On October 11, 1996, President Clinton signed the National Securities
Markets Improvement Act of 1996 ("NSMIA"). NSMIA has been modestly
described by its sponsors as the "first major overhaul of securities
law in 60 years". Its goals are: (a) to keep U.S. securities
markets efficient and competitive with foreign markets; (b) to reduce
the costs of capital formation by eliminating duplicative regulation;
(c) to reallocate regulatory responsibility between federal and
state "blue sky" regulators; and (d) to improve mutual fund regulation.
However, perhaps the most interesting aspect of NSMIA is that it
provides a number of crucial amendments to the Investment Company
Act of 1940 (the "Act"), the result of which could and should
provide sweeping reform to the hedge fund industry (the "Industry").
Among its most significant consequences are that: (1) it removes
the "100 person" limit for certain investment funds; (2) it introduces
a non-integration safe-harbor permitting two funds run by the same
management to operate side by side even if the two have identical
investment programs; and (3) it includes a "grandfather" clause
which enables funds which were established before these new laws
to convert and be covered by the expanded exemptions.
Clearly, the intent of Section 3(c)(7) is to enable previously
denied "high quality" institutions and investors due to legal restraints,
access into the hedge fund community. Given that institutions currently
comprise less than $3 billion of hedge fund capital, and given that
the institutional capital exceeds $16 billion, the notion of this
new "investor" into the hedge fund universe is indeed encouraging
to the growth of the hedge fund industry.
The ultimate historical importance of this reform, however, may
be its unintended consequences -- the first step towards "de-mystifying"
the "murky" world of hedge funds via greater investor participation.
Although hedge fund investing is still limited to, at a minimum,
"Accredited Investors", NSMIA should indirectly trigger lower minimums
by managers, since they could establish a 3(c)(1) fund with low
minimums, and then when their investor limit hits 99, simply create
a parallel (3)(c)(7) fund without fear of integration by the SEC.
Lower minimums will encourage more "Accredited Investors" to invest
and to be accepted. Ultimately, although quite a bit away, as more
and more "Accredited Investors" become hedge fund investors, it
is logical that a new class of "acceptable investors" lower than
"Accredited" may, with proper regulation, be permitted to invest
in hedge funds, the result of which would vastly expand the Industry's
capital base. And, it is quite possible that the "99 Limit" may
be dropped to enable widespread hedge fund investing.
Whatever the outcome, it is clear that this legislation may be
as historic as it claims to be.
Section 3(c)(1) of the 1940 Act
Investment companies are governed by The Investment Company Act
of 1940 (the "1940 Act"). The 1940 Act was promulgated to protect
investors by requiring such companies to go through a significant
registration and disclosure process. However, recognizing that certain
investors did not need these protections, Section 3(c)(1) was established
to except investment companies whose outstanding securities are
beneficially owned by no more than 100 persons, and which are not
and do not presently intend to make a public offering of their securities.
Many of these private investment vehicles which qualify as a 3(c)(1)
exemption are organized as hedge funds, which are investment pools
that invest on a hedged or non-hedged basis in domestic and foreign
securities, commodities and other investments.
The practical application of the 3(c)(1) exception has been burdensome
to both regulators and sponsors of private investment companies
alike. From a practical perspective, Section 3(c)(1) frustrated
the development of the Industry. To place an arbitrary limit
on investor participation has not only been bad policy, but has
also encouraged funds and investors to circumvent the law, through
cleverly developed technicalities. Although the statute foresaw
these problems and the Securities and Exchange Commission ("SEC")
developed tests to prevent such actions, due to the inherent complexities
of the 3(c)(1) exception, the statute has not only failed in its
objective, but has been costly and time consuming to regulate.
As a result of these frustrations, but most importantly due to
the recognition that large scale capital participation by sophisticated
investors in private investment companies were frustrated by the
requirement of 3(c)(1), NSMIA with its Section 3(c)(7) was enacted.
For issuers whose securities are owned exclusively by sophisticated
investors, the public offering prohibition and 100 investor limit
are unnecessary constraints not supported by sufficient public policy
concerns. Therefore, the Division recommends an amendment to the
Investment Company Act of 1940 to create new exceptions for funds
whose securities are held exclusively by qualified purchasers as
defined by the rule.
