WEBMASTER NOTE: This is the unedited transcript of the hedge fund hearings held on May 14-15, 2003, which we received directly from the court reporter. We are posting the transcript in this form to make it available as soon as possible. Staff will review this transcript and will correct any errors that may be contained in it. We will post on our website the corrected transcript, which will also be easier to view and to read, as soon as it is available. -------------------------------------------------------------------------------------- 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 In the Matter of: ) 4 ) File No. 05-007-03 5 HEDGE FUND ROUNDTABLE ) 6 PAGES: 1 through 285 7 PLACE: Securities and Exchange Commission 8 450 Fifth Street, N.W. 9 Washington, D.C. 10 DATE: Wednesday, May 14, 2003 11 12 The above-entitled matter came on for hearing, pursuant 13 to notice, at 9:00 a.m. 14 15 BEFORE: 16 17 WILLIAM H. DONALDSON, Chairman 18 PAUL ATKINS, Commissioner 19 RAUL CAMPOS, Commissioner 20 CYNTHIA GLASSMAN, Commissioner 21 HARVEY GOLDSCHMID, Commissioner 22 23 24 Diversified Reporting Services, Inc. 25 (202) 467-9200 1 C O N T E N T S 2 PAGE 3 4 Welcome and Overview - Chairman Donaldson 8 5 6 PANEL 1 - HEDGE FUNDS - OVERVIEW, ROLE AND STRUCTURE 12 7 8 MODERATOR: 9 PAUL F. ROYE 10 Director, Division of Investment Management 11 12 PANELISTS: 13 DAVID VAUGHAN 14 Partner, Decker, LLP 15 16 RICHARD LINDSEY 17 President, Bear Stearns Securities Corp. 18 19 CHARLES GRANDANTE 20 Managing Principal, Hennessee Hedge Fund 21 Advisory Group 22 23 WILLIAM KEUNEN 24 Director, Citco Fund Services 25 1 GREGORY NEWTON 2 President, Managed Accounts Reports, LLC 3 4 JOEL PRESS 5 Senior Partner, Ernst & Young 6 7 ROBERT SCHULMAN 8 Chairman and CEO, Tremont Investment Management 9 10 MICHAEL NEUS 11 Principal and Chief General Counsel, Andor Capital 12 Management, LLC 13 14 15 PANEL 2 - MARKETING ISSUES - HOW ARE HEDGE FUNDS 16 MARKETED/DISTRIBUTED? 100 17 18 MODERATOR: 19 ELIZABETH G. OSTERMAN 20 Assistant Chief Counsel, Division of Investment 21 Management, Securities and Exchange Commission 22 23 PANELISTS: 24 ALAN BELLER 25 Director, Division of Corporation Fincance, SEC 1 MICHAEL BUTOWSKY 2 Partner, Mayer Brown Rowe & Maw 3 4 LEROY CODY 5 Managing Director, American Express Alternative 6 Investments 7 8 JAMES R. HEDGES 9 Founder, President, and Chief Investment Officer, LJH 10 Global Investments, LLC 11 12 CLARK HOOPER 13 Executive Vice President of Disclosure Policy and 14 Review, NASD 15 16 JUDSON P. REIS 17 Partner, the Sire Group of Partnerships 18 19 CRAIG RUSSELL 20 Managing Director and Global Head of Sales and 21 Marketing, DB Absolute Return Strategies 22 23 MICHAEL TIEDEMANN 24 Chief Operating Officer, Tiedemann Investment Group 25 1 PANEL 3 - ISSUES ASSOCIATED WITH HEDGE FUND DISCLOSURE, 2 TRANSPARENCY AND PAERFORMANCE FEES 100 3 1 MODERATOR: 2 ROBERT E. PLAZE 3 Associate Director, Division of Investment Management, 4 Securities and Exchange Commission 5 6 PANELISTS: 7 8 ROBERT BERNARD 9 Chief of Administration and Finance, RiskMetrics Group 10 11 GEORGE HALL 12 Founder and President, Clinton Group 13 14 DAVID A. HSIEH 15 Professor of Finance, Fuqua School of Business, Duke 16 University 17 18 JEAN KAROUBI 19 President, The LongChamp Group, Inc. 20 21 LARRY SIMON 22 President and CEO, Ivy Asset Management Corp. 1 DAVID SWENSEN 2 Chief Investment Officer, Yale University 3 4 MICHAEL G. TANNENBAUM 5 Director, Hedge Fund Association 6 Partner, Tannenbaum Helpern Syracuse & Hirschtritt, LLP 7 8 9 PANEL 4 - ISSUES ASSOCIATED WITH VALUATION, ALLOCATION, USE 10 OF COMMISSIONS AND PERSONAL TRADING 219 11 12 MODERATOR: 13 DOUGLAS SCHEIDT 14 Associate Director and Chief Counsel, Division of 15 Investment Management, Securities and Exchange 16 Commission 17 18 PANELISTSl 19 ANTHONY ARTABANE 20 Partner, PricewaterhouseCoopers, LLP 21 22 MICHAEL DIESCHBOURG 23 Principal, Silver Creek, LLC 24 25 BING LIANG 1 Assistant Professor of Finance, Weatherhead School of 2 Management, Case Western Reserve University 3 4 ANDREW W. LO 5 Harris & Harris Group Professor of Finance, Sloan School 6 of Management, Massachusetts Institute of Technology 7 8 RICHARD PHILLIPS 9 Partner, Kirkpatrick & Lockhart, LLP 10 11 STEPHEN VINE 12 Partner, Akin Gump Strauss Hauer & Feld, LLP 13 14 15 ROBERT ZACK 16 Senior Vice President and General Counsel, Oppenheimer 17 Funds, Inc. 18 19 CLOSING ARGUMENTS 20 21 PAUL F. ROYE 22 Director, Division of Investment Management, U.S. 23 Securities and Exchange Commission 24 25 1 P R O C E E D I N G S 2 CHAIRMAN DONALDSON: Good morning, ladies and 3 gentlemen. I'm Bill Donaldson, Chairman of the SEC. On 4 behalf of my fellow Commissioners, Paul Atkins, Raul Campos, 5 Cynthia Glassman, Harvey Goldschmid, welcome. It's really a 6 pleasure to have all of you here for our hedge fund 7 roundtable. 8 Although I'm not surprised, I'm pleased to see that 9 we have a large turnout. And I also welcome those of you who 10 are watching by webcast. 11 As you can see by the agenda, we have an impressive 12 group of people, panelists, and a broad range of very timely 13 and engaging issues to explore. 14 As all of you know, this is an exciting and dynamic 15 time for the hedge fund industry. Over the past few years, 16 hedge funds have become more popular and continue to grow in 17 size. It's estimated that there are close to 5,700 hedge 18 funds operating in the United States today, managing 19 approximately $600 billion in assets. 20 By contrast, in 1990, only about $50 billion was 21 under management in hedge funds. And hedge funds play an 22 important role in our markets and have a legitimate place in 23 the array of investment options available to investors. 24 However, while there are frequent reports of high 25 returns for hedge funds, there are also reports just as 1 frequently that highlight possible areas of concern, such as 2 potential conflicts of interest, questionable marketing 3 techniques, valuation concerns, and the market impact of 4 hedge fund strategies. 5 Consequently, since June of last year, SEC staff in 6 the Division of Investment Management and our Office of 7 Compliance, Inspections and Examinations have been engaged in 8 a fact-finding mission aimed at reviewing the operations and 9 practices of hedge funds.] 10 While we still are at the fact-finding stage, and 11 have yet to reach any conclusions, this roundtable is the 12 next stage in the process. With our impressive list of 13 panelists, we hope to have a full and frank discussion of the 14 many issues surrounding hedge funds. 15 The last time the Commission took a good look at 16 hedge funds was in 1998, when the Connecticut-based hedge 17 fund, Long-Term Capital Management, nearly collapsed. 18 After that incident, the Commission, along with the 19 Treasury Department, the Federal Reserve, and the Commodity 20 Futures Trading Commission, as part of the President's 21 Working Group on Financial Markets, issued a report on the 22 risk management and transparency issues raised by LTCM, in 23 particular, and by "highly leveraged institutions," in 24 general. 25 The President's Working Group looked at such issues 1 as firms' adherence to their own stated policy, their margin 2 and collateral requirements, their use of leverage and 3 whether it was excessive, and how well their risk models 4 functioned. 5 The President's Working Group issued a report and 6 recommendations, and the indications are that the industry 7 has taken these recommendations to heart. The President's 8 Working Group continues to function. 9 However, as the markets and the hedge fund industry 10 have continued to evolve, I believe the time has come for us 11 again to advance our review of hedge funds and how they are 12 operated, managed, and regulated. 13 We are looking to ensure investor protection and 14 are focusing on issues such as "retailization" of hedge 15 funds, transparency, risk management, conflicts of interest, 16 and fraud. 17 As part of our fact-finding to date, SEC staff has 18 obtained and reviewed documents and information from 67 19 different hedge fund managers representing more than 650 20 different hedge funds and approximately $162 billion under 21 management. 22 The staff concluded on-site visits to a wide range 23 of hedge funds, large and small, and spoke to employees who 24 are responsible for brokerage, compliance, risk management, 25 legal and other operational issues. The staff also met with 1 a variety of industry experts to get their perspective on 2 these issues. 3 Over the next two days, you will hear from many of 4 these experts, including a host of legal and accounting 5 experts, academics, hedge fund investors, risk managers, 6 prime brokers, representatives from foreign regulators, trade 7 industry representatives, hedge fund consultants and 8 administrators, as well as hedge fund managers and investor 9 advocates. 10 After these two days of discussions, let me assure 11 you that we will continue to listen to all of the various 12 perspectives regarding hedge funds. I encourage you to send 13 us your comments reflecting what you have heard today and 14 tomorrow, because the discussion does not end when we leave 15 here tomorrow. 16 Before I turn the microphone over to Paul Roye, our 17 Director of the Division of Investment Management, I want to 18 thank Paul and the dedicated staff who worked very hard, 19 tirelessly, on the fact-finding mission and roundtable, as 20 well as Lori Richards and her staff in the Office of 21 Compliance, Inspections and Examinations. 22 I also especially want to thank all of our 23 panelists who have been so generous with their time and ideas 24 as we work to bring better understanding to the hedge fund 25 industry. 1 And, finally, I'd like to thank all of you who have 2 taken time out of your busy schedules to be here, whether in 3 person or over the Web, to observe and listen along with us, 4 and I hope we exchange a few ideas as the day progresses. 5 Paul, let me turn the podium over to you. Thanks 6 very much for being here. 7 MR. ROYE: Thank you, Chairman Donaldson, for those 8 welcoming remarks. You've highlighted a number of important 9 issues that we want to explore over the next couple of days. 10 Before I begin, I want to mention a few 11 housekeeping items. As you can see, we have a large audience 12 today, and we won't be able to take questions from the 13 audience. The questions will come from the moderators and, 14 of course, our Commissioners. 15 I'd also ask you to turn off your cell phones. Our 16 agenda does include built-in breaks, where you can turn on 17 your cell phones and make the calls that you have to make, 18 but we ask that you again turn them off at the beginning of 19 each panel. 20 And I would note that if you leave the building, 21 unfortunately, you have to go through our security check once 22 again. 23 Now let's get started with our first panel. And, 24 really, the purpose of our first panel is really to kind of 25 frame the discussion for what follows, for our subsequent 1 panels, really to provide an overview of the industry, to 2 review how hedge funds are structured and operated, the types 3 of services the various service providers provide to hedge 4 funds, and really to give an overview of the current state of 5 the hedge fund industry. 6 We have our Commissioners present, Commissioner 7 Glassman, Commissioner Atkins, Commissioner Campos, and, of 8 course, Chairman Donaldson. Commissioner Goldschmid is going 9 to be joining us later this afternoon. 10 But we do have a distinguished group of panelists, 11 and I'd like to take a quick moment to introduce each of them 12 to you. 13 To my far right is Joel Press. Joe is a senior 14 partner at the accounting firm of Ernst & Young. He's been a 15 contributing author to a number of articles and industry 16 publications in the hedge fund area and is a leader in the 17 field of hedge fund accounting. 