[Senate Hearing 111-273]
[From the U.S. Government Publishing Office]
S. Hrg. 111-273
REGULATING HEDGE FUNDS AND OTHER PRIVATE INVESTMENT POOLS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
EXAMINING THE REGULATION OF HEDGE FUNDS AND OTHER PRIVATE INVESTMENT
POOLS TO ASSIST REGULATORS IN ADDRESSING FRAUD AND PREVENTING SYSTEMIC
RISK IN OUR CAPITAL MARKETS
__________
JULY 15, 2009
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
JIM BUNNING, Kentucky, Ranking Republican Member
TIM JOHNSON, South Dakota MEL MARTINEZ, Florida
CHARLES E. SCHUMER, New York ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey DAVID VITTER, Louisiana
DANIEL K. AKAKA, Hawaii MIKE JOHANNS, Nebraska
SHERROD BROWN, Ohio BOB CORKER, Tennessee
MARK R. WARNER, Virginia
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut
Kara M. Stein, Subcommittee Staff Director
William H. Henderson, Republican Subcommittee Staff Director
Randy Fasnacht, GAO Detailee
(ii)
C O N T E N T S
----------
WEDNESDAY, JULY 15, 2009
Page
Opening statement of Chairman Reed............................... 1
Prepared statement........................................... 33
Opening statements, comments, or prepared statements of:
Senator Bunning.............................................. 2
Prepared statement....................................... 33
WITNESSES
Andrew J. Donohue, Director, Division of Investment Management,
Securities and Exchange Commission............................. 3
Prepared statement........................................... 34
Responses to written questions of:
Senator Shelby........................................... 82
Senator Bunning.......................................... 89
Senator Schumer.......................................... 90
Senator Vitter........................................... 91
Dinakar Singh, Founder and Chief Executive Officer, TPG-Axon
Capital, on behalf of Managed Funds Association................ 13
Prepared statement........................................... 38
Responses to written questions of:
Senator Bunning.......................................... 92
Senator Schumer.......................................... 92
James S. Chanos, Chairman, Coalition of Private Investment
Companies...................................................... 15
Prepared statement........................................... 44
Responses to written questions of:
Senator Bunning.......................................... 92
Senator Schumer.......................................... 93
Trevor R. Loy, Founder and General Partner, Flywheel Ventures.... 17
Prepared statement........................................... 62
Responses to written questions of:
Senator Bunning.......................................... 93
Senator Schumer.......................................... 96
Mark B. Tresnowski, Managing Director and General Counsel,
Madison
Dearborn Partners, LLC, on behalf of the Private Equity Council 19
Prepared statement........................................... 68
Responses to written questions of:
Senator Bunning.......................................... 96
Senator Schumer.......................................... 98
Richard Bookstaber, author of ``A Demon of Our Own Design:
Markets, Hedge Funds, and the Perils of Financial Innovation''. 21
Prepared statement........................................... 73
Responses to written questions of:
Senator Bunning.......................................... 98
Joseph A. Dear, Chief Investment Officer, California Public
Employees'
Retirement System.............................................. 23
Prepared statement........................................... 77
Responses to written questions of:
Senator Bunning.......................................... 100
(iii)
REGULATING HEDGE FUNDS AND OTHER PRIVATE INVESTMENT POOLS
----------
WEDNESDAY, JULY 15, 2009
U.S. Senate,
Subcommittee on Securities, Insurance, and
Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 2:35 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed (Chairman of the
Subcommittee) presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Senator Reed. Let me call the hearing to order. I want to
thank Senator Bunning for participating today and contributing
to the hearing. I also want to welcome all the witnesses--Mr.
Donohue and the succeeding panel.
As we continue the important work of modernizing our
outdated financial regulatory system, I have called this
hearing to explore a key aspect of these reforms: The
regulation of hedge funds and other private investment pools,
such as private equity funds and venture capital funds.
The current financial crisis has reinvigorated my long-held
concern--and I am not alone--that the regulation of hedge funds
and other pooled investment vehicles should be improved to
provide more information to regulators to help them address
fraud and prevent systemic risk in our capital markets.
These private pools of capital are responsible for huge
transfers of capital and risk, and so examining these
industries and potential regulation are extremely important to
this Subcommittee.
Hedge funds and other private investment funds generally
operate under exemptions in Federal securities laws that
recognize that not all investment pools require the same close
scrutiny demand of retail investment products, like mutual
funds. Hedge funds generally cater to more sophisticated and
wealthy investors who are responsible for ensuring the
integrity of their own investments and, as a result, are
permitted to pursue somewhat riskier investment strategies.
Indeed, these funds play an important role in enhancing
liquidity and efficiency in the market, and subjecting them to
fewer limitations on their activities has been and continues to
be a policy choice that has been made by previous
Administrations and previous Congresses.
However, these funds have often operated outside the
framework of the financial regulatory system even as they have
become increasingly interwoven with the rest of the country's
financial markets. As a result, there is no data on the number
and nature of these firms or any regulatory ability to actual
calculate the risks they present to the broader economy.
Over the past decade, the SEC has recognized there are
risks to our capital markets posed by some of these entities,
and it has attempted to require at a minimum that advisers to
these funds register under the Investment Advisers Act so the
FCC staff can collect basic information from and examine these
private pools of capital. The SEC's rule making in this area,
however, was rejected by a Federal court in 2006. As a result,
without statutory changes, the SEC is currently unable to
examine private funds, books, and records, or to take
sufficient action when the SEC suspects fraud. In addition, no
regulator is currently able to collect information on the size
and nature of hedge funds or other funds to identify an act on
systemic risk that may be created by these pools of capital.
To address this regulatory gap, I recently introduced the
Private Fund Transparency Act of 2009, which would require
investment advisers to private funds, including hedge funds,
private equity funds, venture capital funds, and others, to
register with the SEC.
Let me make the specific point that I chose a comprehensive
approach so that we could begin to consider all of these
different types of arrangements and make changes based upon not
presumptions but hearings, evidence, and a detailed discussion
of the range of regulatory authority. And this is the beginning
of that process today.
The bill that I introduced would provide the SEC with the
authority to collect information from these entities, including
information about the risks they may pose to the financial
system. In addition, it would authorize the SEC to require
hedge funds and other investment pools to maintain and share
with other Federal agencies on a confidential basis any
information necessary for the identification and mitigation of
systemic risk.
I hope today's hearing provides an opportunity to discuss
my proposal and other proposals so that we can consider ways to
determine the best approach in this area. The financial crisis
is a stark reminder that transparency and disclosure are
essential in today's marketplace. Improving oversight of hedge
funds and other private funds is vital to their sustainability
and to our economy's stability.
I welcome today's witnesses and look forward to the
testimony, and now I would like to recognize the Ranking
Member, Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman.
In some ways, the structure and incentives of these private
pools of capital are what we should be hoping for in the rest
of the financial system. Success is rewarded and failure is
punished. Pay is based on performance over time and not just in
the short run. And managers have skin in the game with their
own funds at risk. It seems obvious to me that firms and
traders will act more responsibly when they know they will face
the consequences of their actions, which is why bailouts breed
more bailouts.
I do have some concerns about the risk that these firms
could post to our system. Hedge funds in particular use
leverage, which can lead to outsize losses and panic selling.
Losses in one part of a portfolio can force the sale of other
assets, which spreads the losses to a normal, unrelated
investment. Just look at last fall for an example.
I am also concerned about the potential for market
manipulation and fraud. When firms can seek profit by any
strategy they dream up, there will be a great temptation to
cheat. I am not saying all or even most firms are dishonest.
But the temptation will be there, and that cheating is harder
to detect because of the secrecy of portfolios and strategies.
Huge risk in the system could build up out of the sight of
regulators and other market participants as well. How we
address these concerns is not an easy question, and I do not
know the answer. I am skeptical of the idea of a Government
regulator being smart enough to recognize concentration of risk
and act to reduce it. Instead, it may make more sense to limit
how much risk these firms can take on and, thus, how much risk
they pose to others by imposing leverage restrictions. However,
I am not sure if it is better to put restrictions on the firms
themselves or limit the dealings of banks and other regulated
institutions with these firms.
These are by no means all the issues to consider, but I
hope to get some thoughts on them here today.
Thank you, Mr. Chairman.
Senator Reed. Thank you, Senator Bunning.
Senator Bayh.
Senator Bayh. Thank you, Mr. Chairman. I am here to listen
and learn and will reserve comment accordingly.
Senator Reed. You also have the best opening statement, so
thank you.
[Laughter.]
Senator Reed. It is now my pleasure to introduce Mr. Andrew
J. Donohue, who is the Director of the Division of Investment
Management at the Securities and Exchange Commission. Serving
in this role since 2006, Mr. Donohue has been responsible for
developing regulatory policy and administering the Federal
securities laws applicable to mutual funds investment advisers,
and others. Prior to joining the SEC, Mr. Donohue was global
general counsel for Merrill Lynch Investment Managers,
overseeing the firm's legal and regulatory compliance functions
for over $500 billion in assets, including mutual funds, fixed-
income funds, hedge funds, private equities, managed futures,
and exchange funds.
Mr. Donohue, I appreciate your appearing before the
Subcommittee this afternoon, and I look forward to your
testimony. Welcome.
STATEMENT OF ANDREW J. DONOHUE, DIRECTOR,
DIVISION OF INVESTMENT MANAGEMENT, SECURITIES AND EXCHANGE
COMMISSION
Mr. Donohue. Chairman Reed, Ranking Member Bunning, and
Members of the Subcommittee, thank you for the opportunity to
testify before you today. My name is Andrew Donohue, and I am
the Director of the Division of Investment Management at the
Securities and Exchange Commission.
Over the past two decades, private funds, including hedge,
private equity, and venture capital funds, have grown to play
an increasingly significant role in our capital markets. The
securities laws, however, have not kept pace, and as a result,
the Commission has very limited oversight authority over these
vehicles and their advisers. We do not conduct compliance
examinations of them. They do not file registration forms with
us. We have incomplete information about these funds and their
advisers. We sometimes discover them first in the midst of an
investigation by our Enforcement Division.
This presents a significant regulatory gap in need of
closing. The Commission tried to close the gap in 2004--at
least partially--by adopting a rule requiring all hedge fund
advisers to register under the Investment Advisers Act. That
rule making was overturned by an appellate court in the
Goldstein decision in 2006. Since then, the Commission has
continued to bring enforcement action against private funds
that violate the Federal securities laws, and we have continued
to conduct compliance examinations of the hedge fund advisers
that remain registered under the Advisers Act. But we only see
a slice of the private fund industry, and the Commission
strongly believes that legislative action is needed at this
time to enhance regulation in this area.
You can close the regulatory gap by closing one or more of
the exemptions on which private funds and their advisers rely
to avoid registration. Registration under the Investment
Company Act provides a number of important protections for
retail fund investors. But many of those protections may not be
necessary for private fund investors. Moreover, the application
of the Investment Company Act would prohibit or curtail many of
the legitimate investment strategies of private funds.
Investment advisers to private funds often avoid
registration by claiming an exemption from the registration
under the Advisers Act, available only to an adviser that has
fewer than 15 clients. This small-adviser exemption was
originally designed to exempt advisers that were too small to
warrant Federal attention. But, today, advisers to private
funds investing billions of dollars of client assets rely on
this exemption to keep off of our radar scope. They are able to
do this because under the exemption an adviser can count each
private fund as a single client.
The small-adviser exemption is part of the original act,
which was enacted before the modern hedge, private equity, and
venture capital funds were even invented and is today quite an
anachronism. An advisory firm with 15 individual clients and
$30 million of assets under management must register with the
Commission. But an adviser providing the same advisory services
to the same individuals through a private fund could entirely
avoid registering with the Commission. Investment adviser
registration, in our view, is appropriate for any investment
adviser managing $30 million or more, regardless of the form or
number of its clients.
The Private Fund Transparency Act of 2009, which Chairman
Reed recently introduced, would eliminate the small-adviser
exemption from the Advisers Act and, thus, require advisers to
private funds to register. Registration would impose no
impediments on legitimate business activities of private funds.
Indeed, many advisers to all kinds of private funds are
currently registered under the Advisers Act.
The Commission believes that the registration of these
private fund advisers would be beneficial to investors and our
markets in several important ways.
First, registration would allow the Commission to identify
advisers and private funds that participate in our markets and
to collect basic data from them. In addition, the Private Fund
Transparency Act would permit us to keep confidential
proprietary information we collect and to collect information
related to systemic risk to be shared with other regulators.
Second, it would provide us with the authority to examine
the activities of private fund advisers, in particular,
compliance with fiduciary duties advisers owe to private funds
they manage. We would be able to examine, for example, whether
the advisers are keeping fund assets safe, accurately reporting
fund performance, and managing the fund consistent with
disclosures fund investors receive.
Third, registration of private fund advisers under the
Advisers Act would permit us to oversee adviser trading
activities to prevent market abuses such as insider trading and
market manipulation, including improper short selling.
We believe that legislation should not exclude any advisers
from registration with the Commission based on the type of
private fund they manage. The lines which may have once
separated the hedge funds from private equity and venture
capital funds have blurred, and the distinctions are often
unclear. Such an exclusion would likely create market
inefficiencyt and exacerbate conflicts between advisers and
their clients if, as is likely, advisers alter their investment
strategies or investment terms to fit an exemption.
I would be happy to answer any questions you might have.
Senator Reed. Well, thank you very much, Mr. Donohue.
You pointed out that the SEC has sought for many years to
be able to monitor the full range of investment, hedge funds
particularly, and now you have a regulatory gap because
essentially it is a private system after the court ruling. Is
there anything you would like to add to the necessity of this
broad approach that you could see all the data?
Mr. Donohue. There are a couple of points I would like to
make. One is investment advisers are managing other people's
money. That is what the Investment Advisers Act was intended to
cover. It does not make a distinction between whether you are
managing money on behalf of wealthy clients or average clients.
And this is a gap that exists out there that I think is one
that should be filled.
A corollary benefit from filling that gap would be the
ability to obtain information with respect to private funds,
information that would be helpful to us and information that
would also, I believe, be helpful to any systemic regulator
that might be empowered.
Senator Reed. As Senator Bunning alluded to in his
comments, and as you also indicated, there are basically three
approaches: one is to regulate the fund; two is to regulate the
advisers; or three is to give the SEC the authority by
regulation to set up rules for exempt entities under both
statutes.
I appreciate the fact you seem to speak favorably of the
approach of investment advisers, but are there any strengths or
weaknesses that you want to point out vis-a-vis the adviser
approach or the fund approach or a separate approach?
Mr. Donohue. Well, I think the adviser approach is an
essential approach, and so I would say that is a minimum that
is necessary, that the advisers that are managing these pools
are brought within the adviser statute and the protections that
are there.
The potential to bring private funds within the ambit of
the Investment Company Act can have its challenges. The
Investment Company Act provides two exclusions from its
coverage intended to carve out really the private funds, the
3(c)(1) exception for funds that have less than--a hundred or
fewer investors, and 3(c)(7) where the fund is limited to
qualified purchasers, those that really have $5 million or more
invested.
So I think, you know, to try and fit some of the private
funds within the investment company statute that really is
intended for retail investors would be a challenge for us, and
so if there is an alternative approach that is less intrusive
that achieves the goal, that is something that deserves
consideration.
An alternative approach is one that would provide the
Commission with the ability to condition those two exclusions
that I just mentioned on certain conditions that the Commission
could determine from time to time. That would, in effect, keep
private funds outside of the Investment Company Act but give us
the tools that we might need to be able to impose conditions
that.
Those are different approaches that I think all merit
consideration.
Senator Reed. And we are very fortunate because our second
panel has provided excellent testimony from the vantage point
and experience of market participants. Some have pointed out--
in particular, with respect to venture capital--that the
Investment Advisers Act might pose restraints that would
fundamentally change their business model, compensation,
others. In that spirit, are there some areas where you would
see the Investment Advisers Act as being inconsistent with the
appropriate functioning of the markets?
Mr. Donohue. I do not. I would like to point out that we
currently have over 1,800 investment advisers that are
registered with us out of our 11,000-plus that indicate that
they manage private funds, and those include, you know, hedge
funds, private equity funds, and venture capital funds. And we
do have available to us at the Commission exemptive authority
within which we could address particular issues that might
exist.
And I also would like to point out that of the advisers
that are registered with us, almost 70 percent of those
advisers are small advisers that have 10 or fewer employees. So
the Advisers Act itself and the regulatory regime that we have
is certainly scalable to deal with both the largest and the
smallest of the advisers.
Senator Reed. Let me ask a final question. Given these new
responsibilities, it would, I presume, require additional
resources not only in terms of personnel but technology. As you
point out, one of the potential advantages of registration is
to be able to collect on a confidential basis the systemic
information not only for your use but also a potential systemic
regulator. And that I think would require additional technology
and resources. Is that a fair assessment?
Mr. Donohue. It is fair and is true that additional
resources would be necessary for us to be able to do this and
do it effectively. And I would point out, if we are going to do
it, we should do it well.
Senator Reed. Well, I concur with that thought. Thank you
very much, Mr. Donohue.
Senator Bunning.
Senator Bunning. Thank you for being here. Who in the
Federal Government knows the markets well enough to effectively
regulate and understand what hedge funds and other firms are
doing and the risks they might be creating?
Mr. Donohue. That is an excellent question. I think the
ability to oversee the activities of investment advisers and
hedge funds is one that is within the ambit of the
responsibility of the Securities and Exchange Commission. We--
--
Senator Bunning. I did not ask that question. Who in the
Securities and Exchange Commission has enough smarts to know
what exactly is going on with hedge funds and other private
firms that are doing--what risks they might create for the rest
of them? You know, we have had AIG and all these things go on,
and we haven't had anybody that knew what was happening.
Mr. Donohue. A couple of points that I would make, Senator
Bunning. I think it is a challenge. I do think that having the
ability to have the right people with the right skill set is
extraordinarily important, and the Commission has reached out
to get people with some of the skill sets that we would need to
do this effectively. But in order to be able to do that with
the people with the right skill sets, we also need access to
the right information, and we need access to the ability to go
in and to conduct inspections and examinations of the folks,
and----
Senator Bunning. But then you have to have someone who
knows to ask the right questions and get the right information.
The fear I have is a group of hedge funds or investment
advisers getting together, colluding, shorting individual
stocks for their own purpose, and at the end of the line, they
profit by somebody going into bankruptcy. You know, is there
anyone at the SEC that can get a handle on that kind of thing?
Mr. Donohue. Well, I would point out that if that form of
collusion was going on----
Senator Bunning. Somebody could find out if it was.
Mr. Donohue. Well, if it was going on, it would be more
likely to be detected if we had the opportunity to go in and do
examinations, if, in fact, they were required to keep certain
books and records. And, you know, that would increase that
likelihood. Chairman Schapiro has also advocated the
possibility of having a whistleblower-type program in place
that would, you know, enable us to benefit from whistleblowers
in that type of area.
There is always the possibility for collusion inside of our
markets.
Senator Bunning. Yes, we found that out.
Should we put leverage restrictions on hedge funds and
other firms?
Mr. Donohue. The first thing on that, Senator Bunning, is
that the marketplace does place restrictions on the ability of
hedge funds and others to use leverage. They are subject to the
margin requirements. The counterparties that, in fact, lend to
them apply their own market discipline to that. In fact, after
the financial crisis, we saw a degree of deleveraging that
occurred that wasn't the result of any regulatory action but,
rather, was the market itself responding.
So I think leverage restrictions is one of those areas that
you might want to consider, but I do think that there are
market disciplines out there that help achieve that goal.
Senator Bunning. To address systemic risk and fraud, do you
think the SEC is better off focusing on resources on constant
supervision and examination or kind of after-the-fact
enforcement?
Mr. Donohue. Those two activities are very complementary.
The Office of Compliance, Inspections, and Examinations and its
program is there to help us determine things that are going on
and to help catch things early if we can. Enforcement is there,
works hand in glove with Office of Compliance, Inspections, and
Examinations, complements that when, in fact, we do find that
there are violations out there and to bring and hold people
accountable for those. So I think they work hand in glove.
Senator Bunning. OK. To limit the potential harm that could
be done by private investment firms to the system and
counterparties, do you think it is better to place limits on
the firms themselves or to limit the exposure of counterparties
like banks to the investment firms like they have?
Mr. Donohue. The approach that was and has been taken by
the President's Working Group was to work with the
counterparties that were providing leverage to hedge funds and
to approach it from a risk-based approach at that level. I
think that is a meaningful approach to take.
Senator Bunning. You, in other words, would insist that
that would be in any kind of legislation that Jack or myself
would----
Mr. Donohue. Not necessarily. I think that is something
that is occurring and has occurred----
Senator Bunning. Oh, you think it is occurring already?
Mr. Donohue. Yes. Yes, I do believe, and----
Senator Bunning. Some of us have serious doubts about that.
Mr. Donohue. Oh, well, but I do think it is in the best
interests of those counterparties to manage that risk
effectively and, you know, to the extent that----
Senator Bunning. Do you think the counterparties should be
reimbursed dollar for dollar in case there is a systemic
failure with one of the hedge funds or one of the other types
of investment firms? That have insurance, of course, obviously,
like the AIG insurance on the credit default swaps. They got
dollar for dollar. They didn't get 20 cents on the dollar.
Mr. Donohue. My personal perspective on that is that market
discipline is a good discipline to have out there to the extent
that private parties have arranged for protection for
themselves, and they should get the benefit of their bargain.
Senator Bunning. But do you think that it should be on the
Standard & Poor's and Moody's and those who rate risk, if they
lower their risk on a certain entity? That is the thing that
started the spiraling downward of AIG, as you well know, when
their credit got lowered. They then became responsible for the
full value of what they had insured.
Mr. Donohue. Senator Bunning, you had asked before if there
were folks inside the Commission that might have the smarts to
answer all these questions, and with respect to that question,
I would have to say inside the Commission I am not that person.
Senator Bunning. Thank you.
Senator Reed. Thank you, Senator Bunning.
Senator Bayh.
Senator Bayh. We have an honest man with us here today, Mr.
Chairman.
Mr. Donohue, thank you for your service. I know one of the
reasons we are here is so that we can better answer this
question in the future, but I would be interested in your
assessment, as best as you can based upon what we do know,
about what level of systemic risk has been posed to the economy
by these sorts of entities here in the recent past? I gather
that there was--some of the genesis of the trouble at Bear
Stearns involved some funds that related to that company. I am
not familiar with the circumstances at Lehman, but there was
Long-Term Capital years ago. But can you give us any sort of
opinion about the nature of the systemic risk that was posed to
the economy during this crisis by these kinds of firms?
Mr. Donohue. The hedge funds represent--based on
information that I have--about $1.4 trillion of assets. I am
not aware that they have been implicated in the financial
crisis that we are currently in and certainly I don't have any
particular information, but they are significant players in our
capital markets. They represent from between 18 to 22 percent
of the trading volume that occurs on the New York Stock
Exchange. They employ leverage. They----
Senator Bayh. What percentage of trading involvement did
you say?
Mr. Donohue. My understanding is it is between 18 and 22
percent of the trading volume. Now once again, this information
we get from third parties as we don't have the data----
Senator Bayh. No evidence of historical unwinding of
positions that imperiled perhaps counterparties, other
institutions, nothing like that?
Mr. Donohue. Well, I would point out, I don't think that
private funds have been without their challenges during this
period of time. We have witnessed many private funds have had
to institute gates or suspend redemptions during this period of
time because of the nature of the investments that they had.
Senator Bayh. So I take your answer that we really don't
know. There might be some. But one of the reasons for a
proposal like this is so that we can assess in the future the
level of systemic risk that might exist?
Mr. Donohue. Well, they are important players that
currently are not--the information is not available.
Senator Bayh. Let me ask you, hedge funds, venture capital,
private equity, I mean, there are some differences between
these types of vehicles. Do they all deserve the same
treatment?
Mr. Donohue. I think with respect to the advisers, the
advisers are all managing--handling other people's money and I
think that, they all have in common. That is what the Advisers
Act was intended to address. I think with respect to the
information that we may be able to collect with respect to
them, that we might very well differentiate between the type of
information we are collecting based on either the size or the
nature of the private pool with respect to which the
information is being provided.
Senator Bayh. I have seen some suggestions, for example,
that venture capital investments in firms are for the most part
quite different than hedge funds and that systemic risk might
be different between those two types of vehicles.
Mr. Donohue. I do think that, you know, as folks would
describe the different types of private funds, there is a
distinct difference between them. On the other hand, many
advisers manage several of those and several of the vehicles
are less clear with respect to which category they might fall
into. So there has been kind of a blurring that has occurred
over time.
Senator Bayh. Some of them take kind of a hybrid approach,
neither fish nor foul?
Mr. Donohue. Well, at times, and one of the things that we
observed when we had done our previous attempt with respect to
hedge fund advisers was we tried to describe and to come up
with the characteristics of what a hedge fund was. Thereafter,
many were able to change some of their characteristics to fall
outside of the manner in which we tried to describe them. So I
would not try and necessarily come up with a definitional
approach with respect to private funds.
Senator Bayh. My last question, Mr. Donohue, I understand
the EU has proposed a somewhat more stringent approach than has
been recommended by the Administration, including barring non-
EU--barring entities from doing business within their
jurisdiction if they don't meet their standards. Do you have a
reaction to that, and is there an effort being made for some
convergence between our approach and their approach?
Mr. Donohue. Well, they have it out for comment and I am
sure that many are currently providing and will be providing
their assessment of that approach. I don't see the need for our
system to necessarily converge with theirs. You know, the large
proportion of private funds are managed in the United States by
United States managers.
Senator Bayh. You don't see a potential for regulatory
arbitrage, that sort of thing, if these standards are
substantially different?
Mr. Donohue. Well, I think we have observed regulatory
arbitrage that has occurred in the past and that is always a
challenge for us and I think--that doesn't mean we need to come
up with the same regulatory regime, as much as we should be
mindful of that and deal cooperatively with our counterparts in
Europe.
Senator Bayh. And if U.S. entities are barred from doing
business if they don't meet European standards, should the
reverse also apply?
Mr. Donohue. I would not--personally, I would not be an
advocate of taking that particular approach. We have a system
that works very well. We let competition reign in our country
and I think that is what we should do.
Senator Bayh. Thank you very much.
Senator Reed. Thank you, Senator Bayh.
Just let me ask one question, then Senator Bunning has
additional questions, and that one question follows on Senator
Bayh's. Are there ongoing efforts, for example, collaborations
with the FSA and others, to also deal with the issue of hedge
funds and private pools of capital?
Mr. Donohue. We are very--first, I would say we are very
active members of the IOSCO and Standing Committee 5, which is
the standing committee that deals with those, is one that
particularly my division provides a lot of support to. We have
been in discussions with our counterparts about the proposal
that is out there and so there is active discussion that does
take place.
Senator Reed. Thank you, Mr. Donohue.
Senator Bunning.
Senator Bunning. I just am curious, aside from the Madoff
fraud, what kinds of manipulation or conspiracies have you seen
regarding private investment firms, and are the laws against
that kind of activity strong enough?
Mr. Donohue. I think we have the tools to deal with those,
Senator Bunning. We have seen overstatement of performance
for--in private funds----
Senator Bunning. This was pretty sophisticated, I mean, to
give out printed statements and totally and completely false
statements. I mean, he had it set up--it was pretty
sophisticated.
Mr. Donohue. It was.
Senator Bunning. Fifty billion dollars is a lot of money,
or whatever amount it was.
Mr. Donohue. I don't--we certainly had the tools to deal
with it when it was found.
Senator Bunning. Fifteen years, though, it got away.
Mr. Donohue. Well, that is, you know, and that certainly is
something that we are redoubling our efforts, Senator, to look
at what we can do in our agency to hire the right people, to
train them properly, to use technology to help come up with
likely candidates for this, to use risk-based approach and to
do any number of things that would increase the likelihood
that, in fact, we would be able to detect that early on and
take appropriate action.
Senator Bunning. Do you think becoming publicly traded
changes the nature, the natural incentives private investment
partnerships have to be responsible, when the partners have
their own funds at risk?
Mr. Donohue. I think that when folks have their own money
at risk, I do think that that may certainly increase the focus
that one has with respect to managing and to the risks that one
does take. I do think that having your own money invested has
with it some of your own conflicts that exist. So you get
certain advantages and disadvantages from having significant
investment of a manager in a particular pool.
Senator Bunning. My problem is, I don't know if we can
afford to find the brains that we need to hire to get a hold of
this problem, if you see it as a major problem. I know that you
just said $1.2 trillion, 20 percent of the daily activity on
the New York Stock Exchange. That is pretty substantial when
you are talking about these type of entities. So if I were an
investment adviser or somebody who was a hedge fund manager, I
sure wouldn't want to work for the SEC. I would want to do my
own thing, and where are you going to find somebody with that
kind of expertise?
Mr. Donohue. Senator, I would first start off by saying
that I am not sure we can afford not to find these people,
and----
Senator Bunning. I agree. Now where are we going to find
them?
Mr. Donohue. Well, I think we have been fortunate in being
able to attract people to public service----
Senator Bunning. Not for $150,000 a year, you are not.
Mr. Donohue. Well, we have had some success, and I don't
want to understate the challenges that we have when we are
trying to do that, but we need to get those people and we need
to get the ability to do this effectively.
Senator Bunning. I wish you good luck.
Senator Reed. Well, we all wish you good luck because your
luck will influence greatly the economy, and it is also
persistence and hard work and we thank you for that, Mr.
Donohue. Thank you very much for your testimony, and now I will
call the second panel forward.
Mr. Donohue. Thank you.
Senator Reed. Let me introduce our second panel and then
recognize them for their testimony.
Our first witness is Mr. Dinakar Singh, founder and Chief
Executive Officer of TPG-Axon Capital, a leading global
investment firm. He was previously a partner at Goldman Sachs,
where he was cohead of the Principal Strategies Department, a
key proprietary investing franchise of the firm. During his 14
years at Goldman Sachs, he served on a number of the firm's key
leadership committees, including the Operating Committee, Risk
Committee, Partnership Committee, and Asia Management
Committee. Mr. Singh's company is also a member of the Managed
Fund Association, which represents the hedge fund industry.
Our next witness is Mr. James S. Chanos. He is the founder
and Managing Partner of Kynikos Associates, which is the
largest exclusive short-selling investment firm, providing
investment management services for both domestic and offshore
clients. He is also Chairman of the Coalition of Private
Investment Companies, which represents a coalition of private
investment companies whose members and associates are diverse
in both size and investment strategies, managing or advising an
aggregate of over $100 billion in assets.
Our next witness is Mr. Trevor R. Loy. He is the founder
and General Partner at Flywheel Ventures, a venture capital
firm with approximately $40 million under management. Flywheel
Ventures focuses on investments in digital services, physical
infrastructure, energy, and water. Mr. Loy is also a Board
member of the National Venture Capital Association, which is
the premier trade association that represents the U.S. venture
capital industry, comprised of more than 450 member firms.
Our next witness is Mr. Mark B. Tresnowski. He is the
Managing Director and General Counsel at Madison Dearborn
Partners, a large private equity firm. Prior to joining Madison
Dearborn, Mr. Tresnowski was a partner at Kirkland and Ellis, a
firm he had been with from 1986 through 1999 and rejoined in
August 2004 after having served as Executive Vice President and
General Counsel of Allegiance Telecom, Inc. Mr. Tresnowski's
company is also a member of the Private Equity Council, which
is an advocacy, communications, and research organization and
resource center established to develop, analyze, and distribute
information about the private equity industry and its
contributions to the national and global economy.
Our next witness, in order, is Mr. Richard Bookstaber, a
former investment executive and author of four books and scores
of articles on finance topics ranging from option theory to
risk management. Mr. Bookstaber has worked in some of the
largest buy side and sell side firms in capacities ranging from
risk management to portfolio management to derivatives research
and has worked at a number of hedge funds, including More
Capital Management and Bridgewater Associates. He was
previously the Managing Director in charge of firmwide risk
management at Solomon Brothers, overseeing the client and
proprietary risk taking activities of the firm, and prior to
that spent 10 years at Morgan Stanley.
Our final witness is Mr. Joseph Dear. He is the Chief
Investment Officer for the California Public Employees'
Retirement System, CalPERS. At CalPERS, Mr. Dear oversees all
investments, including, among many other asset classes, venture
capital, leveraged buy-outs, and hedge funds. Mr. Dear joined
CalPERS in March 2009 after previously serving as the Executive
Director for the Washington State Investment Board and he has
also served as Chief of Staff for Washington State Governor
Gary Locke and in the Clinton administration as Assistant
Secretary of Labor at the Occupational Safety and Health
Administration. Mr. Dear also serves as the Chairman of the
Council of Institutional Investors.
Thank you all, gentlemen. Your testimony has been
extraordinarily helpful to me and to the Committee. If you
could please make your comments 5 minutes or less, that would
also be helpful to the Committee and to me and to Senator
Bunning. But I want to thank you for the obvious effort and
preparation. We have a full spectrum representing, we think,
all of the parties that have an interest in equity in this
process.
Mr. Singh, if you would begin, please.
STATEMENT OF DINAKAR SINGH, FOUNDER AND CHIEF
EXECUTIVE OFFICER, TPG-AXON CAPITAL, ON BEHALF OF MANAGED FUNDS
ASSOCIATION
Mr. Singh. Chairman Reed, Ranking Member Bunning, my name
is Dinakar Singh. I am the founding partner of TPG-Axon
Capital, a leading global investment firm, and we are a member
of the Managed Funds Association, the MFA. The MFA, as you
know, represents the majority of the world's largest hedge
funds and is the primary advocate for sound business practices
and industry growth for hedge funds, funded funds, and managed
futures funds, as well as industry service providers.
Now, I would note that the opinions I will talk about today
do not represent the individual position of TPG-Axon or any
individual firm, for that matter. They represent the collected
consensus of MFA members on key issues.
Now, over the past two decades, the markets have changed in
two particular and very dramatic ways. They are much more
globally interconnected than they have ever been, and the
velocity of moves has increased dramatically. What happens in
one corner of the world gets transmitted everywhere, and
transmitted at a speed that really was unimaginable once upon a
time. These are simply facts of life in an age of globalization
and technology. The growth of the hedge fund industry is a
reflection of these changes.
Our ultimate investors are pension funds, endowments,
foundations, families. Our job is to help them navigate a
complex and fast-moving world and generate solid returns for
their missions with less volatility than they would have
otherwise.
By definition, we must be flexible, creative, and nimble to
deliver the results our investors expect and depend upon.
