Archives For hedge funds

The NYT reports:

When he rejected a new European accord on Friday that would bind the continent ever closer, Prime Minister David Cameron seemingly sacrificed Britain’s place in Europe to preserve the pre-eminence of the City, London’s financial district. The question now is whether his stance will someday seem justified, even prescient.

Mr. Cameron refused to go along with the new European plan of stricter fiscal oversight and discipline hammered out in Brussels this week, in great part because of fears that the City would be strangled by regulations emanating from Brussels. * * *

But will it matter?  The article points out that:

  • Non-British banks in the UK will still be subject to EU regulation.
  • European activity might be redirected from the UK to Frankfurt.
  • Europe could prohibit its banks from dealing with UK firms that didn’t adhere to EU regulation.
  • But the UK could exit the EU, reducing the impact of EU regulation in the UK.
  • European banks would still have a powerful incentive to remain global by competing in the UK market. 
  • Even if excluded from Europe, UK banks would still compete powerfully for U.S. and Asian business.  The UK didn’t lose its edge when it stayed with the pound, and likely won’t if it opts out of EU regulation.

And of course there’s the question whether UK hedge funds and other financial institutions will be better global competitors without being saddled by more intrusive European regulation.

Cameron’s move is a reminder that the EU has a double edge:  it promotes competition within the EU, but erects a regulatory cartel for the EU against the rest of the world.  With or without the cartel, it’s still a global economy, governed by the powerful forces of jurisdictional competition.  Federal cartels can slow down that completion but not stop it.

It’s a lesson worth remembering for U.S. securities regulators.

The WSJ reports on proposed rules forcing hedge funds to disclose confidential proprietary information:

Under current rules, many managers are required each quarter to publicly disclose their long equity positions in public securities. The proposed rules would require a much greater level of disclosure to regulators about trading positions, counterparties, liquidity, leverage and performance. * * *

“WikiLeaks has more or less proven that anything you give to the government you have to assume could one day be public,” said Nathan Greene, a lawyer with Shearman & Sterling LLP who represents hedge funds, referring to the leaks of thousands of diplomatic cables in recent months.

“It is impossible, after seeing State Department cables, to say to yourself, ‘I’m going to package my most sensitive business information and give it to the U.S. government,’ and do it without a pit in your stomach,” he said. * * *

Systemic-risk monitoring has long been under consideration for the hedge-fund industry.

Onerous disclosure regulation of hedge fund trading positions is costly and unnecessary, as I’ve discussed:

Hedge funds are not part of the systemic risk problem.  It’s more likely they’re part of the solution in the sense that they use proprietary and business methods to bet against the accepted wisdom, rather than following all the other lemmings off of financial cliffs.  For a good statement of this argument, see Jon Macey, Promises Kept, Promises Broken, 275-82 (2008). Increased disclosure may reduce the funds’ incentives to invest in developing these strategies, which could actually increase systemic risk.

More generally, as I’ve said, hedge funds, through short selling and takeovers, have been an important source of market discipline.

And then there are also the risks that (1) the SEC won’t effectively guard the information; and (2) won’t effectively use the data it gets.  Here’s more bearing on those issues.

Lynn Stout, writing in the Harvard Business Review’s blog, claims that hedge funds are uniquely “criminogenic” environments.  (Not surprisingly, Frank Pasquale seems reflexively to approve):

My research, shows that people’s circumstances affect whether they are likely to act prosocially. And some hedge funds provided the circumstances for encouraging an antisocial behavior like not obeying the laws against insider trading, according to these investigations.

* * *

Recognizing that some hedge funds present social environments that encourage unethical behavior allows us to identify new and better ways to address the perennial problem of insider trading. For example, because traders listen to instructions from their managers and investors, insider trading would be less of a problem if those managers and investors could be given greater incentive to urge their own traders to comply with the law, perhaps by holding the managers and investors — not just the individual traders — accountable for insider trading. Similarly, because traders mimic the behavior of other traders, devoting the enforcement resources necessary to discover and remove any “bad apples” before they spoil the rest of the barrel is essential; if the current round of investigations leads to convictions, it is likely to have a substantial impact on trader behavior, at least for a while. Finally, insider trading will be easier to deter if we combat the common but mistaken perception that it is a “victimless” crime.