18 Next to Joel is Robert Schulman. Bob is the 19 Chairman and CEO of Tremont Investment Management, and he's 20 co-chief executive officer of Tremont Advisers, a hedge fund 21 consulting firm that focuses on advising individuals and 22 institutions investing in hedge funds. 23 Next to Bob is William Keunen. William is the 24 Director of Citco Fund Services. It's a firm that provides 25 custodial and fund administration services for the 1 international fund industry, including hedge funds, and 2 they've been in this business for over 30 years. 3 On my immediate right is Mike Neus. Michael is a 4 principal and the chief general counsel of Andor Capital 5 Management. They manage hedge funds. Mike oversees all of 6 the legal and regulatory matters and is also Andor's chief 7 compliance officer. 8 On my immediate left is Charles Gradante. Charles 9 is the managing principal of The Hennessy Group, LLC, a hedge 10 fund consulting firm that he co-founded with Lee Hennessy in 11 1997 after 11 years in the business division of several major 12 financial institutions. They're in the business of advising 13 individuals and institutions regarding hedge fund investing. 14 Next to Charles is David Vaughan. David's a 15 partner in the financial services group of the law firm of 16 Deckert, LLP, in Washington, where his law practice focuses 17 principally on advising hedge funds. 18 Next to David is Dr. Richard Lindsey. Richards is 19 president of Bear Stearns Securities Corporation. They 20 provide prime brokerage, broker-dealer, and registered 21 investment adviser clearing services. And prior to joining 22 Bear Stearns, he served at the SEC as the director of the 23 Division of Market Regulation, and also as the SEC's chief 24 economist. 25 And then next to Richard is Greg Newton. Greg is 1 the president of Managed Accounts Reports, LLC, known in the 2 industry as MAR, a New York-based publisher of several 3 newsletters covering the alternative investment marketplace. 4 It seems appropriate that to begin our discussion, 5 we ought to really try to understand, when you use the term 6 "hedge fund," what we're really talking about. 7 David, could you maybe define "hedge fund" for us, 8 or what people typically view as a hedge fund, and maybe how 9 a hedge fund is distinguished from other types of private 10 investment vehicles. 11 MR. VAUGHAN: Sure, I'd be happy to. I heard some 12 people in the audience kind of laughing to themselves as they 13 heard that I was going to try to define hedge funds, because 14 I think most people in the audience and everyone on the panel 15 knows there is no precise definition of "hedge fund." 16 It's a term used in the industry, people seem to 17 know one when they see one, but there is no legal definition. 18 Usually we're referring to an unregistered fund, 19 not registered with the Commission, typically relying on 20 Sections 3(c)(1) or 3(c)(7) for that exception from 21 investment company regulation. 22 They're usually characterized by the ability to do 23 short selling or leverage or other types of more or less 24 exotic strategies, nontraditional strategies. They often 25 have performance-based compensation. And the thing that 1 makes it a little difficult to know where to draw the line 2 is, there are lots of other funds that may have some of these 3 characteristics, or even all of them, that do not consider 4 themselves hedge funds for one reason or another or not 5 considered by the industry hedge funds. 6 Some of the more obvious examples are private 7 equity and venture capital funds, which are really 8 distinguished more by the level of liquidity of the fund, and 9 that they don't mark their assets to market typically, 10 although, again, that's not a bright line. They are hedge 11 funds that have some crossover aspects to them. 12 And so that's about the best we can do in 13 describing what a hedge fund is from a legal or even a 14 business perspective. I'd be interested in anyone else's 15 views as far as other views as what are essential 16 characteristics of hedge funds. 17 MR. LINDSEY: I think from a business perspective, 18 it can be described somewhat -- a little differently, and 19 that is, that hedge funds are actually nothing very much 20 different than the proprietary trading activities that exist, 21 and have existed for a very long time within street firms. 22 So if you take a proprietary trading desk from one 23 of the major houses of a street and you privatize that 24 operation, that's really what a hedge fund is. And many 25 times, of course, that's where hedge funds even come from, 1 are those traders that step out of the proprietary -- or step 2 out of the houses and form their proprietary interest. 3 Of course, the way that they have to do business 4 is, they have to have capital, they have to have a way to do 5 that. So, typically, they go about with a Reg D offering, 6 they raise capital, and then they invest that capital in the 7 fairly typical proprietary trade strategies. 8 CHAIRMAN DONALDSON: I'd like to comment on that. 9 There's been a reduction in proprietary trading on Wall 10 Street in the last decade. As investment banking firms have 11 gone public, seeking earnings that are stable and more 12 predictable, they've cut back on proprietary trading. 13 It's not a figure I can quote, but it's a feeling 14 that I get from talking to fellow compatriots on the street. 15 And those people leaving proprietary trading desks have gone 16 into the hedge fund industry. Quite simply, the compensation 17 factors are quite similar to what they were receiving on Wall 18 Street to what they would be receiving as a hedge fund. 19 MR. SCHULMAN: And just to amplify for one second, 20 if I could. What we're hearing from managers as they come 21 out of proprietary training desks, of course, is, they're 22 embedded in brokerage firms that have gone through a 23 relatively difficult earning cycle, which means that their 24 earnings are down. 25 So we're at a time now where there's significant 1 inducement for a lot of these people to come out of the 2 marketplace -- come off the trading desks and out on their 3 own. There's little to lose, because their pay scale is down 4 simply because the firm has not done well. 5 But it's not fair to categorize everything as -- 6 every hedge fund as something that would otherwise exist on a 7 trading desk in a brokerage firm. A lot of them are 8 research-driven and not execution-driven. And I think you 9 really have to look at the market in those two ways. 10 Some of them are brilliance of execution and 11 brilliance of trading. Probably more of them are driven by 12 some kind of internal information edge, research edge, or 13 asset allocation edge, not just trading skills. 14 MR. PRESS: I think also you have to look at hedge 15 funds as entrepreneurs. It really is a business of people 16 wanting to create their own culture, their own environment, 17 instead of working either in a large organization, but 18 creating their way of earning dollars in a way that's unique 19 to them, in their own strategy, their own people, their own 20 compensation environment, and allowing them to exist in 21 today's technology wherever they choose to set up their 22 organization and just work and trade and do their research. 23 It's a very unique entrepreneur. No different than 24 any other business in America, but it really is a group of 25 very successful entrepreneurs. 1 MR. ROYE: When you talk about hedge funds, I know 2 there are, you know, just a variety of different types of 3 hedge fund strategies. I guess either Charles or Bob, could 4 you kind of maybe outline the types of various strategies out 5 there in the hedge fund world and how you sort of categorize 6 them generally? 7 CHAIRMAN DONALDSON: Well, we have categorized -- 8 or located 23 different strategies. Lee Hennessy, our 9 founder, saw the need in order to benchmark our consulting 10 practice, the managers we were investing in on behalf of our 11 clients, to put managers into categories, and fundamentally 12 we started using the categories we found in the traditional 13 world, growth, value, and other categories like that. There 14 are 23. 15 And in arbitrage, there are convertible arbitrage 16 and merger arbitrage, and I can -- I don't think we need to 17 list the 23 strategies. 18 But I think what's important is that the need to 19 categorize hedge funds in order to benchmark their 20 performance against their peer group is something that 21 consultants find the need to do. 22 MR. NEUS: I think that one way to look at it is, 23 if you group those various strategies, and because it's an 24 entrepreneurial industry, there are a tremendous number of 25 variations within each strategy and crossover strategy. 1 I think one useful way is to bucket them in three 2 basic groups: market neutral strategies, event-driven 3 strategies, and directional strategies. And that's linking 4 it from the least risky or volatile to the most risky. 5 And it's useful to do that, because then you can do 6 the comparisons between private investment funds, on the one 7 hand, mutual funds, private equity, or other alternative 8 investment asset classes on the other side. 9 MR. SCHULMAN: Another way to look at it is, 10 understanding there are a few strategies that dominate from 11 Charles's list, or even from the list that we just talked 12 about. 13 Long short equity is 35 to 40 percent of all of the 14 money, so it is by far the largest strategy. The other big 15 strategies are the global macro strategies. Recently 16 convertible arbitrage and distressed have become big 17 strategies. 18 Although there may be lots of sub-strategies, 19 contained in that first list of seven or so you're going to 20 find the vast majority of the money. 21 MR. PRESS: But, again, hedge fund people, when you 22 talk to them, the reason there's 5,000 and maybe growing is 23 because each of them feel they bring a uniqueness to what 24 they do, and each has a slightly different way to approach 25 the market, and each will tell you that in general for their 1 strategy, there is a limit to the amount of capital they 2 would want to trade and will work with. 3 And most will find that there is a level that 4 they're comfortable with, and it may take years to grow into 5 in building up a staff and credibility to take on more 6 capital, and it's a very organized, coordinated process in 7 growing their business. 8 MR. KEUNEN: Now, one of the trends that we've seen 9 in terms of capital flows is that capital has flowed out of 10 long short equity funds over the last couple of years into 11 some of the other strategies that were mentioned, in 12 particular, macro arbitrage and fixed income strategies. 13 CHAIRMAN DONALDSON: Paul, I wonder if I could ask 14 a question. And I understand that the Commissioners are 15 allowed to ask questions -- 16 MR. ROYE: Of course. 17 CHAIRMAN DONALDSON: -- without anything being 18 attributed to -- behind that. 19 But what's been the experience of the panel on 20 people who have set out a strategy in some sort of an 21 offering circular and then change it? What happens when that 22 happens? 23 MR. SCHULMAN: As the funds get larger, it is much 24 more difficult for them to do that without it becoming -- 25 without bells going off. 1 In cases of small funds, especially in long short 2 equity, we've seen some of that, not as much as you would 3 think. Typically, these are very small organizations run by 4 a few entrepreneurs that have a particular area of expertise. 