New Paper Looks at “Black Market Capital” in the Hedge Fund & Private Equity Markets

Hedge Fund Regulation 13 Sep 2007

With the best interests of the investing public in mind, financial regulators have long sought to prevent retail investment in hedge funds and private equity.  The Investment Company Act in the United States, for example, expressly forbids small investors from buying into such funds.  And recent SEC overtures about dramatically raising the wealth threshold shows this desire is alive and well.

Obviously, investors want to invest in these funds.  If they did not, regulation wouldn’t be required.  So investors look for a “back door” entrance into the hedge fund club.  Often, this comes in the form of simply buying the stock of a hedge fund manager itself.  It may also come in the form of other publicly-traded entities.  Or, it might come in the form of a foreign market for domestic funds.

An extensive new paper by Steven Davidoff of Wayne State University Law School refers to these investments as “black market capital” since they aim to side-step existing regulations.  He says that black market capital is an “irrational” effect of SEC regulation since it actually causes small investors to invest in potentially “riskier and less suitable investments”.

Stock of Fund Advisers

Far from being victims of oppressive SEC regulations, it seems that owners of hedge fund IPO candidates may actually be the main beneficiaries of regulations preventing mass market investment in hedge funds and private equity.  Says Davidoff:

“The success or failure of a fund adviser is therefore almost wholly dependent upon the fortunes of their underlying funds. But, unlike the funds themselves, these corporate advisers do not automatically come under the aegis of the Investment Company Act. Rather, since they are companies whose business happens to be advising hedge funds and private equity funds, they are treated under the federal securities laws as normal operating companies. Consequently, these advisers can publicly raise capital without triggering the Investment Company Act. Thus, they are a viable alternative for these fund managers to offer the public an opportunity to derivatively invest in hedge funds and private equity and share in the potential returns of these underlying investments.”

Davidoff says that Blackstone’s June 2007 IPO was oversubscribed mainly by investors who wouldn’t have qualified to actually invest in any of Blackstone funds themselves.

Special Purpose Acquisition Companies (SPACs)

SPACs are corporations established for the sole purpose of acquiring an operating business.  When the SPAC executes an IPO, it generally has no idea what business it will buy with the proceeds.  Instead, the SPAC has 18-24 months to buy something.  While shareholders usually have a chance to vote on any potential acquisition, Davidoff says a SPAC is essentially a form of private equity fund that exists outside of the Investment Company Act.  With private equity growing by leaps and bounds, SPACs have found a lot of interest among retail investors who are unable to buy real private equity funds.  According to the paper, 115 SPACs raised over $10 billion between 3003 and mid-2007 (compared to no offerings from the late 1990’s to 2002).

Alternative Markets

Unregulated US Markets

Davidoff says that onerous regulations have not only forced investors to seek new products, but also new markets.  He cites Goldman’s new “Tradable Unregistered Equity OTC Market (GSTrUE)” as one such example:

“The market’s first listing was Oaktree Capital Management LLC, a hedge fund adviser with over forty billion dollars in assets under management, which sold approximately fourteen percent of itself for more than $800 million in a widespread solicitation of a number of potential investors.  Goldman Sachs representatives have publicly stated little about the market or Oaktree’s offering except that they view GSTrUE as a viable alternative listing market for hedge funds, private equity and operating companies who wish to avoid SEC regulation.  GSTrUE is thus a black market that is the product of greater regulatory dissatisfaction than merely the Investment Company Act and Advisers Act, but is still driven in part by these regulatory forces. This is aptly illustrated by Goldman’s public comments that GSTrUE is being marketed heavily to hedge funds and private equity, and that its first listing was a hedge fund adviser, and second listing was Apollo Management L.P., the private equity adviser.

The paper goes on to cite similar markets run by Bear Stearns, JP Morgan, Merrill, Leahman, Morgan Stanley, and Citi.

