A debate brews between the U.S. Security and Exchange Commission (SEC) and the hedge fund industry about proposed changes to the current definition of accredited investor. The Dodd-Frank Wall Street Reform and Consumer Protection Act requires this definition be reviewed every four years. The definition of an accredited investor has not changed since 1982, except for the 2010 exclusion of a potential investor’s primary residence from net worth calculation, which actually flows from passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, not an SEC review.

Fears are that smaller hedge funds, those with under $100 million in assets under management, will experience a disproportionately negative impact as compared to larger hedge funds. This fear is based on the fact that institutional investors tend to favor large hedge funds, while smaller funds are dependent on individual high net worth investors. As a result, any change that shrinks the pool of individual investors operates to the detriment of smaller funds.

What’s on the Table?

One of the more innovative changes being considered revolves around the concept of evaluating the potential investor’s level of financial sophistication. How this would be accomplished is not entirely clear. However, it has been suggested that holding a Chartered Financial Analyst’s credential or a FINRA Series 7 license could be a starting point for accreditation. This would shift the emphasis from income and net worth to a standard that relies on the investor’s financial sophistication.

Another approach having merit consists of establishing a percentage of assets or income that may be invested. In theory, this would not shrink the pool of investors, whereas raising the income and/or net worth thresholds would certainly have that effect.

The Poor Get Poorer and the Rich Get Richer

The current definition of an accredited investor slams the door of opportunity in the faces of all but the wealthiest among us. Existing policy smacks of elitism and is not fundamentally different from Jim Crow laws precluding those not owning land from voting.

To put this in perspective, less than 5 percent of U.S. households meet the current definition of an accredited investor, leaving more than 95 percent of potential investors unable to benefit from investing in hedge or private equity funds.

Equal Opportunity

The SEC is presented with a unique opportunity to expand and invigorate the economy and widen economic participation in the broader investment community by making prudent changes to the crucially important definition of the accredited investor.

With American individual net worth having dropped below that of Switzerland, Australia, Norway and Luxembourg, the time may be right for the SEC to remove its boot from the throat of the nation’s economy. Shouldn’t economic freedom be on a par with the freedom to exercise one’s right to vote, to enjoy equal employment opportunity, to receive equal pay for equal work, and to be free from discrimination because of physical disability, sexual orientation, race or creed? Is there a rational argument for discriminating against someone based on net worth or gross annual income? This act of discrimination affects a greater percentage of Americans than any of the aforementioned. Where is the ACLU on this point?

 

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Every action has consequences. The CalPERS divestiture will have some unanticipated consequences as well. Here are a few.

Doors that May Have Closed

  • Two and twenty was already on the rails and headed out of town before the CalPERS announcement. One of the industry’s worst kept secrets is that most large pension funds and institutional investors are already receiving a sweeter deal than the over-publicized two and twenty fee structure.  None-the-less, media attention surrounding this redemption will serve to grease the rails.
  • CalPERS may have revealed its soft underbelly. As the largest public sector pension fund, it was viewed to have held some sway over smaller pension fund managers. However, recent events have demonstrated that CalPERS leadership role was exaggerated, as evidenced by the legion of ebullient public pension fund managers who have spoken out in support of their hedge fund investments. For example, the California State Teachers’ Retirement System (CalSTRS) has affirmed its intent to stand by the hedge fund investments it has made. This suggests that rather than having been a leader, CalPERS has just been sonorous.

Doors that May Have Opened

  • Public employee pension funds are highly political entities. The complexities of hedge fund investments are not well understood by rank and file public servants who rely on their pension fund for retirement income. However, they do understand is fees and pension fund managers have clearly demonstrated their understanding of the positive role hedge fund investments play in a comprehensive investment strategy. Politics and pensioners may incent fund managers to explore investments in smaller hedge funds with proven track records and more palatable fees. This bodes well for many of the smaller hedge funds.
  • Hedge funds, in the main, are very likely to benefit from this ‘dust-up”. Publicity. Even bad publicity can be good. Hedge funds, now liberated from the decades old general solicitation ban, may see an organic bloom of interest from the retail market. Why? Because the CalPERS split with hedge funds piqued a broader interest in the industry, which may help hedge funds with retail ambitions. Broadly, hedge funds will benefit from the in-depth explanations public pension funds have been compelled to offer in support of their decision to remain invested in hedge funds.

Hedge fund managers need to recognize the doors of opportunity are opening, post CalPERS, and cross those thresholds with alacrity. Managers of smaller hedge funds have a unique opportunity to enhance market share in the public pension sector and they would be ill-advised to pass it by.

Managers of large and small funds would be well-advised to capitalize on the free and favorable publicity proffered by the heads of public pension funds. Large numbers are disavowing CalPERS strategy of divestiture. The cases they have made in support of their positions in hedge funds can be folded into any hedge fund’s retail strategy. Couple this with the rather cogent rationale for hedge fund investment, as articulated by so many public pension fund investors, and you have a powerful marketing tool at your disposal … for free.

 

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