Rather than re-post the whole article, I’ll direct you there to see why she thinks hedge funds are so uniquely anti-social.  Then I urge you to ask yourself whether she has actually demonstrated anything of the sort.  Really what she demonstrates, if anything, is that agency costs exist.  Oh, and people learn from their peers.  Remarkable!  And this is different than . . . the rest of the world, how?  There are Jewish people in the world, a lot of them work on Wall Street, and many of them attend synagogue.  No doubt Jews mimic the behavior of other Jews.  Bernie Madoff was Jewish.  The SEC should be raiding temples all across New York, New Jersey and Connecticut!

The point is that she has no point, and directing her pointless observations toward hedge funds in particular is just silly (and/or politically expedient).  There are bad apples everywhere.  There are agency costs everywhere.  A police state could probably reduce the consequences of these problems (but don’t forget corruption (i.e., bad apples) in the government!).  The question is whether it’s worth it, and that requires a far more subtle analysis than Stout provides here.

And all of this is because insider trading really needs to be eradicated, according to Stout:

Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn’t really doing harm.

Actually, the reason most people feel that insider trading isn’t really doing harm is because it isn’t.

I’ll leave the synopsis of the argument to Steve Bainbridge.  On the adverse selection argument, see Stanislav Dolgopolov.  Sure, there is debate.  Empirics are hard to come by.  But the weight of the evidence and theory, especially accounting for enforcement costs (one study even seems to suggest that making insider trading illegal actually induces more insider trading to occur (and impedes M&A activity)), is decidedly against Stout’s naked assertion.  The follow on claim that, in essence, agency costs justify stepped up dawn raids at hedge funds is even more baseless.

Dodd-Frank imposed registration requirements on advisors of hedge funds.  The act exempted venture capital funds but left it to the SEC to define these funds.  The SEC has now proposed a definition as part of new rules implementing Dodd-Frank’s hedge fund provisions.  According to the SEC’s press release,  a venture capital fund is a private fund that:

       Represents itself to investors as being a venture capital fund.

       Only invests in equity securities of private operating companies to provide primarily operating or business expansion capital (not to buy out other investors), U.S. Treasury securities with a remaining maturity of 60 days or less, or cash.

       Is not leveraged and its portfolio companies may not borrow in connection with the fund’s investment.

       Offers to provide a significant degree of managerial assistance, or controls its portfolio companies.

       Does not offer redemption rights to its investors.

The rule grandfathers existing funds that have represented themselves as venture capital funds “because it could be difficult or impossible for advisers to conform existing funds, which generally have terms in excess of 10 years, to the new definition.”

But the SEC feels comfortable locking new funds into terms that could constrain their activities for long periods in a dynamic investment environment.  Although today’s VC funds may conform to the SEC’s definition, it is not clear that they will always want to, say, avoid debt or redemption rights.  The costs associated with this inflexibility are especially problematic given VC funds’ need to adjust to the drop in initial public offerings, which traditionally provide a critical opportunity to exit from investments.  

Real unemployment is climbing toward 20% and new firms with new ideas can create jobs.  Venture capital is a key mechanism for funding start-ups.  Somebody should pass this information onto the SEC.

While the US, via Dodd-Frank, has increased its regulation of hedge funds by requiring registration and disclosure, one important jurisdiction is pulling back and poised to reap the benefits. Per Bloomberg, Singapore declined in April to require licensing of hedge funds and attracted several new hedge funds in May and June.

