Hedge funds, already an exclusive investment option, have been made even more restrictive by the definition of a qualified investor. Now we are seeing a trend in the direction of even greater exclusivity as hedge funds return outside investors’ capital and transform into family offices, which further restricts investors to family members.
George Soros and Steven Cohen are two high profile examples of this transition. Soros closed his fund to non-family members in 2011, citing a desire to avoid the additional regulatory burdens and scrutiny arising from the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act which had gone into effect in July, 2010. Cohen made the transition out of necessity following his plea deal forbidding him from managing the money of outside investors.
Defining a Family Member
The SEC issued its final rule on family offices which became effective August 29, 2011. More than six pages of the rule are devoted to the definition of a family member. As a result, a complete analysis is not practical in the space allowed here and you are encouraged to click on the above link for details. For the purposes of this article, suffice it to say, the definition is extremely broad, allowing, for example, all lineal descendants of a common ancestor, spouses, spousal equivalents of such descendants, who are no more than ten generations removed from the aforesaid common ancestor. Ex-spouses, step-children, adopted children, and foster children are also considered to be family members. And, by the way, the designated common ancestor can be changed over time. Given the broad definition under the rule, it is not difficult to grasp the lure a family office has for a hedge fund founder.
Potential Abuse and Investor Push Back
Surprisingly, nothing in the rule precludes a hedge fund manager from creating a family office operated in parallel with his existing hedge fund. As a result, several prominent hedge fund managers have done exactly that. Bill Ackman and Ray Dalio, for example, have created single family offices.
This practice has engendered consternation from some institutional investors who see the family office as a potential distraction that may reduce the hedge fund manager’s focus to the detriment of investors.
While there is no tangible evidence that this is occurring, clients are justified in their unease. There is a long-standing tradition of hedge fund managers putting their personal fortunes on the line, in effect, demonstrating that what is good for the goose, is good for the gander.
Clients and regulators have expressed concern with respect to other potential conflicts such as who covers costs for what, and overlapping or conflicting investments.
While it is entirely understandable that hedge fund managers see the family office as a safe haven from burdensome regulation, a respite from investor push-back with respect to fees, an escape from negative public perception and a path to greater operational freedom, they must take steps to avoid even the perception of impropriety. If they fail in this, the family office may suffer the same fate as its hedge fund precursor.