However, beyond that, the hedge fund industry is diverse, both
in terms of what we do and how we do it. Yet we have common
goals: To generate high quality and quantity of return to our
investors while upholding high standards and ensuring that we
don't negatively impact others in our attempts to do our job
for our investors. Fairness and integrity are critical for our
investors, for us, and for markets. Therefore, all leading
hedge funds have a joint responsibility to ensure that high
standards are upheld and best practices followed across the
industry.
Now, in reflecting on events of the past few years, it
would seem clear that sensible, balanced, importantly cohesive
regulation--in short, smart regulation--of all major market
participants is critical to ensuring fair and orderly markets.
We support efforts as an industry to create a thoughtful and
unified regulatory framework.
Now, I appreciate the opportunity to set the record
straight about what hedge funds are and aren't, particularly in
regard to size and leverage. Hedge funds manage nearly $1.5
trillion in global assets. This compares to over $9 trillion in
just U.S. mutual fund assets and over $14 trillion in just U.S.
banking assets. We are a meaningful participant in markets, but
we are not the dominant one.
Regarding leverage, yes, hedge funds generally employ
leverage, but it is far less than is employed in other parts of
the financial services industry. Typical hedge fund leverage is
two-to-one to four-to-one for every dollar of equity, and a
large portion of those balance sheets are used to hedge and
reduce volatility. Some hedge funds don't employ leverage at
all since they hold much riskier assets than others.
Now, overall, these are far less levels of leverage than
the high levels of leverage employed at banks, securities
firms, and insurance companies. As a result, losses at hedge
funds last year didn't pose the same systemic risk that losses
at larger and more highly leveraged institutions did.
Mr. Chairman, hedge funds are not the root cause of the
ongoing difficulties in our financial markets and our broader
economy. Despite the challenges of the past year, the
relatively modest size and low leverage of the industry meant
that we haven't been the cause of problems to the average
American investor or to the taxpayer. However, the
unprecedented collapse in global markets has caused severe
damage to our investors and consequently to the hedge fund
industry, as well. As such, hedge funds have a shared interest
with all market participants and policy makers in
reestablishing stability and confidence in financial markets.
Now, smart regulation means improving the overall
functioning of the financial system through appropriate,
effective, and efficient regulation. We believe that
established best practices are an important component of a
smart regulatory framework as they promote efficient capital
markets, market integrity, investor protection, and they reduce
systemic risk.
Obviously, mandatory SEC registration for all advisers is
one of the key regulatory reform proposals being considered by
policy makers. We believe this approach, registering advisers
to all private funds under the Investment Advisers Act, is the
right approach. I note that your proposal, Mr. Chairman, and
the Administration's proposal for regulation of private funds
both take this approach. I would note that over half of FMA
members are already registered under the Advisers Act.
Now, the Advisers Act provides a meaningful regulatory
regime for registered investment advisers with significant
disclosure and compliance requirements, including publicly
available disclosure with SEC regarding the adviser's business;
detailed disclosure with the clients on appropriate matters;
clear policies and procedures to prevent insider trading in
particular, but in addition to other factors; maintaining
extensive books and records; and periodic inspections and
examinations by SEC staff on a required basis.
We welcome sensible efforts to improve the health and
efficiency of our financial system and to ensure that the very
American principles of fairness and opportunity are represented
in our capital markets, as well.
On behalf of MFA and its members, I appreciate the
opportunity to testify here and would be happy to answer any
questions that you have.
Senator Reed. Thank you, Mr. Singh. Thank you very much.
Mr. Chanos, please.
STATEMENT OF JAMES S. CHANOS, CHAIRMAN, COALITION OF PRIVATE
INVESTMENT COMPANIES
Mr. Chanos. Good afternoon, Chairman Reed, Senator Bunning,
and Members of the Subcommittee. My name is Jim Chanos. I am
testifying today as Chairman of the Coalition of Private
Investment Companies. Thank you for this opportunity.
We share the Subcommittee's commitment to restoring
investor trust and confidence as a key step in helping our
economy grow again. As part of your effort, we believe
legislation to regulate private investment companies should be
designed to protect investors and prevent fraud while fostering
responsible innovation by private investment companies who are
often in the forefront of such innovation.
As this Subcommittee is aware, hedge funds and other
private pools of capital were not the source of the near
meltdown in our financial markets. In fact, as we learned over
the past year, the greatest dangers to the world economy lay
within large, highly regulated, diversified investment and
commercial banks, insurance companies, and GSEs. Even so, CPIC
supports appropriate regulation of private funds as an element
of the regulatory improvements under consideration today.
The benefits of private funds to investors and the economy
are well known. As Mr. Singh said, venture capital and private
equity funds provide funding to startups, growing businesses,
turn-around ventures. Hedge funds improve liquidity, price
discovery, and efficiency in financial markets.
The main risks associated with private funds are those
associated with the relationship between fund managers,
investors, and individual counterparties. These risks center
on, one, the level of transparency for investors and
counterparties; two, the types of safeguards for investors'
assets; and three, the opportunities for fraud and conflicts of
interest. In rare cases, like Long-Term Capital Management in
1998, a fund may go to a size and level of leverage and
interconnectedness that then presents a systemic risk.
Chairman Reed's bill, S. 1276, offers a creative and
flexible approach to regulating private fund managers. It
requires that private fund advisers register with the SEC under
the Advisers Act and makes both the fund manager and the fund
subject to SEC inspection. The bill also enhances the SEC's
rule making authority to write different rules for different
classes of advisers.
CPIC supports registration and has for a while, and SEC
oversight of private fund advisers and supports these elements
of S. 1276. We also suggest that you consider providing
additional statutory direction to the SEC for rules it writes
for private funds and their advisers. This type of direction
could be achieved in a new Private Investment Company Act, a
statute tailored specifically to address the unique nature of
private funds, or through amendments to the pending
legislation.
Some of the key elements of such a statute, in addition to
SEC registration, should be, first, provisions to reduce the
risks of Ponzi schemes and theft by requiring managers to keep
all client assets with qualified custodians and requiring
audits by independent public accounting firms overseen by the
PCAOB.
Second, provisions to protect investors through specific
disclosures, including a fund's valuation methodologies, the
types of assets it holds, the existence of side arrangements,
and the manager's trade allocation policies, and by requiring
the delivery of audited financial statements.
Third, requirements that large funds establish plans to
control operational counterparty leverage liquidity and
portfolio risks, as well as plans for orderly wind-downs that
assure investor parity.
Fourth, requirements to address counterparty risk by
requiring funds to provide key information to their lenders and
counterparties.
And finally, provisions to mandate customer identification
and antimoney laundering programs for both market and national
security reasons.
We believe these provisions will benefit investors by
enhancing regulators' ability to prevent fraud and other abuse
while also reducing systemic risk. Whether the Subcommittee
elects to create a separate act as we suggest or to bring
private fund managers under the Advisers Act, CPIC is committed
to working with you to help provide a better regulatory
framework.
Thank you for this opportunity.
Senator Reed. Thank you, Mr. Chanos.
Mr. Loy, please.
STATEMENT OF TREVOR R. LOY, FOUNDER AND GENERAL PARTNER,
FLYWHEEL VENTURES
Mr. Loy. Thank you, Chairman Reed, Ranking Member Bunning,
and Members of the Committee. We very much appreciate the
opportunity to be part of the discussion today.
I would like to begin today by talking about risk, because
we all understand that is the reason we are here and we are all
very concerned about it. That is what is on everyone's mind.
Risk is something that as venture capitalists we are very
familiar with. In fact, we deal with it every day, although the
risk we deal with is entrepreneurial and technological risk,
not financial risk. And so I would like to give you some
background on our industry and talk a bit about that.
Indeed, the fact that the U.S. actually proactively
embraces entrepreneurial risk is one of the things that sets
our economy apart from other countries and has allowed us as
the venture industry to do what we do best: Translate brand new
ideas, new entrepreneurs into new companies, millions of jobs,
and countless innovations that otherwise would not have gotten
into society.
As Congress and the Administration work to mitigate the
kind of risk that led to the recent financial crisis, we urge
you to continue to embrace entrepreneurial risk because it is
what will help ultimately meet all the other critical goals for
our Nation, including creating the new jobs and industries that
will be part of pulling us out of this recession.
Given the recent financial meltdown, we obviously support
the efforts to increase transparency and protect investors of
all kinds. However, we do not believe that the venture industry
is in the position to contribute to any systemic financial
risk, and we urge caution when considering imposing one-size-
fits-all layers of regulation on the venture community. Let me
explain a little bit more our thinking.
The venture capital industry is very, very simple. We
invest in startup companies run by entrepreneurs using capital
from ourselves and outside investors, known as our limited
partners, or LPs. Now, structurally, this is the same as most
of the other asset classes you are considering, but otherwise I
want to emphasize we are fundamentally different, as Director
Donohue even acknowledged in his testimony. And I will suggest
to you today that this one-size-fits-all approach will not
accomplish the goals that we share of reducing systemic risk.
Going a bit more into how we invest, we invest cash to
purchase equity shares, and we hold that equity typically for 5
to 10 years until the company is sold or goes public. The LPs'
cash remains in their control until the VC identifies specific
companies in which to invest. We then work closely with the
entrepreneurs after we have invested in their companies
alongside of them to grow their companies. Most of the folks in
our industry are experienced company builders and
technologists, not financial engineers.
When a company has grown enough that it has access to the
public markets through an IPO or it can be acquired, the VC
exits the company, and the liquidity from that transaction is
immediately distributed back to our limited partners.
Of course, when we are not successful, which in our
industry is a lot of the time, we lose all of our money
invested. In fact, we expect to lose 40 percent--all of our
money on up to 40 percent of the investments we make. But the
loss doesn't extend anywhere beyond the venture ecosystem.
For over 40 years, this model has been a tremendous force
in U.S. economic growth, building industries like the
biotechnology, semiconductor, and now increasingly the clean
technology industries. In fact, companies that were started
with venture capital since 1970 today account for 12.1 million
private sector jobs in the U.S.--that is nearly 10 percent--and
$2.9 trillion in revenues in the United States, which is nearly
20 percent of the GDP.
We did this, however, without using leverage at all. It is
not part of our equation. We work simply with cash and equity.
As I like to say, we invest in real engineering and not
financial engineering. We do not use debt to make investments
or increase the capacity of our funds, and without debt,
derivatives, or other complex financial instruments, we do not
expose any party to losses in excess of their committed
capital.
Nor are venture firms interdependent with the world
financial system. We do not trade in the public markets, and
our limited partners cannot withdraw capital during the entire
10-year or more life of the fund, nor can they publicly trade
their partnership interest.
While some limited partners are public pension funds--and
one of our esteemed colleagues on the panel today is an expert
in that--under many State laws those public pension funds
themselves are even limited to the amount of money that they
dedicate to venture activity, typically even less than 5
percent of their entire asset portfolio.
The venture capital industry is also very small in size,
despite the outsize impact we have on the economy. In 2008,
U.S. venture capital funds held approximately $197 billion in
aggregate assets raised over the last 10 years, and we invested
just $28 billion into startup companies, which equates to less
than 0.2 percent of the GDP.
In our world, in fact, the total potential loss from a $1
million investment is just that: It is limited to $1 million.
There is no multiplier effect because there are no side best,
no unmonitored securities, no swaps, no counterparties, and no
derivatives traded based on our transactions.
Now, we do recognize the need for transparency into our
activities, and today VCs already provide information to the
SEC that is publicly available when we raise a fund. That
information, submitted on what is known as a Form D, includes
the nature, the size, the terms of the offering, critical dates
and duration data, investment amounts, and the names and places
of business for the fund. We are also subject, I should point
out, to the same antifraud and other securities laws as
regulated funds.
This information should already allow the Government to
assess any systemic risk without the need for additional
regulation. And I would also point out that we are open to
dialogue about changing what is submitted on those forms to
better provide information that is requested. But, in contrast,
the formal requirements of registering as investment advisers
under the current Advisers Act contain additional significant
burdens without providing you any additional relevant
information about our industry or systemic risk in the economy.
From preparing for SEC examinations to establishing complex
compliance programs, overseen by a dedicated full-time
compliance officer, which most of us would have to hire as a
new staff member, SEC registration will demand significant
resources which promise to be costly from both a financial and
a human resources perspective.
Adding these significant administrative burdens in addition
in exchange for information that is neither relevant nor useful
for measuring and managing systemic risk seems
counterproductive to us, at best.
While larger asset classes may be able to absorb the
proposed regulatory costs, I am here to say that the venture
industry--and also the startup entrepreneurial economy--will
not go unscathed by the contemplated regulation.
When the Treasury designed new anti- money-laundering rules
under the PATRIOT Act, they already recognized that not all
investment vehicles posed risks that were worth regulating with
the same one-size-fits-all approach, and they exempted
industries that were not relevant to the money-laundering
threat, including venture capital. In doing so, Treasury has
successfully balanced the support for economic growth with the
transparency required, and we hope that Congress and the
Administration will work with our industry to ensure a similar
outcome now.
Thank you.
Senator Reed. Thank you very much, Mr. Loy.
Mr. Tresnowski, please.
STATEMENT OF MARK B. TRESNOWSKI, MANAGING DIRECTOR AND GENERAL
COUNSEL, MADISON DEARBORN PARTNERS, LLC, ON BEHALF OF THE
PRIVATE EQUITY COUNCIL
Mr. Tresnowski. Chairman Reed, Ranking Member Bunning, and
Members of the Subcommittee, I am Mark Tresnowski, Managing
Director and General Counsel for Madison Dearborn Partners. MDP
is a Chicago-based private equity firm with $18 billion of
assets under management. I appear today on behalf of the
Private Equity Council, a 2-year-old trade association
representing 12 of the largest private equity firms operating
in the United States.
Between 1980 and 2005, the top-quartile PE firms delivered
roughly $1.2 trillion of profits to public and private pension
plans, university endowments, and other investors, and we did
this by helping companies grow, create jobs, and become more
competitive. The question today is whether we created this
value by posing systemic risk to the financial system.
In laying out its financial regulatory reform program, the
Obama administration articulated three fundamental factors that
trigger systemic risk concerns: one, the impact a firm's
failure on the financial system and economy; two, the firm's
combination of size, leverage--including off-balance-sheet
exposures--and degree of reliance on short-term funding; and,
three, the firm's criticality as a source of credit for
households, businesses, and State and local governments and as
a source of liquidity for the financial system. Private equity
contains none of these systemic risk factors.
Specifically, PE firms have limited or no leverage at the
fund level. As I mentioned, our firm is a firm that manages $18
billion in assets. We have only two lines of credit, each for
$50 million, and they are both short-time lines that have to be
repaid in 60 day.
Now, we often do have leverage in our portfolio companies,
and this level of leverage can vary anywhere from zero in an
all-equity transaction to 60 or 65 percent in the leveraged
buyout. That compares to companies like Lehman Brothers which
was leveraged 32:1 when it failed.
Total PE company borrowing represents a small portion of
the overall credit market. Moreover, a World Economic Forum
study of PE investing over 20 years demonstrates that PE
company default rates are substantially below the default rates
for U.S. companies that issue bonds generally during this
period.
In addition, private equity investors are patient and
commit their capital for 10 years or more, with no right to
redeem your investment during that period. We are just this
summer in the process of closing down our first MDP fund that
was formed in 1992, so it had a 17-year life.
Private equity does not invest in short-term tradable
securities like derivatives, swaps, or public equities, and
private equity firms are not deeply interconnected with other
financial market participants. When Lehman Brothers failed, we
immediately did an assessment of our entire firm and our
portfolio companies, and the exposure was minimal. We did the
same thing with AIG and other companies that raised concern.
Private equity investments are also not cross-
collateralized. Each fund stands alone, and each investment
within a fund stands alone. If one fails, we do not borrow from
the successful investments to cover that failure.
Let me turn to some of the specific proposals that the
Subcommittee is considering. We support the creation of an
overall systemic risk regulator which has the ability to obtain
the information it needs, is capable of acting decisively in a
crisis, and possesses the appropriate powers needed to carry
out its mission.
Regarding private equity specifically, the Administration's
plan calls for private equity firms to register as investment
advisers with the SEC. Subcommittee Chairman Reed has
introduced S. 1276, the Private Fund Transparency Act of 2009,
which has a similar goal. We support these registration
requirements.
To be clear, registration will result in regulatory
oversight of many private equity firms, and there are
considerable administrative and financial burdens associated
with being a registered investment adviser. These could be
especially problematic for smaller firms--firms smaller than
ours. That said, we support strong regulation requirements to
restore confidence in the financial markets and in each of its
participants.
We do believe Congress should direct regulators to be
precise in how new regulatory requirements are calibrated, so
the burdens are tailored to the nature and size of the
individual firm and the actual nature and degree of systemic
risk posed.
In this regard, we are pleased that the Administration's
white paper explicitly acknowledged that some requirements
created by the SEC may vary across different types of private
pools. We commend Chairman Reed for his sensitivity to this
issue as well, and we think the emphasis on strong
confidentiality of the information provided is also important.
We stand ready to work with you, Mr. Chairman, Members of
your Committee, and the Administration in this important
effort. I would be pleased to answer questions at the
appropriate time.
Senator Reed. Thank you very much.
Mr. Bookstaber, please.
STATEMENT OF RICHARD BOOKSTABER, AUTHOR OF ``A DEMON OF OUR OWN
DESIGN: MARKETS, HEDGE FUNDS, AND THE PERILS OF FINANCIAL
INNOVATION''
Mr. Bookstaber. Mr. Chairman, Ranking Member Bunning, and
other Members of the Committee, I thank you for the opportunity
to testify today.
I will discuss the need for hedge fund regulation,
specifically required to measure and monitor systemic risk. I
will argue that regulators must obtain detailed position and
leverage data from major hedge funds in order to successfully
execute this task.
To understand why such data are necessary, let us look at
one of the key sources of systemic risk, namely, the leverage.
Leverage amplifies risk in a meltdown. When a market drops,
highly leveraged hedge funds with positions in that market are
to sell to meet their margin requirements, and this selling
pushes prices down further. This in turn leads to more forced
selling, and the result is a cascading liquidity crisis.
And it can get worse from there. Those hedge funds that are
under pressure discover there is no longer liquidity in the
stressed market, so they start to liquidate their positions in
other markets. If many of the funds that are in the first
market also have high exposure in a second one, the downward
spiral propagates to this second market. This phenomenon
explains why a systemic crisis can spread in surprising and
unpredictable ways. The contagion is driven primarily by what
other securities are owned by the hedge funds that need to
sell.
To control this dynamic, we must be able to measure the
crowding of the hedge funds to know how much leverage and
exposure there is in the aggregate. This means knowing the
positions of the individual hedge funds and then being able to
aggregate those positions.
Now, the data acquisition and analysis must be done by the
regulator in a secure fashion. I would like to make two
observations related to the feasibility of achieving an
acceptable level of data security.
First, hedge funds already allow these data to be held by
various agents in the private sector, such as their prime
brokers and clearing corporations. Second, the Government
successfully secures data in areas that are far more sensitive
than position data such as in the military and the intelligence
community where a failure can cost lives and where there are
concerted efforts by adversaries to root out the data.
Let me briefly discuss the institutions that should be
monitored for hedge fund-related systemic risk regulation.
For purposes of systemic regulation, hedge fund oversight
should be extended to include the large proprietary trading
operations within banks. From the standpoint of leverage and
the ability to short, these operations act in the same way as
do other hedge funds. However, venture capital firms and
private equity funds can be excluded. Venture capital and
private equity funds operate outside the publicly traded
markets, they do not short; and, because of the nature of their
collateral, they do not employ the degree of leverage of the
hedge funds that operate in the public markets.
In conclusion, obtaining the position and leverage data
required to measure and monitor this risk need not be invasive
to the hedge funds. It does not affect day-to-day operations of
the funds, and once the systems for transferring these data to
the regulator are in place, it will be an essentially costless
adjunct to the funds' already existing daily risk analysis.
This sort of data management task has already been accomplished
in other settings.
For example, when salmonella was found in a peanut factory
in Georgia, the Food and Drug Administration identified the
contaminated products across the Nation and tracked them all
the way to the store shelves. This was possible because
consumer products are tagged with a bar code. We should do the
same for financial products. We should have the equivalent of
bar codes so that regulators know what financial products exist
and where they are being held.
My testimony does not address the next critical component
of hedge fund regulation, the component that can be invasive,
namely, what to do if the analysis of the health information
technology data shows systemic risk working on the horizon. Who
bears the responsibility for having the hedge funds reduce
their exposure or leverage? Such regulatory authority must
exist for hedge funds, just as it must exist for banks and
other financial institutions of systemic import. However, the
task of acquiring and analyzing data can be separated from the
task of taking action based on that data. And acquiring the
data is the first task to address, because we cannot manage
what we cannot measure.
Thank you for the opportunity to testify today, and I look
forward to your questions.
Senator Reed. Thank you very much, Mr. Bookstaber.
Mr. Dear, please.
STATEMENT OF JOSEPH A. DEAR, CHIEF INVESTMENT
OFFICER, CALIFORNIA PUBLIC EMPLOYEES' RETIREMENT SYSTEM
Mr. Dear. Thank you, Chairman Reed, Ranking Member Bunning,
Members of the Subcommittee. My name is Joe Dear. I am Chief
Investment Officer of CalPERS. We invest over $180 billion on
behalf of 1.6 million active and retired State and local
government employees in California. We are a broadly
diversified investor, essentially investing in all asset
classes and all geographies, including hedge funds, pew, and
venture capital.
We are a long-horizon investor supplying patient capital
with a decades-long investment horizon. Therefore, we have a
vital interest in the quality of regulation of financial
services in the United States and around the world.
Private equity and hedge funds play an important role in
our portfolio. We have been investing in private equity since
1990 and in hedge funds since 2002; $20 billion of our assets
are invested in private equity vehicles and $6 billion of our
assets are invested in hedge funds, or about 14 percent of our
total assets.
Our hedge fund return over the past 5 years has been 3.89
percent, considerably above what we earn in public markets, and
our private equity return over 10 years is 6 percentage points,
600 basis points, above what we would earn in public markets.
These assets, these investments are extremely important to the
success of our investment program.
You have asked about risk, and you have heard from this
whole panel about risk in the system. I would say basically the
fundamental risk posed by private pools of capital is their
ability to choose not to be regulated, to operate in the
shadows of the financial system, depriving regulators of
information about risks, leverage ratios, counterparties, and
other information necessary to ascertain the overall level of
risk in the system and whether that level of risk is excessive
or not.
We have learned that the individual regulation of entities
and activities is insufficient when the risk in the system
builds up to a point where there is a catastrophic event.
Now, the question before you is: What action can Congress
take? Your hearing today coincides with the release of a report
by the Investors Working Group, an entity created by the
Council of Institutional Investors, which I chair, and the CFA
Institute. This is a bipartisan or nonpartisan group of experts
in investment trying to present the investor's voice in this
regulatory reform debate. We have identified four flaws in the
regulatory system exposed by the credit crisis:
First, Federal regulators need to be strengthened and
revitalized.
Second, we need to close gaps in the regulatory system, and
you have heard a lot about that today.
Third, we need to strengthen corporate governance.
And, fourth, there needs to be the designation of a
systemic risk regulator.
I want to highlight the recommendations of the Investor
Working Group report that addressed hedge funds and private
equity in the markets and instruments in which they invest.
With respect to closing gaps, as you have heard, hedge
funds, private equity, and other private pools of capital
should be required to register with the Securities and Exchange
Commission. In addition, they should be required to make
regular disclosures in real time for regulators, particularly
to the systemic risk regulator, and on a delayed basis to
markets and investors.
In particular, with respect to some instruments that are
traded, standardized and standardizable OTC derivatives should
be traded on regulated exchanges, and one party in the
transaction should have an economic interest in the
transaction, an insurable interest in the transaction.
The SEC and the Commodity Futures Trading Commission
should, as they have tried to do, establish who is responsible
for what in the regulation of OTC derivatives.
With respect to securitized products, like asset-backed
securities and mortgage securities, new accounting standards
are required so that the risks posed by these potentially off-
balance-sheet items are visible to investors.
The SEC should also require sponsors of asset-backed
securities to improve the timeliness and quality of
disclosures. There are many instances of shelf registrations
being used to present to investors opportunities which if at
the time an offering statement is not available, and you have
to choose whether to invest or not without adequate
information. That practice needs to be brought to an end.
And, of course, issuers should have skin in the game.
With respect to strengthening Federal regulators, they need
support to carry out their mission. They need the resources to
do that, and they need the skill and training to keep up with
the rapidly evolving markets in which they are responsible for
regulating.
The SEC mission has grown. The size of its staff has not.
That is true for other regulatory entities. So some kind of
stable, long-term funding for these entities needs to be found.
Finally, with respect to systemic risk, an entity should be
created which has the authority to gather all the relevant
information about what is happening in the market and to be
able to get that on a real-time basis. This entity needs to be
independent and well staffed. It needs the ability to compel
action by other regulators, specific regulatory agencies, or
those agencies need to explain why they are not taking the
recommended action. And, finally, great attention needs to be
paid to the adequacy of capital standards and the adequacy of
capital in financial institutions, since that is one of the
principal sources of risk.
Mr. Chairman, we applaud your leadership in this effort,
and we look forward to working with you and others so that we
all get this right. Thank you.
Senator Reed. Thank you very much, Mr. Dear, and I want to
thank all the panelists for very thoughtful and very helpful
testimony. I am going to try to address a question to each of
the panelists. If my time expires, I will stop and then we will
start a second round.
Mr. Singh, you point out in your testimony that you and
your organization feel that the best approach is to use the
Investment Advisers Act. Are there any particular changes or
specific modifications that you would suggest also with respect
to the Advisers Act?
Mr. Singh. Chairman Reed, I think so, here representing the
MFA, I think there are, I would say, a variety of views on
this. From my perspective and from our perspective, the
Advisers Act has sufficient strength and teeth in it to take
the important first step forward.
Second, I think taking that step and getting to a point at
which there is a thoughtful regulatory system, a cohesive
regulatory system, and data is helpful. If in time it seems
clear that the tools are not sufficient, more can be added. But
there is a balance to be struck here.
Generally speaking, investors in most private investment
firms, certainly hedge funds, are large and they are
sophisticated. And, second, by definition, what we do requires
creativity, nimbleness, and flexibility. And so I think the
critical point is to get to a point at which the systemic risk
is clearly addressed, stability in the system is clearly
improved and enhanced; and yet we also do not go so far as to
actually start detracting from the markets themselves.
And so from my perspective, we think the Advisers Act has
the sufficient tools, though it certainly does not prevent
modifications or enhancements down the road.
Senator Reed. Thank you very much, Mr. Singh.
Mr. Chanos, your testimony made some, I think, valuable
suggestions about information and authority that the regulators
should have. This is a common issue that has come up, which is
basically--and Mr. Loy did a very good job of laying out the
one-size-fits-all approach. And Mr. Tresnowski also suggested a
variation in sort of approaches.
Can you comment on that sort of issue?
Mr. Chanos. Well, I would echo some of Mr. Donohue's
comments in that we are looking at bringing the managers under
these statutes or possible statutes, or within enhanced
versions of the act, not the funds themselves. So I think there
are a number of things that managers who are fiduciaries of
both pension funds and wealthy individuals and others share in
common, that we feel enhanced legislation would best suit or
strengthening of existing legislation. Some of that would be
the ability to give specific direction to the SEC, for example,
as opposed to just leaving it to a more vague rule making
process.
Enhanced disclosure is easier with specific mandates, I
think. More modern concerns like anti- money-laundering I
mentioned, which doesn't get the attention I think it deserves,
could be specifically tailored through legislation embodying
all aspects of the private investment world.
And, finally, I think you lessen the risk of judicial
review if you give clear, broad mandates via legislation as
opposed to rule making. We saw that with the SEC's attempt to
register hedge funds a couple years ago.
So I think all these things are easier if done proactively
as opposed to by exemption.
Senator Reed. Thank you.
Mr. Loy, you have made a very thoughtful and strong case in
the venture community about your suitability for, necessity for
regulation. You also pointed out that in Regulation D, you make
a presentation to the SEC, and I appreciate the fact that the
industry were willing to work for improvements or more
information along those lines.
But let me just raise a question that Mr. Donohue
suggested, which is the ingenuity of people to sort of reform
or recalculate themselves to take advantage of an exemption. Is
that something that we should be concerned about in terms of
the venture community? Or, alternatively stated, if there is a
total exemption, will people find ways to exploit that venture
exemption, if it exists?
Mr. Loy. Well, most people want to be venture capitalists,
so----
[Laughter.]
Mr. Loy. Just kidding. I think that is an excellent
question, Mr. Chairman. I do think--and I think our industry
understands--and I want to emphasize, we are not arguing that
the structure or name or nomenclature or semantics should be
the basis of the regulation. What we are arguing is that there
are certain types of investment activities in which our
activities do not pose any systemic risk, and we would
certainly be comfortable, I believe, in some sort of disclosure
in which we, you know, certified that we were not engaging in
any of the types of activities. And if one was engaging in
those activities, then that would require sort of a subsequent
additional amount to become registered, et cetera.
So I want to be clear. We are happy to provide information,
transparency, and certify about the kinds of things we are
doing or not doing and allow the SEC to then choose--or not
choose but, you know, to be instructed as to only follow up on
those kinds of firms engaging in the behaviors that they
believe could potentially contribute to systemic risk.
Senator Reed. Thank you, Mr. Loy.
Mr. Tresnowski, your approach is--I think you suggested
that it would be the flexibility, which the Administration has
talked about and we have tried to talk about, to tailor
investment adviser regulations to the appropriate model. Any
comments that you would like to make?
Mr. Tresnowski. Yes, I think it is important because I
think that--you know, you hear the terms ``hedge fund,''
``private equity fund,'' ``venture capital fund,'' and it is
sometimes very difficult to understand what the differences
are. There clearly are differences. But where you draw the
line, for example, between venture capital and private equity
has always been a mystery to me. We do investments in startup
companies. We also do leveraged buyouts.
I think if you focus on activities, therefore, you are
going to get the kind of information that you need. And I agree
with the suggestion that if there is--you could have a single
set of regulations that elicit information. Do you cross-
collateralize your investments? And in our cases, the answer
would be, no, we don't, and so we wouldn't answer the rest of
the questions on that form.
Do you have leverage at your portfolio companies? We would
answer yes. You would answer no.
So I think there is a way to do it where--and, again, if
the focus is on trying to get the information that allows the
systemic risk regulator to make decisions and monitor risk, I
think that is the right way to go.
Senator Reed. Well, thank you very much.
Mr. Bookstaber, thank you for your testimony. I think you
provided some critical insights about the potential systemic
consequences of some hedge funds' behavior. I was also struck
by your explanation in the testimony, your written testimony,
about Long Term Capital, that it really was not the Russian
ruble collapse; it was the Danish mortgage market. And so that
was an insight that I had not heard, but it was compelling
because it suggests that things are connected together and that
what happens in one market, through what you have described,
can happen in other markets.
You left sort of the--maybe the $64 trillion question,
which is we collect all this information, and what do we do
with it? Do you have any ideas along those lines?
Mr. Bookstaber. I think that is a difficult question and I
think I was smart enough to know where to stop----
Senator Reed. OK.
Mr. Bookstaber. ----because I don't know from a political
standpoint what way would be the most palatable. But Senator
Bunning did mention--ask the question, do you limit the
leverage only if there is crisis? Do you limit the leverage at
the hedge fund level? Do you limit it through the banks? I
believe that if you try to control leverage by just having a
limit on leverage, whether it is from the banks or in the hedge
funds, you will be using a very blunt instrument to get at the
issues of the systemic risk, because there are plenty of times
where you can take leverage without it leading to systemic
risk. Systemic risk will occur if there is leverage plus
crowding.
So to be more precise in controlling the systemic risk that
comes from leverage, I think the way that you want to do it is
to use the data to try to discern the times where there are a
wad of people on the same side of the boat, where there is this
crowding. At that point, the tools for dealing with it, the
lever that you use is really a matter of who ends up with the
authority. Is it done through haircuts at the banking level or
is there authority who can go directly to the hedge funds? You
know, that remains to be seen.
Senator Reed. The one other point I think that you made in
your written testimony was that hedge funds can operate against
themselves in these markets. They are not aware of what the
other hedge fund is doing.
Mr. Bookstaber. Right.
Senator Reed. They have a strategy based upon everybody
else sort of being straight equity investors and they might be
shorting. But if there are two or three funds shorting, then
the whole system----
Mr. Bookstaber. Yes.
Senator Reed. So I think just a comment. I think this
approach of getting the information might also ultimately be
beneficial to some hedge fund participants.
Mr. Bookstaber. Yes, I think that is true. The analogy I
used in my written testimony was it is as if you are sitting in
a darkened theater and you don't know whether there are just
four people there or it is stuffed to the gills. So a hedge
fund, although they can't know who else is in the market, might
want to have some information, or at least have somebody who
has sufficient oversight to know if there is enough crowding at
the very time that there is an exotic shock that forces them to
go out of the market, there are ten other people doing the same
thing.
Senator Reed. Thank you very much.
And Mr. Dear, thank you for your testimony and also for
your leadership. I thought the report issued today will be very
helpful to us going forward. We are going to go ahead, I think,
and pursue an issue of investment registration, adviser
registration. As one of the premier investors in the country,
is there a danger that just simply giving the SEC label of
``registered investment adviser'' would take away from due
diligence, would undermine what the investor himself has to do?
Is that something we should be worried about?
Mr. Dear. I think it could, but I think if it did, it would
involve a breach of fiduciary duty on the part of the pension
funds and endowments who are making those kinds of investments.
Part of the lesson of 2008 is you can't simply rely on a rating
agency or other entity for the information you need to decide
whether the investment makes sense for your portfolio given
your objectives, your risk appetite, and whether the investor
that you are going to put your money with has the degree of
integrity that you demand from a partner.
Registration simply makes it possible for the information
to be out there and for steps to be taken if somebody gets
outside--gets out of bounds. I think you have to look at the
whole system in terms of information requirements, registration
requirements, better scrutiny, better accounting of the
instruments which are traded, and if we don't do all of those
things, then we are going to leave the system vulnerable again
to another crisis.
Senator Reed. Thank you very much.
Senator Bunning.
Senator Bunning. Thank you.
For all the firms, if we had a systemic risk regulator and
that regulator came to you and told you to get out of some
positions, how would you react?
Mr. Loy. I would just say that in venture capital, we would
like to be able to get out of more of our positions right now,
so----
[Laughter.]
Senator Bunning. But if you were told to get out by a
regulator----
Mr. Loy. In all seriousness?
Senator Bunning. Yes, in all seriousness.