Section 3(c)7: A New Exception For Private Pool Investing
There are four basic components of new Section 3(c)(7). First,
in stark contrast to 3(c)(1), 3(c)(7) allow for the creation of
hedge funds with unlimited partners, so long as each partner is
a "Qualified Purchaser". While yet to be finalized, conceptually,
a "Qualified Investor" is simply a super-rich "Accredited Investor".
Specifically, it is:
(a) A natural person who owns at least $5 million in investments.
(The SEC has 180 days to define "investments"). (b) A family controlled
company which owns at least $5 million in investments. (c) A trust
fund managed by "Qualified Investors" that was not expressly formed
for the purpose of satisfying 3(c)(7).
Second, the new laws allow for those hedge funds established under
3(c)(1) to also exceed the "99 Investor" limit and convert to 3(c)(7)
funds so long as all new investors after September 1, 1996 are
"Qualified Purchasers", and that certain procedural matters
have been satisfied. In effect, those previously closed funds will
be able to convert and re-open.
Third, the new laws eliminate the 3(c)(1) concept of integration
as it pertains to parallel 3(c)(1) and 3(c)(7) funds. Although the
SEC will still apply the integration test with respect to parallel
3(c)(1) funds, it will not apply the test if one of the parallel
funds is a 3(c)(7). Thus, a manager may set up funds with identical
investment objectives so long as one is a 3(c)(7).
Fourth, the new laws amend the first "look through" test of
3(c)(1) thereby permitting non- registered investment companies
that are not 3(c)(1) or 3(c)(7) funds to acquire more than 10% of
a 3(c)(1) or 3(c)(7) fund without being subject to the "look-through"
test, and thus being counted as multiple investors. It also eliminates
the second test-- that an investor may invest only up to 10% of
its assets in 3(c)(1) funds. Thus, for entities such as pensions
and endowments, this represents a significant opportunity to get
involved with 3(c)(1) funds, since they will now only represent
1 investor. However, the "look-through" test remains in effect
for 3(c)(1) or 3(c)(7) funds.
As a smaller consequence, the new rules will permit the SEC to
establish guidelines which would permit "knowledgeable employees"
of the hedge fund, or an affiliated person of the hedge fund to
invest in the 3(c)(1) fund without increasing the investor count
and in the 3(c)(1) without violation of the 3(c)(7) fund.
Tax Issue Alert
While the tax implications have yet to be finalized, it is clear
that the intent is not to afford Section 3(c)(7) funds with the
same tax protections of Section 3(c)(1) partnerships. However, what
is unclear is what the tax consequences will be. It is contemplated
that converted 3(c)(1) and newly established 3(c)(7) funds will
be considered by the Internal Revenue Service as "Publicly Traded
Partnerships" ("PTP") and be taxable as a corporation. However,
it is also clear that "carve-outs" for 3(c)(7) funds with only once
a year redemption rights as well as other exceptions are being contemplated
as ways the PTP may still gain certain tax advantages. Stay tuned.
IMPLICATIONS FOR HEDGE FUNDS
Big Winner: Institutional Investors
New Act Enables Full-Scale Invasion by Institutions into the
Hedge Fund Arena
The expressed intent makes it clear that these reforms are to enable
highly qualified investors, such as institutions, which have been
previously unable to invest in hedge funds due to the "look-through",
the "ten-percent rule" or because funds were closed, to gain investing
access to hedge funds. If the institution wants to invest with a
hot, but closed manager, that manager may open a new 3(c)(7) or
convert its 3(c)(1). Either way, previously frustrated institutions
will now be able to dive into hedge fund investing.
Big Winner: Previously Closed, But "Hot in Demand" 3(c)(1)
New Act Permits 3(c)(1) Funds To Convert To a 3(c)(7) and Exceed
"99 Investor" Rule
The previously closed "hot" 3(c)(1) fund will now be able to convert
and "re-open" as a 3(c)(7) fund. It is currently estimated that
around 200 funds are presently closed due to partnership limits.
