Archives For hedge funds

Hedge Fund Deregistration

Bill Sjostrom —  23 September 2006

This Bloomberg article notes that 106 hedge funds have withdrawn their registrations under the Advisers Act since the SEC’s rule requiring registration was struck down in Goldstein v. SEC. According to the article:

SEC spokesman John Heine said 70 hedge fund managers told the agency they opted out because registration is no longer required. The other 36 may have withdrawn for any number of reasons, such as closing down their funds, he said. Heine declined to name any of the hedge funds.


[a] total 2,479 of the roughly 7,000 U.S.-based funds remain registered with the SEC and subject to spot-checks. Those that stay probably are doing so to attract pension plans and charitable foundations, which are more concerned with regulatory compliance, said Barry Barbash, a former director of the SEC’s investment-management division.

As an aside, the article notes that Amaranth did not register. It seems unlikely, however, that registration would have prevented the billions in trading losses. As Dale Oesterle notes in his recent paper “Regulating Hedge Funds,” “registration . . .does not require an adviser to follow or avoid any particular trading strategy, does not require or prohibit any specific investments, and does not require an adviser to reveal specific trading strategies or disclose their specific portfolio holdings.”

It’s not a PIPE bomb

Bill Sjostrom —  26 August 2006

Similar to Gretchen Morgenson’s recent attack on Rule 144A offerings (discussed by Larry Ribstein here), page C1 of yesterday’s W$J assails PIPE offerings (see here). PIPE stands for “private investment in public equity” and is a financing technique used by many small and mid-size public companies. In a typical PIPE, a company privately negotiates a sale of unregistered equity or equity-linked securities to institutional investors. As part of the deal, the company agrees to register the resale of the equity securities, typically within 30 days. The securities are priced at a discount to the applicable public market price to reflect the fact the original issuance is unregistered. PIPEs offer a number of advantages as a financing technique, including quick time to market (no pre-offering delay for SEC filings, abbreviated documentation) and an equity financing option for companies with market caps or deal sizes too small for a registered equity follow-on offering.

The Journal article, however, does not focus on the advantages of PIPE deals. Instead, it seems to try to vilify them. The article begins by talking about a lawyer who pleaded guilty to conspiring to commit securities fraud and then notes that PIPEs are referred to as “toxic converts” and “death-spiral financings.” But it fails to point out that these labels only apply to PIPE deals involving the issuance of convertible securities where the conversion price floats with the market price of the company’s common stock. Many, many PIPE deals do not involve this feature. The article also decries the fact that hedge funds are investing in PIPEs and “often start shorting the company’s stock even before the financing deal is signed or publicly announced.” This is bad according to the article because hedge funds “are simply looking to profit from the short sales, rather than help the company’s prospects.” Shocking!!!

The real importance of PIPEs, which the article mentions but certainly doesn’t highlight, is that they provide an option for many companies that otherwise would be unable to secure financing. Sure the terms may sometimes be onerous or even toxic, but at least the alternative is there for the board to consider. Bottom line: notwithstanding the Journal article, there is nothing inherently wrong PIPE deals.

The following is contained at the end of a June 28, 2006 Wachtell, Lipton, Rosen & Katz memo addressing the recent Court of Appeals decision to vacate SEC hedge fund registration requirements:

In this era of hedge fund activism, the future of hedge fund regulation may impact the balance of power between public companies and activist shareholders. In contests for corporate control, unregistered hedge funds typically enjoy greater advantages of stealth and flexibility. The transparency and restraint created by the Hedge Fund Rule make for a fairer fight when hedge funds attack. At this time, public companies can only hope that some form of hedge fund regulation persists.

This is not surprising considering the firm, according to its website, “originated the so-called ‘poison pill.'” It is also consistent with earlier Wachtell memos concerning hedge funds (see here and here). I would, however, like Wachtell to elaborate on their “fairer fight” point. How does hedge fund regulation make a takeover fight fairer? If anything, doesn’t management currently have an unfair advantage in a takeover fight? In fact, maybe instead of hedge fund regulation, Congress should consider rolling back the Williams Act to increase the disciplinary effect of the market for corporate control.

The current issue of The New Yorker magazine includes an article about hedge funds (click here). The article mentions that hedge funds have been called locusts of the global economy, disasters waiting to happen absent regulation, and instruments of Satan. It notes that hedge funds are easy to hate. “They’re secretive, rarely making public disclosures about their investments or their performance, and so are fertile terrain for fraud and incompetence.�

The focus of the article, however, is not on bashing hedge funds. Instead, it highlights the importance of hedge funds to the financial markets.