Mr. Loy. Senator, we do not trade in public markets, so
there often is for 5 to 7 years no market at all for the
companies we are building until they have reached a point of
maturity.
Senator Bunning. You are not answering my question.
Mr. Loy. The answer is, we would have to shut our
investments down. There is no market on a dime for selling our
companies.
Senator Bunning. Your company or the investments----
Mr. Loy. The companies in which we invest in. If you told
me that I had----
Senator Bunning. There is no market?
Mr. Loy. There is no market. We would shut them down.
Mr. Tresnowski. I would----
Senator Bunning. Let me ask, did you have to get a rating
from a rating company before you bought?
Mr. Loy. No, sir. We only invest in private companies----
Senator Bunning. Private companies----
Mr. Loy. ----started from scratch----
Senator Bunning. Well, sometimes those private companies
have to go get rated before your firm would buy any part of
that company.
Mr. Loy. In the case of venture capital, that is not the
case.
Senator Bunning. I can give you chapter and verse on when
it did. It got a triple-B rating and it cost $250,000 and they
borrowed $200,000 and your risk capital, or venture capital or
whatever you want to call yourself, put in the rest of the
capital and bought the firm.
Mr. Loy. I think, Senator, you may be talking more about a
model that is associated with my colleague here from private
equity. In the case of venture capital, often, particularly in
my case, we are seed-stage investors. The companies often do
not exist when we first invest.
Senator Bunning. Oh. What about ones that do exist?
Mr. Loy. The ones that do exist are still so fledgling,
often just one or two employees that have been funded entirely
on those employees' credits or second mortgage.
Senator Bunning. OK. Let us have the next man answer the
same question.
Mr. Tresnowski. Well, it is--we would have difficulty, as
well. I would say, in general terms, we have two types of
investments. We have investments in private companies, and if
the regulator came to us and said, you have to get rid of that
investment----
Senator Bunning. In other words, it is systemically going
to hurt the market.
Mr. Tresnowski. Right. That would be very difficult for us
to respond to because the only way we can sell a private
company is to take it public or to sell it to somebody else----
Senator Bunning. That is correct.
Mr. Tresnowski. ----and if there is a market to do that, we
would probably be looking at it anyway. And if we are not
looking at it and there is a market for it, it is because the
valuation is far below what we as investment managers think the
value is.
The other type of company we have is a company that we have
invested in that has gone public, and there the problem is our
positions in those companies, because we at one time owned
them, can be 50 to 60 percent of the stock of the company. So
if the regulator came to us and said, you need to get out of
this company, it would be catastrophic to that company because
we would dump the stock on the market.
Senator Bunning. OK. How about the hedge funds?
Mr. Chanos. I was going to say, I think you want to be
looking more toward our end of the table on this question.
Senator Bunning. OK. I look to anybody who had answered the
question. I just happened to get two people that didn't have
the answer.
Mr. Chanos. A few years ago, my firm--speaking for my firm
specifically and not the coalition I represent--we had a very
celebrated short position in the shares of Enron Corporation.
So if the Government regulator came to us and said, we want you
to cover that short position for whatever reason, I think my
first responsibility, quite frankly, Senator, is to my clients
as a fiduciary. So I would have to call my attorneys and say,
well, can the Government force me to do this, because I think
in this particular case, I would want to be short the shares of
Enron because I thought it was a fraud. So it really----
Senator Bunning. You happened to be right, but that is
beside the point.
Mr. Chanos. Well, it would, again, depend. My first
responsibility as a fiduciary, as a money manager, is to my
clients, and I would have to look at it through that prism, get
advice from legal counsel, and if counsel advised me that in
their business judgment it made a lot of sense to unwind the
position because Uncle Sam was asking me to, I would probably
do it.
Senator Bunning. Mr. Singh.
Mr. Singh. Senator, I think there are a host of challenges
and complexities. I think we would all say the obvious, which
is that as you noted in the comments with the previous panel,
the complexity involved with an individual person, institution,
agency in deciding--in understanding complex risks and deciding
when a line has gone too far is enormous. We would note that
over the last decade or so, there have been three crises. The
1998 crisis was a function of a number of things, Long-Term
Capital----
Senator Bunning. I have a question on that.
Mr. Singh. ----was one of them. The tech crisis, if you
will, and the things that trigger it, I think was a second one.
And this last one was a banking and a finance problem. I think
it is probably true that the next one will be different and I
think the ability for anyone to go and predict the future is
difficult.
Senator Bunning. I don't want to predict the future. I want
to prevent it from----
Mr. Singh. Understood. I think, look, from our perspective,
I would say first if something was needed to be done and it was
clear that we had to do it, of course, we would do it. I think,
as my colleague said, presumably we had a sensible reason to do
it in the first place. Our investors clearly presumably would
have asked us questions about something that was an
extraordinary risk. And third, people that lend us money
clearly see our balance sheet and interrogate and investigate
things all the time that are of concern to them. We have lots
of folks asking questions.
So ultimately, it would be surprising to us, because our
first instinct would be, gosh, if we thought it made sense, we
thought it was a sensible, responsible investment to make, if
we thought it made sense to our investors and to our lenders,
it would be surprising to us that the Government would say that
this was a very bad thing to do. So if it were a voluntary
question, we would want to learn more and understand why,
because we all have a responsibility not to get ourselves in
trouble or the country in trouble. Of course, ultimately, if it
is a required decision, then you can ask those questions, but
it is after the fact.
Senator Bunning. This has something to do with what Mr.
Bookstaber suggested. He suggested giving the regulator the
power to collect information on the firm's position and
strategies. How do we protect that information? Specifically,
how do we prevent someone at the regulator from either sharing
that information or leaving the agency with that information in
his head and then profiting from it? Go ahead.
Mr. Bookstaber. As I mentioned in my testimony, you know,
that is a critical question, and certainly from the industry
standpoint, if they want to object to this information being
brought in, that would be the first line of defense is to--but
I would say that, given that we--I am repeating my testimony to
some extent, but I think that, number one, there already are in
the private sector agents who have the position information of
the firms. And number two, the Government does a very good job
of securing information of far more value.
So I could try to posit different safeguards one way or the
other, but I think there is a precedent that exists both on the
private and the public sector that there is the capacity to
protect and safeguard this type of information.
Senator Bunning. Last question, and anybody can answer, the
hedge funds, particularly. What do you think caused the failure
of Long-Term Capital Management in 1998? What do you think
caused it?
Mr. Singh. Senator, I think, sure, there are many factors,
but I think ultimately the one similarity with Long-Term
Capital Management and, frankly, the crisis in the past year is
that when people believe something to be very safe and believe
it can only move modestly and they count on that and it turns
out that is not true, very bad things happen. The difference in
bond movements in 1998 was, in fact, the thing that could never
have happened and it was not contemplated by Long-Term Capital
Management and their balance sheet and structure against it
simply wasn't sensible.
I think the lesson of this last year, as well, of course,
there was an assumption by many that home prices could never go
down and people lent against it assuming they could never go
down. That fundamentally is at the core of this and that has
been shown to be not true, and, of course, anything that people
are certain is true, eventually markets turn out to have a way
of turning around on its head.
I think the lesson of all this, frankly, and this is the
problem with crises, is that we have to make sure that when
there is too much conviction and belief in any one thing, that
there is a responsibility to assess whether or not people are
taking it too far.
Senator Bunning. How do we stop talking heads from telling
us that, then?
Mr. Singh. Senator, I think in some ways this ties to your
last question. I think the reality is, the industry position
and theory is that systemic risk share leaders are a sensible
step forward. I would note two things. With apprehension,
because these are complicated and very difficult things and the
notion that one thing or person can get it right and make
calls, balls and strikes, if you will, in that sense, is a
difficult one.
On the other hand, I think we also know that it has been a
terrible year and environment for many Americans and people
around the world, enormous pain inflicted on people, and so it
may well be that it is worth trying something that is difficult
and complicated in the hope and the attempt to go and at least
see whether we can try to reduce the odds of something like
this happening again.
Senator Bunning. In so doing, we may just double and triple
the problem, so I want you to be aware that that is why we are
hesitant, or at least some of us are, in trying to get our
hands on this market that not a lot of us are fully aware of
the risks that are involved in each and everyone's firm or the
market itself. I mean, the expertise up here is not as good as
the expertise sitting at that table, and to think that we can
go out and hire people for $150,000 a year to do that, I think
is a little foolish, to say the least. Thank you.
Senator Reed. I guess we will have to bring back the draft,
Jim.
Senator Bunning. OK.
[Laughter.]
Senator Reed. I want to thank you all. This has been
extremely helpful. I want to thank Senator Bunning for his
contribution. I thought it was very useful to begin to explore
these issues. This is not the last time we will have to deal
with them.
There seems to be a recognition by all that further
transparency is important, to get the data, to get the
information, to at least be able to gauge the systemic risk.
But I think the question that we have to address is how do you
do it, how do you deal with it, what tools must the systemic
regulator have to step in.
In terms of my recollection of Long-Term Capital, it was
bringing all the significant banks together and saying, pony up
the money. They did that. That worked. So there are maybe other
tools than sort of just going in and telling you, stop.
And I think the other point I would say, and I think this
has been recognized, is that there is a value to have this
information and we just have to be smart about how we collect
it, how we protect it, and then how we use it, which might be
the most challenging issue.
But I want to thank you. This has been a very helpful
session. Thank you.
Senator Bunning. Thank you all.
Senator Reed. The hearing is adjourned.
[Whereupon, at 4:18 p.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF CHAIRMAN JACK REED
I want to welcome everyone, and thank Mr. Donahue and our other
witnesses for appearing today.
As we continue the important work of modernizing an outdated
financial regulatory system, I have called this hearing to explore
another key aspect of such reforms, the regulation of hedge funds and
other private investment pools, such as private equity funds and
venture capital funds.
The current financial crisis has reinvigorated my long-held concern
that the regulation of hedge funds and other pooled investment vehicles
should be improved to provide more information to regulators to help
them address fraud and prevent systemic risk in our capital markets.
These private pools of capital are responsible for huge transfers of
capital and risk, and so examining these industries and potential
regulation are extremely important to this Subcommittee.
Hedge funds and other private investment funds generally operate
under exemptions in Federal securities laws that recognize that not all
investment pools require the same close scrutiny demanded of retail
investment products, like mutual funds. Hedge funds generally cater to
more sophisticated and wealthy investors who are responsible for
ensuring the integrity of their own investments, and as a result are
permitted to pursue somewhat riskier investment strategies. Indeed,
these funds play an important role in enhancing liquidity and
efficiency in the market, and subjecting them to fewer limitations on
their activities has been, and continues to be, a reasonable policy
choice.
However, these funds have often operated outside the framework of
the financial regulatory system, even as they have become increasingly
interwoven with the rest of the country's financial markets. As a
result, there is no data on the number and nature of these firms or any
regulatory ability to actually calculate the risks they pose to the
broader economy.
Over the past decade the SEC has recognized there are risks to our
capital markets posed by some of these entities, and it has attempted
to require at a minimum that advisers to these funds register under the
Investment Advisers Act so that SEC staff can collect basic information
from and examine these private pools of capital. The SEC's rule making
in this area, however, was rejected by a Federal court in 2006. As a
result, without statutory changes, the SEC is currently unable to
examine private funds' books and records, or to take sufficient action
when the SEC suspects fraud. In addition, no regulator is currently
able to collect information on the size and nature of hedge funds or
other funds to identify and act on systemic risks that may be created
by these pools of capital.
To address this regulatory gap, I recently introduced the Private
Fund Transparency Act of 2009, which would require investment advisers
to private funds, including hedge funds, private equity funds, venture
capital funds, and others, to register with the SEC. The bill would
provide the SEC with the authority to collect information from these
entities, including information about the risks they may pose to the
financial system. In addition, it would authorize the SEC to require
hedge funds and other investment pools to maintain and share with other
Federal agencies, on a confidential basis, any information necessary
for the identification and mitigation of systemic risk.
I hope today's hearing provides an opportunity to discuss my
proposal and others, so that we can consider ways to determine the best
approach in this area. The financial crisis is a stark reminder that
transparency and disclosure are essential in today's marketplace.
Improving oversight of hedge funds and other private funds is vital to
their sustainability and to our economy's stability.
______
PREPARED STATEMENT OF SENATOR JIM BUNNING
Thank you, Mr. Chairman.
In some ways, the structure and incentives of these private pools
of capital are what we should be hoping for in the rest of the
financial system. Success is rewarded and failure is punished. Pay is
based on performance over time, and not just in the short term. And
managers have skin in the game, with their own funds at risk. It seems
obvious to me that firms and traders will act more responsibly when
they know they will face the consequences of their actions, which is
why bailouts breed more bailouts.
I do have some concerns about the risks that these firms could pose
to our system. Hedge funds in particular use leverage, which can lead
to out-sized losses and panic selling. Losses in one part of a
portfolio can force the sale of other assets, which spreads the losses
to a normally unrelated investment. Just look at last fall for an
example.
I am also concerned about the potential for market manipulation and
fraud. When firms can seek profit by any strategy they dream up, there
will be great temptation to cheat. I am not saying all or even most
firms are dishonest, but the temptation will be there. And that
cheating is harder to detect because of the secrecy of portfolios and
strategies. Huge risks to the system could build up out of sight of the
regulators and other market participants as well.
How we address these concerns is not an easy question, and I do not
yet know the answer. I am skeptical of the idea of a Government
regulator being smart enough to recognize concentration of risk and act
to reduce it. Instead, it may make more sense to limit how much risk
these firms can take on, and thus how much risk they pose to others, by
imposing leverage restrictions. However, I am not sure if it is better
to put restrictions on the firms themselves, or limit the dealings of
banks and other regulated institutions with these firms.
These are by no means all the issues to consider, but I hope to get
some thoughts on them here today. Thank you, Mr. Chairman.
______
PREPARED STATEMENT OF ANDREW J. DONOHUE
Director, Division of Investment Management,
Securities and Exchange Commission
July 15, 2009
I. Introduction
Thank you for the opportunity to testify before you today. My name
is Andrew Donohue, and I am the Director of the Division of Investment
Management at the Securities and Exchange Commission. I am pleased to
testify on behalf of the Commission about regulating hedge funds and
other private investment pools. \1\
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\1\ Commissioner Paredes does not endorse this testimony.
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Over the past two decades, private funds, including hedge, private
equity, and venture capital funds, have grown to play an increasingly
significant role in our capital markets both as a source of capital and
the investment vehicle of choice for many institutional investors. We
estimate that advisers to hedge funds have almost $1.4 trillion under
management. Since many hedge funds are very active and often leveraged
traders, this amount understates their impact on our trading markets.
Hedge funds reportedly account for 18-22 percent of all trading on the
New York Stock Exchange. Venture capital funds manage about $257
billion of assets, \2\ and private equity funds raised about $256
billion last year. \3\
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\2\ The National Venture Capital Association (NVCA) estimates that
741 venture capital firms and 1,549 venture capital funds were in
existence in 2007, with $257.1 billion in capital under management.
NVCA, Yearbook 2008 at 9 (2008). In 2008, venture capital funds raised
$28.2 billion, down from $35.6 billion in 2007. Thomson Reuters & NVCA,
News Release (Apr. 13 2009). In 2007, the average fund size was $166
million and the average firm size was $347 million. Id. at 9.
\3\ U.S. private equity funds raised $256.9 billion in 2008 (down
from $325.2 billion in 2007). Private Equity Analyst, 2008 Review and
2009 Outlook at 9 (2009) (reporting Dow Jones LP Source data),
available at http://fis.dowjones.com/products/
privateequityanalyst.html.
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The securities laws have not kept pace with the growth and market
significance of hedge funds and other private funds and, as a result,
the Commission has very limited oversight authority over these
vehicles. Sponsors of private funds--typically investment advisers--are
able to organize their affairs in such a way as to avoid registration
under the Federal securities laws. The Commission only has authority to
conduct compliance examinations of those funds and advisers that are
registered under one of the statutes we administer. Consequently,
advisers to private funds can ``opt out'' of Commission oversight.
Moreover, the Commission has incomplete information about the
advisers and private funds that are participating in our markets. It is
not uncommon that our first contact with a manager of a significant
amount of assets is during an investigation by our Enforcement
Division. The data that we are often requested to provide members of
Congress (including the data we provide above) or other Federal
regulators are based on industry sources, which have proven over the
years to be unreliable and inconsistent because neither the private
funds nor their advisers are required to report even basic census-type
information.
This presents a significant regulatory gap in need of closing. The
Commission tried to close the gap in 2004--at least partially--by
adopting a rule requiring all hedge fund advisers to register under the
Investment Advisers Act of 1940 (Advisers Act). \4\ That rule making
was overturned by an appellate court in the Goldstein decision in 2006.
\5\ Since then, the Commission has continued to bring enforcement
actions vigorously against private funds that violate the Federal
securities laws, and we have continued to conduct compliance
examinations of the hedge fund advisers that remain registered under
the Advisers Act. But we only see a slice of the private fund industry,
and the Commission strongly believes that legislative action is needed
at this time to enhance regulation in this area.
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\4\ Investment Advisers Act Release No. 2333 (Dec. 2, 2004).
\5\ See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
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The Private Fund Transparency Act of 2009, which Chairman Reed
recently introduced, would require advisers to private funds to
register under the Advisers Act if they have at least $30 million of
assets under management. \6\ This approach would provide the Commission
with needed tools to provide oversight of this important industry in
order to protect investors and the securities markets. Today, I wish to
discuss how registration of advisers to private funds under the
Advisers Act would greatly enhance the Commission's ability to properly
oversee the activities of private funds and their advisers. Although
the Commission supports this approach, there are additional approaches
available that also would close the regulatory gap and provide the
Commission with tools to better protect both investors and the health
of our markets.
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\6\ Section 203A(a)(1) of the Act prohibits a State-regulated
adviser to register under the Act if it has less than $25 million of
assets under management. The Commission has adopted a rule increasing
the $25 million threshold to $30 million. See Rule 203A-1 under the
Advisers Act. The threshold does not apply to foreign advisers. Section
3 of the Private Fund Transparency Act would establish a parallel
registration threshold for foreign advisers, which would prevent
numerous smaller foreign advisers that today rely on the de minimis
exception, which the Act would repeal, from being required to register
with the Commission.
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II. The Importance and Structure of Private Funds
Private funds are generally considered to be professionally managed
pools of assets that are not subject to regulation under the Investment
Company Act of 1940 (Investment Company Act). Private funds include,
but are not limited to, hedge funds, private equity funds, and venture
capital funds.
Hedge funds pursue a wide variety of strategies that typically
involve the active management of a liquid portfolio, and often utilize
short selling and leverage.
Private equity funds generally invest in companies to which their
advisers provide management or restructuring assistance and utilize
strategies that include leveraged buyouts, mezzanine finance, and
distressed debt. Venture capital funds typically invest in earlier
stage and start-up companies with the goal of either taking the company
public or privately selling the company. Each type of private fund
plays an important role in the capital markets. Hedge funds are thought
to be active traders that contribute to market efficiency and enhance
liquidity, while private equity and venture capital funds are seen as
helping create new businesses, fostering innovation, and assisting
businesses in need of restructuring. Moreover, investing in these funds
can serve to provide investors with portfolio diversification and
returns that may be uncorrelated or less correlated to traditional
securities indices.
Any regulatory reform should acknowledge the differences in the
business models pursued by different types of private fund advisers and
should address in a proportionate manner the risks to investors and the
markets raised by each.
III. Current Regulatory Exemptions
Although hedge funds, private equity funds and venture capital
funds reflect different approaches to investing, legally they are
indistinguishable. They are all pools of investment capital organized
to take advantage of various exemptions from registration. All but one
of these exemptions were designed to achieve some purpose other than
permitting private funds to avoid oversight.
A. Securities Act of 1933
Private funds typically avoid registration of their securities
under the Securities Act of 1933 (Securities Act) by conducting private
placements under section 4(2) and Regulation D. \7\ As a consequence,
these funds are sold primarily to ``accredited investors,'' the
investors typically receive a ``private placement memorandum'' rather
than a statutory prospectus, and the funds do not file periodic reports
with the Commission. In other words, they lack the same degree of
transparency required of publicly offered issuers.
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\7\ Section 4(2) of the Securities Act of 1933 provides an
exemption from registration for transactions by the issuer of a
security not involving a public offering. Rule 506 of Regulation D
provides a voluntary ``safe harbor'' for transactions that are
considered to come within the general statutory language of section
4(2).
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B. Investment Company Act of 1940
Private funds seek to qualify for one of two exceptions from
regulation under the Investment Company Act of 1940 (Investment Company
Act). They either limit themselves to 100 total investors (as provided
in section 3(c)(1)) or permit only ``qualified purchasers'' to invest
(as provided in section 3(c)(7)). \8\ As a result, the traditional
safeguards designed to protect retail investors in the Investment
Company Act are the subject of private contracts for investors in
private funds. These safeguards include investor redemption rights,
application of auditing standards, asset valuation, portfolio
transparency, and fund governance. They are typically included in
private fund partnership documents, but are not required and vary
significantly among funds.
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\8\ ``Qualified purchasers'' generally are individuals or family
partnerships with at least $5 million in investable assets and
companies with at least $25 million. The section 3(c)(7) exception was
added in 1996 and specifically anticipated use by private funds.
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C. Investment Advisers Act of 1940
The investment activities of a private fund are directed by its
investment adviser, which is typically the fund's general partner. \9\
Investment advisers to private funds often claim an exemption from
registration under section 203(b)(3) of the Advisers Act, which is
available to an adviser that has fewer than 15 clients and does not
hold itself out generally to the public as an investment adviser.
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\9\ Private funds often are organized as limited partnerships with
the fund's investment adviser serving as the fund's general partner.
The fund's investors are limited partners of the fund.
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Section 203(b)(3) of the Advisers Act contains a de minimis
provision that we believe originally was designed to cover advisers
that were too small to warrant Federal attention. This exemption now
covers advisers with billions of dollars under management because each
adviser is permitted to count a single fund as a ``client.'' The
Commission recognized the incongruity of the purpose of the exemption
with the counting rule, and adopted a new rule in 2004 that required
hedge fund advisers to ``look through'' the fund to count the number of
investors in the fund as clients for purposes of determining whether
the adviser met the de minimis exemption. This was the rule overturned
by the appellate court in the Goldstein decision. As a consequence,
approximately 800 hedge fund advisers that had registered with the
Commission under its 2004 rule subsequently withdrew their
registration.
All advisers to private funds are subject to the antifraud
provisions of the Investment Advisers Act, including an antifraud rule
the Commission adopted in response to the Goldstein decision that
prohibits advisers from defrauding investors in pooled investment
vehicles. \10\ Registered advisers, however, are also subject to
periodic examination by Commission staff. They are required to submit
(and keep current) registration statements providing the Commission
with basic information, maintain business records for our examination,
and comply with certain rules designed to prevent fraud or overreaching
by advisers. For example, registered advisers are required to maintain
compliance programs administered by a chief compliance officer.
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\10\ See Rule 206(4)-8 under the Advisers Act.
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IV. Options To Address the Private Funds Regulatory Gap \11\
As discussed below, though there are different regulatory
approaches to private funds available to Congress, or a combination of
approaches, no type of private fund should be excluded from any new
oversight authority any particular type of private fund. The
Commission's 2004 rule making was limited to hedge fund advisers.
However, since that time, the lines which may have once separated hedge
funds from private equity and venture capital funds have blurred, and
the distinctions are often unclear. The same adviser often manages
funds pursuing different strategies and even individual private funds
often defy precise categorization. Moreover, we are concerned that in
order to escape Commission oversight, advisers may alter fund
investment strategies or investment terms in ways that will create
market inefficiencies.
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\11\ Commissioner Casey does not endorse the approaches discussed
in sections IV. B and C.
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A. Registration of Private Fund Investment Advisers
The Private Funds Transparency Act of 2009 would address the
regulatory gap discussed above by eliminating Section 203(b)(3)'s de
minimis exemption from the Advisers Act, resulting in investment
advisers to private funds being required to register with the
Commission. Investment adviser registration would be beneficial to
investors and our markets in a several important ways.
Accurate, Reliable, and Complete Information: Registration of
private fund advisers would provide the Commission with the ability to
collect data from advisers about their business operations and the
private funds they manage. The Commission and Congress would thereby,
for the first time have accurate, reliable, and complete information
about the sizable and important private fund industry which could be
used to better protect investors and market integrity. Significantly,
the information collected could include systemic risk data, which could
then be shared with other regulators. \12\
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\12\ The Private Fund Transparency Act includes some important
although technical amendments to the Advisers Act that are critical to
the Commission's ability to collect information from advisers about
private funds, including amendments to Section 204 of the Act
permitting the Commission to keep information collected confidential,
and amendments to Section 210 preventing advisers from keeping the
identity of private fund clients from our examiners.
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Enforcement of Fiduciary Responsibilities: Advisers are fiduciaries
to their clients. Advisers' fiduciary duties are enforceable under the
antifraud provisions of the Advisers Act. They require advisers to
avoid conflicts of interest with their clients, or fully disclose the
conflicts to their clients. Registration under the Advisers Act gives
the Commission authority to conduct on-site compliance examinations of
advisers designed, among other things, to identify conflicts of
interest and determine whether the adviser has properly disclosed them.
In the case of private funds, it gives us an opportunity to determine
facts that most investors in private funds cannot discern for
themselves. For example, investors often cannot determine whether fund
assets are subject to appropriate safekeeping or whether the
performance represented to them in an account statement is accurate. In
this way, registration may also have a deterrent effect because it
would increase an unscrupulous adviser's risk of being discovered.
A grant of additional authority to obtain information from and
perform on-site examinations of private fund advisers should be
accompanied with additional resources so that the Commission can bring
to bear the appropriate expertise and technological support to be
effective.
Prevention of Market Abuses: Registration of private fund advisers
under the Advisers Act would permit oversight of adviser trading
activities to prevent market abuses such as insider trading and market
manipulation, including improper short-selling.
Compliance Programs: Private fund advisers registered with the
Commission are required to develop internal compliance programs
administered by a chief compliance officer. Chief compliance officers
help advisers manage conflicts of interest the adviser has with private
funds. Our examination staff resources are limited, and we cannot be at
the office of every adviser at all times. Compliance officers serve as
the front-line watch for violations of securities laws, and provide
protection against conflicts of interests.
Keeping Unfit Persons From Using Private Funds To Perpetrate
Frauds: Registration with the Commission permits us to screen
individuals associated with the adviser, and to deny registration if
they have been convicted of a felony or engaged in securities fraud.
Scalable Regulation: In addition, many private fund advisers have
small to medium size businesses, so it is important that any regulation
take into account the resources available to those types of businesses.
Fortunately, the Advisers Act has long been used to regulate both small
and large businesses, so the existing rules and regulations already
account for those considerations. In fact, roughly 69 percent of the
investment advisers registered with the Commission have 10 or fewer
employees.
Equal Treatment of Advisers Providing Same Services: Under the
current law, an investment adviser with 15 or more individual clients
and at least $30 million in assets under management must register with
the Commission, while an adviser providing the same advisory services
to the same individuals through a limited partnership could avoid
registering with the Commission. Investment adviser registration in our
view is appropriate for any investment adviser managing $30 million
regardless of the form of its clients or the types of securities in
which they invest.
B. Private Fund Registration
Another option to address the private fund regulatory gap might be
to register the funds themselves under the Investment Company Act (in
addition to registering their advisers under the Advisers Act).
Alternatively, the Commission could be given stand-alone authority to
impose requirements on unregistered funds. Through direct regulation of
the funds, the Commission could impose, as appropriate, investment
restrictions or diversification requirements designed to protect
investors. The Commission could also regulate the structure of private
funds to protect investors (such as requiring an independent board of
directors) and could also regulate investment terms (such as protecting
redemption rights).
C. Regulatory Flexibility Through Rule-making Authority
Finally, there is a third option that in conjunction with advisers'
registration may be necessary to address the regulatory gap in this
area. Because it is difficult, if not impossible, to predict today what
rules will be required in the future to protect investors and obtain
sufficient transparency, especially in an industry as dynamic and
creative as private funds, an additional option might be to provide the
Commission with the authority that allows for additional regulatory
flexibility to act in this area. This could be done by providing rule-
making authority to condition the use by a private fund of the
exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment
Company Act. These conditions could impose those requirements that the
Commission believes are necessary or appropriate to protect investors
and enhance transparency. \13\ In many situations, it may be
appropriate for these requirements to vary depending upon the type of
fund involved. This would enable the Commission to better discharge its
responsibilities and adapt to future market conditions without
necessarily subjecting private funds to Investment Company Act
registration and regulation.
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\13\ For example, private funds might be required to provide
information directly to the Commission. These conditions could be
included in an amendment to the Investment Company Act or could be in a
separate statute.
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V. Conclusion
The registration and oversight of private fund advisers would
provide transparency and enhance Commission oversight of the capital
markets. It would give regulators and Congress, for the first time,
reliable and complete data about the impact of private funds on our
securities markets. It would give the Commission access to information
about the operation of hedge funds and other private funds through
their advisers. It would permit private funds--which play an important
role in our capital markets--to retain the current flexibility in their
investment strategies.
The Commission supports the registration of private fund advisers
under the Advisers Act. The other legislative options I discussed
above, namely registration of private funds under the Investment
Company Act and/or providing the Commission with rule-making authority
in the Investment Company Act exemptions on which private funds rely,
should also be weighed and considered as the Subcommittee considers
approaches to filling the gaps in regulation of pooled investment
vehicles.
I would be happy to answer any questions you may have.
______
PREPARED STATEMENT OF DINAKAR SINGH
Founder and Chief Executive Officer, TPG-Axon Capital,
On Behalf of Managed Funds Association
July 15, 2009
Chairman Reed, Ranking Member Bunning, Members of the
Subcommittee--My name is Dinakar Singh, and I am the founding partner
of TPG-Axon Capital, a leading global investment firm. As with many
leading hedge funds, we are headquartered in the U.S., though we
oversee investments around the world, for investors from across the
world, and with employees and offices in three continents. I am here
today to speak on behalf of the Managed Funds Association (MFA) and its
members. On their behalf, I am pleased to provide this statement in
connection with the Senate Subcommittee on Securities, Insurance, and
Investment hearing, ``Regulating Hedge Funds and Other Private
Investment Pools'' held on July 15, 2009. MFA represents the majority
of the world's largest hedge funds and is the primary advocate for
sound business practices and industry growth for professionals in hedge
funds, funds of funds, and managed futures funds, as well as industry
service providers. MFA's members manage a substantial portion of the
approximately $1.5 trillion invested in absolute return strategies
around the world.
On behalf of MFA and its members, I appreciate the opportunity to
express the industry's views on regulation for managers of private
pools of capital, including hedge fund managers. The opinions presented
today do not represent the individual position of TPG-Axon, or any
individual firm, but rather represent the collected consensus of our
(MFA) members on key issues.
The hedge fund industry is diverse, both in terms of what we do and
how we do it. And yet there are clear issues that all leading hedge
funds have in common, and common goals that we all ought to try to
achieve. We manage money for pension funds, endowments, foundations,
and families. The money they invest with us, and the returns they hope
to receive, are critical to fulfilling their individual missions:
scholarships for students, retirement benefits for workers, supporting
arts and sciences, providing healthcare to communities.
Our mission? To generate high quality and quantity of returns for
our investors, while upholding high standards, and ensuring that we do
not negatively impact others in our attempts to do our job for our
investors. Our investors depend upon us to deliver results for them--
and if we cannot, their ability to serve their communities and
constituencies is damaged. However, fairness and integrity are also
critical, for them, for us, and for markets. Therefore, all leading
hedge funds have a joint responsibility to ensure that high standards
are upheld, and best practices followed, across the industry.
While acknowledging that ``one size does not fit all'' for hedge
funds, or their investors, it is worth noting the primary reasons why
our investors choose to invest with us. Simplistically, institutions
historically found that portfolios invested only in stocks and bonds
delivered suboptimal performance over the long term. Stocks have
historically been highly volatile and correlated to each other, while
bonds have not provided enough return relative to the safety and
diversification they provided. As a result, institutional investors
have broadened their portfolio scope over time to include a broader
array of investments, in the hope that diversification will enhance
return, while diminishing the volatility of that return. For the most
part, hedge funds have accomplished their mission, and helped improve
the quality and quantity of returns of their investors. In turn, this
has led to tremendous growth in the industry, and increased the
influence of hedge fund activity in financial markets. Therefore, as
important and responsible participants in markets, we welcome
systematic and thoughtful dialogue about ways to enhance the stability
and quality of our financial markets.
In our view, any regulatory framework should address identified
risks, while ensuring that private pools of capital are still able to
perform their important market functions. It is critical, however, that
consideration of a regulatory framework not be based on misconceptions
or inaccurate assumptions.
Hedge funds are among the most sophisticated institutional
investors and play an important role in our financial system. They
provide liquidity and price discovery to capital markets, capital to
companies to allow them to grow or improve their businesses, and
sophisticated risk management to investors such as pension funds, to
allow those pensions to meet their future obligations to plan
beneficiaries. Hedge funds engage in a variety of investment strategies
across many different asset classes. The growth and diversification of
hedge funds have strengthened U.S. capital markets and provided their
investors with the means to diversify their investments, thereby
reducing overall portfolio investment risk. As investors, hedge funds
help dampen market volatility by providing liquidity and pricing
efficiency across many markets. Each of these functions is critical to
the orderly operation of our capital markets and our financial system
as a whole.
To perform these important market functions, hedge funds require
sound counterparties with which to trade and stable market structures
in which to operate. The recent turmoil in our markets has
significantly limited the ability of hedge funds to conduct their
businesses and trade in the stable environment we all seek. As such,
hedge funds have an aligned interest with other market participants,
including retail investors and policy makers, in reestablishing a sound
financial system. We support efforts to protect investors, manage
systemic risk responsibly, and ensure stable counterparties and
properly functioning, orderly markets.
Hedge funds were not the root cause of the problems in our
financial markets and economy. In fact, hedge funds overall were, and
remain, substantially less leveraged than banks and brokers, performed
significantly better than the overall market and have not required, nor
sought, Federal assistance despite the fact that our industry, and our
investors, have suffered mightily as a result of the instability in our
financial system and the broader economic downturn. The losses suffered
by hedge funds and their investors did not pose a threat to our capital
markets or the financial system.
