US Senator Chris Dodd believes that only hedge funds – and not private equity or venture funds – should be forced to register with the Securities and Exchange Commission.
The US Senate Banking committee earlier this week released a draft written by Dodd for its financial reform legislation requiring hedge funds to register with the SEC, and specifically exempting private equity firms from registration requirements.
The draft stands in contrast to a similar bill that was approved two week ago by a committee in the other chamber of the US Congress, the House of Representatives. The House bill, which has not received final approval, would require all private equity funds with more than $150 million in assets under management to register as investment advisors. That bill, the Private Fund Investment Advisers Registration Act, also exempted venture capitalists from registration.
Registering as investment advisors would subject private equity firms to increased disclosure requirements, forcing them to spend money to comply with the rules.
The Dodd draft contains language similar to the House bill concerning the registration of hedge funds. But Dodd's draft specifically carves out all private equity and venture capital funds, stating that “except as provided in this subsection, no investment advisor shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund”.
Dodd does not make clear in the draft why private equity should be exempted from registration requirements, but some industry observers believe part of the reason is that private equity does not pose a “systemic” risk to the financial market.
The Private Equity Council, a lobbying group, has repeatedly stressed in its testimonies before Congress that losses on private equity investments cannot cause “cascading losses”, and private equity firms aren’t interconnected enough to endanger the overall financial system, therefore the industry doesn’t deserve the same level of regulatory scrutiny as other institutions. The PEC has supported mandatory registration for private equity firms, however.
“The legislation introduced today by Sen. Dodd represents a thoughtful, targeted and effective way to regulate private pools of capital, avoiding a “one size fits all” approach,” Doug Lowenstein
, president of the Private Equity Council, said in a statement.
Also, the private equity industry has not experienced the major scandals that have driven demand for increased regulation in the hedge fund world, said Craig Miller, a partner at Manatt, Phelps & Phillips.
Private equity and venture capital funds would still be subject to some reporting requirements, but the bill leaves the SEC to decide what those will be, within six months of the passage of any final legislation. “By empowering the [SEC] to obtain extensive records and information from private equity firms, it brings [private equity] into the new regulatory regime and helps ensure that the SEC can protect investors and limit systemic risk,” Lowenstein said.
The SEC will face the difficult task of distinguishing between private equity funds and hedge funds. For some private equity funds, particularly those that invest in distressed debt, the distinction could be blurry.
Since the investment strategies of hedge funds and private equity funds can sometimes overlap, a more likely approach from the SEC would be to examine the underlying fund terms, such as the length of the investment period and how quickly the limited partners can get liquidity.
“For the SEC to come in and figure out what’s a private equity fund and what’s a hedge fund by focusing on investment strategy, that’s a little harder,” Miller said. “They’re more likely to focus on the governing documents for the funds themselves.”
Those firms that manage both private equity and hedge funds would likely have to register as investment advisors, but would only have to follow SEC procedures for registered advisors as they pertain to the hedge fund side of the business, Miller said.
Miller said it is too soon to tell whether the Senate version will triumph over the House bill once the two are reconciled. One consideration, however, is the SEC’s resources, which will be stretched by any new regulatory responsibilities.
“They can’t bite off more than they can chew,” Miller said. “When they are given the authority to regulate these funds and they don’t regulate them well, that’s going to be problematic. So the government may at least want to start by regulating a smaller universe of these investment funds. To the extent that there is increased demand to regulate private equity, assuming the regulation of hedge funds goes well, they may ask Congress to extend their reach.”