Private Funds: Low Systemic Risk, High Operational and Management Risk
The SEC has delivered a private fund one-two punch: systemic risks from private funds due to high leverage and too much reliance on derivatives are not as great as some feared, but risks from operational and management issues within advisory firms and the private funds they manage are significant and need to be policed.
The data release and the speech appeared to be targeting to two groups. The first group is comprised of advocates of prudential regulation, who have sounded alarms about the dangers of too much leverage and too much reliance on derivatives among private funds. The message was that the SEC has a handle on what is happening in the private fund world and that, in any event, leveraging, reliance on derivatives and high-frequency trading are not as great as many have feared.
The second group is comprised of the private fund advisers and funds themselves. The message to them was that the agency has concerns about significant operational risks relating to client transitioning, cybersecurity and market stress, as well as firm-specific risks involving marketing, conflicts-of-interest disclosure, and fees and expenses – all of which White made clear the SEC would be actively looking at.
"If I were a private fund manager and read White’s speech, the good news I’d take away would be that the SEC is using data to better understand the footprint occupied by the private fund space, which should lead to a more informed approach to regulation than has been threatened by prudential regulators," said Willkie Farr partner James Burns. "The more challenging news for private funds is that she still talks about aggressively continuing the type of broken-window policing that we have seen in connection with recent cases."
Since gaining regulatory authority over approximately 1,500 new private fund advisers with the passage of the Dodd-Frank Act five years ago, the SEC has been gathering data, both through Form ADV and through Form PF (for private fund advisers managing more than $150 million in private fund assets), on those advisers and the private funds they manage. In addition, the agency’s Office of Compliance Inspections and Examinations has conducted presence exams of some private fund advisers.
The data, White said, allows the SEC to monitor trends in the industry. For instance, while the number of private fund advisers reported on Form PF has "not changed appreciably since 2013, the number of large hedge fund advisers with at least $1.5 billion in hedge fund assets has increased by approximately 15 percent in the same period," she said. "We have also observed an 8 percent increase in the number of private funds reported from 2013 to 2014, and their total gross assets have increased by nearly $1 trillion, now totaling just shy of $10 trillion." Of that $10 trillion, about $6.1 trillion was reported by hedge funds. In terms of net assets, private funds had $6.7 trillion, while hedge funds had $3.4 trillion, at the end of 2014.
Form PF data provides the SEC with a wealth of information on private fund advisers. It also "allows the staff to monitor investment strategies among private funds and to understand the potential effect of certain markets or global events," White said. "We have used it to assess funds’ reliance on derivatives and leverage, their exposure to certain international markets, and their use of high frequency trading strategies."
The statistics issued by the SEC include a wide variety of measurements, including some related to leverage, reliance on derivatives, and high-frequency trading, all of which have been concerns from organizations like the Financial Stability Oversight Council (FSOC) and the Financial Stability Board (FSB), said Burns. These two organizations, which are concerned with systemic risk, are seen by some as threats to SEC regulation of asset managers. White and others have made clear their view that the SEC is the right organization to regulate any systemic risks in the securities industry.
To that end, the decision to make public the Form PF aggregate data demonstrates that the agency is on top of any and all risks, systemic or firm-specific, that private advisers and their funds face. "The financial crisis re-focused financial regulators, including the Commission, on addressing risks that could have a systemic impact," White said, noting that doing so is "fundamental" to the SEC’s core mission.
"White is essentially saying to that agency’s critics, ‘The SEC knows what’s going on, we’re in charge here, and we’re taking steps to protect the financial system,’" said Mayer Brown attorney Adam Kanter.
As for what the aggregate data from Form PF specifically shows about private funds and systemic risk, White noted the following:
Derivatives. Although the total notional value of derivatives reported on Form PF increased from about $13.6 trillion in the first quarter of 2013 to about $14.8 trillion in the fourth quarter of 2014, the value has decreased relative to total net assets during the same time period, from about 256 percent of net asset value to about 221 percent of net asset value.
Leverage. More than half of all large hedge fund advisers report aggregate economic leverage less than two and a half times their total reported hedge fund net assets. That is a relatively small leverage ratio, said Burns, something he said should help allay the concerns of organizations like FSOC and the FSB.
High-frequency trading. Fewer than 100 reporting hedge funds – representing less than $70 billion in combined net assets – manage some portion of their funds using high-frequency trading. "That is a relatively small incidence of high-frequency trading," said Burns.
"The public availability of aggregated information should help to address persistent questions, and to some degree misconceptions, about the practices and size of the private fund industry," said White.
"The numbers put things in perspective with those critics who are scaremongering that use of leverage, derivatives and high-frequency trading are at high levels," said Kanter. "For instance, with those critics who say that the SEC is not doing a good job with high-frequency trading by private funds, White is saying, in effect, ‘We’ve got the figures and it’s not as prevalent as you seem to think it is.’"
On the other hand, private funds face three specific operational risks that White said "merit close attention" by advisers:
Transition of client accounts from one adviser to another. This occurs when there is an abrupt change in the management of a private fund, or when a fund is liquidated. Private funds may be invested in asset classes that are difficult to sell and where there are fewer alternative advisers, investors in private funds are more likely to have special contractual rights that other advisers may not be willing to accept or that may limit the adviser’s ability to transfer management, and investors in private funds tend to have confidentiality concerns that may affect the ability to find an alternate adviser. "A clear, well-defined transition plan" is a good way to address this, White said.
Cybersecurity. This, of course, is a challenge for all advisers, not just those managing private funds, but White nonetheless listed it. She urged advisers to pay attention to recent staff guidance (ACA Insight, 9/21/15), as well as to a settled enforcement case (ACA Insight, 9/28/15) involving an adviser charged with not having written policies and procedures to protect customer records and information.
Market stress. White noted that while the SEC staff is currently considering ways to implement Dodd-Frank requirements for annual stress testing by large advisers and funds, "there are important questions about how to address this issue for other registered funds and their advisers that meet the Dodd-Frank asset threshold, including private fund advisers." Doing so is challenging, she said, as the stress tests need to be tailored to the specific risks and business models of diverse assets managers. "The traditional models of stress testing for banks and broker-dealers may not be transferable. Indeed, since the financial distress of an investment adviser may affect only the assets of the adviser, rather than the finances of the likely much larger funds in manages, there are real questions about precisely what the goal of stress testing should be for advisers."
The main risk White named was fiduciary duty, under which investment managers must serve the best interests of their clients, which she identified as "the bulwark of investor protection." She then noted that examiners conducting private fund presence exams "identified several areas where cracks in this bulwark were found," including:
Marketing. "Some hedge fund advisers may have used marketing materials that included back-tested performance numbers, portable performance numbers, and benchmark comparisons without key disclosures," she said.
Disclosure of conflicts of interest. Some hedge fund advisers may not be adequately disclosing conflicts related to advisers’ proprietary funds and the personal accounts of their portfolio managers, White said. "Examiners saw, for instance, advisers allocating profitable trades and investment opportunities to proprietary funds rather than client accounts in contravention of existing policies and procedures."
Conflicts involving fees and expenses. Examiners were concerned that some advisers "may have been improperly shifting expenses away from the adviser and to the funds or portfolio companies by, for example, charging a fund for the salaries of the adviser’s employees or hiring the adviser’s former employees as ‘consultants’ paid by the funds," she said. In addition, she said that examiners observed advisers collecting "millions of dollars" in accelerated monitoring fees without disclosing this to clients.