5 It becomes pretty good news and it spreads pretty 6 rapidly through the industry if somebody really abandons 7 their knitting. 8 I don't know about anybody else on this panel, but 9 we don't want to pay 1 in 20 for anybody to learn anything. 10 We're paying 1 in 20 or 2 in 20 for people who are already 11 experts in it. So -- 12 MR. PRESS: If I might -- and hedge funds really 13 adhere to their offering document which defines their 14 strategy and the partnership agreement that also sets in 15 stone effectively their strategy. And most stay within that 16 strategy in my 35 years working in that industry. 17 Where they change or may go differently is, they'll 18 form a new product that allows them to work in a new area, 19 and they have a new offering document, a new partnership 20 agreement that defines the scope, services, leverage issues, 21 and how that strategy operates relative to that performance. 22 But they're very careful. There's always those 23 exceptions, but in my experience it's really very rare, and 24 they don't have what we call "style drift." 25 CHAIRMAN DONALDSON: Just as a follow-on, would 1 your experience indicate that they would communicate with 2 their investors if they've changed the strategy or -- 3 MR. PRESS: In my experience, any time they would 4 go for a style change, they would need to go, per the 5 offering document and the partnership agreement and get 6 permission to go outside. 7 For example, if someone said they could not go 8 short in their offering document, and then decided to go 9 short, they'd have to ask for permission from their 10 investors, and then would about going through a partnership 11 amendment offering document change. 12 So where there are changes, they do go back to 13 their investors and get permission to make those changes. 14 MR. SCHULMAN: And most funds have become pretty 15 good now. And I would say, again, there are exceptions that 16 can demonstrate every concern that this panel might have. 17 But the vast majority of funds do write quarterly 18 letters, and they are quite forthcoming, more forthcoming 19 than the mutual fund industry might be about what their 20 strategy is, what's working, and what their approach is. 21 Perhaps not down to the security level, but certainly down to 22 the type of security, the sector in the industry, and the 23 exposures to the market. 24 There's very good information in those quarterly 25 letters. They have conference calls, they have web sites in 1 many cases, and they're pretty good at communicating that, 2 much better than they were a few years ago. 3 MR. ROYE: Regarding the comments from Joel and 4 Bob, I've seen very little style drift, and managers tend to 5 stick to what their offering documents say, and if they 6 don't, they're advised by legal, by counsel, to notify the 7 limited partners of any movement or any style drift that they 8 feel necessary to fulfill the objectives of the partnership. 9 MR. VAUGHAN: I think one thing in recent years, 10 too, is many of the documents have become more detailed in 11 what exactly the strategy is, and more detailed in what the 12 investment guidelines are; and, as those guidelines need to 13 be adjusted as a style evolves, people do go back to their 14 investors and get permission and give them notice of what the 15 changes are going to be, even if it's a relative -- what 16 would be viewed as a relatively minor change, because the 17 investors are looking for somewhat more detail on these 18 documents, so that it can be triggered if there is style 19 drift. 20 MR. NEUS: I think lastly is -- there's been an 21 increasing tendency for investors to be more activist and 22 investors know a lot more and are much more willing to 23 actively engage the managers. And so I think that the time 24 period is compressed by which changes in the past may not 25 have been communicated as quickly. 1 MR. ROYE: I just want to push back a little bit on 2 this point because in the course of our review, you know, we 3 saw a number of private placement memoranda that did indeed 4 set out a strategy that was going to be employed by the hedge 5 fund manager. But we saw tremendous flexibility to deviate 6 from those strategies in the document, a lot of flexibility, 7 and a lot more flexibility than we typically see in mutual 8 fund registrations. 9 So, I guess, my question is is it a matter of 10 practice that they don't deviate, even though I think in a 11 lot of the documents that at least we saw, there was a lot of 12 flexibility for the manager to really move into another style 13 if circumstances dictated. 14 MR. GRADANTE: I think there is a lot of 15 flexibility in the offering docs when you compare them to, 16 you know, a mutual fund placement; but I think that is the 17 nature of the hedge fund industry. We're entrepreneurial and 18 so it's not, you know, not to give the impression that hedge 19 funds are a bunch of cowboys out there winging it, they do 20 have a defined offering doc, but is very broad to give them 21 and allow entrepreneurial, you know, spirit in investing. 22 MR. SCHULMAN: Just to amplify for another second. 23 These are absolute return vehicles. They come with very 24 broad mandates. They typically have a clientele, a 25 traditional clientele, which is a very high net worth, U.S. 1 and European clientele, that is premised on the idea of not 2 losing money in most cases. They are not mutual funds. They 3 don't have mutual fund kind of narrow mandates. 4 And, as a practical matter, if we looked at what's 5 happened in the mutual fund industry in the last three years, 6 if you have a narrow mandate and you have to be fully 7 invested, you don't actually get to avoid the catastrophic 8 impacts of the market. 9 The hedge fund industry has avoided, in large 10 measure, the catastrophic impacts of the market by having 11 enough flexibility in the document and using it to react to 12 what you would call different market conditions. It's hard 13 for a technology mutual fund that says it's going to be 100 14 percent invested to not have a very bad run when technology 15 has a very bad run. 16 MR. PRESS: It's also critical -- it's not style 17 drift. When they raise the capital through the offering 18 document and the partnership agreement, they're very careful 19 to define the scope of what they're allowed to trade and how 20 they'll use those instruments. 21 And the investors know very well that -- in some 22 cases you might say they're opportunistic reacting to the 23 market, either on a daily, trade-by-trade, or on a 24 philosophical strategy basis on a much longer term, but they 25 stay within that category. 1 MR. ROYE: You see articles about hedge funds being 2 risky, more risky than mutual funds. Any comment on that in 3 terms of various strategies and whether or not there's any 4 truth or merit to that? 5 MR. SCHULMAN: I think you only have to go back 6 to -- well, you can go back as far as you'd like or as short 7 as you'd like. You can go back to any period of real 8 dislocation and look at how hedge funds have performed, or 9 especially fund-to-funds have performed, which is a 10 diversified approach to hedge funds relative to mutual funds. 11 The typical mutual fund in the last really, really, 12 really bad month, which I guess would be August or September 13 of '98, with the Russian crisis -- the typical mutual fund 14 was down in the mid-20's. The average hedge fund was down 15 less than 5. The average fund-to-fund was down less than 3. 16 When you look at the volatility studies of the 17 hedge fund industry, whether it be individual hedge funds, or 18 whether it be fund-to-funds, virtually any metric that you 19 would take to measure how they've done -- if performance is a 20 fair measure of volatility -- suggests that diversified hedge 21 fund investing is much less volatile than diversified stock 22 market investing. And probably approaches the volatility of 23 domestic mid-maturity bond investing in terms of the actual 24 risks. And long term, the risks of the hedge fund industry 25 in aggregate, and now I'm just using our own index, is 1 less -- slightly less than half of that of the S&P. 2 MR. PRESS: Again, here's where the strategies make 3 a big difference. If you look -- you can't look at absolute 4 return. You have to really look at what that hedge fund 5 manager says they're trading, how they're trading it, what 6 they will do within market parameters -- because if you look 7 at the S&P or the Dow, most hedge funds do not look at those 8 as relative to their own styles. 9 So when you're making that investment, they define 10 their risk, they define what they'll call a draw down -- what 11 they think the maximum loss is in a month or in a quarter. 12 And by and large, hedge funds pretty well stick to those 13 numbers; and if the market may be up 40 percent, a hedge 14 fund, for its style, may be up only 18 percent. 15 And people are investing knowing those strategies 16 and knowing those risk parameters, because the managers are 17 very careful to disclose them. 18 MR. GRADANTE: I'd like to make several points. 19 You know, many feel that assuming risk creates a risky 20 investment. We believe that hedge funds expose themselves to 21 risk in an intelligent way. Is shorting necessarily a 22 risking strategy? We believe intelligent use of shorting and 23 derivatives by hedge funds can reduce risk. 24 Leverage doesn't always mean you're taking on more 25 risk. In fact, banks -- of which I was a CEO of one -- and, 1 as Mr. Lindsey mentioned earlier, proprietary trading desk at 2 investment banks are also using leverage. 3 Hedge fund managers add risk with respect to the 4 portfolio as a whole and the prudence of the strategy. 5 Making an investment, which in and of itself assumes greater 6 risk, does not necessarily increase the risk of the overall 7 pool. 8 You know, risk often is measured in terms of 9 volatility risk, leverage risk, and portfolio risk. With 10 respect to volatility risk, which is often measured by 11 standard deviation, as Joel and Bob reported, I think Bob 12 mentioned that the S&P 500 is about double the hedge fund 13 universe. And we see the same thing. And we have indices 14 that go back to '87. 15 Since 1987, the S&P 500 has averaged 18 percent in 16 standard deviation -- I'll drop the decimal points -- and the 17 Hennessey Hedge Fund Index has an average standard deviation 18 of 11 percent. 19 Leverage used by hedge funds is often exaggerated. 20 Our surveys show that 84 percent of hedge funds never use 21 more than Reg T. For the majority of the industry, 22 long/short equity, the average gross exposure will range from 23 a high of 159 percent in 1999 -- that's a average -- to a low 24 of 117 percent in 2001. 25 Only 2 percent of hedge funds we've surveyed -- and 1 our survey was 193 management companies, 763 hedge funds, 2 and, I believe, $137 billion, or about 23 percent of the 3 industry -- only 2 percent used leverage over 500 percent. 4 So -- and in our survey, we exclude CTAs. Since 5 they're registered, we don't include them in the world of 6 hedge funds. But CTA leverage is a whole different matter. 7 Portfolio risk management has greatly improved in 8 the industry as the industry is involved. You know, we're 9 seeing a lot greater use of value-at-risk position limits and 10 stop losses. 11 And, as we mentioned earlier, the performance in 12 this bear market has been another measure of risk. Hedge 13 funds, during this bear market, have out performed 14 traditionally managed, long only, vehicles -- which is a 15 positive, not a negative. And approximately 8 to 9 out of 10 16 hedge fund managers, whether they be arbitrage or long/short 17 equity, have out performed the S&P 500, which represents a 18 diversified portfolio of securities. 