“Singapore did not shoot itself in the foot by putting up proposals that will kill off the business,” said Kher Sheng Lee, a senior associate in the financial services group at Philadelphia-based law firm Dechert LLP in Hong Kong. “While some places are moving towards over-regulation with rigid rules and increase in compliance costs, Singapore has attempted to go for sensible regulation.”

Singapore is vying with Hong Kong for a slice of the global $1.7 trillion hedge-fund industry as the region’s growth leads the world. Singapore has made it easier for hedge funds to set up shop on the island than in other Asian cities such as Hong Kong, where hedge-fund managers face the same licensing requirements as mutual-fund managers. * * *

The regulator has recognized the needs of startups and smaller managers “not to be overburdened by regulatory costs,” said Michael Coleman, chairman of the Singapore branch of the Alternative Investment Management Association. * * *

“Singapore has been as sensible and forward thinking as they can be about this,” said Peregrine Cust, founder of Prana Capital, which moved its investment team to Singapore from London in April. “It’s a very high-margin business, it brings lots of highly paid professionals into the local economy. It’s not going to take them that long to take this industry to critical mass.” * * *

Han Ming Ho, a partner at Clifford Chance, one of the first international law firms awarded a Singapore license, said he is handling more inquiries since the rules were announced. * * *

Singapore, where the top tax rate for individuals is 20 percent, is also attracting more managers after the U.K. increased the top rate of income tax to 50 percent and European regulators work on tougher rules. The island-state was named Asia’s most livable city in a Mercer Consulting survey in May.

Pure Capital, which uses computer models to pick trades, is “seriously considering” moving its head office to Singapore from London * * * “Europe is going to very much become the ‘old world’ and get left behind; the hedge-fund industry will move towards Asia- Pacific over decades to come,” Limbrick said. “We may yet be a year or two away, but we like Singapore’s attitude to encouraging new business.”

Last year I discussed at some length jurisdictional competition between global legal centers, focusing on my travels and discussions in Hong Kong and Singapore. Here’s a taste:

Partly because of their similarities, Hong Kong and Singapore compete for increasingly global rather than regional legal business. In my discussions I didn’t get a strong sense of each jurisdiction’s competitive strategy. That may be partly due the fast-moving nature of the global legal environment and the uncertainty of the roles to be played by various types of offshores. Moreover, the main players in each jurisdiction lack the control over their legal system that Delaware lawyers, for example, exercise. Singapore has long been dominated by Lee Kwan Yew, and is still basically operating under his vision. Hong Kong has China to contend with, subject mainly to China’s self interest and the loose constraints of HK’s SAR status and the Basic Law.

I gathered that Singapore has tended to regulate its financial institutions with a somewhat lighter hand than HK, though I’m still working on the specifics. Singapore evidently has been competing with Switzerland in offering privacy, though both have bowed recently to global demands for transparency. At the same time, Singapore may be more careful in deciding which financial institutions to admit to their zone of safety * * *

In general, the offshores are beginning to realize how to compete in a global environment. Onshores like the US seem increasingly clueless. Does it really make sense to yield to short-sighted demands for financial regulation if this causes the US to lose its edge as a global leader in finance? Does it make sense to cede access to one of the most exciting business environments in the world to other country’s citizens in order to grab a comparatively little more tax revenue?

These questions are even more timely in the wake of Dodd-Frank.

When I last wrote on the carried interest debate I commented on the NYT’s Andrew Sorkin’s support for characterizing private equity managers’ carried interest as ordinary income rather than capital gains. This is supposed to be a simple change that cuts fat cat fund managers down to size and fairly distinguishes what is essentially compensation for managing a business, just like executives’ stock options, from investment income. But what if the distinction isn’t all that straightforward? I noted that

the fund managers are getting paid for the same sort of acumen or luck that underlies any successful stock market investing.  Why should it matter that they happen to be investing through a partnership, essentially borrowing from the investors and paying them interest in the form of the substantial share of the gains the investors get to keep?  * * * Of course none of these nuances matter if what you really want to do is to punish rich capitalists. 

