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Hedge Funds, Private Equity & Investment Advisors

Hedge Funds, Private Equity Funds and the Investment Advisor Act

The hedge fund industry is well over $2 trillion of the world market. It’s size and influence cannot be ignored by the economy or the markets. Watch Ms. Malecki talk about it on Fox Business News.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, Title IV, requires advisors who manage hedge funds and private equity funds to report more information than had been previously required, particularly relating to their systems for monitoring financial risk and fiduciary duty to investors. Hedge funds also now have the risk of an SEC investigation or complaint and bases for investor claims.

In most cases, advisors to Hedge Funds and Private Equity Funds must now register with the SEC under the Investment Advisors Act of 1940, making them fiduciaries. This adds transparency for investors and investors may also gain leverage from the new status of hedge funds.

There will be certain required disclosures by “gatekeepers” too, i.e., lawyers, custodians, auditors, administrators, prime brokers, and marketers. Background information on people working at the fund will be increased, as well as of affiliated brokerage firms. The purpose is to be able to transparently look at compensation for referrals and soft dollar commissions.

The goal of the new regulations is to stop conduct that may harm investors, deter fraud, and enable earlier discovery of potential misconduct.

Hedge funds tend to be highly specialized, relying on expertise of specific managers or a management team. Investment strategies which use leverage and derivatives are more speculative while others are more conservative and employ little or no leverage.

Hedge funds have different investment returns, volatility and risk. Some strategies can deliver consistent returns with low risk of loss, but others are more volatile than mutual funds. The due diligence a brokerage firm must do before recommending a hedge fund should be extensive and is essential, and should include asking probative questions, reviewing pertinent documents and making sure that representations made to customers are accurate with the funds risk style, track record, investment and management philosophy, all of which need to be continuously reviewed by a broker/brokerage firm to monitor and make sure the hedge funds they recommend stay on track.

High incentive fees, split by the broker selling a fund and the hedge fund manager is often a reason for the failure of hedge funds. Often, incentive fees cannot be collected if the investor is losing, not re-starting until the assets lost are regained and surpasses its high point from the prior year. This sometimes causes high turnover at the fund and extraordinary risk-taking to get back to incentive fee status.

The Private Equity market has grown considerably in the last 25 years, with a record 2,000-plus private equity funds seeking to raise in excess of $700 billion in 2015. The broad category of private equity can be divided into three subcategories: venture capital (VC), leveraged buyouts (LBOs), and mezzanine financing. Private Equity is exciting for investors because it offers the promise of spectacular returns assuming that investing in high-risk, illiquid investment in starter companies can yield higher returns than publicly traded securities of public companies. But investors need to carefully question the risk-reward tradeoff and brokers and brokerage firms need to accurately represent to the investor that the investor is trading in benefits like transparency, liquidity, diversification, and daily stock price knowledge for anticipated incremental returns. Private equity investments are like “lottery tickets” they provide a small chance for a huge payout but a much larger chance of a below-average return.

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