19 MR. LINDSEY: I'd like to add a couple of things to 20 what Charles just said. 21 I think that if you look at the averages, hedge 22 funds are somewhere on the order of 4 to 1 maximum leverage. 23 If you look at banks, they're probably in the range of 6 to 8 24 to 1. If you look at broker dealers, they're probably in the 25 range of about 15 to 20 to 1. 1 So in terms of just that pure business, it hearkens 2 back a little bit to what Robert was saying -- is that a 3 large part of the investor base for hedge funds are 4 interested in capital preservation; therefore, the hedge fund 5 managers are interested in capital preservation. 6 And hedge fund managers also have some additional 7 incentives that are built in -- both in terms of the way 8 they're compensated, and the way they're not compensated if 9 they don't meet certain hurdle rates. So if they haven't 10 exceeded a hurdle rate, indeed, their compensation may be 11 dramatically different. 12 So they have an incentive to preserve the 13 performance and preserve the capital. 14 The second point that I'd like to make is if you 15 take a look at sharp ratios associated with hedge funds, 16 you'll find that they actually have very good sharp ratios 17 compared to most standard indices -- meaning, of course, that 18 the return-per-unit risk is actually very good. 19 And finally, I think it's important not to under 20 estimate the value of a portfolio. I don't think anybody in 21 this room would ever advise that you put all of your money 22 into any one investment period. And that's the reason for 23 diversification; and that's the reason for the portfolio 24 effect. 25 When you look at hedge funds as a asset class, if 1 you want to think about it that way -- and there's plenty of 2 academic quirk that can demonstrate that hedge funds look 3 very different than mutual funds, look very different than 4 stock returns, look very different than anything else -- it 5 looks like a very different asset class, both in terms of the 6 mean return, standard deviations, skewness, kurtosis -- 7 whatever metrics you want to apply. 8 And when you look at that, they're fairly 9 uncorrelated with the market, or relatively less correlated 10 with the market. So when you include hedge funds as part of 11 an overall portfolio, you actually increase return and 12 decrease risk. So it's more a matter of what's that 13 diversification effect worth, rather than the idea that any 14 individual investment is or is not risky. 15 COMMISSIONER GLASSMAN: Can I ask a question, Paul? 16 To any of you. What's the failure rate of hedge funds and 17 how does that compare to any relevant benchmark? 18 MR. SCHULMAN: We have some numbers on that which 19 we have published. Last year it was an all-time high. It 20 was at about 14 percent. There was about -- we estimate 21 about 700 funds closed. And I'd like to distinguish closed 22 from failed. 23 Seven hundred ninety-six of the funds that closed 24 closed up, sent the investors their money back, and said I'm 25 going to the beach, thank you. Most of those closed because 1 they had performed poorly for two years, and were in danger 2 of losing the bulk of their investors, and it did not make 3 economic sense for them to continue. 4 Nobody lost money they shouldn't have lost. Nobody 5 dealt with a failed situation. These companies didn't go 6 bankrupt; they went through an orderly close down, which 7 happens in the mutual fund business and in the asset 8 management business all the time. 9 While 700 funds were closing last year -- I know 10 Greg may have different numbers than this -- we think about 11 1300 new funds started. And we have found closing rates to 12 vary between 8 and 15 percent, depending upon market 13 conditions. 14 A lot of very small long/short equity managers 15 closed because they were reaching their second year of bad 16 performance, their clients or their limited partners were 17 withdrawing, they effectively did not have a business. So 18 they, on an orderly basis, just closed the business. 19 And Joel's finishing up the audits on those as we 20 speak. So he can probably speak to what a typical close down 21 might look like. 22 MR. PRESS: I also think we missed the point here. 23 A hedge fund is very different than mutual funds -- again, in 24 the risk area. All really have their own capital invested. 25 And in setting up the hedge funds, especially start-up hedge 1 funds, the key for raising capital is the fact that they're 2 putting in most of their liquid net worth and they keep that 3 money there. 4 So when it comes to risk and managing risk, that's 5 a real part of the capital. And in some cases, it can be as 6 much as 20 percent of the capital; and, in the larger hedge 7 funds, the staff, the employees, have their money and they 8 effectively are eating their own lunch. 9 Very different than other investments where there 10 is a proprietary trading desk -- unless you own stock in the 11 company -- but it's not a direct relationship and in the 12 mutual fund industry. 13 And here's where there's a huge difference in 14 capital and how people approach risk because it's really 15 their own money also. And it does have an impact. 16 MR. NEUS: I'd like to ask you one more thing and 17 that's to pick up with something that Chairman Donaldson 18 asked before. When speaking about hedge funds, if the 19 average hedge fund is less risky or more risky, I think that 20 misses the point. It's not a monolithic institution. Hedge 21 funds, by and large, are incredibly entrepreneurial; are 22 constantly innovating and mutating. 23 So if you look at the 7,000 hedge funds, there's a 24 continuum for much less risky, on a volatility basis, to a 25 mutual fund, say, in the arbitrage area, to going through the 1 continuum to manage futures or macro-funds, which have 2 largely exhibited a greater volatility. 3 And if you look at a portfolio basis of -- as an 4 investor -- an investor may want to hire risk-reward ratio; 5 and so that's why it's important to make sure that they're 6 selecting the right hedge fund to the right strategy for 7 them. I don't think it's necessarily a fair comparison to 8 say, "Is a mutual fund more or less risky than a hedge 9 fund?," because it varies widely. 10 MR. NEWTON: I could just make one quick point that 11 hasn't been mentioned so far. There is a pretty substantial 12 pile these days of academic research on hedge funds, managed 13 futures, and various other bits and pieces, and I'm not aware 14 of any of it which indicates that adding hedge funds to a 15 portfolio, hedge funds as a class -- if they are such a 16 thing -- are inherently riskier, more volatile, than 17 traditional investments. 18 In fact, you know, the over-whelming evidence that 19 I'm aware of is that adding these things to a portfolio 20 almost always reduces their volatility and enhances their 21 performance. And I think that academic research is out there 22 at the moment and it's very important. 23 MR. SCHULMAN: And I would suggest that there are 24 people around the stable who would be happy to supply the 25 Commission with whatever -- if the Commission is not 1 convinced that diversified hedge fund investing reduces the 2 risk of equity investing by the addition, I think there are 3 people around this table who would be happy to do the 4 research in as an exhaustive fashion as they would like, or 5 supply them with the research that's been done. 6 That is not something that I think is in dispute 7 any more. 8 MR. VAUGHAN: I'd just like to comment that sort of 9 ties the two questions together. We're saying hedge funds 10 are not inherently risky, but the press and the offering 11 documents tend to talk about risk and speculation. I think 12 the reason behind that is sort of two-fold. 13 One is because these hedge funds tend to be 14 entrepreneurial. There's a risk that the entrepreneurial 15 enterprise simply won't make it, that the fund will go out of 16 business in a couple of years not having achieved what they 17 really thought they could; and, therefore, there's that risk. 18 And one of the reasons, coming from the legal 19 side -- that the offering documents may seem to be pretty 20 vigorous in their description of risk -- is that often these 21 risks are risks with which at least some investors are just 22 not familiar. Most investors, all investors, ought to be 23 familiar with general market risks. 24 But some of the risks that they're incurring in 25 hedge funds, even if they're not inherently more risky than 1 other investments, are simply novel to the investors; and one 2 wants to be sure that they understand that these risks are 3 different and not be lulled into thinking, because the fund 4 is less volatile, that it is therefore not at all risky. 5 MR. PRESS: Also, hedge funds, because they're 6 entrepreneurial, embrace new strategies, embrace different 7 ways to approach risk -- and on the cutting edge of those 8 strategies. And because of that, they approach risk from a 9 very technical, academic, modeling point of view. Especially 10 as credit derivatives develop, they'll be the first to look 11 at them and try and figure out how they operate, whether it's 12 within their style, and how it will make their strategy safer 13 within the volatility of their strategy. 14 MR. GRADANTE: And in this bear market, Morningstar 15 has reported -- and I believe I'm quoting correctly -- that 16 mutual funds have failed at a rate of about 5 percent per 17 year. There was mention earlier about an 8 to 15 percent 18 failure rate among hedge funds. I'd like to expand that a 19 little bit because it could be misinterpreted. 20 We see four kinds of closures that can be lumped 21 together and interpreted incorrectly. One is the out-right 22 failure -- liquidation through the fund not being able to 23 perform. 24 The second is a voluntary liquidation due to the 25 fact that that's the only way a hedge fund manager can exit a 1 career. He decides to retire and he liquidates his fund. 2 Thirdly, funds that are functioning but are closed 3 to new capital is a large portion of the closures that fall 4 off databases and get counted as terminations. 5 And then the fourth one is -- although it's a small 6 part of it, but it is a part of it -- there are time hedge 7 funds. There are hedge funds out there that have a time 8 limit to them. They will close down after five years, or 9 after ten years. 10 All in all, we see the failure rate -- actual out- 11 right failure rate -- at 5 percent; and then the remaining 10 12 percent is voluntary closures. 13 I might just add -- and speaking here and to the 14 Webcast out there -- that we would love to see any of that 15 academic research that's out there. We would welcome that 16 being sent into the Commission. 17 MR. ROYE: Let me just follow up on Commissioner 18 Glassman's question about the closures. And to what extent 19 do you see hedge fund managers, where they have not 20 performed, shut down the fund, resurfaced elsewhere? Either 21 affiliating with somebody else, starting another hedge fund. 22 Does that go on? And what happens to their track record and 23 are any potential new investors in a new fund aware of that 24 typically? 25 MR. PRESS: My experience has been when a hedge 1 fund manager shuts down, again, there's all these reasons 2 that we just talked about -- when they decide to retire and 3 come back into the business, they will come back in, it will 4 be disclosed in their offering document that they took a 5 period of time off. And in fact, if the strategy is the 6 same, they will tell what their strategy was for that period 7 of time and so forth. 8 Many that come back that have maybe lost money. 