For high-net-worth individuals and
institutions, hedge funds offer appealing investment options and more flexibility with much less regulation than
mutual funds. Savvy fund managers, who
don’t need to register as investment advisers, can do pretty much whatever it takes
— from leveraging to short selling — to
earn return on investment.
Net worth and income requirements have
historically limited these investors to a
small, exclusive group. But changes in the
economy over the past decade or so, have
opened up hedge funds to a larger swath of
individuals.
“Under current Securities and Exchange
Commission (SEC) rules, investors can use
their primary residence to meet their qualification requirements for net worth,” says
Aaron Kase, partner with Levenfeld
Pearlstein, LLC, a Chicago-based law firm.
“With the increase in real estate prices over
the last couple of years, a greater percentage of the U.S. population passes the
accredited investor test.”
Smart Business discussed with Kase the
proposed changes, the potential implications of these changes and the best courses
of action for hedge fund managers and
investors.
Which individuals are currently legally eligible to purchase hedge funds?
Under current securities rules, which
have remained mostly unchanged for the
past 25 years, individuals have to meet
income or net-worth requirements to purchase an interest in a hedge fund. To qualify as an ‘accredited investor,’ individuals
need to have had $200,000 of income in
each of the past three years, or $300,000
including a spouse and have the expectation of making at least as much in the current year. Otherwise individuals need to
have at least $1 million in net worth, which
can include a primary residence.
How could proposed legislation change who
qualifies?
Recently, the SEC proposed changes to
the requirements that would make it harder for investors to participate in the hedge
fund market. These potential amendments
would require individuals to also have $2.5
million in investments, including assets
like securities or investment property. This
would raise the wealth requirements and
mean that individuals could no longer
count the value of their home toward the
total investment assets. Married individuals could only count half of their marital
assets, meaning a couple might need as
much as $5 million in investments to participate in hedge funds.
What are the implications of these proposed
changes?
The SEC has received a large number of
negative comments on its proposal from
the public. The feedback typically states
that it’s inappropriate to limit people’s
investment decisions based on the amount
of investment assets they possess. If the
SEC adopts these proposed modifications,
many individuals would be pushed out of
the hedge fund market.
My sense is that large hedge funds, those
with $1 billion or more in assets, don’t need
to be concerned about this issue. Most of
these funds already limit their investors to
those who meet the higher, more stringent qualified purchaser status requirements of
$5 million in investment assets for individuals and $25 million for most entity investors.
Smaller hedge funds would experience a
much greater impact from these more
restrictive requirements. These smaller
investment entities would have a more limited pool of potential investors. Also,
depending on how any final rule is worded,
hedge fund managers could end up with
investors in their fund who would not have
the ability to further invest in the fund or to
invest in subsequent funds.
What advice would you give to new hedge
fund managers?
It’s essential to stay informed, think about
whether potential investors will meet the
higher standards, and include as many
investors who meet the more stringent
requirements as possible.
Ask if potential investors still qualify under
the higher proposed standard. The proposed rule has some grandfathering provisions. It’s in the hedge fund managers’ best
interest to limit the investor qualification
risk based on possible SEC changes.
Why is it important to select a knowledgeable hedge fund adviser, and why is a proven
track record important?
The key risk in a hedge fund is the hedge
fund manager. Mutual funds are registered
investment companies that have a lot more
restrictions in terms of governance, type of
investments and investment practices.
These constraints limit the ability of managers to take advantage of market inefficiencies, but they also protect investors
from unscrupulous or incapable managers.
It’s important to thoroughly research the
fund manager, including his or her track
record, and to read the fund documents
carefully. If individuals don’t feel comfortable doing this research, they can invest in
a fund of hedge funds. The fund of funds
diversifies manager risk by investing in several different hedge fund managers.
AARON KASE is a partner with Levenfeld Pearlstein, LLC. Reach
him at (312) 476-7524.