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Legal Insights: Hedging the Hedge Fund Market - How Proposed SEC Changes Could Affect Hedge Fund Investments

July 15, 2007

For high-net-worth individuals and institutions, hedge funds offer appealing investment options and more flexibility with much less regulation than mutual funds. Savvy fund managers, who don't need to register as investment advisers, can do pretty much whatever it takes - from leveraging to short selling - to earn return on investment.

Net worth and income requirements have historically limited these investors to a small, exclusive group. But changes in the economy over the past decade or so, have opened up hedge funds to a larger swath of individuals.

Under current Securities and Exchange Commission (SEC) rules, investors can use their primary residence to meet their qualification requirements for net worth," says Aaron Kase, partner with Levenfeld Pearlstein, LLC, a Chicago-based law firm. "With the increase in real estate prices over the last couple of years, a greater percentage of the U.S. population passes the accredited investor test."

Smart Business discussed with Kase the proposed changes, the potential implications of these changes and the best courses of action for hedge fund managers and investors.

Which individuals are currently legally eligible to purchase hedge funds?

Under current securities rules, which have remained mostly unchanged for the past 25 years, individuals have to meet income or net-worth requirements to purchase an interest in a hedge fund. To qualify as an 'accredited investor,' individuals need to have had $200,000 of income in each of the past three years, or $300,000 including a spouse and have the expectation of making at least as much in the current year. Otherwise individuals need to have at least $1 million in net worth, which can include a primary residence.

How could proposed legislation change who qualifies?

Recently, the SEC proposed changes to the requirements that would make it harder for investors to participate in the hedge fund market. These potential amendments would require individuals to also have $2.5 million in investments, including assets like securities or investment property. This would raise the wealth requirements and mean that individuals could no longer count the value of their home toward the total investment assets. Married individuals could only count half of their marital assets, meaning a couple might need as much as $5 million in investments to participate in hedge funds.

What are the implications of these proposed changes?

The SEC has received a large number of negative comments on its proposal from the public. The feedback typically states that it's inappropriate to limit people's investment decisions based on the amount of investment assets they possess. If the SEC adopts these proposed modifications, many individuals would be pushed out of the hedge fund market.

My sense is that large hedge funds, those with $1 billion or more in assets, don't need to be concerned about this issue. Most of these funds already limit their investors to those who meet the higher, more stringent qualified purchaser status requirements of $5 million in investment assets for individuals and $25 million for most entity investors.

Smaller hedge funds would experience a much greater impact from these more restrictive requirements. These smaller investment entities would have a more limited pool of potential investors. Also, depending on how any final rule is worded, hedge fund managers could end up with investors in their fund who would not have the ability to further invest in the fund or to invest in subsequent funds.

What advice would you give to new hedge fund managers?

It's essential to stay informed, think about whether potential investors will meet the higher standards, and include as many investors who meet the more stringent requirements as possible.

Ask if potential investors still qualify under the higher proposed standard. The proposed rule has some grandfathering provisions. It's in the hedge fund managers' best interest to limit the investor qualification risk based on possible SEC changes.

Why is it important to select a knowledgeable hedge fund adviser, and why is a proven track record important?

The key risk in a hedge fund is the hedge fund manager. Mutual funds are registered investment companies that have a lot more restrictions in terms of governance, type of investments and investment practices. These constraints limit the ability of managers to take advantage of market inefficiencies, but they also protect investors from unscrupulous or incapable managers.

It's important to thoroughly research the fund manager, including his or her track record, and to read the fund documents carefully. If individuals don't feel comfortable doing this research, they can invest in a fund of hedge funds. The fund of funds diversifies manager risk by investing in several different hedge fund managers.

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