9 Very often, in my experience, they will continue to offer to 10 their old investors the concept of what's called the high 11 water mark. Hedge fund managers do not get compensated until 12 they make money, so if you put a dollar in and it went up to 13 a dollar fifty, the hedge fund manager would be compensated. 14 But if it lost money, the hedge fund manager doesn't get an 15 incentive fee; they would get a management fee. 16 Until they go back to the dollar fifty, they cannot 17 make more money on the incentive side. And very, very often 18 the managers, because of integrity issues, will put back the 19 high water mark for their old investors. 20 So in terms of the integrity of the process -- now 21 there are others that have surfaced. If they joined another 22 hedge fund, and they're not part of management and so 23 forth -- they're just part of the participants -- there's no 24 issue. It is disclosed, usually in the letters to partners 25 and -- limited partners, about changes in management and 1 additional traders and so forth. 2 MR. SCHULMAN: The typical advisory firms are now 3 doing background checks and full reviews of what the 4 background has been. Although people have come back into the 5 business, it's relatively unusual. 6 Lots of people their funds -- in some cases -- and 7 I agree with Charles about a third of those cases are from 8 people who decided they just didn't want to do it any more. 9 "I wanted to take some time off." Those people have come 10 back; they've gone back to their old clients; they typically 11 have gotten the money back from the old clients, if they've 12 done well. 13 It's relatively unusual to have somebody burn up in 14 the atmosphere. A real flame-out in terms of a closed down, 15 really did very poorly; and successfully come back into the 16 business alone as a stand alone entity. It doesn't happen. 17 Memories are quite long. People like me, and 18 Charles, and Joel, are around to remind people. 19 COMMISSIONER ATKINS: Yes, I'll show you. That's 20 one thing I wanted to ask about. It's a relatively small 21 society, this; and so I was going to ask you if someone could 22 speak to the reputational aspect of this and how those 23 memories are? 24 MR. NEWTON: Those memories are great because I 25 know that we, as a newsletter in this business -- when we 1 hear that someone who has perhaps closed a fund or something, 2 we're all over that like a rash. You know, when someone's 3 coming back into business after perhaps shutting down because 4 he was so far under his high water mark that he, you know -- 5 the bubbles weren't getting to the surface -- that happens. 6 But it's covered very widely and fully. 7 And I guess, you know, you're not around a hedge 8 fund any time for very long before the subject of long-term 9 capital management comes up. And the fact of the matter is 10 that people who have been associated with substantial 11 failures still have sufficient credibility in the marketplace 12 to be able to reappear in the business. It happens. 13 But it's no secret. Their past is no secret. 14 COMMISSIONER GLASSMAN: Presumably, the funds of 15 funds then obviously have the same information and you would 16 avoid those funds as well? Is that a logical conclusion? 17 MR NEUS: But speaking as somebody who is on the 18 other end of filling out those due diligence 19 questionnaires -- field that one -- I think what happened in 20 the last -- I've been in hedge funds -- in-house counsel for 21 10 years, and before that, outside counsel -- and I think 22 what's happened is that the investors have become much more 23 activist, much more interested. The use of consultants has 24 expanded. 25 The investor base has changed from a largely high 1 net worth, both on shore and off shore, to a more 2 institutional investor base. And the institutions, whether 3 they're fund-to-funds, or pensions, or insurance companies -- 4 the institutions tend to have a much more rigorous process. 5 Whether they do it internally of whether they hire a 6 consultant, they do more than kick the tires. They audit. 7 Sometimes they audit results, they do background checks, they 8 do a huge amount of legal work internally, as well as 9 externally -- talking to other investors. 10 And so that the entire process of investing into 11 hedge funds has changed dramatically from a time when it was 12 a cocktail party chatter -- "Which of your investments have 13 done better?" I think the industry as a whole has changed 14 dramatically. 15 The fund-to-funds business, in particular -- 16 because the fund-to-funds has to be generally a registered 17 investment advisor, the fund-to-funds, when they're choosing 18 the hedge funds in which they're going to invest, have a 19 higher due diligence level in disclosure information. And 20 that is, I think, raising the bar across the board on the way 21 hedge funds are operated and the level of disclosure that's 22 out there. 23 MR. PRESS: One of the reasons fund-to-funds have 24 become so important is the complexity of these strategies for 25 people to understand. Fund-to-funds have a tremendous 1 infrastructure dealing with risk strategy and have a great 2 understanding of what those hedge funds are. 3 So in going through the people they want to invest 4 with, it's an incredible process. Takes months, sometime 5 years, for them to make a decision to make that investment. 6 And then they have a whole monitoring, due diligence process 7 to make sure that it's on track, doing what they say they're 8 doing. And very difficult to get through a fund-to-funds to 9 be able to make a bad investment in terms of style or people 10 that don't belong in the industry. 11 MR. KEUNEN: And the due diligence exercises that 12 fund-to-funds perform aren't just of the investment advisors. 13 They're far more. They're for all the accounts -- including 14 administrators. So we experience due diligence exercises 15 just like the investment advisors. 16 MR. SCHULMAN: I would suggest we have times -- as 17 many people doing that today as we did two years ago, as a 18 big fund-to-funds operator; and the chances of us hiring 19 somebody that has something in their background that we don't 20 know about, at a senior level in the organization, I think is 21 quite small. 22 We have the full financial story of somebody going 23 back to when they came into the business. 24 MR. GRADANTE: I think we're all using third party 25 investigative companies; and, insofar as they can determine 1 prior regulatory infractions and impairments, you know, we're 2 aware of it. 3 But the old Wall Street culture, and I go back to 4 the Wall Street in the '80s, when you had a rogue trader and 5 the whole street knew about it. That has carried into the 6 hedge fund industry. 7 So even though it appears to be a small industry, I 8 think that culture will maintain itself as it did on Wall 9 Street, as Wall Street grew; and that people talk, and we 10 know who are the people who've gotten into problems in the 11 past. 12 So you either get it from a third party 13 investigative company, or you hear about it from the Street. 14 The Street's a small place -- whether it's hedge-fund world, 15 or whether it's the real Wall Street. 16 MR. SCHULMAN: And to Charles' point, everybody 17 around this table understands that it's not in anyone's 18 interest to ever hire someone who's going to do something 19 untoward, so even competitors are pretty good at 20 communicating where they think there's a real problem. 21 So I don't think it happens very much. The rogues, 22 if you look at them, the people who have really been 23 dysfunctional or dishonest, are people who basically raised 24 the money in their country club, typically out of one of 25 the -- not in New York City, or San Francisco, or Chicago -- 1 from a bunch of people who knew absolutely nothing, and had 2 no protection, and never got any of the vetting that we're 3 talking about around this table. 4 MR. LINDSEY: I think it also should be noted that 5 this upsurge in due diligence isn't necessarily a function of 6 some of the headlines we've seen in the last few years. I 7 think it's also a function of the kind of financial 8 institutions, the state pension funds, and that sort of 9 thing, that because of their returns in the traditional 10 sectors, they['re suddenly realizing that they need to be 11 looking at alternative investment vehicles. 12 And, of course, those institutions with their ERISA 13 restrains, and various other things, are inclined to -- and 14 also obvious, you know, at some -- to some level, political 15 exposure -- are also inclined to look much more closely at 16 where they're putting their money in these things because, 17 you know, because of the perceptions that might be out there. 18 COMMISSIONER CAMPOS: Well, what -- if I take 19 everything this panel is saying just at face value, then it 20 appears that hedge funds are safer, they're diversified, they 21 have -- they use prudent leverage, they use prudent 22 strategies, they're involved in maintaining principal, you 23 know, absolute returns. So why shouldn't all of this -- all 24 of these good things be made available to the public, instead 25 of just, you know, privileged people who are qualified 1 investors? 2 MR. GRADANTE: I'd like to comment on that. Now 3 since retail investors already have access to shorting Reg T; 4 options; futures; distressed debt; illiquid stocks: 5 unregistered limited partnerships; oil, gas, real estate, you 6 name it, the core of the issue you're addressing is not the 7 regulatory differences between mutual funds and hedge funds, 8 but how can we protect the retail investor without inhibiting 9 the free determination of hedge fund investment objectives 10 and their uses of investment strategies. 11 We need diversified market choices and capital 12 formation, not homogenized choices. 13 COMMISSIONER CAMPOS: I don't follow what you're 14 saying. 15 MR. GRADANTE: I think what you're saying is why 16 shouldn't -- why should we offer hedge funds to the retail 17 public. And those hedge funds that want to go retail, fine; 18 but then there are hedge funds that want to maintain the 19 entrepreneurial spirit and not be registered as a mutual 20 fund -- and they should be allowed the entrepreneurial 21 freedom to do that. 22 COMMISSIONER CAMPOS; I didn't know the two 23 different issues. 24 MR. SCHULMAN: Let me try to answer it. I'm not 25 sure if my answer will be any better than Charles'. I don't 1 see -- if the Commission is willing to recognize and 2 distinguish between the idea of having more risk from 3 understanding the risk, then there is no reason why you 4 shouldn't want to go as retail with these products if you 5 can. 6 Being involved in retail distribution of hedge fund 7 products, I will tell you it is very difficult to communicate 8 and the less financially sophisticated that an investor is, 9 the more pains you must go to to properly communicate what 10 these complex and very different kinds of risks -- not more 11 risk, but very different kinds of risks -- are. 12 We think this is a wonderful asset class. Everyone 13 sitting here around this room is in this business, makes a 14 living at it, has been successful, and done pretty well, and 15 watched investors do pretty well. So we conceptually think 16 that it is a business that other people would profit from. 17 The question is, is it articulatable and is it worth putting 18 up with the inconveniences that come with it? 19 And that's really a decision for the Commission. 