Hedge fund industry braces for showdown

Jan 30, 2006 @ 12:01 am

By Jeff Benjamin

DETROIT - With the deadline requiring hedge fund managers to register as investment advisers with the Securities and Exchange Commission by Wednesday, much of the $1 trillion hedge fund industry is bracing for a showdown.

In addition to the matter of managers dodging the Wednesday deadline by adopting a reason or legal loophole, the registration issue is threatening to divide the ranks of this otherwise tightly knit subculture of the financial services industry.

"We're certainly going to take it into consideration of whether or not a manager is registered," said Virginia Parker, president of Parker Global Strategies LLC.

"We don't like the idea of managers extending their lockup periods to get around registration," she added. "It's inappropriate, and it's just an excuse to hold money."

Ms. Parker's Stamford, Conn.-based firm manages four funds of hedge funds representing 50 underlying hedge funds and $1.1 billion worth of advisory assets.

Loopholes alarm some

Even though Ms. Parker, who has been registered as an investment adviser since 1996, doesn't think registration will make the industry safer, she doesn't like the route most managers are taking to avoid registration.

Although the new rule requires that hedge fund managers with more than $25 million under management register with the SEC, the rule doesn't apply to managers that have investment lockup periods of at least two years.

The provision, which originally was included in the law to exempt managers of private-equity funds, has emerged as a quick fix for managers seeking to avoid registration.

According to Ms. Parker and other large hedge fund investors, applying a two-year lockup period could make those funds less attractive.

The focus on registration and the use of longer lockup periods "will lead to a bit of a shakedown," said one hedge fund manager who asked not to be identified.

"I definitely think there's a possibility we'll see some hedge fund manager turnover come Feb. 1," the manager added.

While the SEC hasn't announced an official position on the use of longer lockup periods, it appears that market pressures from within the hedge fund industry could resolve the issue, and force more managers to conform to a rule that the industry generally has opposed from the start.

Opposition to the rule has been based on the added cost of registration, an aversion to regulatory audits, and claims that the SEC is ill equipped to police an area as diverse as hedge funds.

The irony is that even with widespread opposition to the rule, including a lawsuit challenging the SEC's authority to enact it, and much speculation over the ability to actually monitor hedge fund managers, the mere existence of the rule is emerging as a self-

policing function.

"It will become a question of why someone isn't registered," said John Van, chief financial officer at Van Hedge Fund Advisors International Inc. in Nashville, Tenn.

"[A manager's refusing to register] raises a red flag, and it raises a serious issue of whether you should stay with that manager," he added. "It's really not a good sign, because if something should happen, the clients will look at you and say, 'There was a red flag.'"

In addition to whatever stigma might come with not being registered, the longer lockup periods also can set off a chain reaction of liquidity issues for funds of funds that have lockup periods closer to the industry standard of one year or less for an initial investment.

"If we allocate to too many managers with two-year lockups, that will definitely create liquidity issues for us," said Ed Stavetski, chief investment strategist with CMG Investment Advisors LLC in Radnor, Pa.

CMG, which has $350 million under management, manages two funds of funds that include more than 30 underlying hedge funds.

Mr. Stavetski said that "less than a handful" of his underlying managers have avoided registration by extending their lockup periods.

The registration issue also is likely to add new wrinkles at the so-called F3 level of hedge funds, which includes funds of funds of hedge funds.

"As a fund-of-funds-of-funds manager, I may be giving annual liquidity, but for the first time, there are funds of funds that will have liquidity mismatches," said Richard Van Horne, a registered investment adviser at Diversified Hedge Investment Advisors LLC in Summit, N.J.

Mr. Van Horne, who declined to disclose his total assets under advisement, manages an F3 with eight underlying funds of funds, two of which have avoided registration by extending their lockup periods. He is evaluating if it makes sense to remain with unregistered advisers.

There are more than 9,000 investment advisers registered with the SEC, and the original estimates were that hedge fund manager registration could add about 1,000 registrants to the total, according to commission spokesman John Nester.

Since January 2005, the SEC has seen 465 hedge fund managers register, and through last Wednesday, there were 350 applications in various stages of registration, he added.

Too small to register

There are an estimated 8,000 hedge funds based in the United States, but not all are large enough to require the managers to register with the SEC. And some managers registered long before it was even an issue.

"We've been registered with the SEC since 2000, and we always thought it was one of our strengths. But that's usually the 100th out of 100 questions a potential investor will ask us," said Larry Eiben, chief operating officer at Richmond, Va.-based TFS Capital LLC.

The firm manages $50 million in two hedge funds and a mutual fund.

"To me, being registered is a big deal, and I was somewhat disappointed that nobody cares that we've been jumping through all these hoops and went through an SEC examination," Mr. Eiben said.

As SEC registration takes center stage, there is evidence that even the conformists don't necessarily subscribe to the idea that the rule adds any real value to the hedge funds industry.

"Any investor who feels better about me because I'm registered would just show me how ignorant they are," Mr. Van Horne said. "I can think of 100 things more important than that."

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