Although hedge funds are important to capital markets and the
financial system, the relative size and scope of the hedge fund
industry in the context of the wider financial system helps explain why
hedge funds did not pose systemic risks despite their losses. With an
estimated $1.5 trillion under management, the hedge fund industry is
significantly smaller than the U.S. mutual fund industry, with an
estimated $9.4 trillion in assets under management, or the U.S. banking
industry, with an estimated $13.8 trillion in assets. According to a
report released by the Financial Research Corp., the combined assets
under management of the three largest mutual fund families are at $1.9
trillion, which exceeds the total assets of the hedge fund industry.
Moreover, because many hedge funds use little or no leverage, their
losses did not pose the same systemic risk concerns that losses at more
highly leveraged institutions, such as brokers and investment banks,
did. A study by PerTrac Financial Solutions released in December 2008
found that 26.9 percent of hedge fund managers reported using no
leverage. Similarly, a March 2009 report by Lord Adair Turner, Chairman
of the U.K. Financial Services Authority (the ``FSA''), found that the
leverage of hedge funds was, on average, two or three-to-one,
significantly below the average leverage of banks.
Though hedge funds did not cause the problems in our markets, we
believe that the public and private sectors (including hedge funds)
share the responsibility of restoring stability to our markets,
strengthening financial institutions, and ultimately, restoring
investor confidence. Hedge funds remain a significant source of private
capital and can continue to play an important role in restoring
liquidity and stability to our capital markets. We are committed to
working with the Administration and Congress with respect to efforts
that will restore investor confidence in and stabilize our financial
markets and strengthen our Nation's economy.
I. A ``Smart'' Approach to Financial Regulatory Reform
MFA and its members support a smart approach to regulation, which
includes appropriate, effective, and efficient regulation and industry
best practices that (i) promote efficient capital markets, market
integrity, and investor protection and; (ii) better monitor and reduce
systemic risk. Smart regulation will likely mean increasing regulatory
requirements in some areas, modernizing and updating antiquated
financial regulations in other areas, and working to reduce redundant,
overlapping, or inefficient responsibilities, where identified.
The first step in creating a smart regulatory framework is
identifying the risks or intended objectives of regulation with the
goal of strengthening investor protection and market integrity and
monitoring systemic risk. Identifying the underlying objectives of
proposed regulation will help ensure that proposals are considered in
the appropriate context relative to addressing the identified risks or
achieving the intended objectives. Regulation that addresses the key
objectives of efficient capital markets, market integrity, and investor
protection is more likely to improve the functioning of our financial
system, while regulation that does not address these key issues can
cause more harm than good.
We saw an example of the latter with the significant, adverse
consequences that resulted from the SEC's bans on short selling last
year.
A smart regulatory framework should include comprehensive and
robust industry best practices designed to achieve the shared goals of
monitoring and reducing systemic risk and promoting efficient capital
markets, market integrity, and investor protection. Since 2000, MFA,
working with its members, has been the leader in developing, enhancing,
and promoting standards of excellence through its document, ``Sound
Practices for Hedge Fund Managers'' (Sound Practices). \1\ As part of
its commitment to ensuring that Sound Practices remains at the
forefront of setting standards of excellence for the industry, MFA and
its members have updated and revised Sound Practices to incorporate the
recommendations from the best practices report issued by the
President's Working Group on Financial Markets' Asset Managers'
Committee. MFA and other industry groups have also created global,
unified principles of best practices for hedge fund managers.
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\1\ MFA's Sound Practices is available at: http://
www.managedfunds.org/files/pdf's/MFA_Sound_Practices_2009.pdf.
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Because of the complexity of our financial system, an ongoing
dialogue among market participants and policy makers is a critical part
of the process of developing smart, effective regulation. MFA and its
members are committed to being active, constructive participants in the
dialogue regarding the various regulatory reform topics.
Though regulation cannot solve all of the problems in our financial
system, careful, well thought out financial regulatory reform can play
an important role in restoring financial market stability and investor
confidence. The goal in developing regulatory reform proposals should
not be to throw every possible proposal into the regulatory system.
Such an outcome will only overwhelm regulators with information and
added responsibilities that do little to enhance their ability to
effectively fulfill their agency's missions. The goal should be
developing an ``intelligent'' system of financial regulation, as former
Fed Chairman Paul Volcker has characterized it.
MFA and its members recognize that the framework for the
registration and regulation of managers to private pools of capital is
part of the broader discussion regarding regulatory reform, which
includes regulatory proposals regarding systemic risk, over-the-counter
markets and consumer protection. We are committed to continuing to be
an active and constructive participant in the broader regulatory reform
discussion. My testimony today will focus on the primary topic of
today's hearing, regulation of managers to private pools of capital.
II. Hedge Fund Manager Registration and Regulation
In adopting a smart and effective approach to the regulation of
managers of private pools of capital, it is important to recognize that
many, if not all, of these regulatory issues will be relevant to all
such managers, including firms that manage hedge funds, private equity
funds, venture capital funds and real estate funds. The Obama
administration, in its release ``Financial Regulatory Reform A New
Foundation: Rebuilding Financial Supervision and Regulation'' (the
``Administration Proposal''), \2\ is supportive of this approach,
calling for the registration of advisers of hedge funds and other
private pools of capital with the SEC. MFA and its members support the
Administration's proposal to require the registration of investment
advisers to all private pools of capital, subject to a limited
exemption for the smallest investment advisers with a de minimis amount
of assets under management. We believe that a registration framework
under the Advisers Act is the smart approach to registration and
regulation of managers to private pools of capital.
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\2\ Available at: http://www.financialstability.gov/docs/regs/
FinalReport_web.pdf.
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MFA and its members have publicly supported this comprehensive
approach to adviser registration over the past several months, even
when the Administration called for a narrower registration requirement
only for advisers to the largest and most systemically relevant private
pools of capital. We strongly encourage policy makers also to consider
the issue of registration in the context of all private pools of
capital and the managers of those pools. Likewise, we strongly
encourage regulators to consider regulations that apply to all private
investment firms and not just hedge fund managers. This approach will
both promote better regulation as well support the many benefits
private investment firms provide to the U.S. markets.
MFA and its members recognize that mandatory SEC registration for
advisers of private pools of capital is one of the key regulatory
reform proposals being considered by policy makers. We believe that the
approach set out in the Administration Proposal of registering
investment advisers, including advisers to private pools of capital,
under the Investment Advisers Act of 1940 (the ``Advisers Act'') is the
right approach in considering this issue. In fact, more than half of
MFA member firms already are registered with the Securities and
Exchange Commission (the ``SEC''), as investment advisers. Applying the
registration requirement to all investment advisers, instead of
focusing solely on hedge fund managers is also a smart approach to
registration. We believe that removing the current exemption from
registration for advisers with fewer than 15 clients would be an
effective way to achieve this result. \3\ The form and nature of
registration and regulation of investment advisers to private pools of
capital should be evaluated in the context of how to best promote
investor protection, market integrity and systemic risk monitoring,
each of which may be best achieved by different types of regulation.
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\3\ We note that this approach is consistent with the approach
taken by H.R. 711 and S. 1276.
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We believe that the Advisers Act provides a meaningful regulatory
regime for registered investment advisers. The responsibilities imposed
by Advisers Act registration and regulation are not taken lightly and
entail significant disclosure and compliance requirements, including:
Providing publicly available disclosure to the SEC
regarding, among other things, the adviser's business, its
clients, its financial industry affiliations, and its control
persons;
Providing detailed disclosure to clients regarding, among
other things, investment strategies and products, education and
business background for adviser personnel that determine
investment advice for clients, and compensation arrangements;
Maintaining of books and records relevant to the adviser's
business; \4\
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\4\ Attachment A sets out the extensive list of books and records
required to be kept by registered investment advisers.
Being subject to periodic inspections and examinations by
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SEC staff;
Adopting and implementing written compliance policies and
procedures and appointing a chief compliance officer who has
responsibility for administering those policies and procedures;
Adopting and implementing a written code of ethics that is
designed to prevent insider trading, sets standards of conduct
for employees reflecting the adviser's fiduciary obligations to
its clients, imposes certain personal trading limitations and
personal trading reports for certain key employees of the
adviser; and
Adopting and implementing written proxy voting policies.
Though the Advisers Act already provides a meaningful regulatory
framework for investment advisers, MFA and its members have been
working with policy makers to explore ideas for possible enhancements
to the Act. These enhancements are designed to ensure that regulators
have appropriate authority to conduct meaningful oversight over and
regulation of investment advisers to private pools of capital and the
pools (funds) that those advisers manage. In particular, MFA and its
members have been working to develop proposals that will ensure
regulators have appropriate transparency regarding private funds and
have the authority and tools necessary to prevent fraud. We believe
that an enhanced Advisers Act regulatory framework is the most
effective means to achieve those goals, and we are committed to working
with policy makers on developing that framework.
In addition to registration and regulation of advisers through the
Advisers Act, the hedge fund industry is subject to other, meaningful
regulatory oversight. Hedge funds, like other market participants, are
subject to existing, extensive trading rules and reporting requirements
under the U.S. securities laws and regulations. \5\ Increasing investor
confidence and promoting market integrity are carried about by the SEC
and other regulators through these regulatory requirements.
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\5\ As discussed in section III below, we are also supportive of
providing regulatory authorities, on a confidential basis, with
information regarding trading/investment activities to promote better
monitoring of systemic risk.
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With a comprehensive registration framework comes additional
burdens on Federal regulators. A registration framework that overwhelms
the resources, technology and capabilities of regulators will not
achieve the intended objective, and will greatly impair the ability of
regulators to fulfill their existing responsibilities, as well as their
new responsibilities. Regulators must have adequate resources,
including the ability to hire and retain staff with sufficient
experience and ability, and improve the training of that staff, to
properly oversee the market participants for whom they have oversight
responsibility. The SEC, which is the existing regulator with oversight
of investment advisers, has acknowledged that its examination and
enforcement resources are already seriously constrained. \6\ This
raises the question whether the SEC would have the resources or
capability to be an effective regulator when advisers to private pools
of capital are required to register under an expanded registration
framework. We encourage policy makers to consider the issue of
resources and regulatory capabilities as they develop proposals for an
expanded regulatory mandate.
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\6\ Speech by SEC Chairman Mary L. Schapiro: Address to the
Council of Institutional Investors (April 6, 2009), available at:
http://www.sec.gov/news/speech/2009/spch040609mls.htm.
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In addition to questions regarding the resources and capabilities
of the SEC to regulate advisers to private pools of capital,
consideration must also be given to the organization of the SEC, and
whether changes to the current regulatory structure would lead to a
more effective regulatory outcome. We applaud Chairwoman Schapiro, who
has announced efforts to review such issues to make the SEC a more
effective regulator.
In considering the appropriate adviser registration framework, and
in light of concerns about resources, capabilities, and regulatory
structure, we believe that it is important to establish an exemption
from registration for the smallest investment advisers that have a de
minimis amount of assets under management. This exemption should be
narrowly, though appropriately, tailored so as not to create a broad,
unintended loophole from registration. We are supportive of a
comprehensive adviser registration regime, however, we recognize that
registration carries with it significant costs that can overwhelm
smaller advisers and force them out of business. We believe that the
amount of any de minimis exemption should appropriately balance the
goal of a comprehensive registration framework with the economic
realities of small investment advisers. As mentioned above, regulatory
resources, capabilities, and structure should also be considered as
policy makers determine an appropriate de minimis threshold. \7\ We are
not proposing a specific de minimis amount, however, we encourage
policy makers to determine an amount that is not so high as to create a
significant loophole that undermines a comprehensive registration
regime, and also not so low that the smallest investment advisers are
unable to survive because of regulatory costs.
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\7\ We believe that Congress should ensure that any approach in
this regard is consistent with State regulation of smaller investment
advisers and avoids duplication.
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We would like to share with you today some initial thoughts on some
of the key principles that we believe should be considered by Congress,
the Administration, and other policy makers as you consider the
appropriate regulatory framework. Those principles are:
The goal of any reform efforts should be to develop a more
intelligent and effective regulatory framework, which makes our
financial system stronger for the benefit of consumers,
businesses, and investors.
Regulation should address identified risks or potential
risks, and should be appropriately tailored to those risks
because without clear goals, there will be no way to measure
success.
Regulation should not impose limitations on the investment
strategies of private pools of capital. As such, regulatory
rules on capital requirements, use of leverage, and similar
types of restrictions on the funds should not be considered as
part of a regulatory framework for private pools of capital.
Regulators should engage in ongoing dialogue with market
participants. Any rule making should be transparent and provide
for public notice and comment by affected market participants,
as well as a reasonable period of time to implement any new or
modified regulatory requirements. This public-private dialogue
can help lead to more effective regulation and avoid unintended
consequences, market uncertainty, and increased market
volatility.
Reporting requirements should provide regulators with
information that allow them to fulfill their oversight
responsibilities as well as to prevent, detect, and punish
fraud and manipulative conduct. Overly broad reporting
requirements can limit the effectiveness of a reporting regime
as regulators may be unable to effectively review and analyze
data, while duplicative reporting requirements can be costly to
market participants without providing additional benefit to
regulators. It is critical that regulators keep confidential
any sensitive, proprietary information that market participants
report. Public disclosure of such information can be harmful to
members of the public that may act on incomplete data, increase
risk to the financial system, and harm the ability of market
participants to establish and exit from investment positions in
an economically viable manner. \8\ Regulations should not force
market participants publicly to reveal information that would
be tantamount to revealing their trade secrets to competitors.
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\8\ MFA and its members also believe that regulators should also
ensure that they share information with foreign regulators only under
circumstances that protect the confidentiality of that information. For
example, the SEC has adopted Rule 24c-1 under the Exchange Act (17 CFR
24c-1), which allows the SEC in its discretion to share nonpublic
information with a foreign financial authority if the authority
receiving such nonpublic information provides such assurances of
confidentiality as the Commission deems appropriate. MFA believe that
U.S. regulators should employ this type of approach when sharing
information with foreign regulators.
We believe that the regulatory construct should
distinguish, as appropriate, between different types of market
participants and different types of investors or customers to
whom services or products are marketed. While we recognize that
investor protection concerns are not limited to retail
investors, we believe that a ``one-size fits all'' approach
will likely not be as effective as a more tailored approach.
One such relevant distinction is that between private sales of
hedge funds to sophisticated investors under the SEC's private
placement regulatory regime and publicly offered sales to
retail investors. This private/public, sophisticated/retail
distinction has been in existence in the United States for over
75 years and has generally proven to be a successful framework
for financial regulation. We do not believe this distinction
should be lost, and we strongly believe that regulation that is
appropriate for products sold publicly to retail investors is
not necessarily appropriate for products sold privately to only
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sophisticated investors.
Regulation regarding market issues that is applicable to a
broad range of market participants, such as short selling and
insider trading, should be addressed in the broader context of
all market participants. Market issues are not specific to the
hedge fund industry and, therefore, regulatory reform regarding
these issues should be considered in the broader context and
not in the context of hedge fund regulation.
Lastly, we believe that industry best practices and robust
investor diligence should be encouraged and recognized as an
important complement to prudential regulation. Regulators will
tell you that their oversight is no substitute for a financial
firm's own strong business practices and investors' robust
diligence if we are to promote market integrity and investor
protection concerns.
III. Hedge Fund Best Practices
MFA and its members recognize the importance of a smart regulatory
framework designed to protect investors, prevent systemic risk, and
ensure appropriate oversight by regulators. In addition to regulation,
it is important for market participants to promote investor protection
and limit systemic risk through high standards of business conduct, as
reflected in industry best practices.
As mentioned earlier, MFA and its members have been at the
forefront of developing and promoting industry best practices through
the recommendations in its Sound Practices. Over the past 10 years, MFA
and its members have regularly updated and enhanced Sound Practices to
ensure that the recommendations in that document are at the forefront
of best practices for the hedge fund industry. Most recently, MFA and
other industry groups have developed global, unified principles of best
practice for the hedge fund industry. These unified principles are
designed to be applicable to hedge fund managers in all jurisdictions.
MFA's Sound Practices contains robust recommendations that address,
among other things, important investor protection considerations such
as robust disclosure from managers as well as risk management, which
can help guard against systemic risk concerns. Adoption of these
recommendations by hedge fund managers will help managers develop
strong business practices. Strong business practices are an important
complement to regulation to achieve the goals of investor protection
and prevent systemic risk. \9\
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\9\ To assist investors in their diligence process, MFA has
published a model due diligence questionnaire, which illustrates the
types of information commonly requested by investors prior to
investing. MFA's model DDQ is available at: http://
www.managedfunds.org/downloads/Due%20Dilligence%20Questionnaire.pdf.
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Conclusion
Hedge funds, as sophisticated institutional investors, have
important market functions, in that they provide liquidity and price
discovery to capital markets, capital to companies to allow them to
grow or turn around their businesses, and sophisticated risk management
to investors such as pension funds, to allow those pensions to meet
their future obligations to plan beneficiaries. MFA and its members
acknowledge that smart regulation helps to ensure stable and orderly
markets, which are necessary for hedge funds to conduct their
businesses. We also acknowledge that active, constructive dialogue
between policy makers and market participants is an important part of
the process to develop smart regulation. We are committed to being
constructive participants in the regulatory reform discussions and
working with policy makers to reestablish a sound financial system and
restore stable and orderly markets.
On behalf of MFA and its members, I appreciate the opportunity to
testify before the Subcommittee. I would be happy to answer any
questions that you may have.
______
PREPARED STATEMENT OF JAMES S. CHANOS
Chairman,
Coalition of Private Investment Companies
July 15, 2009
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee. My name is James Chanos, and I am President of Kynikos
Associates LP, a New York private investment management company that I
founded in 1985. \1\ I am appearing today on behalf of the Coalition of
Private Investment Companies (CPIC), a group of private investment
companies that are diverse in size and in the investment strategies
they pursue, with a wide range of clients that include pension funds,
asset managers, foundations, other institutional investors, and
qualified wealthy individuals.
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\1\ Prior to founding Kynikos Associates LP, I was a securities
analyst at Deutsche Bank Capital and Gilford Securities. My first job
on Wall Street was as an analyst at the investment banking firm of
Blyth Eastman Paine Webber, a position I took in 1980 upon graduating
from Yale University with a B.A. in Economics and Political Science.
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I want to thank you for the opportunity to testify on the
regulation of hedge funds and other private investment pools. Among
other subjects, my testimony discusses pending legislative proposals
for private investment funds, including the bill introduced by Chairman
Reed, S. 1276, which I believe offers a creative and flexible approach
to regulating managers of private investment funds under the Investment
Advisers Act of 1940 (Advisers Act). I also suggest for your
consideration an approach that may be more difficult to achieve
legislatively, but which would be more comprehensive and less reliant
upon expansive rule making by the Securities and Exchange Commission to
achieve effective regulation of private investment companies and their
managers. In short, I recommend that you consider drafting a special
``Private Investment Company'' statute, specifically tailored for SEC
regulation of private investment funds.
Private investment company legislation should require registration
of private funds with the SEC; provide that each such fund and its
investment manager be subject to SEC inspection and enforcement
authority, just as mutual funds and registered investment advisers are;
require custody and audit protections to prevent theft, Ponzi schemes
and fraud; require robust disclosures to investors, counterparties and
lenders; require that private funds provide basic census data in an
online publicly available form; require that they implement antimoney
laundering programs, just as broker-dealers, banks and open-end
investment companies must do; and, for larger funds, require the
adoption of risk management plans to identify and control material
risks, as well as plans to address orderly wind-downs. CPIC believes
that these statutory requirements would benefit investors by putting
into place a comprehensive regulatory framework that enhances the
ability of regulators to monitor and address systemic risks while
providing clearer authority to prevent fraud and other illegal actions.
Our approach strives for the highest standards of prevention without
eliminating the beneficial effects of responsible innovation.
Whatever approach this Subcommittee chooses, either through robust
amendments to the Advisers Act or by creating a new Private Investment
Company Act, I look forward to working with you and your staff as you
consider legislation in this area.
Benefits of Private Pools of Capital
Your letter of invitation requests that witnesses discuss the
benefits of private pools of capital to investors and to the broader
economy. Our financial markets benefit from the wide diversity of
market participants--investment bankers and broker-dealers, commercial
banks and savings institutions, mutual funds, commodity futures
traders, exchanges and markets of all types, traders of all sizes, and
a variety of managed pools of capital, including venture funds, private
equity funds, commodity pools, and hedge funds, among others.
Private investment companies play significant, diverse roles in the
financial markets and in the economy as a whole. For example, venture
capital funds are an important source of funding for start-up companies
or turnaround ventures. Other private equity funds provide growth
capital to established small-sized companies, while still others pursue
``buyout'' strategies by investing in underperforming companies and
providing them with capital and/or expertise to improve results. These
types of funds may focus on providing capital in particular sectors,
for example, energy, real estate, and infrastructure, among others.
Hedge funds invest in or trade a variety of financial instruments
on a global level, including stocks, bonds, currencies, futures,
options, other derivatives and physical commodities. Some invest in
securities and hold long term positions, such as some long-short funds
and short-only funds. Some are strictly traders. Many serve as
important counterparties to other participants in the market who wish
to offset risk. Others may become ``activists'' and use a large equity
position in a company to encourage management to make changes to
increase shareholder value. Hedge funds, as a group, add to the depth,
liquidity, and vibrancy of the markets in which they participate. The
individuals who run them bring their research and insight to bear on
the value of various assets, thereby adding to the price discovery and
efficiency of the markets as a whole. The important role of hedge funds
and other private investment funds in the U.S. and global markets has
been widely acknowledged over many years by Government and private
sector groups, including the President's Working Group on Financial
Markets, the Commodity Futures Trading Commission, the Securities and
Exchange Commission, and the Federal Reserve Board. \2\
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\2\ See, e.g., remarks of Bernard Bernanke, who called hedge funds
a ``positive force in the American financial system.'' Hearing on the
Nomination of Bernard S. Bernanke to be Member and Chairman of the
Federal Reserve Board, S. Comm. on Banking, Housing, and Urban Affairs;
(Nov. 15, 2005) (statement of Bernard Bernanke) (unpublished
transcript). Other financial regulators also view hedge funds as a
positive force. For example, the United Kingdom's Financial Services
Authority, releasing a March 2006 report on hedge funds, reiterated its
view that hedge funds are ``a vital segment of the financial services
industry. In particular they play a fundamental role in the efficient
reallocation of capital and risk, and remain an important source of
liquidity and innovation in today's markets.'' Press Release, FSA (Mar.
23, 2006) available at www.fsa.gov.uk/pages/Library/Communication/PR/
2006/026.shtml.
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In addition to the benefits provided by these flexibly structured
pools of capital to investors and to the markets more broadly in terms
of liquidity, efficiency, and price discovery, private investment funds
are a potential source of private investment to participate with the
Government in addressing the current financial crisis. \3\ It therefore
is in the interests of investors, U.S. markets, and the broader economy
that private investment funds continue to participate in our financial
markets and have the flexibility to perform their unique roles.
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\3\ United States Department of the Treasury, ``Fact Sheet:
Public-Private Investment Program'' (Mar. 23, 2009) (available at
http://www.treas.gov/press/releases/reports/ppip_fact_sheet.pdf).
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Risks Posed by Private Pools of Capital
In recent years, prior to the current economic downturn, some
market observers believed that hedge funds and other private pools of
capital would be the source of the next financial crisis. Of course, as
we have all painfully learned, the greatest danger to world economies
came not from those entities subject to indirect regulation, such as
hedge funds, but from institutions such as banks, insurance companies,
broker-dealers, and Government-sponsored enterprises operating with
charters and licenses granted by State and Federal regulators and under
direct regulatory supervision, examination, and enforcement. Indeed,
Bernard Madoff used his firm, Bernard L. Madoff Investment Securities,
LLC--which was registered with the SEC as a broker-dealer and
investment adviser and subject to examination and regulation--to
perpetrate his Ponzi scheme. The Stanford group of companies used an
SEC-registered broker-dealer and SEC-registered investment adviser to
market, among other products, certificates of deposit of an affiliated
offshore bank.
Nonetheless, those of us who are in the private investment fund
industry recognize that a modernized financial regulatory system--one
that addresses overall risk to the financial system and that regulates
market participants performing the same functions in a consistent
manner--will include appropriate regulation of hedge funds and other
private pools of capital.
To address the specific question posed by your letter of invitation
regarding the risks posed by private investment funds, it is fair to
say that the types of risks they pose are different from those posed by
other financial institutions. Private investment funds are not part of
the governmental ``safety net,'' as are insured depository
institutions--no Federal guarantees are provided to their investors.
Moreover, while some hedge funds are large, they are dwarfed by the
sizes of financial institutions such as commercial and investment
banks, the Government-sponsored enterprises, and others. Despite the
rapid growth and size of hedge funds ($1.33 trillion), their relative
size within the financial sector is small, accounting for less than one
percent of the approximately $196 trillion invested in the world's
financial assets--including equities, Government and private debt, and
deposits. \4\ Nor do private investment funds participate as
intermediaries in payment and settlement systems. Finally, because they
are not relying on a Federal safety net or supervision, the
counterparties to transactions with hedge funds and other private
investment funds typically require them to have higher levels of
capital and liquidity and to post strong collateral, as compared to
more heavily regulated financial institutions. For all these reasons,
when a private fund fails, it is not as likely to set off a chain
reaction, such as we saw when Lehman Brothers collapsed.
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\4\ Total hedge fund industry capital stood at $1.33 trillion as
of the first quarter 2009, with 9,284 funds in operation at year-end
2008, according to Hedge Fund Research, Inc. See ``Positive Hedge Fund
Performance Fails To Offset Record Fund of Funds Withdrawals in Q1'',
(Apr. 21, 2009) (available at http://www.hedgefundresearch.com/pdf/
pr_20090421.pdf); Hedge Fund Research, Inc., ``Record Number of Hedge
Funds Liquidate in 2008'', (Mar. 18, 2009) (available at http://
www.hedgefundresearch.com/pdf/pr_20090318.pdf). The total value of the
world's financial assets--including equities, Government and private
debt, and deposits--was $196 trillion in 2007. See McKinsey Global
Institute, ``Mapping Global Capital Markets: Fifth Annual Report''
(Oct. 2008) (available at http://www.mckinsey.com/mgi/reports/pdfs/
fifth_annual_report/fifth_annual_report.pdf).
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In a rare case, such as that involving the super-leveraged Long
Term Capital Management in 1998, it is possible that a private fund
could grow to a level of size, leverage, and interconnectedness that it
might pose systemic risk. Yet, in our experience, the most prominent
risks associated with hedge funds relate to the relationship between
funds, their managers, their investors, and discrete counterparties. In
a nutshell, these are the risks of unfair dealing with clients, lack of
transparency, certain custody issues, potential fraud, and conflicts of
interest.
Congress has sought to ensure that hedge funds and other private
funds deal appropriately with their investors by imposing conditions on
the exemptions from registration under the Securities Act of 1933, the
Investment Company Act of 1940 (Investment Company Act), and in some
cases the Commodity Exchange Act (CEA), under which they operate. \5\
To meet these exemptions, the laws require hedge funds to limit their
offerings to private placements with high net worth sophisticated
investors, who are able to understand and bear the risks of the
investment. A private fund must either limit its beneficial owners to
not more than 100 persons and entities (typically all or most of whom
are ``accredited investors''), or limit its investors to super-
accredited ``qualified purchasers,'' such as individuals with more than
$5 million in investments and institutions with more than $25 million
in investments. Private funds typically file exemptive notices with the
SEC and State securities commissioners under Regulation D of the
Securities Act of 1933. Many also file notices with the National
Futures Association under the CEA exemptions by which they operate
(which impose their own additional restrictions on sophistication and
qualifications of investors).
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\5\ See ``Implications of the Growth of Hedge Funds'', Staff
Report to the United States Securities and Exchange Commission, at 11-
17, 23-25 (Sept. 2003), available at http://www.sec.gov/news/studies/
hedgefunds0903.pdf (Staff Report).
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Moreover, the SEC and criminal prosecutors have significant
regulatory and enforcement authority to address a number of potential
risks posed by private funds--both risks to their clients and risks to
other market participants. For example, private investment funds are
subject to the same restrictions on their investment and portfolio
trading activities as most other securities investors, including such
requirements as the margin rules \6\ (which limit the use of leverage
to purchase and carry publicly traded securities and options); SEC
Regulation SHO \7\ (which regulates short-selling); the Williams Act
amendments to the Securities Exchange Act of 1934 (Exchange Act) \8\
and related SEC rules (which require public reporting of the
acquisition of blocks of securities and regulate other activities in
connection with takeovers); and FINRA's ``new issues'' Rule 5130 (which
governs allocations of IPOs). Private investment funds must also abide
by the rules and regulations of the markets in which they seek to buy
or sell financial products. And, perhaps most important, they are
subject to antifraud and antimanipulation requirements, such as Section
10(b) of the Securities Exchange Act of 1934 \9\ and Rule 10b-5, \10\
as well as insider trading prohibitions, both in the funds' investment
and portfolio trading activities, and in the funds' offers and sales of
units to their own investors. Private fund advisers also are subject to
the antifraud provisions in Section 206 of the Advisers Act, which
applies to both registered and unregistered investment advisers. \11\
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\6\ 12 C.F.R. 220, 221.
\7\ 17 C.F.R. 242.200-203.
\8\ The Williams Act added Exchange Act 13(d), 13(e), 14(d),
14(e) and 14(f), 15 U.S.C. 78m(d), 78m(e), 78n(d), 78n(e), and
78n(f) in 1968. Related legislation added Section 13(g), 78m(g), in
1977.
\9\ 15 U.S.C. 78j.
\10\ 17 C.F.R. 240.10b-5.
\11\ 15 U.S.C. 80b-6.
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However, regulators' lack of detailed information about private
investment funds--the absence of a registration requirement and the
inability of a regulator to subject private funds to periodic reporting
and examination--may handicap the SEC in meeting its investor
protection mandate, and may handicap financial regulators generally in
addressing potential systemic risks. Therefore, CPIC for many years has
advocated that the SEC, at a minimum, be able to collect certain
``census'' data regarding all private investment funds; we further have
advocated basic protections for investors in private funds, including
disclosure requirements (particularly with respect to valuation of fund
assets) and custody requirements, as well as audits by accounting firms
registered with the Public Company Accounting Oversight Board (PCAOB).
Approaches by Market Participants and Regulators To Limit Risks Without
Unduly Limiting Benefits
Private sector groups, often working with regulators, have
developed best practices for hedge funds over the years, and the
industry continues to improve in the areas of risk management and
client protection. For example, for a number of years the Managed Funds
Association has published and updated a ``Sound Practices'' guide for
hedge funds. \12\ Institutional investors have strengthened their ``due
diligence'' processes and have demanded more information and stronger
risk management approaches from the funds in which they invest. As a
report by the Government Accountability Office (GAO) in May 2009 noted,
``hedge fund advisers have improved disclosure and become more
transparent about their operations . . . .'' \13\
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\12\ ``Sound Practices for Hedge Fund Managers 2009'', Managed
Funds Association (available at http://www.managedfunds.org/mfas-sound-
practices-for-hedge-fund-managers.asp).
\13\ ``Hedge Funds: Overview of Regulatory Oversight, Counterparty
Risks, and Investment Challenges.'' GAO-09677T (May 7, 2009) (available
at http://www.gao.gov/products/GAO-09-677T).
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The President's Working Group on Financial Markets since its
formation in 1999 has shared information regarding private investment
funds among regulators and also has launched initiatives with the
private sector, including the PWG's appointment in 2007 of an Asset
Managers' Committee, on which I served, and an Investors' Committee,
each of which issued reports earlier this year on best practices for
private fund managers and investors, respectively. \14\
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\14\ See, e.g., ``Best Practices for the Hedge Fund Industry:
Report of the Asset Managers' Committee to the President's Working
Group on Financial Markets'' (Jan. 15, 2009) (available at http://
www.amaicmte.org/Asset.aspx).
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In my view, one of the most important recommendations of the report
of the Asset Managers' Committee (AMC Best Practices) is that managers
should disclose more details--going beyond Generally Accepted
Accounting Principles--regarding how their funds derive income and
losses from Financial Accounting Standard (FAS) 157 Level 1, 2, and 3
assets. \15\ Another recommendation is that a fund's annual financial
statements should be audited by an independent public accounting firm
that is subject to PCAOB oversight. Still another recommendation would
assure that potential investors are provided with specified disclosures
relating to the fund and its management before any investment is
accepted. This information should include any disciplinary history and
pending or concluded litigation or enforcement actions, fees and
expense structure, the use of commissions to pay broker-dealers for
research (soft dollars), the fund's methodology for valuation of assets
and liabilities, any side-letters and side-arrangements, conflicts of
interest and material financial arrangements with interested parties
(including investment managers, custodians, portfolio brokers, and
placement agents), and policies as to investment and trade allocations.
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\15\ In brief, under FAS 157, Level 1 assets are those that have
independently derived and observable market prices. Level 2 assets have
prices that are derived from those of Level 1 assets. Level 3 assets
are the most difficult to price--prices are derived in part by
reference to other sources and rely on management estimates. Disclosure
of profits and losses from these categories will allow investors to
better assess the diversification and risk profile of a given
investment, and to determine the extent to which fund valuations are
based on the ``best guess'' of fund management.
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Congress may wish to give legal effect to many of these
recommendations; in fact, I believe any private investment company
legislation should do just that. But, I would urge that Congress
carefully tailor legislation in this area, in order to preserve the
flexibility of private funds and their capacity for innovation that has
benefited investors and the capital markets over the years.
What Legislative Changes Are Needed?
Current Advisers Act and Investment Company Act Framework
As this Subcommittee is aware, private investment companies and
their advisers are not required to register with the SEC if they comply
with the conditions of certain exemptions from registration under the
Investment Company Act and the Advisers Act. \16\ Congress created
exemptions under these laws, because it determined that highly
restrictive requirements applicable to publicly offered mutual funds
and advisers to retail investors were not appropriate for funds
designed primarily for institutions and wealthy investors.
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\16\ Section 3(c)(1) of the Investment Company Act excludes a
company from the definition of an ``investment company'' if it has 100
or fewer beneficial owners of its securities and does not offer its
securities to the public. Under the Securities Act of 1933 and SEC
rules, an offering is not ``public'' if it is not made through any
general solicitation or advertising to retail investors, but is made
only to certain high-net-worth individuals and institutions known as
``accredited investors.'' ``Accredited investors'' include banks,
broker-dealers, and insurance companies. The term also includes natural
persons whose individual net worth or joint net worth with a spouse
exceeds $1 million, and natural persons whose individual income in each
of the past 2 years exceeds $200,0000, or whose joint income with a
spouse in each of the past 3 years exceeds $300,000, and who reasonably
expect to reach the same income level in the current year.
