Dodd-Frank strikes again

Just when more sophisticated individual investors have become more comfortable with the idea of investing in hedge funds, the universe available to them might become far smaller. The investment banks that provide prime brokerage services to hedge funds have begun to cut back those services to smaller, less profitable hedge funds. They also have begun to require the hedge funds to find other parking places for their cash reserves because it increases the amount of capital the banks have to set aside under new banking regulations.

This means that smaller hedge funds that cannot direct billions of dollars of trades are likely to be denied access to the services of the major investment banks. Some of them will likely close. Others may hang on, but with higher costs.

SMALLER UNIVERSE

That in turn means a smaller universe of funds for clients of investment advisers. The large, successful, well-seasoned funds that have institutional clients such as pension funds are often open only to the richest of individual investors. The small investor clients of advisers need not apply.

In addition, talented fund managers with good track records planning to split away from the giant funds and go out on their own will find it more difficult and more expensive to get the prime brokerage and other services they need to succeed, so fewer will be started.

RULE CHANGE

The development is more fallout from the Dodd-Frank financial reforms and follows on the Securities and Exchange Commission change made in a rule regarding who is qualified to invest in hedge funds.

What these developments mean is more work for investment advisers who are comfortable putting clients into hedge funds. They will have to do more due diligence to find hedge funds suitable for those clients, knowing that the hedge funds may have trouble getting the services they need from investment banks.