Private fund performance after the Dodd-Frank Act

The American private fund industry is a significant representative of Wall Street’s interests and regulating hedge funds was a politically sensitive undertaking since the inception of the industry. Despite reservations on both sides of the political spectrum, the regulation of hedge funds was eventually included in Title IV of the Dodd-Frank Act. 

Title IV introduced the most significant regulatory change in the history of the private fund industry in the United States. Title IV and SEC implementation rules introduced a registration requirement for private fund managers and increased the disclosure requirements pertaining to confidential and proprietary information. These new rules boosted the permissible regulatory oversight of the private fund industry to an unprecedented level.

Title IV of the Dodd-Frank Act exempts private fund advisers with less than $150 million assets under management (AUM) from registration but requires registration for any private fund adviser with AUM of more than $150 million. The SEC has the authority under the Dodd-Frank Act to require the disclosure of any other reports it considers necessary to protect investors.

In a joint effort to implement the Dodd-Frank Act provisions pertaining to data collection, the SEC and the Commodity Futures Trading Commission (CFTC) proposed Form PF in January 2011. The SEC enacted Form PF in October 2011. Form PF requires that private fund advisers with less than $1.5 billion regulatory AUM attributable to hedge funds file Form PF annually. Quarterly filing of Form PF is required for any private fund advisers managing RAUM in excess of $1.5 billion attributable to hedge funds.

The controversial disclosure obligations in Form PF require the reporting of risk metrics, counterparties and credit exposure, strategies and products used by the investment adviser and its funds, performance and changes in performance, financing information, the percentage of equity and debt, trading practices, the amount of AUM, valuation policies, side letters, the use of leverage, and other information deemed necessary and appropriate to avoid systemic risk.

The new registration and reporting requirements for private funds have been controversial. A survey of private fund managers conducted by Wulf Kaal in 2012, after the registration effective date for private fund managers under the Dodd-Frank Act, March 30, 2014, shows that mandatory private fund adviser registration under the Dodd-Frank Act affects the cost structure of the industry. However, the registration and increased compliance requirements under the Dodd-Frank Act increase the cost structure of hedge funds only marginally. Registration and disclosure requirements under the Dodd-Frank Act do not seem to affect the returns of hedge funds. Rather, compliance costs associated with Dodd-Frank Act appear to affect mostly the profitability of private fund advisors’ investment management companies.

In a new study (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2389416), Wulf Kaal, Barbara Luppi and Sandra Paterlini (Kaal et al.) study the impact of the Dodd-Frank Act and SEC rules pertaining to hedge funds on private fund performance. Their study aims to estimate the impact of private fund adviser registration and increased disclosure requirements under the Dodd-Frank Act on private fund performance. Using self-reported Morningstar earnings data for 2,145 private fund advisers that are based in the United States and are subject to the registration and disclosure requirements under Title IV of the Dodd-Frank Act and SEC rules, the authors employ regression discontinuity and difference-in-difference empirical designs.

Contrary to the claims of the private fund industry suggesting that increased supervision and disclosure would affect their profitability, Kaal et al. find statistical evidence of a positive effect of the requirements introduced by the Dodd-Frank Act on private fund performance. Private fund adviser registration under the Dodd-Frank Act positively affects private fund adviser returns in March 2012. The registration requirement for private fund advisers under the Dodd-Frank Act created a discontinuity in private fund returns in March 2012. However, this effect is not persistent and is completely absorbed in the months following the registration effective date for private fund advisers under the Dodd-Frank Act.

More specifically, the results in Kaal et al. suggest that a discontinuity exists at the threshold value of $150 million AUM, above which private fund adviser registration under the Dodd-Frank Act becomes mandatory. Despite the great volatility of private fund adviser returns displayed over the period under examination, the empirical evidence is robust. However, in the subsequent months after the registration effective date for private fund advisers the discontinuity dissipates.

The regression analyses in Kaal et al. suggest that the mandatory registration requirement imposed by the Dodd-Frank Act affects the private fund industry asymmetrically. Their study provides evidence that some private fund advisers with AUM floating above and below the threshold value of $150 million may strategically reduce their AUM size to avoid the mandatory registration threshold.

Because the Dodd-Frank Act affects private fund advisers with AUM greater than $150 million, private fund advisers may be incentivized to change their organizational structure or act otherwise strategically to avoid the registration and disclosure requirements imposed by the Dodd-Frank Act.

Moreover, Kaal et al. provide evidence that these strategic actions by fund advisers lead to a strong increase in the discontinuity around the AUM registration threshold, albeit the effect is being absorbed in later months.

In an earlier study, Kaal finds non-robust evidence that the higher administrative costs imposed by the Dodd-Frank Act are a second-order effect of the regulation, thereby not affecting the overall returns of hedge funds. Kaal’s result is consistent with the findings in Kaal et al. because the impact of Dodd-Frank Act registration requirements on private fund manager profitability does not persist in the long run. The analysis in Kaal et al. would need to be extended further in order to assess more carefully the impact of the Dodd-Frank Act on administrative costs.

 

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President Barack Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act in Washington, July 21, 2010.
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Wulf A. Kaal

Wulf Kaal is a tenured associate professor of law at the University of St. Thomas School of Law in downtown Minneapolis. He is a leading expert on hedge fund regulation in the United States and the European Union.  Before entering the academy, Kaal worked for Cravath, Swaine & Moore LLP in New York and Goldman Sachs in London.  Kaal has published more than two dozen articles in the United States and Europe. His articles were published in leading peer reviewed law and finance journals and in American law reviews such as the Minnesota Law Review, the Washington & Lee Law Review, and the Wake Forest Law Review, among others.  Kaal’s study on the effects of hedge fund registration requirements under Title IV of the Dodd-Frank Act has gained national attention and was covered in a Business Week article and other journals. He is the author of a book chapter on Investment Advisers and Investment Companies in the Securities Law Handbook published by Edward Elgar.
He has also been a consultant to major corporations and hedge funds regarding various aspects of financial markets and regulation.

 Wulf A. Kaal
Associate Professor
University of St. Thomas School of Law
1000 LaSalle Avenue
MSL 400
Minneapolis, MN 55403
United States
 

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