I also observed that on policy grounds it makes no sense to target this efficient form of compensation. And more ominously I previewed the horse-trading that would accompany this supposedly straightforward change:

The high-powered compensation that Congress is considering attacking is common in venture capital and real estate, two industries whose health is important to any recovery.  * * * If they win their carve-outs, the new tax looks more like Swiss cheese than a return to economic reality. In general, this whole thing looks a lot more complicated than Sorkin would have us believe.

Today’s WSJ makes that clearer:

[The tax change] would be a huge hit to the estimated 6.5 million folks invested in real-estate partnerships, who own assets ranging from a local house to a commercial shopping center. The legislation also potentially hits any partnership invested in certain specified assets, including families who own, say, an auto dealership, fishing boat, construction company or securities. * * *

[B]ecause Democrats chose to target individuals who provide “investment management services,” and because this definition can easily encompass individual family members who manage family projects, entire partnerships could be subject to the higher taxes. Even worse, the higher rates would apply not only to investment gains, but to any gains from the sale of the partnership itself. So the provision would deny families the ability to sell their business at the normal capital gains rate. * * *

Democrats understand this problem, which explains why the House version included a specific carve-out for family farms and ranches held in partnership. The other family partnerships were told to sit back and let the Treasury Department clarify the legislation—and exempt them—via regulation. But if this tax hike is supposed to be about equitable treatment, why exempt some partnerships but not others? * * *

Democrats are rewriting a half century of partnership tax law with no hearings, no analysis and little debate. And they wonder why businesses are creating so few jobs.

In other words, it’s increasingly obvious that this change was never really about fairly treating like income alike but about fleecing fat cats. Indeed, I speculated three years ago that the move was just a way to gin up campaign contributions. Whether or not there was really any theoretical basis for taxing carry like ordinary income (and I’ve been skeptical) mattered little when the proposal got to the Congressional sausage factory. And now we find that it’s not so easy to target the fat cats without causing considerable collateral damage or ending up with even less defensible distinctions than we started with.

Maybe this carried interest move wasn’t such a great idea after all.

The venerable debate over carried interest compensation of private equity managers is heating up again. The NYT’s Andrew Sorkin is predicting Congress will vote to tax it as ordinary income rather than capital gains, which Sorkin thinks is a good thing:

Under their current partnership structure, however, [private equity] general partners * * * receive 20 percent of any profits and they have been treating that as a capital gain even though their own money is not at risk. A lot of people, including me, have been arguing for years that their cut of the winnings is really income, not capital gains. (Of course, profits that executives make by investing their own money in the deals should be considered capital gains.)

But Sorkin says “Wall Street executives are ready”:

If we’ve learned anything from the financial crisis, it seems that new regulations on Wall Street always have a way of breeding another generation of “financial innovation” meant to circumvent them.

These “machinations being whispered about in the industry” include selling the carried interest to a third party and using the cash to invest directly in the deal.  Since the managers would own the interest as investors, they’d be taxed on the interest at the lower capital gains rate.  Or investors would make a loan to the manager, who would then use the loan to buy into the fund, again taxed on the increase as capital gains.  But Sorkin notes that’s specifically ruled out by the latest bill.

Vic Fleischer, whose  “Two and Twenty” paper is a basis for the proposed change, tells Sorkin “[a]ny time there is a new section of the tax code there are going to be lawyers who will try to manipulate the rules.”  Fleischer adds another slippery thing the managers could do:  dismantle the partnership and invest “in companies on behalf of their investors on a deal-by-deal basis,” getting founders’ shares and, again, getting taxed at the capital gains rate.

Sorkin concludes with a warning:  “Whether certain industries get excluded or not, Congress beware: Wall Street will find a loophole.”

I observed three years ago when the idea was first bandied about that it “might have been all along just a tactic to extract campaign contributions.”  Well, Congress got their contributions and now they’re back.