Markets work best when investors are drawing on diverse sources of information and relying on many different kinds of tools to figure out what’s going to happen next. The sheer variety of investing strategies that hedge funds use—in contrast to mutual funds, whose managers mostly just buy stocks and bonds—enhances the diversity of markets. In the U.S. stock market, hedge funds’ willingness to sell stocks short also makes the market smarter and more efficient.

Paradoxically, some of the characteristics of hedge funds that make them seem frightening also make them valuable. Secrecy, for instance, makes it harder for hedge-fund managers to imitate what their peers are doing, a common flaw among mutual-fund managers. And, because investors in hedge funds typically have to give notice of a month or more before withdrawing their money, managers are freer to pursue contrarian trading strategies that may work only over the long term.

As the article points out, “hedge funds have been far more of a boon to financial markets than a bane.”

In today’s W$J, Holman Jenkins stands up for short-sellers, and rightly so. Those folks have taken a bit of a beating lately. They’ve been sued by companies like Biovail and and trashed on talk shows like CBS’s 60 Minutes.

[NOTE: I originally linked to the 60 Minutes segment, but I just realized that the segment includes a warning that unauthorized Internet display is prohibited. The segment is available on Overstock’s website here. Just scroll down to the event on March 26, 2006 — “Biovail Story on CBS’s 60 Minutes.”]

Attacks on short-sellers are nothing new. Those investors — who borrow the stock of companies they believe is overvalued, sell it, and then repurchase it (hopefully at a lower price) before the date by which it must be returned — make their money by betting against companies. This, many believe, is evil. Indeed, Malaysian law deemed short-selling to be grounds for caning (yes, getting smacked with a cane) until just two weeks ago!

Those who reflexively jump on short-sellers for, as Jenkins puts it, “push[ing] down stocks owned by widows, orphans, and other helpless shareholders” assume that higher stock prices must always be better for investors than lower ones. Tell that to the folks who bought Enron at $90/share. They certainly wish there had been more shorting of Enron stock.

In addition to the “investor reliance” losses occasioned by overvaluation, such mispricing can lead to destruction of significant corporate value. Harvard Business School Professor Michael Jensen has recently explained why this is so in his fantastic paper Agency Costs of Overvalued Equity. Jensen shows that a higher stock price is not always better for investors. Indeed, a high but unjustified price can be downright bad for holders of a stock.

Short-sellers play a crucial role in sniffing out those stocks that are priced higher than they ought to be and helping to bring their prices down. In theory, corporate managers and professional stock analysts would take steps to correct overvaluation, but there are good reasons to believe that neither group is up to the task. (For why this is so, see below the fold.) Continue Reading…

A recent W$J article reports that a number of mutual funds have amended their fund investment policies to allow the funds to engage in hedge-fund-like investment strategies such as the use of derivatives, leverage and short-selling.  I think this is a favorable development because it increases the types of investment options available to everyday investors.  Others may not see it this way:Â

[S]ome analysts and financial advisers caution that when traditional mutual funds adopt alternative investment strategies, it could bring added risk and higher fees.  Some advisers also fear that mutual funds may be rushing into a hot strategy just as hedge funds’ performance is beginning to cool.

The “added risk� and “higher fees� criticism seems little more than a statement of the obvious.  Alternative investments, by their nature, are more risky and involve higher fees.  What really matters though is whether a fund’s net risk-adjusted return beats the applicable benchmark.

It should be noted that even with appropriate changes to mutual fund investment policies, mutual funds cannot engage in various strategies to the same extent hedge funds can.  This is because mutual funds are subject to regulations under the 1934 Act and the Investment Company Act (ICA) (among others); hedge funds are not.  These regulations include, for example, limitations on margin borrowing and investing in restricted securities.  Interestingly, the ICA empowers the SEC to adopt limitations on short-selling and margin borrowing specifically for investment companies, but to date it has not.  Look for the SEC to do so if any of these hedge-fund-like mutual funds implode.

$6 Million for Biondi

Bill Sjostrom —  20 February 2006

Matt Bodie at PrawfsBlawg has a nice postscript on Icahn’s settlement with Time Warner (click here). Frank Biondi will get a nice postscript too–$6 million. Biondi agreed late last month to serve as Time Warner’s CEO in the event Icahn was successful in ousting the board. Even though Icahn was unsuccessful, Biondi gets $6 million for the few weeks he helped Icahn. As Biondi put it: “It beats minimum wage, that’s for sure.” See this article for more details.