20 We're talking about complex tax filings; we're talking about 21 K-1's; we're talking about, in many cases, delayed or filed- 22 at-the-last-minute tax returns; we're talking about a set of 23 risks that are not necessarily explainable in easy terms to 24 an unsophisticated investor. Which is why there's a 25 sophisticated investor rule associated with these products to 1 start with. 2 If you're asking is the actual outcome worth having 3 available for retail, the answer is yes. Is there a way to 4 easily surmount some of the issues that have been raised 5 associated with it, as in "Can we give enough disclosure?" 6 That's an answer that the Commission has to -- it's a trade 7 off that the Commission has to accept because -- and, by the 8 way, no one is trying, no one has a product out there that is 9 trying to bring this to retail. 10 Everyone is a qualified investor, even when they 11 buy registered products. So we're not talking about 12 unsophisticated investors. If your question is "Should this 13 go further down the line to unsophisticated investors?," that 14 is "How willing are you to have them make a leap of faith?" 15 If they really need to understand the strategies, that's 16 going to be hard in the size commitments you're talking 17 about. 18 COMMISSIONER CAMPOS: Do you really believe that 19 your investors, because they necessarily have a higher net 20 worth, understand what you're talking about? 21 That, to me, the communication issue is the same 22 regardless. If it's something that's complicated, it's 23 complicated. You know, if you're rich, it doesn't mean you 24 understand it any better. So essentially they've taken a 25 leap of faith, you know, in the particular style, the 1 particular situation that's going on. 2 So if communication is the problem, isn't that 3 something that solvable? I mean, you know, we've got all the 4 great communicators in the world in the industry. Moreover, 5 if you balance the risk that the general public is taking by 6 going long, without any protection, in a bad market, I mean, 7 is that their fate that they're supposed to be able to just, 8 you know -- because it's too complicated for you, sorry, you 9 know, there's nothing available. 10 MR. SCHULMAN: The communication issue is the same. 11 You have to communicate what hedge funds are about, whether 12 it's a retail investor or not; but the experience base is 13 different. A sophisticated investor typically has obtained 14 their wealth and experience in manners that make it easier 15 for them to understand what hedge funds are about. 16 COMMISSIONER CAMPOS: I don't necessarily agree 17 with that, but that's -- 18 MR. NEUS: Let me take a different tact. When we 19 talk about the average returns and average volatility for 20 hedge funds, you're doing it over a period of time. And the 21 traditional hedge fund has a lock-up period, a period of time 22 where investors cannot remove their money. 23 It's not an open-end fund like a mutual fund, and 24 the liquidity requirements of the ordinary investor are well 25 suited for mutual funds -- less well suited for a hedge fund 1 that needs the staying power of making sure that they have a 2 stable capital base when some of them are illiquid 3 investments, or areas where they can't necessarily liquidate 4 and realize investments to cover redemptions on a daily 5 basis. 6 Where the retail investor has been involved, and 7 has had a tremendously increased exposure to hedge funds, is 8 through the indirect way of insurance companies, pension 9 funds, charitable endowments. Those organizations where they 10 are professionally managed can take the risk, and can blend 11 the benefits, of a hedge fund as hedging the risk of mutual 12 funds, and other asset classes, on an aggregated basis for 13 the benefit of retail investors. 14 MR. ROYE: We're going to have to move on. There's 15 been references to the size of the industry, that the 16 Chairman in his remarks talked about a $600 billion dollar 17 industry. Is that about right, you guys who observe and 18 track the industry, and others? This notion that there's 19 been a lot of growth in the industry? Has there been growth, 20 and if there has been growth, where's it coming from? 21 Michael, you alluded to the fact that you have more 22 institutional investors, endowments, that are looking at 23 hedge fund investments. What's driving this growth, if there 24 is growth? Because, you know, they're not registered with 25 us. We're not -- we read the press. We've got the $600 1 billion number from simply reading articles. 2 MR. SCHULMAN: Well, I think people like Charles 3 and I gave it to the press, so -- 4 MR. GRADANTE: We have the institutional investors 5 at 30 percent of the industry. The growth is from $53 6 billion in 1998 -- this is all based upon surveys. We're 7 surveying about 25 percent or more of the capital industry. 8 $53 billion in 1998 to $175 billion in 2002. So that's a 230 9 percent increase, or 30 percent. And by institutions, we're 10 including, you know, ERISA, and corporations, endowments, 11 foundations, in that category. 12 MR. SCHULMAN: You know, we think -- Charles and I 13 think the $600 billion is about correct. We think the 6,000 14 hedge funds is approximately correct. That's our polling 15 from the TAS database that we operate. We think those are 16 reasonable numbers, but I think it's important to realize 17 that this explosive growth that has been talked about, we 18 estimate as $32 billion in 2001, and $16-odd billion in 2002; 19 with the fourth quarter of 2002 being negative. 20 And the first quarter numbers are in, by the way. 21 We think assets grew -- and, again, this is not appreciation; 22 this is just the grown of new assets -- by about $6 billion 23 in the first quarter. 24 So you have a business arguably over the last two 25 years that is growing at $25 billion or so a year. That is a 1 rapidly growing, but not an explosively growing business on a 2 $600 billion base. 3 MR. GRADANTE: And just of the growth that has 4 happened since January 2000, or roughly when the bear market 5 began, where the hedge fund industry was around $300 billion 6 in size. So it's at $600 billion. 7 So prior to that point in time, when the S&P was 8 doing 20 - 25 percent, you know, people said, "Why should I 9 invest in a hedge fund and pay one and twenty when I can 10 invest in an S&P 500 fund and get 25 percent?" So a lot of 11 this phenomenon we're seeing lately is the bear market and 12 the performance of hedge funds relative to traditional 13 managed funds. 14 MR. PRESS: I think also this is a global, 15 international market. When you go to England, Australia, 16 Hong King, Singapore, there's a vibrant hedge fund market. 17 That's all part of this industry. So it's not just an 18 American market by far, but truly is an international market. 19 MR. KEUNEN: That's an interesting point because of 20 that $600 billion, a very substantial portion of it is out of 21 Europe. And a very substantial proportion of that -- 22 although Europe's hedge fund management sector is growing, 23 you know, much more rapidly than it is here, in fact, because 24 it's starting from such a small base -- a very large 25 proportion of those European assets are invested with U.S. 1 domicile managers, if not necessarily U.S. domicile money. 2 MR. GRADANTE: We show 55 percent of the money is 3 off shore and 45 percent on shore. 4 MR. NEUS: Of the off shore, Charles, does that 5 include U.S. non-taxable? 6 MR. GRADANTE: Yes, it would include ERISA money 7 and other U.S. non-taxable. 8 MR. ROYE: That's kind of a nice segue. Bob, did 9 you have a comment? 10 MR. SCHULMAN: Yes. I just want to comment one 11 more point here. The vast majority of this growth -- and 12 this would be echoed by these small fund-to-fund operators 13 and the people we've talked to -- the vast majority of this 14 growth is coming institutionally. 15 So although there's been a lot of talk about the 16 retailization of the business, and all of these retail 17 products, the reality is it is large commitments from big 18 public plans and part leaders, like CALPERS and Texas 19 Teachers, that is leading the way towards the growth in this 20 asset. It is not a massive flow of money from retail or high 21 net worth investors using registered products. That's not 22 what's fueled the growth here to date. It may come to be 23 that, but that's not what it's been today. 24 COMMISSIONER CAMPOS: But isn't that diverting 25 institutional monies from the product they normally would be 1 if they're going into hedge funds? Isn't there some -- 2 MR. SCHULMAN: Yes. 3 MR. GRADANTE: I mean, diverting it from what? 4 COMMISSIONER CAMPOS: From operative investments. 5 MR. GRADANTE: No, could be diverting it from 6 venture capital, from private equity. 7 MR. SCHULMAN: Or from -- banks. 8 COMMISSIONER CAMPOS: Yes, I understand. 9 MR. GRADANTE: Okay. Let's move a little bit to 10 structure. You know, we talked about the off shore funds. I 11 guess, we observed that a number of hedge fund managers have 12 both domestic and off shore funds. Can we go into -- maybe, 13 David -- the reason for that, and maybe outline sort of the 14 typical hedge fund structure and how the funds are managed? 15 MR. VAUGHAN: Sure, be happy to. The classic hedge 16 fund structure here in the United States was a limited 17 partnership, with the manager, and potentially management 18 affiliates, providing the management of the partnership, and 19 the investors being the limited partners. The idea being 20 it's the most tax-efficient vehicle domestically in an 21 unregistered form. 22 In recent years, limited liability companies have 23 become popular because they provide the same tax benefits and 24 slightly more liability shield for the manager. 25 The other type of vehicle you typically see is an 1 off-shore corporation, which looks very much like the U.S. 2 corporation. Has a board of directors, typically; has an 3 investment advisor that has a contract with the corporation; 4 and shareholders are the investors. 5 Now this is all simplifying it quite a bit. There 6 are a number of structures I'm sure the staff has seen as we 7 go through -- of different structures, different combinations 8 of this, off shore partnerships, things like that, that can 9 be used in different structures, depending on the tax 10 aspects, the types of investors you have, and where the 11 manager is located. 12 We talked about the itnernationalization. There 13 are certain tax aspects for a manager based in the United 14 States which are different if you're based in the U.K.; and 15 you may want, depending on your investor base -- you've got a 16 taxable U.S. investor base -- they'll typically go into a 17 partnership vehicle. 18 Non-taxable U.S. investors often want to have a 19 corporate vehicle; and the non-U.S. investors typically will 20 prefer the corporate vehicle. And so you often have a 21 combination of these vehicles really designed to appeal to 22 the investors and provide a way, with other benefits that 23 they see to being in off shore funds, for the investors to be 24 comfortable and make it attractive to them. 25 MR. PRESS: Hedge funds also have a very complex 1 compensation structure. They're different than mutual funds 2 where it's one sum of money for all investors at one moment 3 in time. Hedge funds actually track the investment returns 4 by investor domestically; and off shore, which makes it even 5 more complicated because the off shore fund, as David has 6 said, is a corporation -- we actually have separate share 7 classes by kinds of investors so that you can track each 8 investor's return separately. 9 And it becomes very complex. The administrators do 10 an incredible job of doing that accounting for the off shore 11 fund. 12 But it is very different than mutual funds because 13 it's an investor-by-investor performance. 14 MR. GRADANTE: David, you alluded to the fact that 15 off shore, it's a corporation. It would be a board of 16 directors. I guess, typically an administrator. Is that 17 driven by the regulatory framework of the jurisdiction where 18 the hedge fund is organized? 