Politics and pejoratives like “loophole” and “machinations” aside, it might be useful to take a deeper look at economic realities.  Three years ago I noted David Weisbach’s paper (since published) that the fund managers are getting paid for the same sort of acumen or luck that underlies any successful stock market investing.  Why should it matter that they happen to be investing through a partnership, essentially borrowing from the investors and paying them interest in the form of the substantial share of the gains the investors get to keep?  From this perspective, “machinations” like loans and founders’ shares really disassemble the transaction back to what it is in reality.

Of course none of these nuances matter if what you really want to do is to punish rich capitalists.  But even then you might consider the effects of the plan.  If carried interest compensation really is just compensation for investing, then there should be a lot of ways to restructure the compensation to accomplish almost the same thing. Congress might try to close one exit (e.g., by explicitly covering loans) but others will remain. At best Congress is just increasing transaction costs.

Even if carried interest compensation is just that, and fundamentally different from investment gains, then you should consider whether, as I’ve argued, it’s an efficient form of compensation that minimizes agency costs between investors and managers and helps make private equity viable.  Indeed, hedge and private equity funds incentive structure arguably helped it avoid the problems that beset ill-managed corporate banks in the meltdown.  It would be ironic if financial “reform” targeted the very firms that least needed reforming.

Another effect of the tax change, as Fleischer told Sorkin, might be to drive the funds offshore. The jurisdictional competition angle is becoming more important as countries get more aggressive in regulating highly mobile capital.

Finally, some influential political oxen will get gored.  The high-powered compensation that Congress is considering attacking is common in venture capital and real estate, two industries whose health is important to any recovery.  Sorkin quotes the National Venture Capital Association as noting the folly of “discouraging investment in new companies at a time when Congress should be doing all it can to support the start-up ecosystem.” They’re seeking exemptions from the tax and they have some significant Congressional support.  If they win their carve-outs, the new tax looks more like Swiss cheese than a return to economic reality.

In general, this whole thing looks a lot more complicated than Sorkin would have us believe.

Antitrust & Private Equity

Josh Wright —  24 February 2008

WSJ Deal Journal reports some important movement on the antitrust and private equity front.  Specifically, Judge Richard Jones (W.D. Washington) granted the defendants’ motion to dismiss in Pennsylvania Avenue Funds v. Borey, dismissing the plaintiffs’ allegations that two private equity firms had violated the Sherman Act by bidding jointly on the target company (Watchguard Technologies) in order to “artificially fix the price … or rig the tender offer bids for WatchGuard shares” after initially submitting independent bids.

Wilson Sonsini, who argued the successful motion, has posted an informative Client Alert summarizing the highlights of the decision.  Apparently, the Court rejected the per se characterization of joint bidding because it recognized the potential for joint bidding to increase rather than suppress competition in some circumstances.  The court found that the bidding arrangement could not survive a motion to dismiss on the alternative rule of reason characterization because “dozens of other suitors who expressed interest in WatchGuard refused to make bids. . . . The result was a contest for corporate control in which it appeared that there were only two bidders, but the appearance is a mirage. An acquiror who believed that WatchGuard was worth more than [the] bid could have made a topping bid. The agreement between [the funds] would have had no effect on such a bid. Moreover, had WatchGuard’s shareholders believed that the [] bid was too low, they retained power to reject the merger by voting it down.”  Finally, it is worth noting that Judge Jones did find that the bidding arrangement was not impliedly immune from the antitrust laws because of overlapping securities regulations.

Private equity deals have been the subject of a good deal of speculation in antitrust circles in the past several years as bidding arrangements are the subject of pending litigation and have come under the scrutiny of the Department of Justice.  Its just one decision, but this one seems pretty dismal for plaintiffs in these private equity collusion suits.  Judge Jones’ decision seems to suggest that in the post-Twombly world, and with the market definition problems inherent in a rule of reason type case in the “market for corporate control,” plaintiffs are going to have a difficult time surviving the pleading stage without a plausible story that a specific “club deal” is tainted by collusion with a tangible impact on acquisition price.   I just don’t know if that kind of evidence is out there.  Its certainly tough to get without the benefit of discovery.  Anyway, I thought that the “club deal” collusion story was about facilitating tacit or explicit collusion on a series of deals (you don’t bid here, I won’t bid there).  That might be much harder to identify in practice.

