It's an odd scenario. Hedge fund managers are being increasingly pressured by regulators and politicians to be more open about the way in which funds are invested and how they are run, and yet they are not allowed to talk about their businesses publicly for fear of being accused of solicitation.The stand off is quite bizarre, actually.
By raising money privately, rather than in the public markets, and from wealthy investors, hedge funds are able to avoid the stringent regulations set forth in the U.S. Securities Act of 1933. But as part of that deal, "issuers" — in this case, the hedge fund advisers — and those acting on behalf of the issuer cannot sell securities by any form of "general solicitation or general advertising, including but not limited to the following: any advertisement, article, notice or other communication published in any newspaper, magazine or similar media or broadcast over radio or television; any seminar or meeting whose attendees have been invited by any general solicitation or general advertising."
Hedge funds can raise private money in the form of a 3(c)1 funds, which require that there not be more than 100 investors and that they be moderately rich. In December, the SEC set a new standard of a net worth of $2.5 million. Or they can raise 3(c)7 funds with no limits on the number of investors but a higher wealth standard of "qualified" investors — a net worth of $5 million. Being private and raising money via 3(c)1 or 3(c)7 means not having to comply with the Investment Company Act of 1940.
So this begs the question. If only people that have a few million to invest can invest in the funds why would a general exclusion on advertising be in place?
Let's say the hedge fund advertises in the Wall Street Journal for investors in its new wizzo fund and they get applications from Mable Goldstein out in nowhere USA who has $5000 to invest... The hedge fund wouldn't be able to take that investment anyway, even if they were interested (which they wouldn't be) at the risk of being in big trouble with the SEC.
It really doesn't make any sense to me.
In a bizarre twist, the SEC seems to agree. In 2003 when it published "Implications in the Growth of Hedge Funds," it entertained the idea of lifting the prohibition on advertising and general solicitation on funds who market to the very wealthy. "There seems to be little compelling policy justification for prohibiting general solicitation or general advertising in private placement offerings of Section 3(c)7 funds that are sold only to qualified purchasers," the staff report said.
Nothing much has happened since. In the meantime, the commission passed a rule requiring hedge funds to register, and then saw that rule overturned by the courts. The Massachusetts State securities regulator, William Galvin, sued Philip Goldstein, the hedge fund manager who successfully challenged the SEC over the registration rule, over violating the solicitation rules and letting investors onto his Web site.
The lawsuit "is bizarre," Goldstein said. "If someone asks for info and you give it to them, isn't that First Amendment activity? I'm not selling anything, I'm just providing information."
In April 2006, Steven Jay Seidemann, general counsel to D.E. Shaw (a $20bn fund) wrote a letter to the commission arguing that the rule should be removed for funds that are marketed only to qualified buyers. The SEC, he noted, had summed it up best: "In all the private offerings since the beginning of regulatory time, no offeree has ever lost any money unless he or she became a purchaser,"
That to me seems extremely good logic. Maybe the powers that be fear a back lash from the public who are barred from investing in these magical investment vehicles, gripped by 'hedge fund envy'. Doubtful..
Personally I think it is a more obvious reason. Advertising in gambling in the UK had been banned for years, you could only become a member of a casino after waiting 48 hours (thus discouraging walk in traffic) all because the government wanted to protect its citizens from the evils of gambling. (UPDATE..01 Sept 07. TV advertising is now allowed for gambling after the 9pm watershed). I feel there is a similar issue going on here. Restrict advertising, restrict investment. However, it is not really working is it? How many billions of pound, Euros, Dollars or any other currency has been invested in hedge funds in the last 6 months?? My guess would be..a lot.. Would this increase if the ban was lifted? I don't think so. In fact I think other factors would come into play.
There are generally accepted standards of advertising around the world for financial adverts. In the UK the FSA say they must be "clear, fair and not misleading". This would seem the best way to discover what hedge funds are doing and how they are performing.
If advertising was allowed the adverts and information that would be out there for hedge funds would be regulated by these advertising laws. If a hedge fund says that it made 40% in the last few months a regulator would be able to ask for the information to back up that advert. In fact in the UK, this information must be filed along with the advert and signed off by a compliance manager..
If the regulatory industry really wants to unmask hedge funds they should let them advertise, as much as they like. This would bring the free market rocking and rolling into the hedge fund world. We would know that a hedge fund that advertised good returns must be doing so, otherwise they would be in serious trouble for false advertising, those that didn't advertise we would view as a little more suspicious, rightly or wrongly.
The whole issue does bring into light another situation which has galled me for years and that is the issue of the 'Nanny State'. Hardly a day goes by when the government do not issue a new warning about cholesterol, sugar, salt, the dangers of not getting enough sun, the dangers of getting too much sun, the dangers of exercise, the dangers of not exercising... I could go on, and on.
I am appreciative of a system that is in place to highlight areas in which I may be putting myself in danger but banning me from doing it is a step too far and this is what we are seeing in the financial industry. Restrictions on advertising, entry into hedge funds, classification of investors is, in effect, financial exclusionism.
A system such as this is also not really that affective. Are the regulators saying that just because you can afford to invest $5mn you are financially savvy? You and I both know that is not true. I have met plenty of people who have vast wealth but would not know one end of a derivative from another. I have met many people who would not have $5mn to invest who are extremely investment savvy.
To exclude people on the basis of wealth is, in my opinion, just as bad as excluding people on the basis of ethnicity. Imagine if the SEC said that only African Americans can invest in hedge funds, or only white people can invest in IPO's... There would be carnage.
The regulators argument is that people need protecting from themselves. I happen to (half) agree with this, but assuming wealthy people are intelligent enough to invest in hedge funds and less wealthy people are not, is an insult to the wider investment community and a disservice to people who have worked hard to create wealth.
When the hedge fund Armageddon comes (and we all know it will) there will be a law suit from Mr X in XVille USA who made millions from a trucking business and invested $5mn in the latest fund to explode. He will sue on the basis that, although he was wealthy, he was not sophisticated enough in financial markets to understand what he was investing in. He will name the SEC as co-conspirators in his downfall because they effectively 'certificated' him as sophisticated on the basis of his wealth.
A much better way would be to classify individuals on their knowledge of the markets and put the onus on hedge funds to make sure that their investors are sophisticated enough to understand the risks. This would then force the hedge funds to deliver material explaining, in layman's terms, the risks associated with investing and make proper enquiries into the sophistication of investors.
An investor who wants to invest without all this should, in our opinion, be able to take the risk if he wants to, signing away his rights to complain in the process.
Mark Twain said "Twenty years from now you will be more disappointed by the things that you didn't do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover".
Mark Twain was obviously not thinking about the constraints of regulators and governments. A time adjusted quote should perhaps be:
"Twenty years from now you will be more disappointed by the things that you didn't do than by the ones you did do, however, you may be retiring around this time, and the government does not want to bail you out if you have risked and lost your money. So throw off the bowlines (but don't invest in anything risky). Sail away from the safe harbor (but read the 'Safe Harbor Statements' very, very carefully). Catch the trade winds in your sails (but make sure you pay your taxes while you are travelling - remember its on worldwide income.) . Explore (carefully). Dream (but don't reach too high). Discover (but if you discover anything too risky let the regulators know and they will protect you from it, unless of course you are wealthy enough then you can do what you want)".
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