Are the New Hedge Fund Rules Stifling Growth?

February 21, 2011

New regulations under the Dodd-Frank Act may force those starting hedge funds to choose between “friends and family” money rather than go after institutional capital.

Under the new rules, a manager has to commit to building an infrastructure to support SEC registration in order to attract institutional money. Or choose to remain exempt from SEC registration by managing less than $150 million during the first few years, according to an article from AdvisorOne.

In the past, a hedge fund start-up could gather capital from friends and family, build a track record for a few years, then decide if the time was right to expand with institutional investors. Now, if they go after institutional funds, they have to commit to a specific strategy and a major financial outlay for infrastructure even before their first trade.

The higher barrier to entry has altered the landscape for hedge fund startups, according to Ellen Schubert, chief advisor to Deloitte’s hedge fund practice. Today the so-called “seeders”, large, established funds willing to sponsor new startups, are “in the driver’s seat.”

“They can attract new portfolio managers to their platforms much more easily than they have in the past because they can afford to set them up with an infrastructure that is compliant out of the gate. But that means they get more ownership of the fund,” Schubert said.

However, there is another option that may open the door for new hedge funds. Single family offices (SFOs) are not required to register with the SEC as investment advisors, even if they manage more than $150 million. They must meet three conditions: 1) carefully define who the family members and directors of the SFO are, who are eligible to invest; 2) not promote themselves as investment advisors; 3) manage only family assets and those of certain key employees.

Thus, using the SFO model, a new hedge fund manager could potentially attract more than $150 million, develop a track record, and gradually, over time, build the compliance infrastructure needed to serve bigger, institutional clients.

On a positive note, Schubert said she does not think the increased regulatory burden will necessarily be a bad thing for the hedge fund industry. In the wake of the Madoff scandal, having tighter compliance and greater transparency may give institutions greater comfort in investing in alternative assets. Something that could spur long-term growth overall.

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