But this is not the last of these suits.  It will be interesting to see how the plaintiffs antitrust bar adjusts to this ruling in future cases.

The Financial Times reports today on a Moody’s study that finds “[a]ctivist hedge funds and other short-term shareholders are almost always bad for the credit quality of their target companies . . . .” (See here for the FT article).

I’m interested in reading the Moody’s study but have been unable to find it online. If anyone has a link, please post it in the comments to this post. Thanks.


Bill Sjostrom —  12 June 2007

I recently posted on SSRN one of the two articles I have committed to write for the Entrepreneurial Business Law Journal. It’s entitled PIPEs (note that I went with a “micro-title” and successfully resisted the urge (at least for now) of being “very punny,” e.g., PIPE bomb, Sewer PIPE, Burst PIPE, Smoking PIPE, PIPEline . . . .). You can download the piece here. Below is the abstract:

The Article examines Private Investments in Public Equity (PIPEs), an important source of financing for small public companies. The Article describes common characteristics of PIPE deals, including the types of securities issued and the basic trading strategy employed by hedge funds, the most common investors in small company PIPEs. The Article argues that by investing in a PIPE and promptly selling short the issuer’s common stock, a hedge fund is essentially underwriting a follow-on public offering while legally avoiding many of the regulations applicable to underwriters. This “regulatory arbitrage” makes it possible for hedge funds to secure the advantageous terms responsible for the market-beating returns they have garnered from PIPE investments. Additionally, the article details securities law compliance issues with respect to PIPE transactions and explores recent SEC PIPE-related enforcement actions and regulatory maneuvers. The Article concludes that a more measured and transparent SEC approach to PIPE regulation is in order.

I’m hoping to have a related piece about reverse mergers up on SSRN next month.

Two and Twenty-five?

Bill Sjostrom —  9 April 2007

See here.

A post on DealBook pointed me to a recent SEC release I missed over the holidays. The proposed rules contained in the release “are designed to provide additional investor protections” with respect to hedge funds. The proposed rules include amendments to Regulation D that change the definition of accredited investor to be applied to a natural person with respect to an investment in a “private investment vehicle,” i.e., hedge fund. Under the proposal, for a natural person hedge fund investor to be considered accredited (what the release refers to as an “accredited natural person”), he or she would need to meet the existing definition of accredited investor under Rule 501(a)(5) or (6) (i.e., net worth of at least $1,000,000, annual income of at least $200,000, or joint annual income of at least $300,000) and own at least $2.5 million in investments. Note that it appears a hedge fund would still be able to take money from up to 35 non-accredited investors as allowed under Rule 506 provided it furnishes them the requisite disclosure and believes the investors are sophisticated (although, it seems highly unlikely that a hedge fund would bother with non-accredited investors (many funds have seven-figure minimum investment requirements), and I would view it as a red flag if it did (it can’t attract the smart money)).

I have not studied the release in depth, but one interesting thing of note is that the proposal provides that the $2.5 million threshold will be adjusted every five years for inflation, which is not the case for the $1,000,000/$200,000/$300,000 thresholds referenced above. These thresholds, as the release notes, have remained unchanged since the SEC established them in 1982. Putting aside “nanny state” criticisms referenced in the DealBook post, it strikes me as curious that the SEC would include an inflation adjuster in this new threshold yet say nothing about adding one for the old thresholds. Maybe it has something in the works.

[Have you noticed that this is the most action we’ve had in a single day on this blog in a long time? Perhaps Frank has emboldened us TOTMers.]