19 MR. VAUGHAN: It's typically, primarily driven by 20 the tax aspects of the fund, plus the off shore investors are 21 often more comfortable in a fund that's administered off 22 shore. And part of the off-shore administration business 23 grew up before a tax law change, which is no longer very 24 recent; but basically required the off shore funds to be 25 administered off shore if they were going to be managed in 1 the Unites States. 2 It was really a tax benefit to encourage investment 3 in the United States, I think, going back to the 1960s. And 4 that was liberalized to allow some of those administrative 5 services to come on shore; but partly out of investor comfort 6 and partly out of just where the infrastructure is, a lot of 7 the administration has remained off shore. 8 MR. KEUNEN: Yes, I'd just like to add to that. 9 Many of the off shore domiciles actually require 10 administration to be performed off shore. But as you were 11 saying, David, the -- when the ten commandments were 12 repealed, we expected many of the functions to move back on 13 shore. And mainly because of investor-driven initiatives, 14 most of those services did not move on shore because the 15 investors remained comfortable with the process the way it 16 was, the way there was an independent administrator, the way 17 that certain functions were performed independently. 18 COMMISSIONER CAMPOS: Well, since everybody's got 19 statistics here, what percent of hedge fund managers are 20 registered investment advisors and what's the difference in 21 performance for their funds, if any? If there's any 22 statistics kept? 23 MR. GRADANTE: I have numbers on that. From our 24 last survey, we asked managers if they were registered 25 investment advisors, CPOs, or broker dealers. And, once 1 again, that's 173 management companies; 793 hedge funds, or 2 14 percent of what we think is the industry; and 20 percent 3 of the capital in the industry. And 75 percent of those 4 surveyed were either an IRA, and/or CPO, and or broker 5 dealer. 6 So they're registered with one of the agencies, one 7 or more of the agencies, on that sample. So to the extent 8 that sample is representative, it is increasing. And that 9 IRA number, by the way, the 75 percent, of that 54 percent 10 were registered investment advisors, up from 38 percent in a 11 prior survey. So there is a movement. 12 MR. SCHULMAN: We have almost identical numbers, by 13 the way. 14 COMMISSIONER CAMPOS: Do you have stats as to 15 who -- which of those managers also managed mutual funds? 16 MR. GRADANTE: No, I don't at this time. But the 17 other question is, well, you know, why this increase? And I 18 think the market is segmenting, or the hedge funds are 19 segmenting themselves into those that need registration to 20 address a client base that requires it, like ERISA money. 21 And then the hedge funds that are not registered 22 are basically saying we don't want to address that 23 marketplace. We will stay with high net worth individuals, 24 and other entities that don't require it. So there are three 25 C-7's being segmented and -- so as money -- as Bob mentioned 1 earlier -- money is moving in from the institutional world, 2 much of which require registrations in order to place the 3 investment, hedge fund managers have been stepping up to that 4 to receive that capital formation. 5 COMMISSIONER CAMPOS: Is there any difference in 6 performance? Registered in some fashion versus not? 7 MR. GRADANTE: I don't have that answer. 8 MR. NEWTON: I was going to say I was pretty sure 9 that if there was a difference in performance if getting 10 registered was going to increase your performance by 5 11 percent. 12 COMMISSIONER CAMPOS: I was thinking -- maybe tell 13 me -- 14 MR. NEWTON: No, they would all be rich -- 15 MR. GRADANTE: I mean, there is -- I think we all 16 have seen a reversion to the mean sometimes. Not for 17 everyone, but some managers, if they get too big, they can 18 revert to some sort of mean; but that's a generalization, 19 that's not true of everybody. 20 MR. VAUGHAN: We don't have statistics on it, but I 21 think anecdotally we do see more registered hedge fund 22 managers, mostly because institutions have gotten into the 23 hedge fund management business and, therefore, have other 24 businesses which drive them to be registered investment 25 advisors. 1 Traditionally, going back 10 years, it was mostly 2 CFTC registration in the industry. Now they're registered 3 advisors, as the institutions have gotten into it, for two 4 reasons: 5 One, to keep talent in the mutual fund organization 6 by offering the ability to do other types of products that 7 the manager finds interesting and challenging; and also 8 because of the interest of investors in hedge funds, being 9 able to offer a full menu of investment products to their end 10 investors by having their own in-house, or proprietary, hedge 11 funds. 12 MR. PRESS: And the Commission has looked at least 13 at almost every organization that I'm aware of where they 14 have mutual funds, hedge funds, or other kinds of investment 15 product, and had extensive examinations on trading, 16 allocations, commissions, and so forth. And, to my 17 knowledge, it's shown to be an incredibly clean examination 18 with great compliance, great procedures being put in place, 19 and some of the conflicts that the press has reported have 20 not come up on those kinds of examinations. 21 MR. SCHULMAN: We have about 100 funds in our 22 database where the manager is also involved, either directly 23 or indirectly, in a mutual fund company. 24 We have also -- a survey -- we also have a study in 25 the TAS database that says a little more than half the 1 managers are RAA's, and I think there's a subsetting: People 2 who are out there building businesses and raising money are 3 registering because it's one of the things you need to do. 4 It's one of the ways that you can raise money. It would 5 involve being registered, whether it's retailization or 6 institutionalization. 7 A lot of the bigger funds that have been around for 8 a long period of time and have operated very successfully, or 9 who are closed to new investors, but have not yet thrown out 10 the existing investors, are not registering because they have 11 no purpose associated with doing it. 12 MR. KEUNEN: Many of the funds that we service also 13 have stock exchange listings. So there obviously there are 14 requirements associated with that. 15 MR. VAUGHAN: One thing to keep in mind, too, the 16 managers that are not based in the United States are often 17 registered in their home jurisdiction. So while the 18 institutionalization -- there may be a few clients who want 19 them to be registered with the Commission if they're trying 20 to give them a mandate, many are comfortable if they're 21 registered with the U.K. regulatory authorities, that that, 22 if they're based in London, is substantial equivalent from 23 their due diligence standpoint. 24 MR. GRADANTE: Did want to move on to just the 25 roles that various service providers play in the hedge fund 1 industry. 2 And since we talked about the domestic off shore 3 fund distinction, William, maybe you could go into an outline 4 of really what off-shore administrators do, the types of 5 services they provide to hedge funds. 6 MR. KEUNEN: Yes, sure. I mean, the first thing to 7 say is that the services that we perform are defined in an 8 administration agreement that is between the fund and the 9 administrator. So that's the first thing; and, obviously, 10 that varies fund by fund. 11 Also, hopefully, the disclosure in the offering 12 documentation properly outlines what the functions and 13 responsibilities of the administrator are. But we tend to 14 split our services between cost services and added-value 15 services. 16 The cost services include accounting, which 17 basically comprises maintaining the books and records of the 18 fund, typically, independently; taking the activities of the 19 fund on a day-to-day basis from the accounts -- to the fund, 20 the prime brokers; reconciling positions and cash balances -- 21 typically, daily; and then, you know, producing a portfolio 22 in cash balances; pricing the portfolio, again, subject to 23 the rules of the fund; calculating fees and accruals; and 24 then, you know, preparing -- calculating the net asset value; 25 and producing financial statements. 1 Typically, the cycles for that are at the very 2 least, you know, at intervals whenever investors can either 3 come or go out of the fund. But they can also be daily, 4 weekly, or monthly. 5 Other services are investor-related services. We 6 typically verify investors in accordance with applicable 7 anti-money laundering rules. We process capital flows. We 8 process subscriptions, redemptions, and other transactions 9 such as dividends, and distributions, and transfers; we 10 communicate with investors on a periodic basis -- typically, 11 monthly, with standard information about the fund and the 12 investor's holdings in the fund. 13 So those are sort of cost services. 14 Added-value services include corporate and legal 15 services; possibly tax reporting, typically in the U.S.; 16 compliance with investment restrictions; compliance 17 monitoring with investment restrictions; and other 18 administrative services. 19 So those are the primary services. 20 And again, over the last few years, we've seen a 21 trend towards out sourcing more of the operational work that 22 hedge funds would have historically and typically 23 traditionally done. And that, you know, that could include 24 operational support such as trade rate reporting, cash 25 exposure reporting, currency exposure reporting, on a daily 1 basis. 2 But again, the parameters are covered fund-by-fund, 3 with the funds that we service, by virtue of the agreement 4 that we have. 5 MR. GRADANTE: Now William, you've outlined some 6 very key functions in terms of accounting, valuation, 7 pricing -- typically occurring by you as the independent 8 third party for what we refer to as off shore funds. 9 Who does that in a domestic fund context and 10 where's the independence? Or is there any independence in 11 terms of those functions in the domestic hedge fund arena? 12 MR. KEUNEN: I think, again, for domestic funds, it 13 tends to vary and it depends on the fund and the nature of 14 the fund. But, you know, I guess there are a number of 15 different parties who perform this. For some funds, it's 16 done in house by the investment advisor. For other funds, 17 it's done by the administration. 18 We see a trend towards more independent 19 administration for domestic funds. And for other funds, it's 20 done by sometimes the accountant. 21 MR. NEUS: I think also the prime brokerage plays 22 an increasing function on both the off-shore and domestic, 23 but specifically with regard to reconciliation, valuations, 24 and the other issues. 25 MR. PRESS: There are numerous checks and balances 1 within the hedge fund organization; but again, it also 2 depends -- as an entrepreneurial organization, some hedge 3 funds can just be the manager. That doesn't require lots of 4 technology, if he's trading long/short. Call your broker to 5 execute the trade. It goes right through on a bookkeeping 6 service, or you can do it yourself. Not a lot of checks and 7 balances to very large organizations that have no different 8 than a mutual fund complex, or broker dealer complex -- a 9 very elaborate compliance, accounting, risk, technology, 10 analytics, and so forth and so on. 11 And each organization really has to structure it, 12 but the administrators have the -- driving force, and the 13 bookkeeping, and accounting part. To my knowledge, no big 14 four accounting firm does bookkeeping for -- as a part of its 15 business. It's just not something that we do. It's also a 16 conflict in our minds; so bookkeeping is not done by the 17 accounting -- large accounting firms. 