Section 3(c)(7) of the Investment Company Act excludes a company
from the definition of an ``investment company'' if all of its
securities are owned by persons who are ``qualified purchasers'' at the
time of acquisition and if the Company does not offer its securities to
the public. Congress added this section to the Investment Company Act
in 1996 after determining that there should be no limit on the number
of investors in a private investment fund, provided that all of such
investors are ``qualified purchasers.'' In brief, ``qualified
purchasers'' must have even greater financial assets than accredited
investors. Generally, individuals that own not less than $5 million in
investments and entities that own not less than $25 million in
investments are qualified purchasers.
Section 203(b)(3) of the Advisers Act exempts from registration any
investment adviser that, during the course of the preceding 12 months
has had fewer than 15 clients and that does not hold itself out as an
investment adviser nor act as an investment adviser to any investment
company. Advisers to hedge funds and other private investment companies
are generally excepted from registration under the Advisers Act by
relying upon Section 203(b)(3), because a fund counts as one client.
In some cases, where these companies and their advisers engage in
trading commodity futures, they also comply with exemptions from
registration under the ``commodity pool operator'' and ``commodity
trading advisor'' provisions of the CEA. These exemptions generally
parallel the exemptions from registration under the securities laws.
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To date, legislative proposals to regulate private investment
companies have focused on limiting the exemptions from regulation of
private investment companies under the Investment Company Act or
removing an exemption under the Advisers Act and thus subjecting
private investment companies or their advisers to the requirements of
one of those Acts. \17\ Although I agree that private investment
companies and their managers should be subject to additional regulatory
requirements to protect investors and counterparties, I believe simply
eliminating the exemptions in either or both of these statutes will
prove unsatisfactory. \18\
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\17\ For example, a bill introduced in the House, H.R. 711, simply
strikes the ``private adviser'' exemption under Section 203(b)(3) of
the Advisers Act and makes private funds subject to the Advisers Act in
its entirety. Another bill introduced in the Senate, S. 344, attempts a
more tailored approach by altering the current private fund exemptions
under the Investment Company Act to make them conditional exemptions,
available only where a fund registers with the SEC and provides
specified disclosures.
\18\ In my testimony before the SEC's public roundtable on hedge
funds in 2003, I recommended that, as a further condition to exemption
under the Advisers Act, hedge funds should be subject to specific
standards relating to investor qualifications, custody of fund assets
(an issue on which there now is significant focus as a result of the
Madoff scandal), annual audits and quarterly unaudited reports to
investors, clear disclosure of financial arrangements with interested
parties (such as the investment manager, custodian, prime broker, and
others--in order to address conflicts issues), clear disclosure of
investment allocation policies, and objective and transparent standards
for valuation of fund assets that are clearly disclosed, not stale, and
subject to audit. Statement of James Chanos, President, Kynikos
Associates, SEC Roundtable on Hedge Funds (May 15, 2003) (available at
http://sec.gov/spotlight/hedgefunds/hedge-chanos.htm).
When I testified before this Committee in 2004, I expanded upon
these points and recommended that the SEC require, as a condition to a
hedge fund's exemption under the Advisers Act, that hedge funds file
basic information with the SEC and certify that they met the standards
outlined above. Testimony before the Senate Committee on Banking,
Housing, and Urban Affairs, Hearing on Regulation of the Hedge Fund
Industry (Jul. 15, 2004) (available at http://banking.senate.gov/
public/index.cfm?FuseAction=Hearings.Hearing&Hearing_ID=79b80b77-9855-
47d4a514-840725ad912c). See also Letter from James Chanos to Jonathan
Katz, SEC (Sept. 15, 2004) (available at http://www.sec.gov/rules/
proposed/s73004/s73004-52.pdf). This would have provided the SEC with
hedge fund ``census'' data it has long said it needs; it also would
have provided a basis for SEC enforcement action against any fund
failing to meet the above standards. Had the SEC adopted this
recommendation, the agency would have avoided the legal challenge to
the rule it adopted later that year to change its interpretation of the
term ``client'' under the Advisers Act in order to require hedge fund
managers to register. See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir.
2006).
As this Subcommittee knows, the SEC's hedge fund adviser
registration rule was struck down in 2006, (id.) and the SEC decided
not to appeal. Some hedge fund managers that had registered with the
SEC under the rule withdrew their registrations. I decided that my firm
should remain registered as an investment adviser (which we are still
today), but, as I testified in 2006 before this Committee, the Advisers
Act is ``an awkward statute for providing the SEC with the information
it seeks . . . and for dealing with the broader issues that are outside
the Act's purposes.'' Testimony of James Chanos, CPIC, before the
Senate Committee on Banking, Housing, and Urban Affairs, Subcommittee
on Securities and Investment; Hearing on the Hedge Fund Industry, at 7
(available at http://banking.senate.gov/public/_files/ACF82BA.pdf).
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The first lesson we all learned in shop class was to use the right
tool for the job. Neither the Investment Company Act nor the Advisers
Act in its current form is the right tool for the job of regulating
hedge funds and other private investment companies. They do not contain
the provisions needed to address the potential risks posed by the
largest large private investment companies, the types of investments
they hold, and the contracts into which they enter. At the same time,
those laws each contain provisions designed for the types of businesses
they are intended to regulate--laws that would either be irrelevant to
oversight of private investment companies or would unduly restrict
their operation.
The Advisers Act and the Investment Company Act (which applies
primarily to the retail mutual fund sector), are both designed
primarily for retail investor protection in individual accounts that
invest in publicly traded stocks and bonds. Neither has specific
provisions designed to protect funds' counterparties or control
systemic risk. Many requirements of the Advisers Act are irrelevant, or
would be counterproductive, if applied to private investment companies.
For example, Advisers Act restrictions on transactions with affiliates
conducted as principal that require client consent on a transaction-by-
transaction basis may work against investors' needs by impinging on a
fund's ability to seize rapidly emerging opportunities, particularly in
the cases of private equity and venture capital funds. Such funds
routinely conduct transactions as principal or as a coinvestor
alongside affiliated funds, and transaction-by-transaction consents
from large numbers of private fund investors are, as a practical
matter, not possible to collect.
In addition, the SEC's custody rules under the Advisers Act are
insufficient to protect private investment fund assets from theft or
prevent other forms of fraud. Although the SEC recently proposed
amendments to these rules, even as proposed to be amended, the rules do
not fully protect the assets of private investment funds. For example,
the rules exclude from custody requirements certain types of
instruments that are commonly owned by private investment funds, an
exclusion that would deprive investors in those funds of the protection
that a custodian provides. \19\ Access control requirements under the
rules are rudimentary at best, particularly for assets other than
publicly traded securities. Detailed formal requirements on the means
by which private investment fund assets enter and exit the custodian's
control are needed to assure that the fund's assets really exist and
cannot easily be stolen. \20\
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\19\ These instruments are privately issued uncertificated
securities, bank deposits, real estate assets, swaps, and interests in
other private investment funds, as well as shares of mutual funds,
which, under current law, can simply be titled in the name of the
private investment fund care of the manager, and the evidence of
ownership held in a file drawer at the manager of the private
investment fund. The issuers of those assets are permitted to accept
instructions from the manager to transfer cash or other value to the
manager. This gaping hole in current Advisers Act custody requirements
can allow SEC-registered advisers easily to abscond with money or other
assets and falsify documentation of ownership of certain categories of
assets, and makes it difficult for auditors, investors and
counterparties to verify the financial condition of advisory accounts
and private investment funds. Requiring independence between the
function of managing a private investment fund and controlling its
assets, by requiring that all assets be titled in the name of a
custodian bank or broker-dealer for the benefit of the private fund and
requiring all cash flows to move through the independent custodian,
would be an important control. Similarly, requiring an independent
check on the records of ownership of the interests in the private
investment fund, as well as imposing standards for the qualification of
private investment fund auditors--neither of which currently is
required by the Advisers Act--would also greatly reduce opportunities
for mischief.
\20\ CPIC is separately filing a comment letter with the SEC in
connection with its pending rule making, in which we advocate a further
strengthening of the custody rules.
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Moreover, the Advisers Act is generally silent on methods for
winding down an investment fund or client account, an area which the
law should address in some detail for large private investment
companies. In sum, the Advisers Act, which was adopted in largely its
current form in 1940, is not well suited to today's investment
structures, strategies, and qualified investors' needs.
Neither is the Investment Company Act suited for regulation of
private funds. As an example, requirements for boards of directors set
by the Investment Company Act are designed to protect the large numbers
of retail investors in mutual funds, and are a poor fit for vehicles
that are offered only to select groups of high net worth and
institutional investors. Similarly, the Investment Company Act
generally provides for either daily liquidity (mutual funds for which
investors can redeem shares every business day), or no liquidity
(closed-end funds for which investors can rarely be redeemed out),
while private investment funds are able to adopt a flexible range of
redemption dates to address the liquidity of the assets in which the
particular fund invests.
Scope of S. 1276
The Chairman's bill, S. 1276, would require registration under the
Advisers Act for those private fund managers that have $30 million or
more under management. It would also provide that records of the
adviser's related private funds (those exempted under sections 3(c)(1)
and 3(c)(7) of the Investment Company Act) are deemed to be records of
the adviser and subject to SEC inspection. Thus, under the bill, the
SEC would have full authority under the Advisers Act over all private
fund managers (other than foreign advisers) meeting the specified
threshold, and would have broad inspection authority over all records
of private funds, even though the funds themselves would not be
registered.
The legislation further amends existing section 211 of the Advisers
Act to enhance the SEC's authority to adopt different sets of rules to
address different types of advisers. Under this authority, the SEC
could, for example, write a set of rules under the Advisers Act
applicable only to advisers to private funds and tailored for those
advisers. The bill, therefore, offers a creative and flexible approach
to regulation of private investment fund managers and oversight of the
funds themselves.
However, you may wish to consider whether the bill, as drafted,
provides too little direction from Congress--both as to what elements
of the Advisers Act should be modified or omitted with respect to
private funds, and what additional requirements, going beyond those
currently applicable to registered investment advisers, should be added
for advisers to private funds and for the funds themselves. Indeed, the
legislation, as currently drafted, could leave some doubt as to how
broadly Congress intends the SEC to act in this area.
We therefore recommend that Congress consider developing a Private
Investment Company Act, which would contain targeted controls and
safeguards needed for oversight of private funds, while preserving
their operational flexibility. More detailed requirements could be
considered for large private investment companies (or families of
private investment companies) in order to address the greater potential
for systemic risk posed by such funds, depending upon their use of
leverage and their trading strategies. If you choose not to develop a
separate act for private funds and use the approach of S. 1276
regulating private investment funds under the Advisers Act, we suggest
that the legislation further direct the SEC to use its authority under
Section 211 and tailor the requirements of the Advisers Act to impose
appropriate requirements on private investment funds. We believe the
legislation should specify those requirements.
Below, we discuss provisions relating to systemic risk and investor
protection that we believe should be included in any Private Investment
Company Act or, alternatively, addressed under the Advisers Act in
further amendments to S. 1276.
Consideration of a Private Investment Company Act
We have given some thought to what the elements of a special
``Private Investment Company Act'' statute should contain. Many of the
elements of such a statute should be similar to provisions currently in
the Advisers Act or Investment Company Act, but others would be
tailored to private investment funds. Such a new statute could be
codified as new Section 80c of Title 15 of the U.S. Code (Section 80a
is the Investment Company Act, while Section 80b is the Investment
Advisers Act) and should apply to private investment funds of all kinds
with assets under management of more than $30 million, no matter
whether a fund is called a ``hedge,'' ``venture capital,'' ``private
equity'' or other type of fund; and should include all foreign
investment companies that conduct U.S. private offerings, so that a
fund would gain no benefit by organizing or operating as an
``offshore'' entity. Private funds subject to the new statute would not
be subject to registration under the Investment Company Act if they
continue to meet the standards for exclusion under Sections 3(c)(1) or
3(c)(7) \21\ or other relevant exemption, nor would they be subject to
registration under the Advisers Act if they continue to meet the
requirements for exemptions under that Act. They would, however, be
required to register under the new Private Investment Company Act and
be subject to its provisions. The following are key elements of any
private fund legislation.
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\21\ Certain family owned companies that are deemed ``qualified
purchasers'' pursuant to Section 2(a)(51)(A)(ii) or (iii) of the
Investment Company Act should not be covered by the new requirements,
however. Companies, trusts, and estates, etc., that are owned by
members of one family and that own investments should not be deemed to
be investment companies or regulated like other private investment
funds.
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Registration Requirements/SEC Examination and Inspection Authority.
As stated above, private funds (or their advisers) should be required
to register with the SEC. Registration--whether under the Advisers Act
or under a new Private Investment Company Act--should entail
requirements for the filing of basic census data in an online publicly
available form. Registration will bring with it the ability of the SEC
to conduct examinations and bring administrative proceedings against
registered advisers, funds, and their personnel. The SEC also will have
the ability to bring civil enforcement actions and to levy fines and
penalties for violations.
Prevention of Theft, Ponzi Schemes, and Fraud. Any new private fund
legislation should include provisions to reduce the risks of Ponzi
schemes and theft by requiring money managers to keep client assets at
a qualified custodian, and by requiring investment funds to be audited
by independent public accounting firms that are overseen by the PCAOB.
\22\ Custody requirements should be extended to all investments held by
covered funds. Fund assets should be held in the custody of a bank,
registered securities broker-dealer, or (for futures contracts), a
futures commission merchant. While the SEC has adopted custody rules
for registered advisers pursuant to its antifraud authority under the
Advisers Act (and recently proposed amendments to those rules), we
believe Congress should provide specific statutory direction to the SEC
to adopt enhanced custody requirements for all advisers.
---------------------------------------------------------------------------
\22\ This requirement is consistent with the AMC Best Practices,
and would close the above-described gaps in the protections provided by
the Advisers Act custody rule.
---------------------------------------------------------------------------
Transparency for Investors. Private investment fund legislation
should require funds or their managers to provide potential investors
with specific disclosures before accepting any investment, and provide
existing investors with ongoing disclosures. \23\ Among other things, a
private fund should be required to disclose in detail its methodologies
for valuation of assets and liabilities, the portion of income and
losses that it derives from Financial Accounting Standard (FAS) 157
Level 1, 2, and 3 assets, \24\ and any and all investor side-letters
and side-arrangements. Likewise, private funds should have to disclose
the policies of the fund and its investment manager as to investment
and trade allocations. They should also disclose conflicts of interest
and financial arrangements with interested parties, such as their
investment managers, custodians, portfolio brokers, and placement
agents. Funds should also be transparent with respect to their fees and
expense structures, including the use of soft dollars. Investors should
receive audited annual financial statements and quarterly unaudited
financial statements.
---------------------------------------------------------------------------
\23\ This requirement is consistent with the AMC Best Practices.
\24\ See n. 15 supra.
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Reduction of Risks Through Transparency for Counterparties and
Lenders. Consistent with recent recommendations from the
Administration, we believe Congress should focus on particular points
where private funds could have an impact on the financial system, such
as counterparty risk and lender risk. Thus, private fund legislation
should include requirements that lenders and counterparties be provided
with certain information by a private fund, such as the company's
audited annual financial statements, current private placement
memorandum, information as to the fund's valuation methodology, the
existence of side-letters and side-arrangements and any material
conflicts of interest or financial arrangements.
Implementation of Antimoney Laundering Measures. Private investment
companies should have to implement customer identification and
antimoney laundering programs, and file suspicious activity reports and
currency transaction reports, just as securities broker-dealers, banks,
and open-end investment companies are required to do. \25\ Currently,
neither registered investment advisers nor registered closed-end
investment companies are subject to customer identification or other
formal antimoney laundering rules.
---------------------------------------------------------------------------
\25\ This requirement is consistent with the AMC Best Practices.
---------------------------------------------------------------------------
Special Requirements for Large Private Investment Funds.
Consideration should be given to establishing requirements for a fund
(or a family of funds and/or its manager) that controls gross assets in
excess of a specified amount that would not apply to smaller private
investment companies. For example, larger funds should be required to
implement disaster recovery, business continuity, and risk management
plans to identify and control material operational, counterparty,
liquidity, leverage, and portfolio risks. \26\ In addition, such a fund
should be required to adopt a detailed plan to address liquidity and
for conducting an orderly wind-down that assures parity of treatment of
investors in the event of a major liquidity event.
---------------------------------------------------------------------------
\26\ These requirements are consistent with the AMC Best
Practices.
---------------------------------------------------------------------------
Conclusion
Private investment companies have operated remarkably well in the
absence of direct Government oversight and subject to the due diligence
of large and sophisticated investors. CPIC nonetheless supports the
call for enhanced oversight, with the SEC as the primary functional
regulator. But, simply imposing new regulation without properly
tailoring it to address the relevant risks would add to the burdens of
hard-working, but already overstretched agency staffs. Moreover, simply
requiring registration under the Advisers Act or Investment Company Act
could degrade investor due diligence by causing undue reliance upon SEC
regulation under statutes that are insufficiently robust to address the
unique characteristics of private funds. We believe that the twin goals
of improved investor protection and enhanced systemic oversight could
be better achieved with a stand-alone statute, tailored for private
investment funds. If this Subcommittee determines, however, to bring
private funds under SEC oversight by requiring fund managers to
register under the Advisers Act, we believe that any such legislation
should include the key provisions discussed above.
We appreciate the work that this Subcommittee is doing in crafting
legislation in this area, and we stand ready to work with you in the
days ahead. Thank you for giving CPIC the opportunity to testify on
this important subject.
PREPARED STATEMENT OF TREVOR R. LOY
Founder and General Partner,
Flywheel Ventures
July 15, 2009
Introduction
Chairman Reed, Ranking Member Bunning, and Members of the
Committee, my name is Trevor Loy and I am the founder and a general
partner of Flywheel Ventures, a venture capital firm based in Santa Fe,
New Mexico, with offices in Albuquerque and San Francisco. Flywheel
invests in seed and early stage companies based on innovations in
information technology and the physical sciences. We invest primarily
in the Southwest and Rocky Mountain regions of the U.S. in companies
targeting global markets in digital services, physical infrastructure,
energy and water. Since raising our first fund in 2002, we have grown
to a staff of seven with approximately $40 million dollars under
management in three active funds. Our firm targets initial investments
of $100,000 to $1 million into private, start-up companies which are
often built around innovations coming out of the region's research
universities, R&D organizations, and national laboratories. Our goal is
for these companies to one day become viable, market-leading public
companies or be acquired by larger corporations so that their
technologies can reach millions of people.
In addition to my responsibilities as a venture investor, I am also
a member of the Board of Directors of the National Venture Capital
Association (the NVCA) based in Arlington, Virginia. The NVCA
represents the interests of approximately 460 venture capital firms in
the United States which comprise more than 90 percent of the venture
industry's capital under management.
It is my privilege to be here today to share with you, on behalf of
the industry, the role of venture capital investment in the financial
system, particularly as it relates to systemic risk. Our asset class is
unique in many ways, with a critical distinction being that while the
companies we have funded have had a proven and profound positive impact
on the U.S. economy in terms of job creation and innovation, our
specific asset class remains a small cottage industry that poses
little, if any, risk to the overall financial system.
As Congress and the Administration examine the forces that led to
the financial markets crisis, including regulatory weaknesses that may
have slowed an earlier response by the Government, we appreciate the
opportunity to be part of the discussion. Our goal is that the role of
the venture capital industry in the economy be clearly understood. We
also appreciate the opportunity to offer recommendations on how
regulators can meet transparency needs by using information already
disclosed by venture firms, while also protecting the continued ability
of venture firms to create companies and grow jobs for the U.S.
economy.
The Fundamentals of Venture Capital Investment
I would like to begin with a brief overview of the structure and
dynamics of venture capital investing. Venture capital funds typically
are organized as private limited partnerships. Generally, 95 to 99
percent of capital for the venture fund is provided by qualified
institutional investors such as pension funds, universities and
endowments, private foundations, and to a lesser extent, high net-worth
individuals. These investors, referred to as the limited partners
(LPs), generally seek the high risk/high reward exposure afforded by
venture capital as a relatively small component of a diversified
investment portfolio. The venture capitalists that make investment
decisions on behalf of the fund form the general partner (the GP), and
we supply the rest of the capital for the fund from our own personal
assets. Importantly, the capital supplied to a venture capital fund
consists entirely of equity commitments provided as cash from investors
in installments on an as-needed basis. Although venture capital funds
may occasionally borrow on a short-term basis immediately preceding the
time when the cash installments are due, they do not use debt to make
investments in excess of the partner's capital commitments or ``lever
up'' the fund in a manner that would expose the fund to losses in
excess of the committed capital or that would result in losses to
counter parties requiring a rescue infusion from the Government.
A venture fund is typically structured with a fixed term of at
least 10 years, sometimes extending to 12 or more years. At the outset,
a limited partner commits a fixed dollar amount to the fund. Pending
the draw down of the limited partner's cash when the venture capitalist
has identified a company or idea in which to invest, the cash remains
in the LPs' control. The ``capital calls'' for investments generally
happen in cycles over the full life of the fund on an ``as needed''
basis as investments are identified by the general partners and then as
further rounds of investment are made into the portfolio companies. As
portfolio company investments are sold in the later years of the fund--
when the company has grown so that it can access the public markets
through an initial public offering (an IPO) or when it is an attractive
target to be bought--the liquidity from these ``exits'' is distributed
back to the limited partners. The timing of these distributions is
subject to the discretion of the general partner, and limited partners
may not otherwise withdraw capital during the life of the venture fund.
Once the venture fund is formed, our job is to find the most
promising, innovative ideas, entrepreneurs, and companies that have the
potential to grow exponentially with the application of our expertise
and venture capital investment. Often these companies are formed from
ideas and entrepreneurs that come out of university and Government
laboratories--or even someone's garage. Typically, the venture industry
has focused on high technology areas such as information technology,
life sciences, and more recently, clean technology. Some of our recent
investments at Flywheel include MIOX Corporation and Tred Displays both
based in Albuquerque, New Mexico. MIOX solves one of the world's most
pressing problems, the need for clean and safe water. MIOX's patented
technology purifies water beyond EPA standards in over 1,300
installations around the world. The advantage of MIOX's solution, which
was originally developed with funding from Los Alamos National
Laboratory, is eliminating chlorine and all other dangerous and costly
chemicals from the water purification process. Tred Displays is another
company in Flywheel's portfolio. Much of the world's printed signage is
now changing to digital technologies such as LED or LCD displays, both
of which are expensive and consume tremendous energy. The Tred sign
provides similar digital capability with its proprietary innovative
technology that uses batteries or solar cell energy to power digital
content, cutting the energy consumption of a digital sign by more than
95 percent.
Once we have identified a promising opportunity, we vet the
management team and conduct due diligence research on the company, the
market, the financial projections, and other areas. For those companies
who clear this investigation, we make an investment in exchange for
equity ownership in the business. Importantly, investments into start-
up companies are structured as cash in return for an equity share of
the company's stock. Leverage is not part of the equation because
start-ups do not typically have the ability to sustain debt interest
payments and often do not have collateral that lenders desire. We also
generally take a seat on the company's board of directors. We expect to
hold a typical venture capital investment for 5-10 years, often longer
and, since the technology bubble burst, rarely much less. During that
time, we continue to invest additional capital into those companies
that are performing well; we cease follow-on investments into companies
that do not reach their agreed upon milestones. Our ultimate goal is
what we refer to as an exit--which is when the company is strong enough
to either go public on a stock market exchange or become acquired by a
strategic buyer at a price that ideally exceeds our investment. At that
juncture, the venture capitalist ``exits'' the investment, though the
business continues to grow. Essentially we make way for new investors
who may be the public (when the company issues an IPO) or a new
corporate owner (when there is an acquisition). The nature of our
industry is that many companies do not survive, yet a few companies are
able to generate very significant returns.
Our industry is no stranger to technological and entrepreneurial
risk. At least one third of our companies ultimately fail, and those
that succeed usually take 5-10 years to do so. In many ways, our
industry is one of the only asset classes with the long-term patience
and fortitude to withstand the high rates of failure among start-up
businesses. This high tolerance for risk, however, is limited entirely
to the operational success or failure of the start-ups in which we are
owners. This risk is very different from the systemic risk that is the
basis for the recent SEC registration proposals. Because there is
typically no leverage component between the VC fund and its outside
investors or between the VC fund and the companies in which we invest,
venture capital investment risk is contained and measured. Those
portfolio companies that succeed do so in significant ways,
counterbalancing the losses elsewhere in the portfolio, while losses do
not compound beyond the amount of capital committed by each partner.
The venture industry has operated under this risk-reward model for the
last 40 years.
The Economic Contribution of Venture Capital
Historically, venture capital has differentiated the U.S. economy
from all others across the globe. Since the 1970s, the venture capital
community has served as a builder of companies, a creator of jobs, and
a catalyst for innovation in the United States. According to a 2009
study conducted by econometrics firm IHS Global Insight, companies that
were started with venture capital since 1970 accounted in 2008 for 12.1
million jobs (or 11 percent of private sector employment) and $2.9
trillion in revenues in the United States in 2008. Such companies
include historic innovators such as Genentech, Intel, FedEx, Microsoft,
Google, Amgen, and Apple. Our asset class has been recognized for
building entire industries including the biotechnology, semiconductor,
online retailing, and software sectors. Within the last year, the
venture industry has also committed itself to funding companies in the
clean technology arena which includes renewable energy, power
management, recycling, water purification, and conservation. My
partners and I are extremely proud of the work that we do each day
because we are creating long-term value for our investors, our
companies, their employees, and the communities in which our companies
operate. In fact, a 2007 study by the NVCA found that New Mexico was
the fastest growing venture capital economy in the country in the past
decade. We are also dedicated to playing an important role in our
country's economic recovery.
Venture Capital and Lack of Systemic Risk
In light of the financial meltdowns of the past year, we believe
that Congress has a right and duty to examine regulatory policy to
protect investors from systemic risk. However, the venture capital
industry's activities are not interwoven with U.S. financial markets.
We believe an examination of any of the measures of size, complexity,
or interconnection reveals that venture capital investment does not
qualify as posing such risk for the following reasons:
Venture capital firms are not interdependent with the world
financial system. We do not trade in the public markets. Most venture
capital funds restrict or prohibit: (i) investments in publicly traded
securities; (ii) investor redemptions prior to the end of the fund's
term (which, in most cases, is 10 to 12 years); and (iii) short selling
or other high risk trading strategies. Moreover, our firm stakeholders
are contained to a defined set of limited partners and their interests
in the funds are not publicly traded. LPs make their investment in a
venture fund with the full knowledge that they generally cannot
withdraw their money or change their commitment to provide funds.
Essentially they agree to ``lock-up'' their money for the life of the
fund, generally 10 or more years as I stated earlier. This long-term
commitment is critical to ensure that funds are available not just for
the initial investment into a start-up, but also for the follow-on
rounds of investment which provide the company continued resources to
grow. LPs agree to this lack of liquidity because the venture industry
has historically achieved higher returns than the public markets.
However, the length and risk profile of the investment also means that
LPs typically limit the amount of money that is dedicated to venture
activity. A pension fund, for example, typically will only invest 5-15
percent of its investable assets in what are called alternative
assets--the broad category of hedge fund, private equity, real estate,
and venture capital investments. The percentage or component of that
allocation that is then committed to venture investing is often quite
small.
Whereas a hedge fund in distress may leave a chain of unsettled
transactions and other liabilities, a venture capital fund in distress
would generally only have consequences limited to the investors'
returns, the fund sponsor's inability to raise a subsequent fund, and
the fund's portfolio companies potentially losing access to additional
equity capital. With its relatively small allocation to venture, the
totality of the capital at risk is known and transparent, bounded by
the level of capital initially committed.
The venture capital industry is small in size. While certain pooled
investment funds may present a systemic risk due in part to their size,
the same cannot be said about venture capital funds, as the collective
venture industry equates to a fraction of other alternative asset
classes. In 2008, U.S. venture capital funds held approximately $197.3
billion in aggregate assets. That same year, U.S. hedge funds held, in
the aggregate, approximately $1.3 trillion in assets. \1\ From the
period 2004 to 2008, only 13 U.S. venture capital funds had $1 billion
or more in commitments. In comparison, approximately 218 U.S. hedge
funds held over $1 billion in assets in 2008 alone. In 2008, venture
capitalists invested just $28 billion into start-up companies which
equates to less than 0.2 percent of U.S. GDP. The average size of a
venture capital fund in 2008 was $144 million dollars, although areas
such as cleantech and biotech investing are very capital intensive and
often require larger funds.
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\1\ See Hedge Fund Intelligence Ltd., ``United States: The End of
an Era?'' Global Review 2009, GLOBAL REVIEW 2009 (January 2009)
(available at http://www.hedgefundintelligence.com/
Article.aspx?Task=Report&IssueID=71697&ArticleID=2186589).
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Venture capital firms do not use long-term leverage or rely on
short-term funding. Borrowing at the venture capital fund level, if
done at all, typically is only used for short-term capital needs
(pending draw down of capital from its partners) and does not exceed 90
days. In fact, many venture capital funds significantly limit borrowing
such that all outstanding capital borrowed by the fund, together with
guarantees of portfolio company indebtedness, does not exceed the
lesser of (i) 10-15 percent of total limited partner commitments to the
fund and (ii) undrawn limited partner commitments. Additionally,
venture capital firms do not generally rely on short-term funding. In
fact, quite the opposite is true. Our firms gradually call down equity
capital commitments from investors over a period of approximately 10
years on a ``just-in-time basis,'' with initial investments in a
company typically made within the first 3 to 5 years.
All risk is contained within the venture ecosystem of limited
partners, venture capital funds, and portfolio companies. This
ecosystem differs significantly from others where leverage,
securitization or derivatives are used. For example, a million dollar
mortgage can create a multiple of asset flows--perhaps $100 million--
because of derivatives and bets regarding interest rates for that
mortgage pool. In our world, a million dollar investment is just that--
a million dollars. There is no multiplier effect because there are no
side bets or other unmonitored securities based on our transaction.
When one of our companies fails, the jobs may go away and our million
dollars is gone but the losses end there. Even when certain industries
broadly collapsed in the past--such as the optical equipment industry--
the failure and losses remained contained to that industry and those
investments. Although entrepreneurs and their companies were impacted,
the impact remained a very isolated, nonsystemic exposure. Without the
layer of securities or use of derivatives that were at the heart of the
many problematic transactions that catalyzed the recent financial
crisis, the financial pain of failure remains self contained. No
outside parties are betting on the success or failure of the venture
industry and therefore they can not be impacted.
Risk is very much at the heart of the venture industry but it is
entrepreneurial and technological risk not systemic financial risk.
Indeed, it is critical that our country proactively support this
entrepreneurial risk as it has translated into new companies, millions
of jobs, and countless innovations that would otherwise never be
brought to life. As the fundamentals of our industry are expected to
remain unchanged, we do not believe that we will find ourselves in a
position to contribute to any systemic risk going forward.
Meeting the Need for Transparency
As I stated at the outset, we do recognize the need for
transparency into our activities and, in that spirit, venture firms
have provided information to the SEC for decades. We believe this
information remains sufficient to meet the need for transparency
without burdening our firms with additional regulations that do not
further the understanding of systemic risk. I would like to take a
moment to review our current disclosure activities.
As limited partnership interests are securities, venture capital
fund offerings must either be registered with the SEC or meet an
exemption from registration proscribed by the Securities Act of 1933
(the Securities Act). Venture capital funds typically rely on the Rule
506 ``safe harbor'' of Regulation D, as an exemption from publicly
registering their securities with the Securities and Exchange
Commission (the SEC).
To comply with the Rule 506 safe harbor, most venture capital funds
file a ``Form D'' disclosure document with the SEC during or shortly
after their offering has commenced. The Form D requires disclosure of
significant information about the private offering.
An initial Form D must be filed with the SEC no later than 15
calendar days after the ``date of first sale'' of securities in the
venture capital fund's offering. Any information contained in a Form D
filing is publicly available. As part of the current Form D filing
requirements, venture capital funds are required to disclose many
aspects of their business that can assist the Government in assessing
whether or not the venture capital fund imposes any systemic risk to
the financial system.
Form D currently requires venture capital funds to disclose
information about the fund, including (i) the fund's name, (ii)
principal place of business, (iii) year and jurisdiction of
organization, and (iv) the form of legal entity. Form D also requires
venture capital funds to disclose material information regarding the
size and terms of the offering. This information includes (i) the date
of first sale of the fund's securities, (ii) the intended duration of
the fund's private offering, (iii) the minimum investment amount
accepted from a third party investor, and (iv) the total number of
accredited and nonaccredited investors to which the fund has sold
securities (a Form D amendment is required if the total number of
nonaccredited investors increases to more than 35). This information
also discloses the relevant Securities Act and Investment Company Act
of 1940 exemptions that the fund relies upon in privately offering its
securities.
A venture capital fund must also disclose the total dollar amount
of securities the fund is offering. In contrast to hedge funds and some
other types of pooled investment funds, a venture capital fund offering
is generally neither continuous nor for an indefinite amount of
interests. The stated offering amount is also often disclosed in the
venture capital fund's offering memorandum or in the limited
partnership agreement among the limited partners and general partner of
the fund.
Additional SEC Registration Requirements Could Hamper Venture Activity
The SEC previously used the Investment Advisers Act of 1940 (the
Advisers Act) as a mechanism to attempt to regulate hedge fund
activity. It is important to note that the SEC also explicitly exempted
venture capital activity from that regulatory push. We strongly believe
that the Government's need to understand the venture industry's
financial commitments can be met with current disclosure. Using the
Advisers Act brings layers of additional regulatory requirements that
can prevent us from focusing our time and financial resources on
helping to start and grow new companies, does not provide the
Government with meaningful insight into systemic risk assessment and
will divert Government resources.
A venture capital firm employs a small administrative staff to
handle firm operations. Often an investing partner will take on the
role of Chief Administrative Officer and in that capacity will manage a
Chief Financial Officer. The CFO is fully engaged in the financial
operations of the firm, including portfolio company reporting, and all
investor relations activities. At Flywheel, we have a single full-time
Director of Finance and Operations. This individual, who I proudly note
has been honored as one of the top CFO's in our region, manages all
aspects of our quarterly and annual financial reporting, our portfolio
company reporting, our relationships with our tax, audit, accounting
and legal service providers, our investor relations, our capital
management, and other miscellaneous financial activities. In addition,
as a small firm, her responsibilities also encompass general management
and office management duties, including seemingly mundane activities
such as booking travel, filing expense reports, and coordinating team
logistics. By requiring venture funds to register with the SEC under
the Advisers Act, the administrative burden on the firm and the CFO
would grow exponentially. In addition to filing information regarding
the identification of the firm, its partners and assets under
management, the Advisers Act establishes a number of substantive
requirements that would change the operation of a venture fund and the
relationship between the venture fund and its limited partners. Many of
these requirements, which are summarized below, would demand
significant resources and overhead which sophisticated investors have
not requested and venture funds currently do not have in place.
