Thursday, March 21, 2013

Regulatory Indigestion at a Cayman Dinner

Regulatory Indigestion at a Cayman Dinner

I don’t engage in conversation with many money managers these days, as I’ve abandoned the business.  So over dinner last night on Grand Cayman, I asked about the current regulatory environment.  After posing one question about the SEC, I was left with plenty of time to enjoy my grilled Mahi Mahi, plantains, beans, and rice as my dinner mates launched into a diatribe about the emerging regulatory environment.  Despite the cooling sea breeze, the atmosphere at our table grew heated.

Portable Alpha (2003)

Private equity and hedge fund managers are now subject to SEC registration, so the SEC is actively poking around their affairs for the first time.  The lawyer at our table related that the SEC’s examinations and inquiries had been excellent for his business. The money manager fumed about the aggressiveness of SEC’s examiners and the intrusiveness of the audit process.  Having been subject to the SEC as a manager of stock, bonds, and mutual funds for three decades, none of the SEC’s tactics struck me as particularly onerous or peculiar.  However, my fellow diners, having avoided examinations up until now, were none too pleased.

According to The Wall Street Journal[1], the SEC is exhibiting a keen interest in “other fund expenses” charged to funds by alternative managers.  These are the costs incurred above and beyond the management fee.  I’m quite certain the SEC is going to unearth a treasure trove of questionable charges.  The Journal reports some hedge fund and private equity managers have been charging all sorts of private jet travel and lavish entertainment to the funds under their management, rather than absorbing those expenses out of their management fee.  By the time the SEC completes its examination of all of the 1,500 alternative managers newly subject to its scrutiny, we’re going to be treated to some scandalous headlines and sensational Congressional hearings.

During the course of the dinner, I learned about two irksome provisions of the Dodd-Frank law.  First, banks can no longer include their name in a fund offering in the US.  For example, Bank of America cannot sponsor the BofA European Private Equity Fund or BofA Asian Equity Long Short Fund (by the way, the people at dinner were from another bank).  As a result, banks are spending time coming up with names for their new fund products.   To be honest, I’m having a hard time thinking of a credible rationale for this provision.

Second, banks cannot invest more than 3% in any one fund that they manage.  While regulators like this provision because it limits the amount of bank capital tied up in alternative investments, investors hate it.  Investors want managers to have skin in the game.  It’s called alignment of interest, and it’s particularly important when you have a big bank as the sponsor of a fund.  The 3% limit, coupled with the Volcker Rule that restricts the total amount of capital that banks can allocate to alternatives, is clearly driving my fellow diners to distraction and making it hard for them to raise money from institutional clients.

By the time the coffee arrived, the managers were fuming over the more rigorous regulatory regime coming into place in the UK, known as the Financial Conduct Authority.  And they lambasted the European Union[2] for new restrictions that, among other complicated provisions, restrict their ability to market to European institutions.   In Europe, banks can still use their name in describing a fund product, and they can put more that 3% in a fund.  However, they can’t market such a product to US investors.  On the other hand, it’s far easier to put together marketing materials and approach US institutional investors than it is to solicit European institutions.

There’s little doubt that portions of Dodd-Frank and the European response don’t make much sense and aren’t coordinated.  What do you expect of a regulatory response borne out of a financial crisis and crafted by politicians?  Moreover, banks and money managers alike have spent the last several years vigorously resisting and muddying up the new regulations, so it shouldn’t be surprising that the regulators are being a tad feisty.  As we settled our bill, my dinner companions pined for the days when the regulations were lax and the regulators were meek.  Despite their distaste for the new scrutiny, my dinner mates weren’t about to abandon a business that pays them 1.5% and 20% of the profits.

By the way, I think our dinner was a fund expense.


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