[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


                              __________

                        U.S. GOVERNMENT PRINTING OFFICE
54-883 PDF                    WASHINGTON: 2010
__________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512-1800
Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001










            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\
---------------------------------------------------------------------------
     \1\ Commissioner Paredes does not endorse this testimony.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \4\ Investment Advisers Act Release No. 2333 (Dec. 2, 2004).
     \5\ See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \10\ See Rule 206(4)-8 under the Advisers Act.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \11\ Commissioner Casey does not endorse the approaches discussed 
in sections IV. B and C.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \1\ MFA's Sound Practices is available at: http://
www.managedfunds.org/files/pdf's/MFA_Sound_Practices_2009.pdf.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \2\ Available at: http://www.financialstability.gov/docs/regs/
FinalReport_web.pdf.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \3\ We note that this approach is consistent with the approach 
taken by H.R. 711 and S. 1276.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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 
---------------------------------------------------------------------------
        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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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 
---------------------------------------------------------------------------
        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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
    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).
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
     \2\ The Global Economic Impact of Private Equity Report 2008, 
``Private Equity and Employment'', World Economic Forum, January 2008.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
                                 ______
                                 
                  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.
                                ------                                


       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.