SEC Examinations: The SEC can and does conduct periodic
examinations of registered investment advisers. The SEC inspection
staff looks closely at, among other things, the firm's internal
controls, compliance policies and procedures, annual review
documentation, and books and records. SEC examinations may last
anywhere from a few days to a few months. The intent of these
inspections is to evaluate the firm's compliance with various policies
and procedures imposed on registered advisers. We do not believe that
requiring periodic inspections of venture capital firms would provide
meaningful insight for the Government's assessment of systemic risk;
however, we do believe it would further divert the SEC's resources from
inspection of firms that do present systemic risk. Moreover, the costs
and administrative burdens associated with preparing for an examination
can be substantial.
Performance Fees: The Advisers Act prohibits contracts that provide
for compensation based on a percentage of the capital gains or capital
appreciation in a client's account, subject to certain exceptions,
including a provision that permits a performance fee to be charged to
certain ``qualified clients'' of the adviser that have a minimum net
worth or a minimum amount of assets under management with the adviser.
This limitation was designed to preclude advisers from subjecting
client funds and securities to unnecessary speculation in order to
increase fees to the adviser. However, venture firms are intentionally
structured to make investments in companies that may fail and requiring
venture firms to register could unintentionally prohibit carried
interest payments for certain investors, thereby denying them access to
a high-growth alternative asset class. In particular, it would require
significant restructuring issues for existing funds formed in reliance
on existing exemptions. More fundamentally this restriction alters the
long-standing practice of LPs providing increased incentives for the GP
to demonstrate long-term commitment to company growth. Doing so could
change the dynamics of the industry unnecessarily.
The following administrative requirements, while not controversial,
would require venture firms to dedicate resources beyond those which
their investors have asked them to devote:
Compliance Programs and Appointment of Chief Compliance Officer:
The Advisers Act would require venture firms to implement written
policies and procedures designed to prevent violations of the Federal
securities laws, to review the policies and procedures annually for
their adequacy and the effectiveness of their implementation, and to
designate a chief compliance officer (a ``CCO'') to be responsible for
administering the policies and procedures. The CCO selected by the
venture firm must be competent and knowledgeable regarding the Advisers
Act and should be empowered with full responsibility and authority to
develop and enforce appropriate policies and procedures for the firm.
The SEC has indicated that it expects that written policies and
procedures would address, at a minimum (i) portfolio management
processes; (ii) trading practices; (iii) proprietary trading of the
adviser and personal trading by the adviser's supervised persons; (iv)
accuracy of disclosures made to clients, investors, and regulators; (v)
safeguarding of client assets; (vi) accurate creation and maintenance
of required books and records; (vii) advertising and marketing
practices; (viii) processes to value client holdings and assess fees
based on those valuations; (ix) safeguards for the privacy protection
of client records and information; (x) disaster recovery and business
continuity plans; (xi) insider trading safeguards; and (xii) antimoney
laundering efforts.
Codes of Ethics: The Advisers Act would require venture firms to
adopt a code of ethics (a ``Code'') which must set forth, among other
things, (i) standards of conduct expected of personnel; (ii) a system
of preclearance for investments in initial public offerings and private
placements, (iii) a requirement that all violations of the Code be
promptly reported to the CCO or his or her designee; and (iv) a
requirement that certain advisory personnel periodically report their
personal securities transactions and holdings in securities. As venture
capital funds do not typically trade in the public markets and
generally limit advisory activities to the purchase and sale of
securities of private operating companies in private transactions, the
latter requirement is of limited relevance to venture capital funds,
yet would still apply.
Reports in relation to securities holdings must be submitted to the
CCO on an annual basis; reports in relation to securities transactions
must be submitted on a quarterly basis. The adviser must provide each
supervised person with a copy of its Code and must obtain each
supervised person's written acknowledgment of receipt of the Code, as
well as any amendments.
Form ADV and Periodic Filing: The Advisers Act would require a
venture firm to file Form ADV Part I with the SEC in order to become
registered under the Advisers Act. In addition, all registered venture
firms would need to furnish each limited partner or prospective limited
partner with a written disclosure statement that provides information
concerning the venture firm, its operations, and its principals. This
would need to be done on at least an annual basis.
Custody: The Advisers Act would require a venture firm that has
custody of limited partner funds or securities to maintain such funds
or securities with a qualified custodian. If a venture firm has custody
of the limited partner funds or securities, then the firm must send
quarterly account statements directly to each limited partner, member,
or other beneficial owner. However, the venture fund need not send
these quarterly account statements if such entity is subject to audit
at least annually and distributes audited financial statements to all
limited partners. In the alternative, a venture firm possessing custody
may also have an independent public accountant verify the assets held
by the firm at least once a year. This auditing procedure must be
conducted on a surprise, rather than a scheduled, basis.
Recordkeeping: The Advisers Act sets forth the books and records
investment advisers must maintain. The CCO and at least one member of
the professional staff of a venture firm would have to be fully
familiar with this rule, which lists approximately 20 categories of
records to be maintained, and with all operating procedures for
complying with the recordkeeping rule. Generally, a registered
investment adviser's books and records must be kept for a total period
of 5 years (and longer in some cases).
All of these compliance elements promise to be costly from both a
financial and human resources perspective. They also promise to change
the way venture capital firms operate, adding significant
administrative burden in exchange for information that is neither
relevant nor useful for measuring and managing systemic risk.
We have been in this place before. In 2001, then President Bush
signed into law the USA Patriot Act, broad legislation intended to
combat terrorism and money laundering activity. The legislation imposed
antimoney laundering (AML) compliance obligations on ``financial
institutions,'' including broker-dealers, commodity trading advisors,
commodity pool operators, and investment companies. While the term
``investment companies'' was not specifically defined, most legal
opinions concluded that the term was intended to encompass both
registered investment companies (e.g., mutual funds) and private
investment funds (e.g., U.S. and offshore unregistered hedge funds,
funds-of-funds, commodity pools, private equity funds, and venture
capital funds).
In addition to complying with existing AML requirements such as
reporting currency transactions and complying with the economic
sanctions imposed by the U.S. through the Office of Foreign Assets
Control (OFAC), the new statute imposed significant new obligations,
including designating a compliance officer, establishing ongoing
training programs and arranging independent audits to ensure
compliance.
However, as the regulatory process unfolded, the Treasury
Department ultimately recognized that venture activity did not meet the
criteria for money laundering risk. The Treasury concluded that funds
which do not permit investors to redeem investments within 2 years of
their purchase would not be required to comply with the USA Patriot
Act's AML compliance program obligations. In this instance the
regulations were tailored to meet the need for information and
transparency while not affecting activity ultimately unrelated. We hope
that the Congress and the Administration will work together with our
industry to ensure a similar outcome in the current regulatory
overhaul.
Summary
We understand that the implosion which occurred in the financial
system in the last year--and the economic strife which ensued--is a
just reason to examine how to better protect investors and the overall
market. We agree that those entities and industries which could cause
financial system failure should be better monitored so that the events
of 2008 are never repeated. However, venture capital is not one of
those industries. Our size and operations within the private market do
not pose broader financial risk. Venture capital played no role in the
recent financial meltdown and does not have the fundamental investing
principles to cause a future financial system failure. By requiring the
venture industry to comply with the requirements of the Advisers Act,
Congress would be unnecessarily weighing down an asset class that
should be focused on building companies and creating jobs, rather than
redirecting our resources and time toward administrative functions that
our investors did not request and that do not help the entrepreneurs
that we fund to create valuable businesses and the jobs that follow.
For innovation and entrepreneurship to continue to succeed in the
U.S., the venture capital industry needs a supportive public policy
environment. In many areas we acknowledge and are thankful for a public
policy framework in the U.S. that not only supports our industry and
our entrepreneurs but remains the envy of the rest of the world. As a
small and dynamic industry, however, we remain highly susceptible to
seemingly minor changes in our ecosystem. While some larger asset
classes may be able to absorb the proposed regulatory costs and
requirements, I am here today to say that the venture industry--and
subsequently the start-up economy--will not go unscathed by the
contemplated regulatory changes. We ask that you please examine each
asset class that will be impacted by this legislation and make your
policy decision based upon the systemic risk posed by each as well as
the implications of regulation, and focus the Government's resources
where it can have the most impact. We believe you will come to the same
conclusion: venture capital does not belong in this mix. I thank you
for your consideration today and I am happy to answer any questions.
______
PREPARED STATEMENT OF MARK B. TRESNOWSKI
Managing Director and General Counsel,
Madison Dearborn Partners, LLC,
On Behalf of The Private Equity Council
July 15, 2009
Introduction
Mr. Chairman and Members of the Committee, thank you for giving me
the opportunity to present the Private Equity Council's views on
creating a forward looking approach to regulating the financial
services sector in the aftermath of the systemwide financial crisis
that has shaken so many investors, consumers, and institutions.
The Private Equity Council is a 2-year-old trade association
representing 12 of the largest private equity firms operating in the
United States. \1\ Our mission is to educate public policy makers on
the positive role private equity investments have played in both
strengthening hundreds of companies of all sizes and from all sectors
of the economy, and in generating above average returns for scores of
public and private pension funds and other investors that have
allocated a portion of their portfolios to private equity funds. While
PEC members are among the most visible and well known in private
equity, each with more than $10 billion in assets under management, the
Committee should bear in mind that there are more than 2,000 PE firms
doing business in the U.S. The overwhelming majority of these are local
firms doing small transactions that rarely attract much attention and
yet help power local, State, and the national economies.
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\1\ Apax Partners; Apollo Global Management LLC; Bain Capital
Partners; the Blackstone Group; the Carlyle Group; Hellman & Friedman
LLC; Kohlberg Kravis Roberts & Co.; Madison Dearborn Partners; Permira;
Providence Equity Partners; Silver Lake Partners, and TPG-Capital.
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The Business of Private Equity
Before directly addressing the policy issues before the Committee,
it is useful to describe briefly the private equity industry, how it
works, and how it fits contextually into the financial marketplace.
A private equity firm, regardless of its size, creates funds in
which it invests its own capital, along with larger amounts of capital
raised from third-party investors. In these partnerships, the private
equity firm acts as the general partner, or GP, and the third-party
investors are the limited partners, or LPs. In fact, highly
sophisticated investors such as large public and private pension funds,
endowments and foundations account for 70 percent of the funds invested
with the top 100 PE firms since 2005. The 20 largest public pension
funds for which data is available (including the California Public
Employees Retirement System, the California State Teachers Retirement
System, the New York State Common Retirement Fund, and the Florida
State Board of Administration) have invested nearly $140 billion in
private equity.
The PE firm (or GP) uses the partnership's capital, along with
funds borrowed from banks and other lenders, to buy or invest in
companies that it believes could be significantly more successful with
the right infusion of capital, talent, and strategy. Historically, PE-
owned funds carry virtually no debt at the fund level. Private equity
firms do use debt to acquire portfolio companies, but this debt is
maintained at the portfolio company level. The typical capital
structure of the companies acquired by a private equity fund is
approximately 60 percent debt and 40 percent equity (though this
proportion can vary based on the cost of credit, the economic outlook,
and the nature of the business).
A key to the success of private equity investments is the
requirement that both the PE firm (the owners/shareholders) and the
senior managers invest their own money into the sponsored business. By
definition, when you have your skin in the game, when your equity is at
risk, you are highly incented to make decisions that will grow the
value of your investment. Failure to do so means you lose your own
money--not just the investment of a faceless shareholder. In short, the
PE model ensures that the interests of the shareholders (GPs and LPs)
and the interests of management are fully aligned. In contrast to
publicly owned companies, PE owned companies can operate without the
pressures imposed by public equity markets' focus on quarterly earnings
and short-term gains. As a result, they make management decisions
focused entirely on what is required to improve long-term performance
and value.
In seeking companies to purchase or invest in, PE firms have
focused on a number of broad categories, including: struggling and
underperforming businesses such as Toys 'R Us or J Crew; unwanted
divisions of large conglomerates, such as Dunkin Donuts or Burger King;
promising or strong companies in need of venture or growth capital,
such as NASDAQ or the online video service Hulu; and family businesses
where the founders are seeking to transition beyond family ownership.
Regardless of the type of firm acquired, the objective is the same:
increase the value of the business during the time that it is owned by
a private equity fund. PE firms accomplish this by adding managerial
expertise, making capital and R&D expenditures, expanding into new
markets and developing new products, and making strategic acquisitions
to create the scale required to compete and become market leaders.
Importantly, the PE firms do not share in any profits unless and until
they have paid an 8-10 percent per annum return to their investors.
PE and Jobs
Private equity funds have a proven track record of creating jobs.
The World Economic Forum reported that before they were acquired,
private equity-owned companies on average were losing jobs at existing
facilities faster than their competitors. But by the fourth year of
private equity ownership, employment levels at those companies had
increased to above the industry average. It also reported that in the
first 2 years of private equity ownership, private equity portfolio
companies increased the rate of job growth at new U.S. facilities to 6
percent above the industry average. \2\
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\2\ The Global Economic Impact of Private Equity Report 2008,
``Private Equity and Employment'', World Economic Forum, January 2008.
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Ernst & Young (E&Y) reported that at eight out of ten private
equity portfolio company's employment is sustained or increased over
time. \3\ And economists Dr. Robert Shapiro and Dr. Nam Pham found that
large companies acquired by major U.S. private equity firms increased
domestic employment by 13 percent between 2002 and 2005, a period when
employment at all large U.S. businesses grew by only three percent, and
manufacturing companies owned by private equity investors grew
employment by 1.4 percent during the same 4-year period, while
employment in the overall manufacturing sector declined by 7.7 percent.
\4\
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\3\ Ernst & Young, ``How Do Private Equity Investors Create Value?
A Study of 2006 Exits in the U.S. and Western Europe'', 2007.
\4\ Robert Shapiro and Nam Pham, ``American Jobs and the Impact of
Private Equity Transactions'', Private Equity Council, January 2008.
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PE and Performance and Value
According to E&Y, the value of U.S. businesses owned by private
equity grew 83 percent during the years they were owned by PE firms,
three times faster than their equivalents in the public sector. \5\ E&Y
also found that more than half of the earnings growth (before taxes,
interest, and capital expense) at PE-owned portfolio companies came
from business expansion, not cost-cutting or new acquisitions. \6\ And
Shapiro and Pham reported that 85 percent of PE firms studied increased
capital expenditures in the 3 years after the PE investment. \7\
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\5\ Ernst & Young, 2007.
\6\ Ernst & Young, ``Beyond the Credit Crunch: How Do Private
Equity Investors Create Value?'' A Global Study of 2007 Exits--2008.
\7\ Robert Shapiro and Nam Pham.
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PE Returns to Investors
Improving the performance of portfolio companies has enabled
private equity firms to deliver above average returns for the pension
funds and other limited partners that invest in their funds. Between
1980 and 2005, the top-quartile PE firms delivered average annualized
net returns of 39 percent, \8\ significantly beating the S&P 500 and
other indices. The overwhelming majority of these returns--80 percent
typically--is returned to investors in the form of profit. That 80
percent translates into real dollars--$1.2 trillion to be exact--the
total profits distributed to pension funds and other investors
worldwide from their PE investments between the early 1980s and 2008.
\9\ This massive infusion to public and private pensions serving
teachers, firefighters, policemen, and other retired public employees
strengthens the solvency of the pension system.
---------------------------------------------------------------------------
\8\ PEC analysis of data from Venture Economics and Bloomberg.
\9\ Preqin 2008 Global Private Equity Review.
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On a mark-to-market basis, PE investors have seen the current value
of their investments decline due to the financial crisis. But since PE
firms hold investments for the long term, the current valuation
snapshot is of marginal utility in assessing the eventual returns
likely to flow to investors. Many investments now marked down as a
result of the recession are likely to recover and be profitable for
LPs, though perhaps not as profitable as was the case in more robust
economic cycles.
But despite lower valuations now, on a relative basis, private
equity performance through the third quarter of 2008 still surpassed
the performance of public equity markets. One year performance for
private equity in the period ending September 30, 2008, was -8.2
percent, compared to -21.4 percent for the NASDAQ and -22 percent for
the Standard and Poor's 500 index. \10\ Importantly, as noted, these
results do not reflect ``returns'' as these investments are still owned
and as the economy improves and their value recovers, many will be sold
at a profit.
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\10\ Thomson Reuters Private Equity Performance Index (PEPI).
---------------------------------------------------------------------------
The investment report of an actual LP is illustrative. In its just
released Comprehensive Annual Financial Report, the Pennsylvania State
Employees' Retirement System reported that in 2008 its PE investments
declined 6.8 percent while its investment in domestic, global, and
international equities fell from 37.5 percent to 52.4 percent. Over the
last 3 years, total returns from PE have been 17 percent compared to -
10.5 percent for U.S. stocks and -11.0 for non-U.S. stocks.
PE Today
Like other financial institutions, the private equity sector has
been adversely impacted by the recession and credit crisis. Restricted
credit markets have effectively shut down the market for financing new
acquisitions, and many portfolio companies are under stress as they
manage through this recession. In this regard, the challenges private
equity faces are similar to those that virtually every public and
private business in the U.S. is addressing. The good news, if there is
any, is that over the last decade top private equity firms have made a
major commitment to adding very sophisticated management resources to
their portfolio companies, thus allowing them to provide hands-on
guidance both from an operational and capital structure perspective,
especially in such perilous economic times. The combination of
operational expertise and favorable financing terms should enable most
portfolio companies in viable sectors of the economy to ride out the
economic downturn without violating debt covenants that could force
them into default.
To be sure, some portfolio companies will not survive this deep
recession, just as is the case with dozens of public companies with
household names like GM and AIG. Nonetheless, bankruptcies associated
with PE investments made in the 2005-7 period will create hardships on
workers, communities, and investors, not to mention the PE firms that
will lose tens or hundreds of millions of their own equity. \11\ But
the critical takeaway for the Members of this Subcommittee is that the
failures of individual PE-owned companies, while hardly trivial, do not
give rise to the kind of systemic risk relevant to policy makers
seeking to prevent global financial shocks.
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\11\ That said, according to a World Economic Forum study of PE
investing over 20 years, private equity-owned companies defaulted on
debt obligations at a rate substantially lower than all U.S. companies
that issued bonds--and much lower than companies that issued high-yield
debt.
---------------------------------------------------------------------------
Despite the challenges facing the industry, private equity is
poised to play a constructive role in the economic recovery. Today,
private equity firms have more than $450 billion in committed capital
to invest. But that capital is mostly sidelined due to the credit
crisis and the recession. This industry is poised to be part of the
solution, whether it is helping to recapitalize the banking system or
investing in companies that desperately need growth capital and
management expertise. We will continue to support traditional U.S.
industries like steel and manufacturing, while also providing capital
for new companies that are developing green technologies and energy
efficient products.
PE and Systemic Risk
As Congress evaluates issues relating to systemic risk, we think it
is important that policy makers distinguish among different types of
private capital. Private equity is just one form of private capital.
Other private investment vehicles include hedge funds, real estate
partnerships, and venture capital funds, among others. All these pools
of capital have features in common. But there are also important
distinctions between them. Accordingly, we believe Congress should
focus on regulating activities, not what businesses call themselves.
In laying out its Financial Regulatory Reform program, the Obama
Administration articulated three fundamental factors that trigger
systemic risk concerns: (i) the impact a firm's failure would have on
the financial system and economy; (ii) the firm's combination of size,
leverage (including off-balance sheet exposures), and degree of
reliance on short-term funding; and (iii) the firm's criticality as a
source of credit for households, businesses, and State and local
governments and as a source of liquidity for the financial system.
Private equity contains none of these systemic risk factors and thus
should pose little concern for policy makers seeking to develop a new
regime to guard against catastrophic, cascading financial shocks.
Specifically:
PE firms have limited or no leverage at the fund level (as
distinct from leverage maintained a the portfolio company level
for a particular acquisition). Thus, PE funds are not subject
to unsustainable debt or creditor margin calls.
Private equity funds typically use 3:1 leverage for
acquisitions compared to companies like Lehman Brothers, which
was levered at 32:1 when it failed. Further, Lehman's leverage
was maintained at the parent company level, thus exposing the
entire firm to collateral calls.
PE funds do not rely on short-term funding. Rather, private
equity investors are patient and commit their capital for 10-12
years (or more) with no redemption rights. Therefore, investors
cannot withdraw their money on short notice, triggering ``asset
fire sales'' to find cash to make the repayments.
PE firms are not deeply interconnected with other financial
market participants through derivatives positions, counterparty
exposures or prime brokerage relationships.
Private equity investments are not cross-collateralized,
which means that neither investors nor debt holders can force a
fund to sell unrelated assets to repay a debt. In a sense,
private equity investments are firewalled from one another so
that any nonperforming investment does not negatively affect
another investment. Losses are limited to the underlying value
of the original investment.
Private equity funds invest in long-term illiquid assets
that are typically operating companies. Private equity does not
invest in short-term traceable securities, like derivatives,
swaps, or equities.
Private equity investments are diversified across multiple
industries and there is no over-exposure to any single sector.
PE firms are not a source of credit to households,
businesses, or Governments, nor do they act as a primary source
of liquidity for the financial system.
PE companies' borrowing is still a small portion of the
overall credit market, well under 5 percent of all U.S. credit
market obligations outstanding. The total value of all private
equity holdings is equivalent to just 2.6 percent to 4.3
percent of corporate stocks and 3.1 percent to 5.3 percent of
GDP.
In short, when applying the Administration's systemic risk factors to
private equity, it is hard to see how any particular private equity
fund could be considered a systemic risk.
Financial Services Reform Issues
The goals of financial regulatory reform should be to restore
confidence in financial markets generally and the credit markets in
particular, and to protect our financial system from the kind of
meltdown that has devastated the global economy. We believe the Obama
Administration's plan can accomplish these objectives. Although we do
not have a direct stake in many specifics of the plan, we do feel very
strongly that Congress should take deliberative action to provide
clarity to market participants.
More specifically, we support creation of an overall systemic risk
regulator capable of acting decisively in a crisis, empowered to
implement needed policies, and possessing sufficient international
credibility to instill confidence in global markets. If the systemic
risk regulator finds that an activity, an institution, or a class of
institutions is systemically significant it should be empowered to
examine and require reports, and promulgate rules on capital adequacy,
operational controls, information and audit systems, and credit risk or
other significant risk exposure. Further, the systemic regulator should
be granted enforcement authority powers to take actions deemed
necessary to protect the financial system.
Regarding private equity specifically, as I said PE does not have
the potential to create the kind of systemic shocks that contributed to
the financial crisis. Therefore we do not believe this form of
investment poses significant concerns in the context of the financial
regulation debate. As the Committee knows, the Administration's plan
calls for private equity firms to register as investment advisers with
the Securities and Exchange Commission. Subcommittee Chairman Reed has
introduced S. 1276, the Private Fund Transparency Act of 2009 which has
a similar goal. We generally support the registration requirements
contemplated by the Administration and S. 1276.
Registration will result in new regulatory oversight for many
private equity firms. There are considerable administrative and
financial burdens associated with record keeping and audits as
registered investment advisors. These could be especially problematic
for smaller firms. Given the fact that PE firms are not a cause of
systemic risk, these additional regulatory requirements are arguably
unnecessary. That said, we are mindful of the fact that excluding any
asset class from the new regulatory regime could contribute in some way
to diminishing confidence in the effectiveness of new regulatory regime
and therefore we support the casting of a wide net.
While supporting the concept of registration and data collection
from market participants including PE firms, we do believe Congress
should direct regulators to be precise in how new regulatory
requirements are calibrated so the burdens are tailored to the nature
and size of the individual firm and the actual nature and degree of
systemic risk it may pose. In this regard, we were pleased that the
Administration's White Paper explicitly acknowledges that some of the
requirements created by the SEC ``may vary across the different types
of private pools.'' We commend Chairman Reed for his sensitivity to
this point in his own bill. Further, it is absolutely vital that any
information provided to the SEC pursuant to a new registration
requirement be subject to strong confidentiality protections so as not
to expose highly sensitive business and financial information beyond
that required to carry out the systemic risk oversight function. We
stand ready to work with Chairman Reed on these and other provisions in
S. 1276.
Conclusion
Mr. Chairman, according to research by Dr. Robert Shapiro, private
investments typically rise during recessions and continue to rise
during the initial years of recovery. Further, Shapiro reports that
total private equity investments grow much faster during the initial
year of recovery than overall business investment and there is some
evidence suggesting that private equity-held firms create jobs during
the initial stages of recoveries while employment across the economy
continues to contract. \12\
---------------------------------------------------------------------------
\12\ Robert Shapiro, ``The Role of the Private Equity Sector
Promoting Economic Recovery'', Private Equity Council, March 2009.
---------------------------------------------------------------------------
Today, private equity firms have more than $450 billion in
committed capital to invest. This industry is poised to be part of the
solution. That is our business, it's what we've done in the past, and
it is what we will do in the future.
As Dr. Shapiro wrote, ``In good and bad times, the core business of
private equity funds is to identify firms with long-term potential for
higher productivity, sales, and profits; secure the capital to purchase
these firms; and inject additional capital, improve their strategies,
and reorganize their operations, to achieve higher returns. Public
policy should support these activities, especially during the current
crisis, and refrain from imposing additional burdens that could hamper
these activities or redirect them to other economies.'' \13\ We believe
the Administration's financial reform plan strikes a good balance
between regulating PE while still allowing it to play its historically
valuable role in making American companies stronger and more
competitive.
---------------------------------------------------------------------------
\13\ Ibid.
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Thank you.
______
PREPARED STATEMENT OF RICHARD BOOKSTABER
Author,
``A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of
Financial Innovation''
July 15, 2009
Mr. Chairman and Members of the Committee, I thank you for the
opportunity to testify today. My name is Richard Bookstaber. Over the
past decade I have worked as the risk manager in two of the world's
largest hedge funds, Moore Capital Management and, most recently,
Bridgewater Associates, and I have run my own hedge fund, the
FrontPoint Quantitative Fund. In the 1990s I oversaw firmwide risk at
Salomon Brothers, which had a large internal proprietary trading
operation. From my vantage point at Salomon I was familiar with the
trading approach of some of the dominant hedge funds of the time, such
as Long Term Capital Management.
I am the author of ``A Demon of Our Own Design: Markets, Hedge
Funds, and the Perils of Financial Innovation.'' Published in April,
2007, this book warned of the potential for financial crisis resulting
from the growth of leverage and the proliferation of derivatives and
other innovative products.
Although I have extensive experience on both the buy-side and sell-
side, I left my position at Bridgewater Associates at the end of 2008,
and come before the Committee in an unaffiliated capacity, representing
no industry interests.
My testimony will discuss the need for hedge fund regulation. I
will limit my testimony specifically to the hedge fund regulation
required to address systemic risk. I will argue that regulators must
obtain detailed position and leverage data from major hedge funds in
order to successfully monitor systemic risk.
The Benefits and Risks of Hedge Funds
Two characteristics that differentiate hedge funds from other
investment funds are their ability to lever and to take short
positions. \1\ These tools give hedge funds more freedom than their
traditional counterparts in executing investment ideas. If a hedge fund
manager finds a trade that is particularly attractive, leverage allows
him to borrow fund in order to put more exposure into that trade than
can a traditional fund manager who is not permitted to lever. If a
hedge fund manager wants to express a negative view, he can short a
security, while the long-only fund manager's expression of such a view
is limited to excluding the security from the portfolio. The ability to
short also allows the hedge fund manager to eliminate exposures that
are unavoidable for the traditional manager. For example, an equity
hedge fund manager can construct a portfolio that has little market
exposure by holding an equal weighting in long and short positions. \2\
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\1\ Another characteristic that can be argued to differentiate
hedge funds from traditional funds is their fee structure. Hedge funds
typically have a performance incentive fee. The fund manager receives a
percentage of any positive returns. The manager does not, however,
similarly share in losses. This leads to an incentive to take on risk,
especially if the fund is ``under water.''
\2\ The ability to reduce exposure to the market leads to the
broadly applied differentiation between portfolios with ``beta'' and
``alpha'' exposure. Beta refers to exposure to the market. A
traditional equity fund has unavoidable beta exposure, because it holds
nothing but long positions in equities. Its return will tend to move up
and down with the overall equity market. Alpha refers to exposure that
is unrelated to the underlying market. A hedge fund can largely
eliminate its beta exposure by holding equal positions long and short.
Its return is then alpha-based, because it will not be correlated with
the underlying market.
---------------------------------------------------------------------------
Because hedge funds have more tools at their disposal, they have
the potential to generate higher returns. Put another way, because
hedge funds do not have some of the constraints of traditional
investment funds, they can construct superior portfolios--portfolios
that more precisely match the fund manager's intentions--when these
constraints are binding.
But this freedom also means that hedge funds can take on more risk
in more dimensions, and thus lose more money if things go wrong. And
the risk posture of hedge funds is more difficult to assess, because
the leverage and short positions give hedge funds a measure of
complexity beyond that of traditional, long-only funds. \3\ On the face
of it, it is noteworthy that the most free-ranging, risky, and opaque
type of investment fund has been so lightly regulated.
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\3\ The leverage and short positions also lead to a greater demand
for opacity, because if a leveraged or short position becomes known,
others can trade against it to force the fund to cover its shorts or to
reduce its leverage.
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Systemic Risk From Hedge Funds
The first task in managing systemic risk is aggregating position
and leverage data. To understand why, let's look at the sources of
systemic risk.
One source of systemic risk is leverage. Leverage amplifies risk in
a meltdown. When a market drops, highly leveraged investment funds with
positions in that market are forced to sell to meet their margin
requirements, and their selling pushes prices down further. This in
turn leads to more forced selling. The result is a cascading liquidity
crisis.
And it can get worse from there. Those funds that are under
pressure discover there is no longer liquidity in the stressed market,
so they start to liquidate their positions in other markets. If many of
the funds that are in the first market also have high exposure in a
second one, the downward spiral propagates to this second market. This
phenomenon explains why a systemic crisis can spread in surprising and
unpredictable ways. The contagion is driven primarily by what other
securities are owned by the funds that need to sell. \4\ For example,
when the silver bubble burst in 1980, the silver market became closely
linked to the market for cattle. Why? Because when the Hunt family had
to meet margin calls on their silver positions, they sold whatever else
they could. And they happened also to be invested in cattle.
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\4\ As an illustration, the proximate cause of Long Term Capital
Management's (LTCM's) demise was the Russian default in August, 1998.
But LTCM was not highly exposed to Russia. A reasonable risk manager,
aware of the Russian risks, might not have viewed it as critical to
LTCM. But the Russian default hurt LTCM because many of those who did
have high leverage in Russia also had positions in other markets where
LTCM was leveraged. When the Russian debt markets failed and these
investors had to come up with capital, they sold their more liquid
positions in, among other things, Danish mortgage bonds. So the Danish
mortgage bond market and these other markets went into a tail spin, and
because LTCM was heavily exposed in these markets, the contagion took
LTCM with it.
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Another source of systemic risk from hedge funds can come from the
potential for widespread manipulation of critical markets. \5\ When it
comes to market manipulation, the ability of hedge funds to lever
multiplies the impact of their capital base, and their ability to short
means that they can take actions to depress prices. The potential for
this risk can be appreciated by reflecting on the markets in the weeks
surrounding the failure of Lehman Brothers in September, 2008. During
that period short-selling contributed to a spectacular decline in
equity prices, and there was huge pressure on the credit default swaps
of the major financial institutions. The credit default swap spreads
widened to a level that had previously been all but unimaginable.
Because the spreads were viewed as indications of creditworthiness, and
indeed were used in various loan covenants, the extreme widening of the
spreads threatened the viability of these institutions. \6\ The role of
hedge funds in precipitating these market events remains to be studied,
but given the history of this crisis it is not difficult to imagine the
potential for a coordinated assault on the credit default swap market
or on some other critical market precipitating a crisis in the future.
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\5\ Manipulation is the intentional concentration of positions in
a market with the objective of distorting the market price. This
distortion can be intended to convey the impression of information, or
to trigger actions that are price-dependent.
\6\ The SEC issued a temporary ban on short sales in the wake of
the Lehman crisis. But the SEC had no control over hedge fund trading
in the credit default swap market. Indeed, regulators did not have
transparency into the activities of that market.
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Regulating Hedge Funds for Systemic Risk
To control the systemic risk posed by hedge funds we must be able
to measure crowding, the unintentional concentration of separate funds
in the same trade. This means knowing the positions of the individual
hedge funds and then being able to aggregate those positions. Whatever
their own risk management capabilities, the individual funds--and
regulators that might be providing oversight on an institution-by-
institution basis--cannot keep systemic risk in check because they do
not have this aggregate information. \7\ It is as if each fund is
sitting in a darkened theater unaware of how many others might run for
the exit. To regulate and monitor the systemic risk arising from
manipulation, the first task again is for the regulator to know the
positions of the hedge funds that are capable of such manipulation, and
know those positions on a frequently updated basis.
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\7\ For example, over a few days in August, 2007 a number of
large, quantitatively oriented long-short equity hedge funds saw their
value plummet by 20 to 40 percent. Among these were highly regarded
funds, including Greenwich, Connecticut-based AQR Capital and Goldman
Sachs's flagship Global Alpha Fund. These funds all used high leverage;
after the debacle hit, Goldman reported its fund was leveraged six to
one. These hedge funds had strategies in common, indeed they shared
common lineage: The principals of AQR came from Global Alpha, and the
principals of Tykhe Capital came from DE Shaw, both other funds
embroiled in the crisis. An exogenous shock initiated a drop in their
primary strategies, and due to their high leverage they were forced to
reduce their positions. With many funds running for the door at the
same time, this precipitated a leverage-induced liquidity crisis. These
funds had substantial investments in risk management talent and
systems. But what they did not appreciate--and would have had
difficulty knowing given the secrecy with which the quantitative
portion of the hedge fund industry operates--was the potential crowding
from having many large competitors in the same strategies.
---------------------------------------------------------------------------
Thus an essential task for the regulation of hedge funds is to get
data on leverage and positions from the institutions. We must be able
to track the concentration of hedge funds by assets and by strategies
to understand how the failure of one firm might propagate out to affect
others. This is missing in the current regulatory structure, and is at
the core of systemic risk.
Position data must be reported in a standardized form so that
similar positions can be aggregated across the various hedge funds.
