Registered Funds of Hedge Funds

A New Alternative

Investment management professionals are increasingly trying to reach a compelling demographic of investors, the so-called “mass affluent.” According to a recent Wall Street Journal article, there  are approximately 17.8 million Americans with between $100,000 and $1 million in investable assets. According to the Wall Street Journal article, after suffering losses in the current bear market, these investors are looking for more help in managing their assets. In order to reach this desirable group, financial institutions are making available to them many of the services traditionally  offered only to the extremely wealthy. One way to reach the mass affluent, which is becoming increasingly popular, is the registered fund of hedge funds. Registered funds of hedge funds are not  actually hedge funds themselves. They are closed-end investment companies registered with the SEC who invest in underlying private hedge funds.

Most of the registered funds of hedge funds brought to market to date, like private hedge funds, are sold through private placements to investors who meet certain suitability standards. However,  some have been registered under the Securities Act of 1933 (the 1933 Act), which opens the door to selling the funds outside the strict restrictions placed on private placements. For a more detailed description of the regulatory structure of registered funds of hedge funds, see Hot Legal & Business Topics for 2002: Registered Fund of Funds – A New Frontier for Hedge Funds, by  Michael P. Malloy, in the March 2002 edition of the MFA Reporter.

There are a number of benefits of a registered fund of hedge funds over a private hedge fund. The most notable of these is the ability to sell to the millions of investors who are interested in hedge  funds but lack the capital to invest in them. While most registered funds of hedge funds are not without limits on whom they can sell to, these limits are much less stringent than those of private hedge funds.

Whereas hedge funds must either be limited to 100 investors or to those who meet substantial net worth requirements, registered funds of hedge funds can be sold to a much broader range of investors. A registered fund of hedge funds can sell to investors who meet lower suitability standards than is the case with a private fund. Registering a fund of hedge funds under the 1933 Act  also relieves that fund from the restrictions on general solicitation and advertising that a hedge fund is subject to.

Aside from less stringent investor suitability standards, there are a number of other benefits to registered funds of hedge funds. The investor protection afforded by registration under the federal  securities laws makes registered funds of hedge funds attractive options for investors interested in alternative investments, but wary of the lack of regulation in the hedge fund industry. There has been a great deal of focus lately on fraud and misrepresentation both in the hedge fund industry and the securities industry in general. This is highlighted by the SEC Chairman’s recent  announcement that the SEC is going to conduct a fact-finding investigation into abuses in the hedge fund industry. The SEC’s regulatory scheme may be seen by investors as offering an added  degree of protection and accountability over unregistered hedge funds. Registration means, among other things, that there is more transparency than with unregistered funds, fund governance is  more regulated, and the fund is subject to periodic SEC examination.

While registered funds of hedge funds must comply with the regulations imposed by the SEC, they actually avoid other regulations that private hedge funds normally must comply with. Notably,  registered funds of hedge funds can avoid certain restrictions under ERISA that hedge funds cannot, without limiting the amount of assets invested by an ERISA account.

While registered funds of hedge funds present an exciting new opportunity for investment management professionals to expand the market for alternative investment products to reach the mass  affluent, there are a number of important factors about these funds that should be considered. While registration opens the door to a much broader class of investors, it also subjects the fund to more  expensive and potentially burdensome regulation. Governance of a registered fund is very strictly regulated. For instance, the fund’s board must be composed of at least 40% independent  directors (a majority in many cases), and these independent directors must approve certain matters separately from the fund’s board as a whole. Transactions with affiliates are highly regulated, and  there are other investment restrictions as well.

Another consideration is that the adviser of a registered fund of hedge funds must itself be registered. A registered adviser is subject to many more SEC restrictions than is an unregistered adviser.  Of particular concern for hedge fund managers are restrictions on performance fees.

As more investors seek access to alternative investments as well as the security of a registered product, the registered fund of hedge funds is becoming an increasingly popular method to meet  these needs.

Financial Reporting by Registered Funds of Hedge Funds

Doing business as a registered fund of hedge funds will clearly have financial reporting implications. The SEC imposes registration statement updates and annual financial reporting requirements. In  many respects, these financial reporting requirements are similar to the financial reporting typically done by private hedge funds, i.e. an annual financial statement audit of financial statements  prepared in accordance with generally accepted accounting principles (GAAP) is typically distributed to fund investors. Compliance with SEC rules will result in more frequent, more detailed and more transparent financial reporting. While there will clearly be additional administrative effort, the incremental effort of compliance with SEC financial reporting is not so burdensome that a fund sponsor should be overly concerned.

Potential fund investors may take a positive view and take comfort in investing with an entity that has a certain degree of regulatory oversight. The investing public has been warned against hedge  fund investing by much of the mainstream media, and hedge funds are frequently referred to as lightly regulated and high risk. Registered funds of hedge funds subject to SEC oversight, with more  public financial reporting requirements and an independent board of directors with some auditor oversight responsibilities, will appeal to some investors who might not otherwise invest in hedge  funds.

The Investment Company Act of 1940 (the 1940 Act) contains the financial reporting compliance requirements for registered funds of hedge funds. The 1940 Act requires semi-annual reporting  through Form N-SAR, including semi-annual financial statements prepared in accordance with GAAP and an annual independent audit of the financial statements. The 1940 Act also calls for a fund’s independent auditor to provide an annual report on the adequacy of the fund’s system of internal controls.

One example of more detailed and more transparent financial reporting by registered funds of hedge funds is the requirement to provide a schedule of investments. Private funds may provide a  condensed schedule of investments, or in many cases fund sponsors consider such investment information to be proprietary and may choose not to disclose the information required by GAAP.  Registered funds of hedge funds should be prepared to disclose all investments as of each semi-annual financial reporting date whose fair value is in excess of 1% of a fund’s net asset value.  Another example is that registered funds of hedge funds may need to disclose more detail than many private funds may provide regarding fee structures, including, to a certain extent, the fee  structures of underlying investments in other funds.

A registered fund of hedge funds will have an independent board of directors. Oversight of the independent audit of a fund’s financial statements is one of their responsibilities. An additional  responsibility of the board under SEC guidelines is to make a “good faith” determination of the fair market value of illiquid securities. Such a “good faith” valuation can be highly judgmental and is  obviously an important aspect of determining net asset value as presented in a fund’s financial statements. The 1940 Act makes it incumbent upon the board of directors to satisfy themselves that all  relevant factors, methods and judgment involved in determining the fair market value of illiquid securities have been considered and applied appropriately. A registered fund of hedge funds sponsor  will need to spend time educating and informing its board of directors.