Title IV of the Dodd-Frank Act created a paradigm shift for the regulation of private funds in the United States.
Title IV introduced the most significant regulatory change in the history of the private fund industry in the United States – requiring mandatory registration for private fund managers with over $150 million in assets under management and increasing the disclosure requirements pertaining to confidential and proprietary information (Dodd–Frank §§ 401, 402).
Implemented under Title IV, the controversial disclosure obligations in Form PF require private fund adviser to report 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.
Mandatory private fund adviser registration under the Dodd-Frank Act affects the cost structure of the industry1. However, the registration and increased compliance requirements under the Dodd-Frank Act increase the cost structure of private funds only marginally.
Registration and disclosure requirements under the Dodd-Frank Act do not seem to affect the returns of private funds. Rather, compliance costs associated with the Dodd-Frank Act appear to affect mostly the profitability of private fund advisors’ investment management companies. This article describes the results of a recent study on the compliance costs for private fund advisers under the Dodd-Frank Act and suggests strategies for private fund advisers to address such compliance costs.
Title IV and SEC implementation
After more than thirty years of controversy between the private fund industry and regulators, with both sides asserting their positions in an effort to determine the appropriate level of regulatory oversight, the enactment of Title IV was divisive. Industry representatives were concerned that Title IV could unnecessarily burden investment advisers and undermine clients’ secrecy. Legislators opposing Title IV predicted that the enactment would promote unaccountable and unrestrained regulatory agencies.
The Treasury Department favored the enactment of Title IV to facilitate strong oversight for critical financial institutions. The Securities and Exchange Commission also supported the enactment of Title IV to increase its understanding of the private fund market including the type of risk-taking in that market, the types of securities involved, and the total dollar amount at stake.
Congress enacted the Private Fund Investment Advisers Registration Act of 2010 in Title IV of the Dodd-Frank Act (PFIARA, Act, or Title IV) (Dodd-Frank §§ 401-416) to close regulatory gaps and end the speculative trading practices that contributed to the 2008 financial market crisis.
After multiple unsuccessful attempts by the SEC to increase the regulatory oversight over private fund advisers, PFIARA amends the Investments Advisers Act of 1940 (Advisers Act) and establishes rules and regulations for the registration of private funds with the SEC. Title IV attempts to provide greater protections for investors by mandating private fund adviser registration and increasing record-keeping and disclosure (Dodd-Frank § 408). Private fund advisers with more than $150 million in assets under management are required to register as investment advisers and have to disclose information about their trades and portfolios to the SEC (Dodd-Frank §§ 408, 403).
Registered investment advisers are required to maintain records and any other information that may be necessary and appropriate to avoid systemic risk (Dodd-Frank §§ 404, 405). Investment advisers must provide reports with respect to certain information related to systemic risk (Dodd-Frank § 404(b)(3)), such as trading practices, trading and investment positions, the amount of AUM, valuation policies, side letters, the use of leverage, including off-balance sheet leverage, counterparty credit risk exposures, and other information deemed necessary (Dodd-Frank § 404(b)(3)(H)). These reports are confidential and not publicly available.
Systemically relevant information includes information about the funds managed by the investment advisor, information about the investment advisor, and information about individual investors. Investment advisers are required to disclose information pertaining to their strategies, performance and changes in performance, the products used by the investment adviser, financing information, risks metrics, credit exposure, and positions held by the investment advisor, among others.
As for the private funds advised by investment advisers, investment advisers are required to list net asset value managed by private fund strategy and the percentage of the reporting fund’s NAV managed by using computer-driven trading algorithms. Investment advisers also have to disclose the reporting fund’s greatest net counterparty credit exposure, including the name of the creditor and the dollar amount owed to each creditor, information about the collateral and credit support, and changes in market factors and their effect on the long and short components of the portfolio as a percentage of NAV.
In a recent study, the author relies on the highest number of compliance cost estimates (N=94) collected in the aftermath of the enactment of mandatory registration requirements for the private fund industry. The compliance cost data used in that study was collected in the context of a 2012 survey with a population of 1,264 private fund advisers registered before the SEC’s registration effective date for private funds, March 30, 2012.
Respondents in the survey (N=94) answered questions in several categories designed to identify the effects of compliance with Title IV of the Dodd-Frank Act. The categories relevant for the compliance cost analysis in the study are also the dependent variables for its regression models: (1) cost of Title IV compliance, (2) median cost measures, (3) annual time required for Title IV compliance, and (4) median annual time measures for Title IV compliance. The two datasets in the study measuring the number of funds managed by investment advisers and the AUM data were coded based on publicly available data from SEC Form ADV.
The graph above shows the responses to the author’s open-ended survey question pertaining to the effects of Title IV on the private fund industry by percentage. Most respondents (43.59 percent) stated that the industry would be affected primarily by increased costs. See figure 1
Most respondents believed that Title IV compliance would cost $100,000 annually. See figure 2
Most common fund adviser response (47.67 percent) estimates the annual compliance costs under Title IV to be between $50,000 and $100,000 annually. See figure 3
Survey respondents suggested that the time it would take to comply with Title IV requirements ranged from 100 hours to 1,000 hours per year. See figure 4
Forty-six percent of respondents stated that it would take them between 100 and 250 hours per year to comply with Title IV requirements. Thirty-two percent of respondents believed it would take them between 250 and 500 hours per year. See figure 5
Estimation results and implications
The estimation results of that study indicate that the number of funds managed by a private fund adviser is associated with Dodd-Frank Act compliance costs. To evaluate the relationship between the number of private fund advisers’ managed funds and Dodd-Frank Act compliance costs, the study uses linear and non-linear regressions for two independent datasets on the amount of funds managed by an investment adviser.
For all compliance cost proxies, including median cost estimates, the linear coefficients are positive and half of the positive coefficients are statistically significant. This suggests that the number of funds managed by a private fund adviser is associated with Dodd-Frank Act compliance costs. While only one third of all non-linear coefficients in the study were negative, the majority of significant non-linear coefficients were positive.
Therefore, both the study’s linear and non-linear regression results suggested that the number of funds managed by a private fund adviser was associated with Dodd-Frank Act compliance costs.
Several implications derive from the study’s estimation results. While larger private fund advisers may be largely unaffected by the increased compliance costs, smaller private fund advisers and startup hedge fund advisers that are more cost conscious may wish to lower their compliance costs under Title IV. Smaller private fund advisers may be able to lower their Title IV compliance costs by managing a smaller number of private funds.
Managing a smaller number of private funds lowers the reporting obligations via Form PF (Form PF needs to be filed for each managed fund) and, thus, lowers Dodd-Frank Act compliance costs. However, decreasing the number of managed funds may not always be possible from a managerial, operational and client relations perspective. Decreasing the number of managed funds could also have a negative impact on the investment strategy of smaller fund advisers and limit their ability to raise funds, rendering them overall less competitive.
Several factors mitigate the increased compliance costs associated with Dodd-Frank Act. The author demonstrated in another study that the most significant Title IV compliance costs are associated with the initial reporting obligations2. Subsequent reporting obligations are associated with significantly reduced compliance costs for both large and small private fund advisers.
In the long run, private fund advisers may decide to forego the services of third party service providers and device strategies that allow them to fulfill their reporting obligations under the Dodd-Frank Act more effectively, thus lowering compliance costs further.
- Kaal 2013 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2150377
- Wulf A. Kaal, “The Effect of Private Fund Disclosures under the Dodd-Frank Act.” Brooklyn Journal of Corporate, Financial & Commercial Law (forthcoming 2015. http://goo.gl/lvbbyQ. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2447306