This sort of data management task has been accomplished in other
settings. For example, when salmonella was found in a peanut factory in
Georgia, the Food and Drug Administration identified the contaminated
products across the Nation and tracked them all the way to the store
shelf. This was possible because consumer products are tagged with a
bar code. We should do the same for financial products; have the
equivalent of bar codes so that regulators know what financial products
exist and where they are being held. This will help us anticipate the
course of a systemic shock. It will identify cases where many investors
may be acting prudently, but where their aggregate positions still lead
to a level of risk which they themselves cannot see. It also will give
us the means to evaluate crises after the fact. Just as the National
Transportation Safety Board can use ``black box'' flight recorders to
help improve airline safety by determining the causes of an airline
accident, this position and leverage data will act as the black box
data to help us understand how a crisis started, and help us understand
what we need to do to improve the safety of the markets.
I believe this is a regulatory task that can be readily
accomplished. Initially the task need only focus on the largest hedge
funds, and those funds already amass the required position data as part
of their daily risk management process. And the task can bear fruit
even if it does not exhaustively pull in and tag every position. The
exhaustive reporting of all positions for all hedge funds would be
difficult, but it is not necessary, because what matters for evaluating
systemic risk is getting a critical mass of positions that reflects the
biases and interdependencies that can lead to a crisis. \8\
---------------------------------------------------------------------------
\8\ There are many thousands of hedge fund, most small and
inconsequential for systemic risk. And there are a range of customized
and complex financial products--which with regulatory pressure might
move over time into increasingly standardized forms--that will be time
consuming to identify and tag. However, if we do get to the point where
position information is provided on an exhaustive basis, then this
process can also be used as a tool to detect fraud. The regulator can
cross-check the reported positions against the fund's registered prime
broker or clearing corporation for verification. Once verified, the
returns from the reported positions can be cross-checked against the
hedge fund's reported returns.
---------------------------------------------------------------------------
The data acquisition and analysis must be done by the regulator in
a secure fashion. I am not an expert in such security issues, but I can
make two observations related to the feasibility of achieving an
acceptable level of data security. First, an acceptable standard for
position security already exists, because hedge funds allow these data
to be held by various agents in the private sector, such as their prime
brokers and clearing corporations. Second, the Government successfully
secures data in areas that are far more sensitive than position data
such as the military and the intelligence community where a failure can
cost lives and where there are concerted efforts by adversaries to root
out the data.
Hedge Funds That Should Be Monitored for Systemic Risk Regulation
For purposes of systemic regulation, hedge fund oversight should be
extended to include the large proprietary trading operations within
banks. From the standpoint of leverage and the ability to short, these
operations act the same as hedge funds. \9\ They too can contribute to
liquidity crisis events, and can participate in systemically relevant
market manipulation. However, venture capital firms and private equity
funds can be excluded. Venture capital and private equity funds operate
outside the publicly traded markets, they do not short, and, because of
the nature of their collateral, they do not employ the degree of
leverage of the hedge funds that operate in the public markets. They
also have long-term holding periods with positions that they recognize
as being illiquid from the outset. Their business model is more that of
creating a conglomerate of embryonic businesses than it is of trading
like a hedge fund. The so-called 130-30 types of investments funds also
can be excluded. \10\ These funds can employ leverage and can short,
but only within tight limits.
---------------------------------------------------------------------------
\9\ Also, compensation within proprietary trading groups is
generally incentive-based, similar to that of hedge funds.
\10\ The 130-30 type of funds add a limited degree of leverage and
ability to short to a traditional long-only structure.
---------------------------------------------------------------------------
Conclusion
My testimony has focused narrowly on what is required to regulate
hedge funds, looking specifically at the issue of systemic risk, and
within that at the data required to measure and monitor this risk.
Systemic risk regulation is seen by some as the key to averting
market and economic crises like those we have faced over the past 2
years. But while systemic risk is fresh on our minds given recent
events, it is just one of many risks that require regulatory oversight.
And it is not that difficult to address. Granted we failed to do so
this time around, and that failure exacted a huge toll. But if we make
the effort to look, systemic risk is more visible than many other
risks. Compared to risks from insider trading or fraud, where the whole
objective is to remain hidden, it is hard to be stealthy when there are
hundreds of billion of dollars of assets and multiple financial
institutions involved. And that is the scale for a risk to build to
systemic proportions.
Obtaining the position and leverage data is not invasive to a hedge
fund. It does not affect day-to-day business, and once the systems for
transferring these data to the regulator are in place it will be an
essentially costless adjunct to the funds' daily risk analysis. But I
have not addressed the next critical component of hedge fund
regulation, the component that can be invasive: What to do if the
analysis of the hedge fund data shows a systemic risk lurking on the
horizon. Who pulls the emergency brake? Who bears the responsibility
for having the hedge funds reduce their exposure or leverage? Such
regulatory authority must exist for hedge funds, just as it must exist
for banks and other financial institutions of systemic import. \11\
However, the task of acquiring and analyzing data can be separated from
that of taking action; indeed, I believe there are advantages to such a
separation. And acquiring the data is the first task to address,
because we cannot manage what we cannot measure.
---------------------------------------------------------------------------
\11\ This means that the task of data aggregation also must extend
to these other institutions, as must the ability to control leverage.
For banks, the regulatory authority already is in place to obtain these
data.
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______
PREPARED STATEMENT OF JOSEPH A. DEAR
Chief Investment Officer,
California Public Employees' Retirement System
July 15, 2009
Chairman Reed and Members of the U.S. Senate Banking Subcommittee
on Securities, Insurance, and Investment, it is an honor and pleasure
to provide this statement on behalf of the California Public Employees'
Retirement System (CalPERS). Our mission is to advance the financial
and health security for over 1.6 million public employees, retirees,
and their families. CalPERS is the largest public pension system in the
United States with a total fund market value of approximately $180
billion and annual payout obligations of over $10 billion to California
pensioners.
Acting as fiduciaries first and foremost, the goal of the CalPERS
investment program is to achieve the highest possible long-term,
sustainable, risk-adjusted returns. To discharge that responsibility,
we are inherently long-term investors in the capital markets, providing
patient capital with a decades-long investment time horizon. Because of
the sheer size of our fund and the need to diversify to provide sound
investment returns, we are broadly invested throughout the capital
markets in most asset class investment strategies including hedge funds
and private equity funds.
We are vitally interested in the quality of regulation of financial
services since effective investor protection is essential to creating
and maintaining the trust necessary for investors to put their capital
to work.
We applaud the Committee's leadership in holding this hearing to
address options for regulating hedge funds and other private pools of
capital. You have asked about the benefits of investing in these
vehicles, the risks they pose to financial markets and the broader
economy, how market participants and regulators can reduce these risks,
without unduly limiting their benefits and what legislative changes are
needed to assure that regulators have the tools they need to prevent
fraud and reduce risks posed to the financial system.
1. What benefits do private pools of capital--including hedge funds,
private equity funds, and venture capital funds--provide to
financial markets, investors, and the broader economy? In
particular, what benefits are not available through other
financial structures?
As the Nation's largest public pension fund, CalPERS investments
span domestic and international markets. The CalPERS Board of
Administration has investment authority and sole fiduciary
responsibility for the management of the System's assets. Our goal is
to efficiently and effectively manage investments to achieve the
highest possible return at an acceptable level of risk. In doing so,
CalPERS has generated strong long-term returns. The CalPERS investment
portfolio is diversified into several asset classes, so that over the
long run any weaknesses in one area can be offset by gains in another.
The CalPERS Board follows a strategic asset allocation policy that
targets the percentage of funds to be invested across a broad array of
asset classes and strategies, such as U.S. equity, international
developed and emerging equity, fixed income securities including U.S.
Treasury bonds, corporate bonds, mortgages, sovereign bonds, and high
yield bonds, private equity, venture capital, real estate, hedge funds,
and infrastructure.
Our target rate of return over the long term is 7.75 percent. The
return enhancement attributes of private equity and the risk management
characteristics of hedge funds make them indispensable elements of our
investment program. CalPERS invests in private equity and hedge fund
investment structures with the objective of diversifying its investment
portfolio, managing risk, and adding value to the total fund. For
example, private equity is an important asset class for CalPERS and
other public pension funds because top-performing private equity funds
consistently outperform other classes of investments, invest for the
long term, and align their interests and incentives with those of their
investors. Part of the above market return expected by private equity
investors is compensation for the risk of holding illiquid securities.
Public pension funds, by virtue of their long investment horizon are
ideally suited to invest in private equity vehicles. The value of
patient capital invested for the long term and not obsessed with short
term performance is important to the health of the national economy.
Important benefits to CalPERS provided by investing in private
equity and hedge funds include effective risk management and investment
value creation through allowance for the diversification of our
portfolio across a broad array of asset classes. We have been investing
in private equity since 1990 and in hedge funds since 2002. Today, we
have approximately $20 billion invested in private equity strategies
and $6 billion invested in hedge fund investment strategies that
combined represent just over 14 percent of CalPERS' total asset
allocation. The 5-year hedge fund program annualized return is +3.89
percent versus +1.32 percent for all of Global Equity giving value
added of 2.57 percent annually over the same period after expenses. As
of March 31, 2009, the private equity portfolio at CalPERS has
outperformed the public stock market index by over 1,000 basis points
over a 10-year period.
This performance translates into substantial value added to the
pension fund over a sustained time period. It makes realization of our
target rate of return feasible. The consequences to our beneficiaries,
their Government employers and taxpayers of our not meeting this
objective are substantial and real: lower wages, higher contribution
rates and higher taxes. Can these performance benefits be delivered
through other investment products? No. Sure, investors can boost
returns from investing in publicly listed equities by borrowing to
enhance returns, but that does not necessarily bring with it the long
term focus of a partnership with an expected duration of 10 to 12
years. Some hedge fund returns can be duplicated with lower cost
replication strategies, but, by definition, they only work for existing
strategies, not the innovations that competitive markets constantly
call forth.
In summary, hedge funds, private equity, and other pools of private
capital provide:
Useful components of a diversified investment portfolio to
enhance returns and add effective risk management tools.
The ability to bring together like minded investors that
have been committing long term capital to a number of
investment areas.
More flexibility to invest in accordance with opportunities
in contrast to being limited to a particular category or
``style.''
Benefits to the larger financial system including
innovation, gains in growth and employment and the provision of
capital for economic and technological advancement.
2. What risks do private pools of capital pose to financial markets and
the broader economy?
The fundamental risk posed by private pools of capital is that they
can choose to operate outside the regulatory structure of the United
States. When these entities operate in the shadows of the financial
system, regulatory authorities lack basic information about exposures,
leverage ratios, counterparty risks and other information necessary to
assure that overall risk levels in the financial system are reasonable.
Moreover, without the disclosure, reporting and licensing requirements
that accompany registration, investors may be deprived of the timely
and accurate information they need to ascertain the suitability of an
investment fund given their financial objectives and risk tolerance.
Clearly, the buildup of massively leveraged positions was enabled
by the absence of any effective regulatory oversight. Combined with
misaligned compensation practices that, among other things, encouraged
excessive risk taking by rewarding short term success without penalty
for subsequent losses, the result was an unprecedented degree of risk
in the system. The harm that has ensued as overleveraged investors have
had to unwind their positions extends far beyond them and their
investors, to other market participants and ultimately to the national
economy as a whole.
3. What approaches by market participants and regulators can best
reduce these risks, without unduly limiting the benefits of
such funds?
Policy makers, investors, regulators, and the public need to accept
that risk is inevitable and necessary; return without risk is like love
without heartache--they go together. If risk cannot be avoided then it
has to be managed.
One of the powerful lessons of the crash for us was the limited
value of many quantitative risk management tools. So an obvious
imperative for us is to improve our quantitative and qualitative
comprehension of the risks in our portfolio. In addition to better risk
management, investors can improve the depth and detail of their due
diligence, adhere scrupulously to best practices in decision making,
and make timely disclosures of their investment policies, holdings and
performance.
Regulators need new tools and authority to deal effectively with
the gaps exposed by the crash. But not all of the regulatory
shortcomings we see so clearly now are the product of gaps and
omissions. Regulators also failed to use the authority they possessed
to protect investors and assure the integrity of markets, exchanges and
investment providers. Enforcement is not the only tool of effective
regulatory systems, but its absence can dangerously weaken the
credibility of those systems. Regulatory agencies need resources,
support and leadership to make the most of the authority granted to
them so they can fulfill their mission.
Institutional investors also need the flexibility to invest,
consistent with their fiduciary responsibilities, in an unconstrained
investment opportunity set. This is critical to enable public pension
funds to meet our obligations. Limitations on the universe of available
investments will potentially reduce our ability to generate the needed
returns and may increase the risk of the plan.
4. What possible legislative changes are needed to ensure that
activities of private pools of capital are sufficiently
transparent, and that regulators have the tools they need to
prevent fraud and reduce risks posed to the financial system?
Today's hearing coincides with the release of a report by the
Investors' Working Group on U.S. Financial Regulatory Reform: The
Investors' Perspective. I was a member of the group which was formed by
the Council of Institutional Investors and the CFA Institute Centre for
Financial Market Integrity. The IWG report focuses on four major areas
that the credit crisis has revealed to be fundamentally flawed:
Strengthening and reinvigorating existing Federal agencies
responsible for policing financial institutions and markets and
protecting investors and consumers.
Filling the gaps in the regulatory architecture and in
authority over certain investment firms, institutions, and
products.
Improving corporate governance at U.S. financial companies.
Designating a systemic risk regulator, with appropriate
scope and powers.
A number of the recommendations of the IWG are relevant to the
issues posed by private pools of capital. These include:
A. Strengthening Existing Federal Regulators
Congress and the Administration should nurture and protect
regulators' commitment to fully exercising their authority.
Regulators should have enhanced independence through
stable, long-term funding that meets their needs.
Regulators should acquire deeper knowledge and expertise.
B. Closing the Gaps for Products, Players, and Gatekeepers
OTC Derivatives
Standardized derivatives should trade on regulated
exchanges and clear centrally.
OTC trading in derivatives should be strictly limited and
subject to robust Federal regulation.
The Financial Accounting Standards Board (FASB) and the
International Accounting Standards Board (IASB) should improve
accounting for derivatives.
The SEC and the CFTC should have primary regulatory
responsibility for derivatives trading.
The United States should lead a global effort to strengthen
and harmonize derivatives regulation.
Securitized Products
New accounting standards for off-balance sheet transactions
and securitizations should be implemented without delay and
efforts to weaken the accounting in those areas should be
resisted.
Sponsors should fully disclose their maximum potential loss
arising from their continuing exposure to off-balance sheet
asset-backed securities.
The SEC should require sponsors of asset-backed securities
to improve the timeliness and quality of disclosures to
investors in these instruments and other structured products.
Asset-backed securities sponsors should be required to
retain a meaningful residual interest in their securitized
products.
Hedge Funds, Private Equity and Investment Companies, Advisers, and
Brokers
All investment managers of funds available to U.S.
investors should be required to register with the SEC as
investment advisers and be subject to oversight.
Existing investment management regulations should be
reviewed to ensure they are appropriate for the variety of
funds and advisers subject to their jurisdiction.
Investment managers should have to make regular disclosures
to regulators on a real-time basis, and to their investors and
the market on a delayed basis.
Investment advisers and brokers who provide investment
advice to customers should adhere to fiduciary standards of
care and loyalty. Their compensation practices should be
reformed, and their disclosures should be improved.
Institutional investors--including pension funds, hedge
funds, and private equity firms--should make timely, public
disclosures about their proxy voting guidelines, proxy votes
cast, investment guidelines, and members of their governing
bodies and report annually on holdings and performance.
Nonbank Financial Institutions
Congress should give regulators resolution authority,
analogous to the FDIC's authority for failed banks, to wind
down or restructure troubled, systemically significant
nonbanks.
Mortgage Originators
Congress should create a new agency to regulate consumer
financial products, including mortgages.
Banks and other mortgage originators should comply with
minimum underwriting standards, including documentation and
verification requirements.
Mortgage regulators should develop suitability standards
and require lenders to comply with them.
Mortgage originators should be required to retain a
meaningful residual interest in all loans and outstanding
credit lines.
C. Corporate Governance
In uncontested elections, directors should be elected by a
majority of votes cast.
Shareowners should have the right to place director
nominees on the company's proxy.
Boards of directors should be encouraged to separate the
role of chair and CEO, or explain why they have adopted another
method to assure independent leadership of the board.
Exchanges should adopt listing standards that require
compensation advisers to corporate boards to be independent of
management.
Companies should give shareowners an annual, advisory vote
on executive compensation.
Federal clawback provisions on unearned executive pay
should be strengthened.
D. Systemic Risk Oversight Board
Congress should create an independent governmental Systemic
Risk Oversight Board.
The board's budget should ensure its independence from the
firms it examines.
All board members should be full-time and independent of
Government agencies and financial institutions.
The board should have a dedicated, highly skilled staff.
The board should have the authority to gather all
information it deems relevant to systemic risk.
The board should report to regulators any findings that
require prompt action to relieve systemic pressures, and should
make periodic reports to Congress and the public on the status
of systemic risks.
The board should strive to offer regulators unbiased,
substantive recommendations on appropriate action.
Regulators should have wide latitude to implement the
oversight board's recommendations on a ``comply or explain''
basis.
In closing, we appreciate your consideration of CalPERS'
perspective as a large public plan, institutional investor, and
fiduciary to the financial interests of hard working pensioners and
their families. Independent robust regulatory and enforcement authority
over hedge funds and other unregulated investment pools that emphasizes
transparency and accountability is vitally important to CalPERS as a
long-term participant in the capital markets. We encourage you to move
forward with care and skill to bring about comprehensive financial
regulatory reform.
Thank you.
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM ANDREW J. DONOHUE
Q.1. Mr. Donohue, your testimony was not endorsed by
Commissioner Paredes. Please transmit to us an explanation
authored by Commissioner Paredes of why he did not endorse the
testimony.
A.1. Commissioner Paredes' response follows:
I appreciate the opportunity to explain why I did not
endorse the July 15, 2009, testimony of Andrew J. Donohue,
Director of the Division of Investment Management at the U.S.
Securities and Exchange Commission (SEC), before the
Subcommittee on Securities, Insurance, and Investment of the
U.S. Senate Committee on Banking, Housing, and Urban Affairs
(Testimony). The Testimony addresses regulating hedge funds and
other private investment pools, including venture capital funds
and private equity funds.
Introduction
Although I agree with aspects of the Testimony, I did not
endorse the Testimony for four primary reasons.
First, the Testimony understates the extent to which
private investment pools are subject to existing regulation and
market discipline that constrain how the funds are managed.
Second, to the extent private investment pools fall within
limited statutory exemptions from certain regulatory
obligations, the Testimony does not adequately account for the
important interests these exemptions advance.
Third, the Testimony does not properly recognize the
potential cost to our financial markets and our economy more
generally if private investment pools are subject to additional
regulation beyond the regulatory demands that hedge funds,
venture capital funds, and private equity funds already must
satisfy. The Testimony obscures the rigorous analysis that is
needed to determine the appropriate oversight of private
investment pools by framing their regulation in terms of
closing a ``regulatory gap,'' suggesting that the decision to
regulate funds more is straightforward when, in fact, it is
not. The desirability of closing any such ``gap'' is not self-
evident but depends on a number of considerations, some of
which recommend against subjecting the funds to more
regulation.
Fourth, although the Testimony correctly explains that, in
some instances, it can be difficult to distinguish among hedge
funds, venture capital funds, and private equity funds, the
Testimony too readily concludes that regulatory distinctions
should not be made among different types of funds. To the
contrary, funds can and should be distinguished and, when
appropriate, subject to different regulatory treatment. Indeed,
Federal securities regulation is replete with instances of
regulatory line-drawing designed to refine regulation to avoid
unduly burdening investment funds, investors, and businesses.
If private investment pools are to be regulated more, such
regulation should be focused on those funds that present the
most serious systemic risk instead of subjecting qualitatively
different funds to an ill-fitting one-size-fits-all regulatory
regime.
The Current Regulatory Framework
Calls for more regulation should begin by assessing current
regulation. As the Testimony summarizes, private investment
pools are structured to benefit from certain regulatory
exemptions. The Testimony's characterization of the regulatory
regime, while technically accurate insofar as it goes, is
incomplete and thus imbalanced. For example, the Testimony
recognizes that the Investment Advisers Act (Advisers Act)
imposes certain fiduciary obligations on an adviser to a hedge
fund, venture capital fund, or private equity fund, even if the
adviser is not required to register under the Advisers Act.
However, the Testimony neglects to explain that private
investment pools must comply with a host of other regulatory
requirements, including prohibitions against fraud, insider
trading, and manipulation and obligations to make various
disclosures.
In addition, it is important to recognize that private
investment pools are subject to market discipline that holds
funds and their managers accountable. Consider, for example,
that funds issue securities to their investors in private
offerings. Even though not statutorily required, most funds
nonetheless provide extensive disclosures to their investors--
both when investors initially invest in the fund and
periodically throughout the life of the fund--because investors
demand information. Concerning the Advisers Act, many managers
of private investment pools have chosen to register with the
SEC, despite no regulatory mandate to do so.
These two examples illustrate how funds and their advisers
organize their affairs to meet investor demands. Put
differently, market discipline can fill so-called ``gaps'' in
the regulatory regime and should be part of analyzing what
additional regulation may be warranted and for what purpose.
The Testimony does not acknowledge the influence of market
discipline as it should.
The Benefits of Existing Statutory Exemptions
The Testimony identifies regulatory requirements that are
scaled back as a result of certain exemptions from the Federal
securities laws but does not equally stress the benefits that
follow when funds and investors are allowed additional
flexibility to privately order their affairs and transact more
freely. By emphasizing the regulatory mandates that are scaled
back as a result of the exemptions without fully crediting how
more tailored regulation can benefit the U.S. economy, the
Testimony's tone is biased toward more regulation because the
value of the exemptions is understated.
The Testimony's use of the term ``regulatory gap'' to
characterize well-established statutory exemptions under the
Federal securities laws is problematic. The term ``regulatory
gap'' has taken on a negative meaning, connoting that there is
an inherent flaw in the regulatory regime. When a ``gap'' is
identified, it seems to predetermine the outcome in favor of
more regulation. Calling something a ``regulatory gap,''
however, should not distract from a rigorous analysis of the
pros and cons of a regulatory initiative. Many so-called
``gaps'' are purposeful, reflecting an informed determination
that the net consequence of closing the ``gap'' is adverse to
the interests of investors and our economy overall. In many
instances, a ``regulatory gap'' affords the latitude needed for
private sector innovation and entrepreneurism to prosper,
unbridled by unjustified regulatory constraints. The beneficial
activities of private investment pools--which promote economic
growth by facilitating capital formation, spurring research and
development, creating jobs, and contributing to efficient,
liquid securities markets--would be impeded if the funds were
subject to the full measure of the Federal securities laws.
In addition, the tailoring of regulation through statutory
exemptions can allow the SEC to allocate its resources more
efficiently and effectively. A determination that sophisticated
and institutional investors are able to protect their own
interests--such as by negotiating for disclosures, pressuring a
fund manager to register as an adviser, or simply refusing to
invest if investor demands are unmet--argues in favor of
certain regulatory exemptions, the effect of which is to
empower the SEC to dedicate its resources to other goals,
including protecting retail investors. Even if the SEC enjoys
additional resources, the agency's resources still will be
limited. As a result, there is an inevitable opportunity cost
associated with overseeing private investment pools. More
resources spent overseeing private investment pools means fewer
resources spent on other priorities.
Considerations in Assessing Additional Regulation
Whether or not to impose additional regulation on private
investment pools requires a careful balancing of interests. It
is always possible to take another regulatory step, but is the
cost of the additional regulation warranted? The answer may
differ for different types of funds under different
circumstances. Given that the Testimony emphasizes the
potential benefits of more regulation, the following is a
nonexclusive set of other considerations that inform the
analysis but that the Testimony does not adequately address.
First, moral hazard is a potential cost of regulation. One
should consider the extent to which subjecting private
investment pools to more regulation could foster moral hazard
by promoting an undue sense of security that dissuades
investors from taking steps to protect their own interests,
such as engaging in demanding due diligence. In other words,
more regulation may undercut market discipline. Active investor
skepticism and due diligence may do more to deter and detect
misconduct than particular regulatory demands.
Second, the additional steps that hedge funds, venture
capital funds, and private equity funds would have to take to
meet new regulatory requirements could take time and effort
away from more productive matters that benefit investors and
our markets as a whole. Time and effort that fund managers and
other professionals otherwise could have spent analyzing
investment opportunities, assessing trading strategies, or
providing managerial guidance to start-up businesses likely
would be redirected to tend to new administrative obligations.
Third, expanded regulatory demands may erect barriers that
preclude entry by new funds and thus undercut competition.
Similarly, well-established funds that are better positioned to
incur the added cost may gain a competitive advantage over
smaller, less-established competitors that struggle to meet the
added burdens.
Fourth, additional regulation may jeopardize the benefits
that private investment pools generate. As the Testimony
summarizes, hedge funds, venture capital funds, and private
equity funds benefit investors, financial markets, and our
economy. The Testimony explains:
Private equity funds generally invest in companies to which
their advisers provide management or restructuring assistance
and utilize strategies that include leveraged buyouts,
mezzanine finance and distressed debt. Venture capital funds
typically invest in early stage and start-up companies with the
goal of either taking the company public or privately selling
the company. Each type of private fund plays an important role
in the capital markets. Hedge funds are thought to be active
traders that contribute to market efficiency and enhance
liquidity, while private equity and venture capital funds are
seen as helping create new businesses, fostering innovation and
assisting businesses in need of restructuring. Moreover,
investing in these funds can serve to provide investors with
portfolio diversification and returns that may be uncorrelated
or less correlated to traditional securities indices.
The Testimony, however, does not expressly recognize that
subjecting private investment pools to more regulation runs the
risk that these benefits will be lost, at least to some degree.
Stated differently, the potential cost of more regulation of
funds includes less efficient and less liquid securities
markets, less commercialization of cutting-edge technologies
and innovative products, fewer restructurings and control
transactions that can lead to job preservation and job growth,
and fewer investment opportunities for investors. That private
investment pools--particularly venture capital funds and
private equity funds--generally do not pose the type of
systemic risk that regulatory reform has focused on is one
important factor in determining whether more regulation is
justified in light of the cost of further constraining fund
activities.
Regulatory Options
The Testimony endorses subjecting investment advisers of
private investment pools to registration under the Advisers
Act. The Testimony also suggests the option of subjecting
private investment pools to the Investment Company Act of 1940
(Investment Company Act) and suggests giving the SEC additional
rule-making authority.
Registration of Private Fund Investment Advisers
In supporting Advisers Act registration, the Testimony
argues for treating hedge funds, venture capital funds, and
private equity funds alike on the grounds that it is too
difficult to distinguish among them. The Testimony also
explains that ``[w]e [the SEC] are concerned that in order to
escape Commission oversight, advisers may alter fund investment
strategies or investment terms in ways that will create market
inefficiencies.''
If there is to be more regulation, regulatory distinctions
should be made among funds. Economically different activities
argue for different regulatory treatment. For example, funds
that buy and hold stock present different regulatory
considerations than funds that actively trade debt, equities,
and derivatives. Funds of different sizes with different
leverage ratios also raise different concerns. By way of
illustration, subjecting the manager of a venture capital fund
to investment adviser registration does not seem to be cost-
justified when the fund does not present a systemic risk
because it is not leveraged or interconnected with the rest of
the financial system. Even if hedge fund managers are required
to register under the Advisers Act, it does not necessarily
follow that the manager of a private equity fund that takes
long-term controlling stakes in companies should be required to
register. Indeed, depending on their size, leverage, and
trading activities, different hedge funds may present different
concerns arguing for different regulatory treatment.
Drawing regulatory distinctions is central to balanced
regulation. The failure to draw appropriate regulatory lines
when it comes to private investment pools will mean that new
regulatory requirements will be overinclusive--burdening funds
that do not present the kinds of concerns that may justify more
costly regulation.
B. Private Fund Registration
Subjecting private investment pools to the Investment
Company Act would result in direct substantive regulation of
the funds as opposed to their advisers. Direct regulation of
hedge funds, venture capital funds, and private equity funds
would unduly constrain their investment and trading activities.
Pools of capital should not be homogenized into mutual funds.
Private investment pools need flexibility to undertake
different strategies that serve different functions in our
economy.
C. Regulatory Flexibility Through Rule-Making Authority
The Testimony suggests that the SEC could be given
additional rule-making authority, including the authority to
impose conditions on the availability of the current section
3(c)(1) and section 3(c)(7) exceptions to the Investment
Company Act. This option is objectionable because it again
raises the specter that funds themselves, and not just their
advisers, will be subject to direct regulation. A further
objection is that the applicability of the Investment Company
Act and the nature and scope of the regulation a fund might
face would be uncertain and unpredictable. The lack of a stable
regulatory regime risks frustrating valuable private sector
enterprise by, for example, injecting undue regulatory
uncertainty into commercial dealings. Regulatory predictability
promotes business and investing.
Disclosure to Regulators
The SEC has a legitimate interest in ensuring that the
agency has adequate information concerning private investment
pools, particularly if funds of a certain character pose a
systemic risk. To the extent the regulatory objective is to
monitor and stem systemic risk, the SEC should consider the
information that is required by it or other regulators to
monitor our markets effectively and seek legislation, if
needed, that would ensure that such disclosures are made to the
Government, perhaps on a confidential basis. Neither the
Advisers Act nor the Investment Company Act was crafted to
address systemic risk. So it seems ill-fitting to unwind
exemptions from these statutes in order to advance systemic
risk regulation.
Conclusion
In this response, I have highlighted some of the
considerations and tradeoffs that need to be accounted for in
deciding the extent to which private investment pools should be
subject to more regulatory burdens. Whatever may be the
benefits of additional regulation, it is necessary to consider
the attendant costs in assuring that any regulatory response is
properly calibrated and tailored.
Thank you again for the opportunity to explain why I did
not endorse the Testimony. My staff and I are available to
expand upon this written response to your question and to
answer any other questions you may have.
Q.2. Mr. Donohue, your testimony noted that Commissioner Casey
does not endorse the approaches discussed in Sections IV. B and
C. Please transmit to us an explanation authored by
Commissioner Casey of why she does not endorse the approaches
discussed in Sections IV. B and C.
A.2. Commissioner Casey's response follows:
Thank you for inviting me to explain why I did not endorse
several components of SEC Division of Investment Management
Director Andrew Donohue's July 15, 2009, testimony before the
Subcommittee on Securities, Insurance, and Investment of the
U.S. Senate Committee on Banking, Housing, and Urban Affairs
relating to the regulation of hedge funds and other private
investment pools.
I agree generally with Mr. Donohue's testimony as to many
of the benefits that would come of broadening the investment
adviser registration requirement to include managers of private
funds. Many regulatory issues touch upon investment advisers
irrespective of the type of private pool at issue. Furthermore,
it would be a perverse (but not an unexpected) result if
investment advisers were to migrate to different products or
services merely because they are seeking to avoid registration.
In evaluating whether to broaden investment adviser
registration requirements, I believe Congress should begin by
clearly identifying its objective. As part of a broader
financial regulatory restructuring, I agree that appropriate
regulation of private pools of capital is an important element
in addressing overall risks to the financial system, enhancing
market confidence, and strengthening investor protection. As a
next step, I believe Congress should acknowledge that there are
real differences among private funds (for instance, how they
are managed, how they are structured, and the risks they
present) and that it is important to ask serious questions from
the outset about what standards investment advisers should
operate under, what information regulators should obtain about
them and the products and services they offer, and how that
information should be used. For example, while it may make
sense to have access to information about the use of leverage,
position or sector concentration, or other factors relating to
the operation of a $20 billion hedge fund, I do not believe
such information is necessary for the SEC (or a systemic
regulator) to obtain from the adviser to, say, a small VC fund
or a family office. Likewise, we should think carefully about
the nature of the inspection regime, recordkeeping, compliance
policies and procedures, and other requirements we impose on
registrants.
In any mandatory registration scheme, I believe Congress
should encourage the SEC to tailor the standards and
information requirements to suit the size and nature of the
adviser. As Mr. Donohue's testimony suggests, it is critical
that Congress establish a regulatory approach that does not
unnecessarily impede capital formation or stifle innovation:
``Any regulatory reform should acknowledge the differences in
the business models pursued by different types of private fund
advisers and should address in a proportionate manner the risks
to investors and the markets raised by each.'' Moreover, I
believe Congress's regulatory approach should not engender
false confidence that registration can serve as a panacea for
all ills. Enhanced requirements are an important means of
filling a regulatory gap, but will never be a substitute for
care and due diligence on the part of private fund investors in
choosing an investment adviser.
Where I depart more substantially from Mr. Donohue's
testimony is in its discussion of the potential regulatory
option of requiring registration of private funds under the
Investment Company Act of 1940. I do not believe there is a
sufficient rationale for endorsing such an approach (and,
indeed, I believe it would be unadvisable) for several reasons.
First, private funds--especially those relying on section
3(c)(7) of the Investment Company Act--have been excepted from
the registration requirements of the Act primarily on the
theory that investors are sophisticated enough to evaluate
their investment decisions without the regulatory intervention
of fund registration. While it may be appropriate to rethink
(and perhaps to reconcile) the thresholds we associate with who
should be deemed a sophisticated investor, I believe the
underlying concept is still valid. Whereas the regulation of
investment advisers can be designed to prevent and detect fraud
in areas such as trade allocations, where even sophisticated
investors lack the means to protect themselves, in other areas,
such as investment risks, fund structure, and other particular
terms of a private fund, I believe that these are still areas
where sophisticated investors can protect themselves
adequately. I think that if Congress or the SEC were to
regulate the structure of or redemption rights associated with
a private placement, we risk stifling innovation and capital
formation.
Second (and in a similar vein), I believe that private fund
registration is not advisable for much the same reason that
broadening the investment adviser registration requirement is a
good idea. Namely, mandatory registration of private funds may
prompt a migration away from such structures into other
products and services, such as separately managed accounts. As
a result, this option is likely to substitute one method of
regulatory arbitrage for another. Another way of putting this
point is that I believe we can get the essential information we
need and exercise sufficiently comprehensive oversight by
obtaining jurisdiction over and setting sensible requirements
for advisers rather than focusing on the private funds they
manage. Moreover, we are less likely to obtain duplicative or
inaccurate information if we focus on the lead (the investment
adviser and the assets it manages) rather than on the
supporting cast of characters (the various funds, series of
funds, or other products organized in various jurisdictions and
along different lines for a host of different reasons).