IPO Allocation Abuse Rules

Bill Sjostrom —  13 February 2006

A recent W$J article entitled “Can Bankers Resist the Temptation?� notes that the IPO market is heating up and wonders whether underwriters can resist the temptation of allocating hot IPOs to hedge funds for flipping. Hedge funds now account for as much as a third of IPO allocations and “an increasing chunk of Wall Street’s overall revenue.� According to the article “if the new-issue market remains hot, hedge fund will no doubt start pressing their bankers for ways to bend [IPO allocation] rules to their advantage.� This is nothing new, as many hedge funds pushed the envelope and beyond in trading mutual fund shares.

The SEC did approve NASD Rule 2790 in October 2003 to tighten up restrictions on the allocation of hot IPOs. The NASD, NYSE and SEC also proposed some additional rules in 2003 and 2004 to address other IPO allocation abuses from the dot-com era such as spinning and laddering (see here and here). From what I can tell, however, the SEC has never adopted these rules.  Did they die with Donaldson’s resignation?

Record Hedge Fund Launch

Bill Sjostrom —  3 February 2006

The FT reports today that Jack Meyer, former manager of Harvard’s $25 billion plus endowment, has raised more than $5 billion for his new hedge fund, Convexity Capital. This represents the most successful launch in hedge fund history. Does this mean the talk of the decline of hedge funds was overblown? Perhaps not. Meyer is “arguably the best hedge-fund manager of the past 15 years while at Harvard,� so its not surprising he can attract a lot of money. Additionally, some say Convexity really is not a hedge fund because it will employ a fixed income strategy. Also, Convexity will not be charging the hedge fund standard “2 & 20�—2% management fee on all assets, plus 20% of the profits. Instead, it will charge a 1.25% management fee plus 20% of the profits above the benchmark index’s return.

hedgeFollowing up on this post, according to an article in today’s FT, 1,000 hedge fund advisers had already registered with the SEC prior to adoption of the registration requirement, so it appears that about 1,800 hedge fund advisers will be registered. Again, there are an estimated 8,000 hedge funds. Granted some advisers likely manage more than one fund, it looks like somewhere near a quarter of hedge fund advisers will be registered.

On another note, today’s FT also reports that registered hedge fund advisers deemed high risk by the SEC will be inspected every three years. Other hedge fund advisers will be selected randomly for inspection. The article does not specify the criteria for an adviser being categorized as high risk. But given the numbers, isn’t there a high risk that the truly high risk advisers will not be registered and therefore not subject to inspection?

The hedge fund registration requirements debated extensively in the blawgosphere a few months back (see, e.g., here, here, and here) will take effect on Wednesday of next week. According to this article in the W$J, so far 530 hedge fund advisers have registered and a few hundred more are expected before Wednesday. Recent estimates put the number of hedge funds at around 8,000 (although the number may be on the decline). So why haven’t there been more registrations? Well, the rules do not require registration if customers cannot withdraw money from an adviser’s fund for two years or more or if the fund is not taking new investors. Hence, a number of advisers have increased the lockup period for their funds to two years and others have closed their funds to new investors. Additionally, some hedge funds advisers have previously registered or are waiting to register pending the outcome of litigation challenging the rules (see this article).

The SEC’s reasons for adopting the new rules include the incredible growth of hedge fund assets, the fact that some hedge funds have expanded their marketing to attract retail investors, the gradual and detectable decline in investment minimums, and fraud deterrence. The SEC believes that fraudsters are attracted to the hedge fund industry specifically due to the lack of oversight. Likewise, the SEC hopes that similar to tax audits the prospect of random compliance examinations will serve to deter fraud. You can quibble with whether these reasons warrant additional regulation and whether adviser registration is the right answer (and many have). But if the SEC truly believes additional regulation is warranted and adviser registration is the right answer, why did they draft rules that appear to result in less than 25% of hedge fund advisers registering?

For a brief overview of the new rules (put together by my research assistant, Ron Taylor), see below the fold. Continue Reading…

This Business Week article reports that net inflows of money into hedge funds have dried up, performance has lagged the broader market (although several commenters take issue with the index used for comparison), and 484 funds, more than 6% of the total, have shut down during the first three quarters of 2005 (data for the 4th quarter isn’t available yet). Conversely, as I noted in this post yesterday, inflows into buyout and venture funds are way up. It looks like some sector rotation is going on.