Almost 10 years have elapsed since the Dodd-Frank Act imposed mandatory registration and periodic reporting requirements on private funds, including US hedge funds and private equity.
Now, the US Securities and Exchange Commission (SEC) is proposing a swathe of new rules, in what many are saying is the biggest regulatory onslaught to face the industry since the rollout of the EU’s Alternative Investment Fund Managers Directive (AIFMD).
A roundtable hosted by INDOS Financial, a JTC Group company, looked at the implications these rules could have on the private funds industry:
There are a whole range of policies being proposed by the SEC, including heightened transparency provisions around short-selling and securities lending, together with amendments to the Form PF filing. In the case of the latter, the proposed rule would (if implemented) require hedge fund and private equity managers to report key events (i.e. significant losses, margin events, etc.) within one business day of them happening to the SEC, so as to help regulators spot potential build ups of systemic risk more easily and quickly.
Two proposed regulations from the SEC are causing particular consternation among the industry, according to Jack Inglis, CEO at the Alternative Investment Management Association (AIMA).
The first of these is the SEC’s Private Fund Advisers Rule, which if implemented in the form proposed, would oblige investment adviser firms to provide enhanced information to investors detailing performance, fees and expenses. This Rule will also ban private fund advisers from seeking reimbursement, indemnification or limitation of liability by their funds or investors for a breach of fiduciary duty.[1] This would likely create added costs for an industry already grappling with significant revenue pressures.
The second proposal is especially egregious, notes Inglis. According to law firm Davis Polk, the SEC is looking to re-interpret the “dealer-trader” distinction in what will widen the scope of financial institutions that are required to register as broker dealers and government security dealers. Davis Polk continues that the proposals are aimed at actively trading private funds and principal trading firms.[2]
While the rules were most likely aimed at capturing major proprietary trading houses, Inglis says the way they have been drafted will result in a large number of hedge funds and private fund advisers being ensnared as well, including small to mid-sized firms. “There are various standards determining whether managers meet the threshold of being a securities dealer, which are both qualitative and quantitative. Ultimately, it boils down to whether a manager is routinely providing liquidity to the market in their activities,” he continues.
Required registered as a dealer is likely to throw up all sorts of logistical challenges for impacted hedge funds. A recent AIMA article notes that even the smallest managers forced to register could face initial costs of up to $1 million, and hundreds of thousands of dollars in ongoing annual compliance charges. For the bigger managers, AIMA reckons those costs could reach $10 million, with annual compliance costs nearing $6 million. [3]
Aside from saddling the industry with prohibitive costs, Inglis says the SEC’s proposed provisions risk undermining liquidity too. “A lot of hedge funds out there are going to think about changing their strategies and moving away from being liquidity providers so to avoid registering as dealers. This means there will be a lot of unintended consequences from this regulation, namely less competition and less liquidity in the market,” says Inglis.
AIMA also notes that dealer registration will likely force affected managers to implement numerous structural changes, including the application of capital requirements which are not suited for off-balance sheet business. It continues organisations could also incur negative tax implications and suffer from client withdrawals. [4] “A lot of asset owners will not want to invest in a broker-dealer, because they want to invest in a fund. There is a potential risk we could see investors pulling out of impacted funds because the very nature of what they are investing in has changed,” says Inglis.
After a ten-year lull, the US authorities are clamping down on the alternatives sector. Initiatives such as the Private Fund Advisers Rule and dealer registration obligations could inundate the industry with unnecessary costs at a time when margins are being compressed. Should these rules come into effect in their proposed forms, their collective toll on the hedge fund ecosystem in the US could be devastating.
To discuss the ongoing regulatory changes or hedge funds in general, please get in touch with Jon Masters.
[1] K&L Gates – April 7, 2022 – SEC proposes significant new rules for private fund advisers
[2] Davis Polk – April 4, 2022 – SEC proposes requiring many private funds and proprietary trading vehicles to register as dealers
[3] AIMA – June 17, 2022 – Nightmare on F Street – Be aware, be very aware
[4] AIMA – June 17, 2022 – Nightmare on F Street – Be aware, be very aware
