WASHINGTON — The Securities and Exchange Commission
is considering whether to raise the financial bar for investing in
private-investment pools other than hedge funds.
“We could raise the standards for every kind of offering that relies on Reg D,” Douglas Scheidt, associate director and chief counsel of the division of investment management, said of Regulation D, which exempts certain
investment vehicles from many of the regulatory requirements imposed upon standard public offerings.
Although Regulation D often is associated with hedge funds, it also is applied to investments in private-equity securities, such as pooled mortgages and other types of pooled consumer debt.
“We could identify every security or type of security, issued by a fund or issued by a company, and decide which ones are so risky that we should raise the accredited-investor standards,” Mr. Scheidt said.
The SEC has proposed limiting participation in hedge funds to investors who have a minimum of $2.5 million in investible assets, excluding the value of their primary home. Currently, investors must have a minimum of $1 million in net worth, including real estate, or earn at least $200,000 a year.
Venture capital funds are specifically excluded from the SEC’s proposal so as not to impede small-business development. The comment period on the proposed change, which would apply only to hedge funds, ended last Friday.
In their comments to the SEC, some individual investors and small
hedge fund operators questioned why the commission is limiting its proposal to raise the minimum eligibility requirements to just hedge funds when investing in private-equity securities often carries as much — if not more — risk.
Commissioner Paul Atkins, who opposed the SEC’s first attempt to register
hedge fund advisers but last December voted for issuing the higher-wealth-threshold proposal, thinks they have a valid point.
“There’s little to differentiate hedge funds from private-equity funds and
venture capital funds from the way business is trending in the last few years,” he said.
Under the Securities Act of 1933 and the Investment Company Act of 1940, the SEC has authority to require securities to be registered. Regulation D exempts private offerings from having to register as long as they are not offered publicly and are available only to investors who meet the higher wealth standards.
The SEC says that its
hedge fund proposal is aimed at protecting unsophisticated investors who would not be able to bear the risk of losing a substantial part of their wealth. Last year, the U.S. Court of Appeals for the District of Columbia Circuit overturned the SEC’s previous attempt to register
hedge fund advisers. One former SEC member warns that the agency’s rationale for imposing a higher standard for
hedge fund eligibility may run into legal trouble.
Typically, hedge funds are diversified, said Steven Wallman, who was commissioner of the SEC from 1994 to 1997. Therefore, the risk associated with investing in them probably is lower than the risk associated with investing in a non-diversified, privately held small business, said Mr. Wallman, the founder and chief executive of Vienna, Va., brokerage firm FOLIOfn Inc.
The justification for the proposal “is probably backward,” he said. “The risk level is probably lower in the
hedge fund area, as opposed to higher.”
Although Mr. Wallman thinks it could be a good idea to raise accredited-investor standards “to protect the SEC from the potential of another failed court proceeding, you have to ask whether other areas are less risky. If not, why shouldn’t this superaccreditation level apply to those other areas, as well?”
The problem with trying to differentiate between hedge funds and other private-
investment vehicles is that the lines have blurred between them, said Barry Barbash, a partner in the Washington office of New York law firm Willkie Farr & Gallagher LLP, who was director of the SEC’s division of investment management from 1993 to 1998.
Traditionally, private-equity funds have invested in a portfolio of companies with the goal of taking those companies public or selling shares in the fund. Managers of private funds typically get involved in the governance of the companies they invest in but are more patient investors than their
hedge fund counterparts.
Shares of private-equity funds can not be redeemed until the investments are sold. Venture capital funds typically invest in startup companies, and fund managers often take activist roles. Hedge funds traditionally have invested in many different types of investments and usually are owned by money managers who are passive investors.
But “the traditional definitions are breaking down,” with private-equity funds investing the way hedge funds traditionally have been thought to invest, and hedge funds engaged in
venture capital and
private equity, Mr. Barbash said.
That is raising the question “of whether the logic behind the accredited investor person should be applicable to all three kinds of funds. The same kinds of investors go into all three kinds of funds,” Mr. Barbash said. “It’s not clear to me how the SEC is going to answer that.”