Coupled with the fact that it will now have access to billions of
new investing dollars, the positive impact of this legislation can
only be described as a major victory for marquee hedge funds.
There are indications that some of the leaders have already begun
to move on this notion. Julian Robertson's $7.5 billion Tiger fund,
which has been closed for some time, is now expected by many to
reopen sometime in 1997.
Winner: Start-Up Hedge Funds
New Act Allows Easier Access To Capital For Start-Up Hedge Funds
For once however, not only the "strong will get stronger". One
of the major barriers to entry in the Industry, is that start up
funds are often caught in the dilemma of when to accept capital.
If it established too high a minimum it might not attract investors.
If it was too low, it might close out due to the "99 Investor" limit
with much less capital than its potential. No more fear, NSMIA is
here. Now, a start-up could set up a 3(c)(1) fund with low minimums
and then when it caps-out, to simply establish a 3(c)(7) fund without
fear of integration, a concept which prohibited such parallel funds
Winner: The 3(c)(1) Fund Desiring Big Investors, Yet Wishing
to Remain a 3(c)(1): S
New Act Will Enable Certain Entities To Invest Without Being
Counted as Multiple Investors
The new law benefits those 3(c)(1) funds wishing to retain their
3(c)(1) special status but yet eager to attract investors with large
pools of capital, by permitting certain types of entities, such
as endowments and foundations to be counted as one investor. Previously,
such investors were subject to "look-through" tests, and if they
owned more than 10% of the fund's assets, they would be counted
as multiple investors.
Winner: "Accredited" But Not "Qualified Investors"
Under the old regime, only "Accredited Investors" could invest
in hedge funds. However, due to the "99 Investor" rule, they were
often unable to gain access due to either a fund's decision to have
high minimums (since they were limited in number of investors),
or because many were closed. After all, if given the choice between
a $1,000,000 and $250,000 investor, and there was only one spot,
it is fairly obvious who would be accepted. Now, many funds which
may have been either unwilling or unlawfully able to accept these
investor's might now find a place for them. However, it is not a
major victory for this class of investor yet, because 3(c)(7) or
converted 3(c)1 funds are only permitted to take "Qualified Investors".
The one area that these investors will be able to gain access is
to new start-up funds.
Mixed Verdict: Fund of Funds
As a by-product, the fund of funds stands to gain from increased
institutional participation. Yet, it is conceivable, that many "Accredited
Investors" who opted for the fund of funds because they were unable
to get into a fund which was either closed or which had high minimums,
might now be able to go straight to that fund. As a result, it is
too early to tell what the outcome on the fund of funds might be.
Little Affect: Distressed and Value Managers
Not all investment styles will be affected the same. For example,
small-cap players need to keep their assets under management down
in order to stay nimble. Many believe that big does not necessarily
Loser: The Mid-Size Fund Hoping to Grow Into The "Mega-Fund"
If there is a losing participant, it will probably be the mid-size
fund hoping to grow to a "mega-fund". By way of example, many "Qualified
Investors" who may have wanted to get into a mega-fund but couldn't
because it is closed, may now be able to. As a result, there may
be a flight of capital from those near giants, to the giants.
The trend is obvious, and the historical consequences are clear.
The U.S. is the last G-7 nation whose investors do not culturally
embrace the concept of "hedging". One day it is quite conceivable
that the notion of "hedging" will be considered the prudent method
to invest. With increased volatility, and the increased maturation
of the Industry, hedge funds may prove safer bet than mutual funds
in the years to come. After all, few would disagree that the
U.S. equity market is frothy, so why not hedge while participating
in a pricey market. It's simply prudent to have insurance against
a market decline at the moment. Finally, with the improved sophistication
of investors, many of the former safeguards to protect investors
from hedge fund investing are obsolete.
Whether or not history takes this course, only time will tell.
But one thing is for certain --this legislation will dramatically
reshape the landscape of the hedge fund industry. Whether, due to
new institutional or retail capital, it is quite possible that NSMIA
has placed the Industry at a historical crossroads, and, it may
never be the same.