A heightened focus by officials at the Securities and Exchange Commission on how fees are earned by hedge fund and private equity firms has some managers braced for more oversight, including a long-resisted move to make them register as broker-dealers.
Driven in part by the SEC's interest in fee-related activity, pension funds and other investors “have increased their expectations and requests for information,” said Ron Geffner, an attorney with Sadis & Goldberg, New York, and who serves on the Hedge Fund Association's regulatory and government advisory board. “The marketplace has become more sensitive to how people are compensated,” which is causing the hedge fund industry to “shrink a little.”
Hedge funds “have been weeded out by virtue of performance, and some of the fat has been trimmed by the regulatory butcher,” Mr. Geffner said.
Private fund managers knew they were in for more SEC scrutiny when the agency launched its new “presence exam” campaign in October, after the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 required them to register with the SEC. At the time, SEC officials said their priorities for the risk-based exams were portfolio management conflicts of interest, safety of client funds and asset valuations. The agency also launched a compliance outreach roadshow, with upcoming stops in Chicago, New York, Atlanta and San Francisco.
But as the exams continue to reveal more about how managers of hedge funds and private equity firms operate, SEC officials are raising more questions about fees, even questioning whether more managers should be registering as broker-dealers.
Private fund managers' antennae started tingling in April, when the issue of private funds registering as broker-dealers was raised in a speech by David Blass, chief counsel of the SEC's Division of Trading and Markets, which oversees broker-dealer activity. Private fund officials are acting as brokers, he said, if they participate in securities transactions “at key points in the chain of distribution,” including marketing shares or interests in a private fund, soliciting or negotiating transactions, and handling customer funds and securities.
Compensation based on the outcome of any transaction is “a hallmark” of being a broker, Mr. Blass said, but the absence of such fee arrangements doesn't rule out it out either.
“I believe that private fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions,” said Mr. Blass, citing such examples as marketing departments, transaction fees or bonuses, investment banking-type fees for leveraged buyouts, and fees paid to general partners. “Taking the activity out of the private equity space and applying it in other contexts would leave little question about the need for broker-dealer registration,” said Mr. Blass.
While he encouraged private-fund managers to suggest situations where they could be exempt, he also warned that not registering “can have serious consequences,” including SEC sanctions and voided transactions. What some industry observers see as the first enforcement shot over the bow came in March, when private equity firm Ranieri Partners paid $375,000 to settle a case involving an unregistered placement agent, where the agency took the unusual step of charging Ranieri senior managing director Donald Phillips with “aiding and abetting” the outside agent.