Foreign Markets

Since European markets are more friendly to IPOs of funds themselves than are US markets, many large hedge fund and private equity firms have recently executed IPOs in those markets.  According to Davidoff, several of these ostensibly European IPOs were actually targeted directly at US investors:

“Ripplewood Holdings LLC targeted qualified U.S. investors in a €729 million capital raising and listing on Euronext Brussels for RHJ International fund, a holding company for Ripplewood’s Japanese and other businesses.  RHJ International specifically provided a private placement offering tranche for individual U.S. investors with a net worth of five million dollars to invest in its offering through a certificated restricted security.”

The paper says that the use of other markets such as this “is a common economic effect for any black market good“.

Other Vehicles

Davidoff provides examples of various other securities that are derivatives of private equity, but are easier to buy than a private equity fund itself.  One such example is the Business Development Corporation (BDC) which invest only in the debt portions of LBOs.  Not surprisingly, listed BDCs increased 17-fold from 1997 to 2006.

Structured Trust Acquisition Companies (STACs) operate in a similar manner to SPACs, but provide a list of acquisition targets prior to their IPO.

ETF companies have taken advantage of all this publicly-traded PE exposure to create private equity ETFs.  Davidoff says these are made up of STACs, BDCs and other similar entities.  So far, the only example is the PowerShares Listed Private Equity Portfolio.  This ETF was lauched in October 2006 and by mid-July 2007 had about $175 million of assets.

Finally, he also mentions hedge fund replication ETFs as another example of the “black market” caused by the inability for retail investors to buy real hedge funds.

Market Distortion

Okay, so what?  None of these products is particularly nefarious, right?  Well, according to Davidoff, the emergence of so many back doors into hedge funds and private equity actually has a distortive effect on markets.  Says the paper:

“The consequence is that public investors who purchase black market capital investments bear more risk in their investment portfolios and aggregately inject such heightened risk into the U.S capital market itself than if they were permitted to invest in hedge funds and private equity.”

There’s no doubt that hedge fund companies are riskier than the hedge funds they manage.  In fact, Davidoff uses Amaranth as an example.  Investors, he says, got back about 35% of their assets while owners of the company itself lost everything.  His unsaid question: why should investors be allowed to invest in the (riskier) company and not the (less risky) fund?

Furthermore, argues Davidoff, SPAC managers are generally less qualified to executive take-overs than bona fide private equity managers.  This also makes SPACs more risky than actually private equity funds.

In conclusion, Davidoff worries that US markets will suffer as hedge funds and private equity funds continue to list in overseas markets (Euronext, LSE etc.) creating “path dependencies” that entrench those jurisdictions as market leaders (witness, he says, the emergence of the Euro-bond market in response to the US tax regime of the 1960’s).

Davidoff’s prescription is an “open market solution” involving the removal of market-perverting regulation:

“The Investment Company Act and its legislative sibling, the Investment Advisers Act (Advisers Act),21 and the promulgated rules thereunder, should be updated for the modern age. A new regulatory scheme should be created which permits hedge funds and private equity, as they are currently structured, to voluntarily make offers and sales to the general public. This would not only end a primary force driving black market capital, but would also permit average investors to benefit from possible extraordinary returns, reduced risk and increased diversification provided by these investments.”

Some readers might find Davidoff’s specific proposal to create a “Specialist Fund” to be excessive financial libertarianism given recent negative press about compensation, leverage, lock-ins and short-selling.  But he raises some important issues.

He concludes the paper by methodically walking through many of the positive arguments for hedge funds that we have also made on this website (he even cites some of the same sources).  This dispassionate, methodical style may destine Davidoff’s paper to be a beacon for the industry as it struggles to debunk commonly-held misperceptions.  As such, it reminds us of an article written last year by Sebastian Mallaby (in the December 2006 edition of Foreign Affairssee related posting)

In the end, Davidoff is proposing an end to prohibition.  The question is, would the relaxing of hedge fund and private equity regulations be like an end to the prohibition of alcohol or more like the legalization of crack?

Ed: for more financial insights from a lawyers perspective, check out Davidoff’s blog.

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