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Rekenthaler Report

Should Private Investment Funds Be for Everyone?

Yes, but with a very large asterisk.

The SEC's Proposal
The headline's query was once asked specifically about hedge funds. Fifteen years ago, it was widely thought that that individual investors would benefit from owning hedge funds, which boasted better investment talent. Mutual funds hired the benchwarmers; the true stars were working for higher-paying hedge funds. That argument has dwindled as hedge fund performance has since languished.

But hedge funds are not the only private, unregistered investment pools. That universe also includes private-equity funds and venture-capital funds. Such investments have better retained their reputations, such that several private-equity managers have felt emboldened enough to lobby the SEC to permit private equity be sold into 401(k) plans.

The agency hasn't yet tackled that argument, but it has offered its thoughts about how private funds overall should be distributed. (Its discussion also involves private-placement equities, a somewhat different animal that this column will therefore ignore.) December's "Amending the 'Accredited Investor' Definition" addresses long-standing rules that limit the direct purchase of private funds to 1) professional buyers and 2) individual investors who meet certain wealth standards.

The SEC seeks to retain the current system, but with several adjustments. Most notably, those who possess securities licenses (such as Series 7 or Series 65) would be allowed to buy private funds for their personal accounts. Other changes include modifying the spousal definition to include "spousal equivalents," and expanding the list of qualifying institutions, including family offices that manage at least $5 million.

That's all fine and good; regulations that date from the 1980s are indeed due for a checkup. But perhaps the SEC's proposal was too cautious. Perhaps it should have jettisoned the existing structure, offering a much simpler alternative. The SEC's document runs 153 pages. That might be 143 pages too many.  

He Dissents
Bloomberg's Matt Levine thinks so. He suggests dispensing with the complications altogether. Scrap the wealth tests and open private funds to all interested buyers.  "If someone knowingly wants to take the risk of investing in a possible dud, the SEC shouldn't stop them because they are not rich enough. That's why I have long advocated my own definition of accredited investor, which is that anyone can be accredited just by acknowledging, in writing, to the SEC that 1) they know they're going to lose their money and 2) they are not allowed to complain when they do."

His first point exaggerates: Nobody invests expecting to lose money. Properly, the Levine Proclamation should require prospective buyers of private securities to acknowledge that "they are making their purchase in ignorance, and thus anything could happen to their money, including losing most or all of it."

Therein lies the problem. Levine's approach might be acceptable if individual investors could reasonably anticipate the risks. In such a case, one could argue, investors should be granted their freedom. If they wish to brave cannon fire, so be it. However, private funds are not required to disclose anything. In practice, most funds do provide some data, but selectively. Generally, the more desirable the fund, the less it divulges, and the wealthier the potential investor, the more the fund will co-operate.

Which means that the weakest funds would target retail investors. Those that could sell to the world's largest pension and endowment funds would. Those that could not, would move one notch down the ladder, and so forth, until the bottom rung was reached. Yes, even the most successful private funds might also take money from everyday buyers, because every dollar spends, but they would be unlikely to offer much information in return. They would be near-blind pools.  

Subjecting individual investors to adverse selection wouldn't seem to be sound public policy. That situation could be avoided by mandating that private funds publicly file the data requested by powerful institutional investors (for example, Yale's endowment fund). But then those funds would no longer be private. They would merely be another version of registered fund.

My Counterproposal
In short, Levine's intent is salutary--153 pages is indeed far too many!--but his solution is suspect. A better approach for simplifying private-fund regulations is to segment the marketplace. Radically increase the wealth standard for accredited investors to $100 million. Whether the buyer is an institution, an individual, or something in between (for example, a family office or a financial advisor's practice) matters not. Proceed only with at least $100 million in investable assets.

That would shorten the rule book!

My suggestion comes from personal experience. The law permits me to invest in private funds. Sad to report, the law is bunk. Those with my level of investable assets, or even considerably higher, are but gnats buzzing near the ears of the leading hedge funds, private-equity funds, and venture-capital funds. We are of interest only to the desperate. The SEC says that I am a qualified investor. It is legally right, but practically wrong.

The solution for those in my position, and for everybody else who lands under that admittedly arbitrary $100 million figure, is not to invest directly into private funds, but instead indirectly, through publicly registered vehicles that hold private funds. No such funds exist today, because the Investment Company Act of 1940 prevents public funds from placing more than 15% of their assets into private securities. That is a sound rule, given the liquidity demands of mutual funds and exchange-traded funds.

However, both closed-end funds and the newer invention of interval funds could serve the purpose. Closed-end funds are never redeemed, and with some modification, the rules governing interval fund redemptions could also accommodate the limited liquidity of private funds. Through such structures, everyday investors could safely own a pool of professionally vetted private funds rather than a single fund that was bought, almost certainly, on a hunch.

To be sure, many of these funds of funds would be overpriced--probably almost all of them, at the beginning. But the glare of scrutiny has a powerful effect on public fund expenses. Before too long, I suspect, those funds of funds that are priced aggressively would dominate sales, as they have throughout the mutual fund and ETF industry. Eventually, the indirect buyer of private funds would receive almost the same pricing as the direct owner.

 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.