regulations
SEC scrutiny partially stems from the March 2020 GameStop “meme-stock” controversy, of which hedge funds and private equity funds were at the center. When Robinhood Markets Inc. and other brokers suddenly restricted trading of the GameStop stock, attention was drawn to processing of U.S. stock trades.
The current February proposal follows a set of disclosures proposed in January aimed at enabling financial regulators to spot risks that build up in these private markets more quickly. The January proposal would shorten the time it would take to settle securities trades. Settlement is the process in which securities are delivered to buyer and cash distributed to the seller. The proposed process would change the settlement period from two to one business day. Regulators believe the shorter period would lower the amount of collateral that brokers must post at the National Securities Clearing Corp. (“NSCC”). The NSCC serves as the clearinghouse for U.S. stock trades.
Anticipated push back and approval
As expected, various parties involved in private equity and hedge funds disagree with these new regulations. The Managed Funds Association emphasizes concerns raised by large financial firms like Blackstone Inc. and KKR & Co. Inc, which worry that new regulations are unnecessary and will be burdensome on “the most sophisticated investors.” Furthermore, Hester Peirce, the only Republican SEC commissioner, pushed back on the proposal. She stated that it felt like a shift in the agency’s mission to protect small investors and that resources should be allocated to different areas like retail-investor protection.
On the other hand, progressives applaud the proposal of more detailed disclosures. Carter Dougherty, a spokesman for the advocacy group Americans for Financial Reform states that “Wall Street titans” continuously reminds everyone how great they are. If they oppose more detailed disclosures, it begs the question: what are they hiding?
Ultimately this and many other recent proposals demonstrate Gensler’s push to regulate an expansive yet vaguely policed area of investment. With more eyes on the details of private equity and hedge funds, we may see investors pull away from this sector.