Finally, I note that there may be significant costs that
would come of private fund registration that would be borne by
funds, managers, investors, and the Commission. In thinking
about how best to allocate resources to an effective
registration and examination program, enhancing adviser
regulation seems the better course than focusing on private
fund registration.
I also have concerns about the testimony's discussion of
the advisability of devolving broader authority for the
Commission to condition the use by a private fund of the
section 3(c)(1) and 3(c)(7) exceptions. In connection with
establishing any new regulatory authority, Congress should
clearly enunciate what it wants to do and why and not leave it
in the purview of the Commission to rethink the purposes behind
a mandate to impose new conditions. Otherwise, because the
process of rule making is almost always accretive and rarely
results in streamlining, I fear that too broad a delegation
will lead in time to overlapping, cumbersome requirements that
will handicap our thriving private fund market. While I
appreciate the desire for our regulatory approach to be
sufficiently flexible to adapt to evolving market conditions, I
think this can be done in a way that more narrowly
circumscribes the authority under which the Commission operates
without the broad mandate that Mr. Donohue's testimony
discusses.
I hope these points are responsive. My staff and I would be
happy to provide a more detailed response to this or other
questions you may have.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM ANDREW J. DONOHUE
Q.1. If we create a systemic risk regulator and give that
regulator the power to collect information on firms' positions
and strategies, how do we protect that information?
Specifically, how do we prevent someone at the regulator from
either sharing that information or leaving the agency with that
information in his head and then profiting from it?
A.1. Confidentiality is very important, especially with respect
to information about lending and trading activities that are
systemically significant. With respect to the SEC, the various
Federal securities laws and SEC rules generally prohibit the
disclosure of nonpublic information by members, officers and
employees of the Commission, and prohibit the use of that
information for personal gain. For example, section 24(b) of
the Securities Exchange Act of 1934 makes unlawful the
unauthorized disclosure or misuse for personal gain of any
information contained in any application, statement, report,
contract, correspondence, notice, or other document filed with
the Commission. \1\ A willful violation of this section is a
crime. Similarly, the Commission's Conduct Regulation prohibits
any use of confidential or nonpublic information for private
gain. \2\
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78x(b).
\2\ 17 CFR 200.735-3(b)(1).
---------------------------------------------------------------------------
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM ANDREW J. DONOHUE
Q.1. The Administration's proposal only requires disclosure of
information related to whether the fund poses systemic risk.
Following the Madoff and Stanford fiascos, as well as countless
other frauds that got fewer headlines but wreaked no less havoc
on their victims, it seems obvious to me that closer attention
needs to be paid to these funds to avoid future Ponzi schemes
from flying under the radar for decades, sweeping up more and
more victims while remaining unnoticed and unpunished. The
Administration's proposal last week to require that broker-
dealers observe the same fiduciary standards as investment
advisors is an important step in this direction. But the simple
fact is we need to empower the SEC to do more. This doesn't
necessarily require new rules--after all, fraud is already
illegal--but we need to make sure the SEC has the information
and resources it needs to go after these sophisticated schemes.
Shouldn't private investment funds be required to disclose
information to the SEC for the purpose of investigating and
enforcing antifraud rules, not just for systemic risk purposes?
A.1. I agree that private fund advisers should be required to
provide information to us about the private funds they manage
not just for systemic risk monitoring but also for market
integrity and investor protection purposes. Advisers Act
registration is a vital step in obtaining this information.
Q.2. Also, the SEC currently has only about 450 examiners to
oversee approximately 11,300 investment advisors plus 8,000
mutual funds. Requiring that all hedge funds, private equity
funds and other similar private investment pools register with
the SEC and that the SEC perform some level of oversight and
enforcement of their activities, would result in those
examiners being responsible for approximately 2,000 more
investment advisors. Won't the SEC need significant additional
resources to perform these oversight functions?
A.2. The SEC has already suffered declines in the examination
staff overseeing existing registrants. Because of flat or
declining budgets from FY2005 through FY2007, this fiscal year
the SEC expects to have 8 percent fewer examination staff in
this area than it did in FY2005, while the number of
registrants has jumped by 32 percent.
As a result, the SEC has been able to maintain a regular
examination cycle only for advisers that the agency believes
are ``high-risk.'' In recent years this relatively small group
of firms has been inspected once every 3 years. The rest of the
firm population, which represents approximately 89 percent of
firms, is only inspected as resources allow, and as a result
can go a decade or longer without a visit from the SEC's
examination staff. Furthermore, the SEC's examinations are now
taking longer to complete, because of the growing complexity of
advisory firms and the need to determine compliance with new
regulatory requirements. As a result, the agency may not be
able to conduct regular inspections of all firms with higher
risk profiles going forward and has even fewer resources to
dedicate to non- high-risk firms.
If Congress were to require the registrations of private
funds advisors, then the SEC would require a significant
increase in its examination and rule-making staff. At a
minimum, we would require approximately 100 additional staff
members in order to maintain our current examination frequency
levels and regulatory oversight functions and expand them to
the 2,000 additional private fund advisers. It is likely,
however, that more frequent examinations would be necessary,
and that the need for resources would be greater, depending on
the level of oversight expected under any bill that may be
enacted.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER
FROM ANDREW J. DONOHUE
Q.1. In your testimony you say that ``the registration and
oversight of private fund advisers would provide transparency
and enhance Commission oversight of capital markets. It would
give regulators and Congress, for the first time, reliable and
complete data about the impact of funds on our securities
markets. It would give the commission access to information
about the operation of hedge funds and other private funds
through their advisors.''
Please provide me, in detail, the role that private funds
and private fund managers played in creating the turmoil in the
U.S., and global, financial markets over the last 2 years.
A.1. Unfortunately, we have only an incomplete idea of the role
that private funds and private fund managers played in creating
the turmoil in the U.S., and global, financial markets over the
last 2 years. Adviser registration and reporting requirements
would help us understand better the role of these important
market participants going forward.
We understand that certain private funds, as significant
users of leverage, may well have contributed to the market
turmoil as those leveraged private funds unwound highly
leveraged positions. That being said, from what we can tell,
private funds were not a direct cause of the market turmoil in
the fall of 2008, and in many cases they were casualties of it.
Q.2. Why would private funds continue to operate in the United
States if the Commission requires detailed information about
their business practices which would dramatically increase the
risk that those business practices would be made public? If
that is not a concern, why not?
A.2. I am certainly concerned about maintaining the
confidentiality and integrity of legitimate proprietary
information. The SEC deals with extremely sensitive information
everyday, and we protect the information provided to us. The
Federal securities laws and SEC rules generally prohibit the
disclosure of nonpublic information by members, officers and
employees of the Commission, and prohibit the use of that
information for personal gain. For example, section 24(b) of
the Securities Exchange Act of 1934 makes unlawful the
unauthorized disclosure or misuse for personal gain of any
information contained in any application, statement, report,
contract, correspondence, notice, or other document filed with
the Commission. \1\ A willful violation of this section is a
crime. Similarly, the Commission's Conduct Regulation prohibits
any use of confidential or nonpublic information for private
gain. \2\
---------------------------------------------------------------------------
\1\ 15 U.S.C. 78x(b).
\2\ 17 CFR 200.735-3(b)(1).
---------------------------------------------------------------------------
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM DINAKAR SINGH
Q.1. Who in the Federal Government knows the markets enough to
effectively regulate and understand what hedge funds and other
firms are doing and the risks they might create?
A.1. Answer not received by time of publication.
Q.2. Should we put leverage limits on hedge funds and other
firms?
A.2. Answer not received by time of publication.
Q.3. To limit the potential harm that could be done by private
investment firms to the system and counterparties, do you think
it is a better approach to place limits on the firms
themselves, or limit the exposure of counterparties like banks
to the investment firms?
A.3. Answer not received by time of publication.
Q.4. Do you think becoming publicly traded changes the natural
incentives private investment partnerships have to be
responsible when the partners have their own funds at risk?
A.4. Answer not received by time of publication.
Q.5. To address systemic risk and fraud, do you think the SEC
is better off focusing its resources on constant supervision
and examination, or on after-the-fact enforcement?
A.5. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM DINAKAR SINGH
Q.1. Can you give me a good reason why we shouldn't require all
hedge funds to register with the SEC or, assuming there are
appropriate safeguards in place to ensure that confidential
information remains confidential, disclose information to their
regulators so the regulators can see if they pose systemic
risk?
A.1. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM JAMES S. CHANOS
Q.1. Who in the Federal Government knows the markets enough to
effectively regulate and understand what hedge funds and other
firms are doing and the risk they might create?
A.1. The Securities and Exchange Commission is the Federal
agency with the most knowledge regarding the markets, hedge
fund and other investment vehicles to evaluate the riskiness of
their activities.
Q.2. Should we put leverage limits on hedge funds and other
firms?
A.2. In the context of the systemic risk legislation, firms
that meet the legislation's criteria as systemically important
should be subject to regulatory disclosure, as well as possible
capital, leverage, and other requirements.
Q.3. To limit the potential harm that could be done by private
investment firms to the system and counterparties, do you think
it is a better approach to place limits on the firms
themselves, or limit the exposure of counterparties like banks
to the investment firms?
A.3. Regulators should consider both sides of a transaction
where it involves regulated entities on each side.
Q.4. Do you think becoming publicly traded changes the natural
incentives private investment partnerships have to be
responsible when the partners have their own funds at risk?
A.4. Clearly the incentives are somewhat different. Of course,
publicly traded companies have a host of regulatory
requirements and potential liability that should operate to
keep managers operating responsibly.
Q.5. To address systemic risk and fraud, do you think the SEC
is better off focusing its resources on constant supervision
and examination, or on after the fact enforcement?
A.5. Up-front supervision and examination is always better than
after-the-fact-enforcement.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM JAMES S. CHANOS
Q.1. Can you give me a good reason why we shouldn't require all
hedge funds to register with the SEC or, assuming there are
appropriate safeguards in place to ensure that confidential
information remains confidential, disclose information to their
regulators so the regulators can see if they pose systemic
risk?
A.1. As I testified, CPIC supports the registration of hedge
funds (and other private investment funds) with the SEC. CPIC
has also been supportive of confidential disclosure information
necessary for regulators to assess the potential for systemic
risk posed by private funds.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM TREVOR R. LOY
Q.1. Who in the Federal Government knows the markets enough to
effectively regulate and understand what hedge funds and other
firms are doing and the risks they might create?
A.1. In my experience, the Securities and Exchange Commission
(SEC) has significant knowledge and expertise regarding
privately offered pooled investment vehicles and the systemic
risks related thereto. Venture capital firms already submit
information to the SEC when they raise a fund. Venture firms
are also already subject to antifraud rules under the SEC's
purview. Although I can't speak directly to the SEC's knowledge
of hedge funds since that is a different industry, I would
assume that the SEC would have the knowledge and expertise to
examine hedge funds given that the Commission in 2003 conducted
an exhaustive study on the operations and practices of the
hedge fund industry.
I would respectfully assert that the SEC should devote its
time and attention to effectively regulating firms that may
actually present systemic risk (e.g., hedge funds) rather than
diverting its limited resources to firms that present little to
no systemic risk, such as venture capital firms. The SEC's
Hedge Funds Study arrived at the same conclusion, citing that
the SEC is ``mindful that the Commission's resources available
to examine advisers is limited'' in arguing that venture
capital funds should be distinguished from hedge funds for
purposes of registration under the Advisers Act. \1\
---------------------------------------------------------------------------
\1\ Id. at p. 96.
Q.2. Should we put leverage limits on hedge funds and other
---------------------------------------------------------------------------
firms?
A.2. Since venture capital firms use little or no leverage, it
is difficult to respond to this question with regard to our
industry. A typical venture capital fund limits its borrowing
to short term capital needs (pending the draw down of capital
commitments from its partners) which does not exceed 90 days
and which does not exceed available equity commitments. As a
result, placing a limitation on leverage would have very little
impact on the activities of venture capital firms.
Q.3. To limit the potential harm that could be done by private
investment firms to the system and counterparties, do you think
it is a better approach to place limits on the firms
themselves, or limit the exposure of counterparties like banks
to the investment firms?
A.3. Venture capital firms generally do not act as borrowers
from or lenders to counterparties. As a venture capitalist, I
have only limited experience with counterparty risk and am not
an expert.
Venture capital firms present an extremely limited universe
of risk. Whereas a hedge fund in distress may leave a chain of
unsettled transactions and other liabilities, a venture capital
fund in distress generally would result in limited
consequences. Because of the lack of leverage, in a worst-case
scenario where a venture capital fund loses money, the venture
capital partners and outside investors will lose their invested
capital and/or will have limited investment returns, but there
is no multiplier effect to increase the amount of the loss or
trigger losses at other institutions or in other portfolios.
When a venture capital fund loses money, the venture capitalist
may be unable to raise a subsequent fund and portfolio
companies may have to seek new sources of equity capital, but
there is no spread of economic harm.
Q.4. Do you think becoming publicly traded changes the natural
incentives private investment partnerships have to be
responsible when the partners have their own funds at risk?
A.4. In my experience, venture capital firms do not become
publicly traded entities. The economics of becoming publicly
traded necessitate that any firm or partnership contemplating
doing so have significant, growing revenues above a certain
threshold. Because venture firms are relatively small, going
public does not make sense.
Generally, venture capitalists (like managers/general
partners of most private equity funds) are compensated with 20
percent of the fund's realized profits if successful, but their
losses are limited to their own contributions if the fund is
unsuccessful. This compensation scheme reflects the investors'
desire to encourage long-term ``high risk, high reward''
investing (as a means of diversification to a larger
portfolio), with the loss of committed capital acting as a
governor on unwarranted or reckless risk taking. The general
partners also receive, very generally, an annual management fee
of approximately 2 percent of investors' capital commitments.
It is difficult to answer this question without knowing the
particular proposed compensation scheme resulting from being
publicly traded. For example, if the entity that becomes
publicly traded owns only the annual management fee (but not
any of the 20 percent profit share), the incentives might
remain the same. That is, the general partners will have
increased liquidity earlier, but that liquidity will be based
on a relatively certain stream of income. If, however, the
entity that becomes publicly traded also owns all or a portion
of the 20 percent profit share, then the general partners can
achieve liquidity based on unrealized profits rather than
realized profits through a sale in the public market. In that
instance, the incentives to bring about a liquidity event for
the limited partners, through realization events involving the
fund's underlying portfolio companies (for example, in the form
of a public offering or a sale), may be different.
Furthermore, I would respectfully assert that the costs and
administrative burdens of becoming publicly traded would result
in significantly less entrepreneurial activity in the private
investment fund industry and would create a substantial barrier
to entry for most start-up venture capital fund managers.
Q.5. To address systemic risk and fraud, do you think the SEC
is better off focusing its resources on constant supervision
and examination, or on after-the-fact enforcement?
A.5. As the events surrounding Bernie Madoff, Allen Stanford,
and others have shown, ``after-the-fact enforcement'' may
accomplish little in the way of protecting investor assets or
increasing investor confidence. Constant supervision and
examination is expensive and fraudulent actors will seek to
evade detection. A combination, therefore, seems warranted.
If constant supervision and examination is pursued, the SEC
should focus on the market participants that present
significant systemic risk to the economy and financial system,
and should allocate its limited resources to closely
supervising and inspecting these high-risk institutions.
Requiring venture capital firms and other low-risk financial
institutions to register with the SEC under the Advisers Act or
similar Federal securities laws would significantly and
unnecessarily dilute and divert the SEC's resources from where
it can have the most impact, namely hedge funds and other
financial industry participants that present much greater
systemic risk.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM TREVOR R. LOY
Q.1. Can you give me a good reason why we shouldn't require all
hedge funds to register with the SEC or, assuming there are
appropriate safeguards in place to ensure that confidential
information remains confidential, disclose information to their
regulators so the regulators can see if they pose systemic
risk?
A.1. While hedge fund managers may need to be subject to at
least a limited form of regulation by the SEC, I respectfully
assert that venture capital fund managers do not present the
same systemic risks as hedge funds and therefore do not require
equivalent regulation. The goal of venture capital funds is to
identify and nurture young businesses and realize returns
through a sale of those businesses at an appropriate time,
generally 5-10 years in the future. Unlike hedge funds, venture
capital funds (i) generally do not make investments in publicly
traded securities, (ii) offer little, if any, opportunity for
investors to redeem their investments in the fund prior to the
end of its specified term (which is often 10 to 12 years),
(iii) do not generally utilize short selling or other high risk
trading strategies (investments are held long-term), and (iv)
generally limit the use of leverage to short-term borrowing
pending draw downs of capital. Accordingly, the systemic risks
to the financial system that were well-publicized in connection
with the financial distress of large hedge funds such as Long
Term Capital Management (1998) and Amaranth Advisors (2006) are
not applicable to venture capital funds.
Our venture capital asset class is unique in many ways,
with a critical distinction being that--while the companies we
have funded have had a proven and profound positive impact of
significant magnitude on the U.S. economy in terms of job
creation and innovation--our specific asset class remains a
small cottage industry that poses little, if any, risk to the
overall financial system. Our job is to find the most
promising, innovative ideas, entrepreneurs, and companies that
have the potential to grow exponentially with the application
of our expertise and venture capital investment. As a small and
dynamic industry, however, we remain highly susceptible to
seemingly minor changes in our ecosystem. While some larger
asset classes may be able to absorb the proposed regulatory
costs and requirements, using the Investment Advisers Act of
1940 to regulate venture capital firms brings layers of
additional regulatory requirements that can prevent us from
focusing our time and financial resources on helping to start
and grow new companies and which may force some venture firms
to close, thereby negatively impacting job creation activities.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM MARK B. TRESNOWSKI
Q.1. Who in the Federal Government knows the markets enough to
effectively regulate and understand what hedge funds and other
firms are doing and the risks they might create?
A.1. The last year and a half has been devastating for nearly
every financial market participant and there is no question
some regulatory deficiencies were exposed. But I believe the
oversight from your Committee and others has illuminated ways
to strengthen the regulatory system. Accordingly, I believe the
SEC, with access to more information from market participants,
and through interaction with a new systemic risk regulator, is
fully capable of providing appropriate oversight. I do believe
that the new registration requirements will increase the number
of registered investment advisers the SEC oversees
significantly. I commend the leadership at the SEC for
recognizing this and for renewed and increased focus on
improving its risk assessment capabilities, hiring new,
talented examiners and strengthening internal training all of
which will ensure they are well suited to regulate the
industry.
Q.2. Should we put leverage limits on hedge funds and other
firms?
A.2. Since my firm engages in private equity activity I can
speak to the validity of imposing leverage limits on private
equity funds. In this regard, I would say there is no basis for
any leverage limits on PE. In fact, private equity firms have
limited or no leverage at the fund level (as distinct from
leverage maintained at the portfolio company level for a
particular acquisition). Thus, private equity funds are not
subject to unsustainable debt or creditor margin calls. Private
equity funds typically use 3:1 leverage for acquisitions
compared to companies like Lehman Brothers, which was levered
at 32:1 when it failed. Further, Lehman's leverage was
maintained at the parent company level, thus exposing the
entire firm to collateral calls.
Q.3. To limit the potential harm that could be done by private
investment firms to the system and counterparties, do you think
it is a better approach to place limits on the firms
themselves, or limit the exposure of counterparties like banks
to the investment firms?
A.3. The question is predicated on the belief that PE firms
could create systemic risk. As I said in my testimony and as
others, including the European Commission and the Committee on
Capital Markets Regulation, have concluded, this is simply not
the case. Systemic crises, such as the one we all witnessed
last year, are caused by cascading effects across multiple
financial institutions which ultimately produce ``correlated
defaults.'' This is when a major instance creates large losses
for several highly leveraged investment banks or other
financial institutions forcing them to sell assets to service
debts and raise capital. A private equity held company that
fails is very unlikely to be so interconnected financially to
cause this type of cascading effect. In fact, PE firms are not
deeply interconnected with other financial market participants
through derivatives positions, counterparty exposures, or prime
brokerage relationships. Therefore, I do not believe imposing
limits on PE firms is necessary.
Q.4. Do you think becoming publicly traded changes the natural
incentives private investment partnerships have to be
responsible when the partners have their own funds at risk?
A.4. No. Even though firms are publicly traded, the fact
remains that the partners in the PE firms still have their own
equity invested in every transaction they complete. Thus, an
alignment of interests between GPs and LPs remains in place.
Q.5. To address systemic risk and fraud, do you think the SEC
is better off focusing its resources on constant supervision
and examination, or on after-the-fact enforcement?
A.5. The SEC should have access to specific information from
financial market participants based on the type of activity it
performs to identify financial institutions that are
systemically significant and consequently to monitor their
activities through supervision and examination. However, the
SEC also needs strong enforcement tools to deter fraudulent
activities. Both functions are equally important for a world-
class regulatory regime.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM MARK B. TRESNOWSKI
Q.1. Can you give me a good reason why we shouldn't require all
hedge funds to register with the SEC or, assuming there are
appropriate safeguards in place to ensure that confidential
information remains confidential, disclose information to their
regulators so the regulators can see if they pose systemic
risk?
A.1. We do not think that any asset class--hedge fund, private
equity, or venture capital--should be excluded from the new
regulatory regime. Congress should direct regulators to be
precise in how new regulatory requirements are calibrated so
the burdens are tailored to the nature and size of the
individual firm and the actual nature and degree of systemic
risk it may pose. In this regard, we were pleased that the
Administration's White Paper explicitly acknowledges that some
of the requirements created by the SEC ``may vary across the
different types of private pools.''
As I said in my testimony, it is important to recognize
that registration will result in new regulatory oversight for
all newly covered firms. There are considerable administrative
and financial burdens associated with record keeping and audits
as registered investment advisors. Registration could be
especially problematic for smaller firms regardless of asset
class and you should bear this in mind in establishing the
threshold for regulation.
Finally, your question refers to the importance of
confidentiality. I want to stress that in any regulatory
regime, it is absolutely vital that any information provided to
the SEC pursuant to a new registration requirement be subject
to strong confidentiality protections so as not to expose
highly sensitive business and financial information beyond that
required to carry out the systemic risk oversight function.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM RICHARD BOOKSTABER
Q.1. Who in the Federal Government knows the markets enough to
effectively regulate and understand what hedge funds and other
firms are doing and the risks they might create?
A.1. I do not believe any agency has sufficient knowledge to
effectively regulate and understand what hedge funds and other
firms are doing and the risks they might create. The SEC is
focused on the legal issues related to fraud and compliance,
not on the issues of risk management and trading strategies.
The Federal Reserve has a stable of academics with strong
analytical capability but with limited financial market
experience, and is not focused on the practical, micro-market
issues related to hedge funds.
Understanding the risks of hedge funds and other trading
operations requires an infusion of experienced risk
professionals from the industry. It also requires communication
between these professionals and the financial institutions in
order to learn quickly of new investment strategies and trading
methods that might have systemic importance.
Q.2. Should we put leverage limits on hedge funds and other
firms?
A.2. There should be limits on the leverage of hedge funds.
Controls are needed because it is through leverage that
liquidity crisis cycles begin. By liquidity crisis cycles, I
mean the situations I discussed in my testimony where a drop in
the market forces leveraged investors such as hedge funds to
sell positions, which in turn leads to yet further drops in
prices.
Hedge funds and other risk-taking firms already monitor
leverage as part of their internal risk management. But hedge
funds cannot self-regulate leverage because if some hedge funds
elect to increase their leverage, they will outperform their
competitors at times when adverse risks are not realized. And
in some strategies, such as credit-related and certain
derivative strategies, adverse risks are realized infrequently,
though when they do occur, they are substantial. Therefore, to
stay competitive, the other hedge funds will also have to
increase their leverage.
A blanket leverage limit will be too blunt an instrument,
however. The limits for leverage should vary by instrument and
strategy. For example, short-term Treasuries can support more
leverage than emerging market equities. The limits should also
depend on the amount of crowding in a market. If many hedge
funds are pursuing the same strategy, there is more of a chance
that when it's time to unload, many hedge funds will be running
for the door at the same time, hence the leverage limits should
be tighter in this instance. Currently, data are not available
to any regulators to assess the degree of crowding, however.
Q.3. To limit the potential harm that could be done by private
investment firms to the system and counterparties, do you think
it is a better approach to place limits on the firms
themselves, or limit the exposure of counterparties like banks
to the investment firms?
A.3. Limiting the leverage of the firms by way of the
counterparties/banks is a more elegant solution than dealing
with each of the many hedge funds, because there are fewer
points of contact when dealing with the banks. And the banks--
which are the main sources of leverage financing--already have
regulatory controls and oversight in place.
There must be sharing of information across the leverage
providers, either directly or by way of a regulator, in order
for hedge fund leverage to be controlled at the source level.
Otherwise a fund might be able to generate high leverage by
borrowing across many banks, without each bank knowing the full
scope of the fund's leverage. The leverage implications of
derivatives must also be taken into account because it is
possible to garner high leverage through derivatives without it
being readily apparent. For these reasons, if the banks are
used as the control point, regulators must be involved to
verify that hedge funds are not finding alternative routes to
meet their leverage demands.
Q.4. Do you think becoming publicly traded changes the natural
incentives private investment partnerships have to be
responsible when the partners have their own funds at risk?
A.4. The pressure already exists for most hedge funds to
perform well month by month. That is to say that they currently
have the adverse incentives common to many public companies,
which focus on the next quarter's earnings. However, there can
be no denying that the incentives of the fund and the client
are more closely aligned when the fund partners have a
substantial portion of their wealth at risk.
Given the opacity of hedge funds and the many strategies
and trading instruments at their disposal, it is difficult to
be confident that a fund is not taking short-term risks that
are opposed to the clients' interests. Having the principals
invest a substantial portion of their wealth in the same
strategies is one safeguard against such imprudent short-term
risks.
Q.5. To address systemic risk and fraud, do you think the SEC
is better off focusing its resources on constant supervision
and examination, or on after-the-fact enforcement?
A.5. The answer to this question is different for systemic risk
than it is for fraud. Fraud is by design hidden from ready
observation and will usually affect only one firm, while
systemic risk by its scale will be more evident before the fact
and will have wider-ranging effects. Therefore, for systemic
risk it is both more plausible and more important to have
before-the-fact supervision.
But such supervision is not a matter of having lawyers walk
in the door armed with a subpoena under one arm and a sixty
page questionnaire under the other. As I stated in my
testimony, the proper starting point is to require hedge funds
and other financial institutions--especially those that are
large enough to pose a systemic risk--to provide key position
and leverage data in an aggregatable form. Regulators must then
have the analytical capability and market experience to analyze
the data to assess systemic risk. As I noted above, I believe
this capability and experience is not yet in place within the
Federal Government.
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RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM JOSEPH A. DEAR
Q.1. Who in the Federal Government knows the markets enough to
effectively regulate and understand what hedge funds and other
firms are doing and the risks they might create?
A.1. Nobody does.
The SEC should understand the strategies deployed by hedge
funds; the Fed should understand the explicit leverage being
provided to them by member banks; the CFTC should understand
the implicit leverage made available through derivative
exposures. Ideally these functions would be better understood
by all relevant regulators and/or incorporated under fewer
regulatory bodies to ensure consistency of supervision.
The patchwork of regulatory regimes means that various
agencies have jurisdiction over related activities--in some
cases, economically identical activities. It might help to
think about insurance companies, banks, and investment managers
(including hedge funds, investment bank proprietary trading
operations, mutual funds, etc.) as one category of entity:
underwriters of risk. These entities may operate in different
environments, but at the end of the day they all do the same
thing--underwriting and/or transferring risk.
Let's use MetLife as an example.
MetLife's primary business is underwriting the risk
of a person's death and is paid a premium to accept
that risk.
A MetLife stockholder provides equity capital and
accepts the risk that the company's liabilities will
exceed its assets (rendering the equity worthless) in
exchange for a variable stream of dividends and capital
gain or loss.
A MetLife bondholder lends capital to MetLife (that
is, provide leverage) and is paid interest to accept
the risk the issuer will default on its obligation.
An investment bank can enter into an interest-rate
swap with MetLife and is paid a variable amount to
accept the risk from fluctuations in interest rates.
These are all the same type of economic function--
underwriting risk or paying another entity to accept those
risks. Yet:
MetLife's life insurance business is regulated by
State insurance commissioners.
The stockholder and bondholder may be regulated by
the SEC, a State regulator, an overseas entity such as
the UK's FSA, or (for unregistered hedge funds)
virtually nobody.
The investment bank may be regulated by the SEC,
the Fed, FINRA, and myriad other entities.
The absence of a comprehensive means of regulating the
underwriting of risk makes developing a full understanding of
the system's risks nearly impossible.
A valuable first step would be requiring SEC registration
of (and information from) hedge funds, private equity funds,
and other risk-taking entities with sufficient capital and risk
exposures to provide meaningful incremental information to
regulators.
A valuable second step would be aggregating Congressional
oversight of financial risk-underwriting activities under fewer
committees. For example, does having the Senate Agriculture
Committee oversee the CFTC and the Senate Finance Committee
oversees the SEC result in uneven regulatory scrutiny being
applied to risk-underwriting activities which are functionally
equivalent?
Q.2. Should we put leverage limits on hedge funds and other
firms?
A.2. Not unless those limits are necessary to avert systemic
risks.
Leverage (which should be thought of as any risk exposure
which exceeds the risk-taker's equity capital, or where the
risk-taker can lose more than the amount initially invested) is
not provided in a vacuum; someone has to be bearing the credit
risk associated with providing any investor leverage, and
arbitrarily limiting leverage improperly usurps the role (and
ability) of the risk-taker to determine how much leverage is
appropriate.
The simplest everyday analogy is a home mortgage: everyone
with a home mortgage is using leverage, often at levels much
higher than ``risky'' hedge funds. Borrowers who put 5 percent
down on their home purchases and borrow the remaining 95
percent are levered 20 to 1 on their equity investment. Even
putting 20 percent down still requires leverage of 5 to 1. Is
20 to 1 ``too much leverage''? Is 5 to 1? Should we simply
eliminate subprime mortgages (thereby ``putting leverage
limits'' on riskier homebuyers) because those borrowers are
more likely to default? The answer is no--strict leverage
limits do not take into account other risk factors that may
mitigate or exacerbate the risks from the leverage itself. (The
borrower putting 5 percent down may be Warren Buffett.)
Similarly, we should not eliminate or arbitrarily restrict
the ability to provide leverage to investment strategies. The
price of a risk-taking society is that, sometimes, risk-taking
results in failure. Query whether the Government's powers are
better oriented toward ensuring that the failure of any subset
of risk-takers does not result in systemic failure, for example
by better assessing the risks taken by providers of leverage
both to ``consumers'' of leverage and to each other.
Q.3. To limit the potential harm that could be done by private
investment firms to the system and counterparties, do you think
it is a better approach to place limits on the firms
themselves, or limit the exposure of counterparties like banks
to the investment firms?
A.3. Counterparty risk exposure assessment and management is
the better approach.
A key regulatory focus should be on ensuring that parties
that take risk are capable of handling the consequences of
their activities without resorting to the assets of unrelated
parties (such as taxpayer bailouts).
It is almost certainly wiser, from a systemic-risk
perspective, to exercise tighter controls over the providers of
leverage (banks and derivative clearinghouses) than over the
users of leverage. (It is also easier to engage the major
providers of leverage than the users, as there are perhaps only
a few dozen major counterparties but tens of millions of risk-
taking entities. These are certainly more complex and
interrelated entities, but it is these complexities and
relationships that makes effective oversight of them that much
more vital to the Nation's economic stability.)
Returning to the mortgage analogy, the problem was not that
individual homeowners borrowed more than they could repay and
ended up defaulting; that scenario happens to some degree in
any economic environment. The problem was that the providers of
leverage failed to properly assess the risks inherent in their
lending practices on a broad scale, and the relationships
between these providers were not adequately monitored.
The example most frequently cited for the ``hedge funds as
systemic risks'' concept was Long-Term Capital Management
(LTCM). LTCM's equity capital was effectively levered over 100
to 1 because of their extensive use of derivative transactions.
The danger to the system was not, however, from LTCM's
deploying that leverage; it was from the counterparties'
willingness to provide enormous amounts of leverage through
over-the-counter transactions such as swaps.
The complexity of the major risk-underwriting institutions
makes a well-financed, well-staffed, well-informed, and
properly empowered regulator absolutely essential.
Q.4. Do you think becoming publicly traded changes the natural
incentives private investment partnerships have to be
responsible when the partners have their own funds at risk?
A.4. It can, but that probably isn't the right way to think
about the alignment-of-incentives issue.
The shareowner structure of an investment vehicle or firm
will always play a role in the alignment of interests and
balance of incentives, and the private/public distinction,
while important, is not by itself enough to fully assess
interests and incentives. Some shareowner and compensation
structures reward asset-gathering over performance; others
reward excessive risk-taking in a ``heads-I-win-tails-you-
lose'' manner. Finding the right balance of shareowner
structure and compensation structure is critical for proper
incentivization of investment risk-takers.
Typically a public structure encourages its managers to
raise assets--the market values consistent revenues from
management fees more highly than the irregular revenues from
performance fees. That said, a manager of a privately held
hedge fund firm with a ``2 and 20'' fee structure may also be
quite content with mediocre performance as long as it can keep
earning the 2 percent management fee.
And even a well-designed structure is not absolute
protection against inappropriate risk-taking. Joseph Cassano's
group at AIG appears to have had a very well-designed incentive
structure, with long-term payouts and compensation in both cash
and equity. That did not stop the group from destroying the
firm and costing taxpayers billions of dollars.
Q.5. To address systemic risk and fraud, do you think the SEC
is better off focusing its resources on constant supervision
and examination, or on after-the-fact enforcement?
A.5. Without a doubt, the SEC is better off focusing its
resources on supervision and examination.
Supervision and examination, if properly executed, should
help avoid the excesses that give rise to the need for
extraordinary levels of after-the-fact enforcement. For
example, the SEC's mission to protect investors would have been
much better carried out in the Madoff case by better
supervision and quicker intervention; investors would have lost
far less. Far better to close the barn door before the horse
has left.
That being said, neither focus will succeed if the
resources provided are insufficient. Far too often the fight
between the SEC and a bad actor is an unfair one, with the SEC
outgunned and outmanned. CalPERS believes existing SEC funding
and staffing levels are insufficient to keep pace with the
increasingly complex and rapidly shifting securities markets.
The SEC must maintain robust regulatory and enforcement
authority over security market practices, transactions, the
policing of market professionals and intermediaries, the
maintenance of accounting standards, and the disclosure of
relevant information. To carry out the mandate of investor
protection, the SEC must be provided with resources adequate
for this vital task.