18 There may be some medium-sized firms that do it 19 within the context of the AICPA rules and regulations; and 20 it's perfectly acceptable under certain specific guidelines. 21 But the administrators have really picked it up. 22 There is a shortage of CFOs in this industry. It's 23 hard to learn and train. It takes years of knowledge. 24 Legal, compliance, hard-to-get operations people. The prime 25 brokers are a large source of operations people that work in 1 the hedge fund industry and there's not enough of those. 2 COMMISSIONER CAMPOS: What are the statistics, if 3 you have any, about the valuation of assets and how regular 4 reports are produced for investors and hedge funds? 5 MR. PRESS: In general, hedge funds value their 6 securities on a daily basis. No different than any 7 proprietary trading. And they go through elaborate steps. 8 On reporting to investors, it depends on what the 9 offering document or partnership agreement has said. Most 10 report on a minimum of a quarterly basis and the investors 11 have accepted that. Or monthly. Some will report more 12 often; others have elaborate Web sites, with secure 13 identification procedures to get in, to give daily 14 information. 15 It really depends on the hedge fund, investor needs 16 or desires; but at a minimum, quarterly. Some with a one- 17 page letter: "Here's how we've done." Others with -- 18 there's one particular hedge fund that produces a 20-page 19 thesis on the market and their philosophies; and it's quite 20 elaborate. And it's really very different by hedge fund. 21 COMMISSIONER CAMPOS: Well, you're saying that -- 22 do you have statistics for how many actually have a net asset 23 value per day -- daily? You're saying most of them do? 24 MR. PRESS: Most value the positions. They don't 25 necessarily go to an NAV-type of calculation. Some do, some 1 don't. They don't need to report "I've done a daily NAV." 2 Remember, in the hedge fund industry in general, 3 you cannot get out on a daily basis. 4 COMMISSIONER CAMPOS: I understand. I'm just 5 wondering what the practice is. Secondly, is GAAP being 6 used, or other standards being used for evaluation? 7 MR. PRESS: For the audit that we perform on the 8 clients we service, all the opinions are within GAAP unless 9 there's some form of qualification required, but in general, 10 the offering documents require GAAP or valuations in 11 accordance with GAAP, and GAAP is dominant in the industry on 12 a very small percentage. 13 I don't have statistics for you on international 14 GAAP. U.S. GAAP dominates the hedge fund industry nb is 15 followed rigorously. 16 CHAIRMAN DONALDSON: What goes on within the hedge 17 fund is very much like getting back to Mr. Lindsey's point, 18 proprietary trading. 19 If you have a hedge fund manager that is long on 20 short equities that he can mark his portfolio off the screen, 21 typically that's the way it's done, and they have realtime, 22 on-line P&L systems. 23 As you deviate from that and get into more 24 illiquid, less tradeable, on the proprietary desk of an 25 investment bank, you would call an independent company to 1 value that asset. We see that being done more often. You 2 know, some do it monthly, where they call in an independent 3 firm to value assets that they cannot value off the screen 4 properly. 5 MR. PRESS: Hedge funds also have another 6 uniqueness, depending on their documents, where they, what we 7 call a side pocket, where literally they take illiquid 8 investments and say there are no valuations -- I'm going to 9 leave out the financial statement for the moment. There are 10 no valuations. 11 Once you invest and you know you're investing, 10 12 percent of your capital may go into this pocket, and you 13 can't get out. 14 Even if you take your liquid money out, that stays 15 forever until there's a disposition on those assets, and they 16 track those assets very rigorously by investor, and it 17 usually is a year-by-year, in some cases it's a quarterly by 18 quarterly investment, so they're tracking to that, because 19 they know the difficulty in trying to value those illiquid 20 assets in terms of someone getting in and out, and their own 21 performance. 22 So that's another part of the industry that's, 23 again, a little bit different than in the mutual fund 24 industry. 25 From the GAAP perspective, we're required to go 1 through, and the clients are required to go through a 2 valuation/fair value, and they go through rigorous steps 3 trying to get to those valuations, and we review those steps. 4 MR. ROYE: Am I better off, as an investor in a 5 hedge fund, from an investor protection standpoint, being in 6 the offshore fund versus the domestic fund because of the 7 presence of the offshore administrator providing a lot of 8 these independent checks, accounting, valuation, where you 9 don't necessarily have that, and I guess our understanding is 10 largely you don't have that, the third party administrator in 11 the domestic fund context? 12 MR. PRESS: I would say that investing onshore or 13 offshore, any investment manager would be the same. Checks 14 and balances exist between the prime broker and the trading 15 desk, the internal people, offshore administrators and 16 onshore administrators. 17 MR. ROYE: But the onshore administrators, I mean, 18 that is not typical -- 19 MR. PRESS: It's no different than any major 20 brokerage house, has its own internal people determining its 21 earnings per share and publishing it. 22 The requirements and the recordkeeping are as 23 strong as they are in any hedge fund organization, as they 24 are in other organizations, and people comply with proper 25 bookkeeping and accounting procedures wherever possible. If 1 it's a very small entrepreneurial, then that's a different 2 issue. 3 MR. ROYE: I guess the only thing that I'm -- the 4 point I'm making is that, you know, there's an independent 5 party in the offshore context providing a lot of these 6 functions. Within a domestic context, the party is not 7 necessarily independent, and we know from experience that 8 from time to time people stray, and there are incentives to 9 stray. 10 But I guess what I'm saying is that, I mean, maybe 11 the answer is that Rich Lindsey and the prime brokers are 12 doing part of this, and they're part of the independent 13 check, but I mean, it is a fact that in the offshore fund 14 arena, you have an independent third party providing a lot of 15 these critical functions, and you don't have that 16 independence in a domestic context. 17 MR. PRESS: You do in many, in large organizations 18 that have their own internal controls. 19 MR. ROYE: But those are inside folks doing it. 20 MR. PRESS: No different than a mutual fund complex 21 in the same capacity. It has not changed, and any other -- 22 MR. ROYE: You have different directors in a mutual 23 fund context. You sometimes have third party administrators 24 in a mutual fund context. 25 MR. PRESS: And you sometimes have third party 1 administrators in domestic hedge funds, also, and in business 2 today -- 3 MR. ROYE: What percentage of domestic funds have a 4 third party administrator? 5 MR. PRESS: Today more than ever on startups I 6 would tell you that at least 75 to 90 percent go with a third 7 party administrator for onshore and offshore startups, 8 because there are not enough internal people, and the 9 technology costs for the accounting systems that are out 10 there are significant, and you have to be a larger hedge fund 11 to be able to support it, so the small hedge funds have 12 onshore and offshore administrators doing the ascertaining 13 values, also. 14 MR. KEUNAN: I would say there's definitely a trend 15 there. I mean, I think that administrators now have a U.S. 16 presence. 17 They've demonstrated that they have the expertise 18 with specific U.S. requirements such as tax reporting and 19 partnership allocations in the accounting for that, so the 20 trend is there, definitely, as Joel says, towards using 21 administrators on domestic funds. 22 MR. NEWTON: A lot of the players in this business 23 are tuning into the same people who are processing mutual 24 fund transactions. 25 They're all standing on the sidelines, you know -- 1 well, not standing on the sidelines anymore. 2 They're in there, you know, some very big names in 3 the securities processing business, and they are fulfilling 4 these, and they are competing for these functions onshore 5 since the repeal of Tinker-Monmouth. 6 MR. NEUS: Paul, I think the other aspect to this 7 is disclosure documents of hedge funds and increasingly, the 8 due diligence by the gatekeepers and the significant 9 institutional investors are going into great depth of the 10 reconciliation process, when you get independent valuations, 11 when they're reported, and that has increasingly been for 12 firms that do it in-house. There is a vetting process that 13 has emerged within the market. 14 MR. LINDSEY: Since you raised it, I should be very 15 clear though, that a prime broker actually does not have the 16 capability to value a hedge fund. 17 They could not compete an NAV on any basis, because 18 they neither see the cash accounts, bank accounts that might 19 be held by a hedge fund when they do not see any of the off- 20 balance-sheet activity that a hedge fund may be engaged in. 21 That's even if you're the sole prime broker, and of 22 course, typically, hedge funds, at least if we're talking 23 about hedge funds of any size, you know, if you're in the, 24 say, 50 to 150 or $200 million range, they probably have on 25 average one-and-a-half prime brokers, and as you start to get 1 larger, the number of prime brokers increases. 2 MR. ROYE: How about, can you just outline for us 3 the roles that a prime broker would play in the hedge fund? 4 MR. LINDSEY: Well, the prime broker plays a 5 relatively simple role, which, you know, I think a lot of 6 people have had confusion about what a prime broker does over 7 the years, and that is, you know, traditionally, of course, 8 if you wanted to trade with six different houses on the 9 street, and you were a proprietary trading desk, a hedge fund 10 type of operation, you would have to open up six brokerage 11 accounts around the street to do that, and you'd have to have 12 assets held at each one of those accounts. 13 What a prime broker does is essentially allow the 14 hedge fund to give up the name of a prime broker that may 15 hold a substantial portion or at least some sizable portion 16 of their assets, and let them trade anywhere on the street. 17 So the prime broker becomes responsible for the 18 clearance and settlement of the trading activity. 19 The prime broker may or may not trade on any given 20 trade or even at all with the hedge fund, so they may or may 21 not be a counter-party to the hedge fund in some cases, but 22 basically, it provides basic clearance and settlement 23 services. 24 There are some additional services that prime 25 brokers provide to try to facilitate a client relationship 1 with the hedge fund, and those, you know, range from simple 2 things like perhaps the facilitation of them obtaining office 3 space in certain locations to helping them sometimes find a 4 CFO if we know that people are looking to, unfortunately, 5 sometimes, taking personnel from the prime broker to help 6 augment their back office, but it's a wide variety of what 7 I'll call services that are only meant to maintain 8 relationships. 9 MR. ROYE: And the compensation flows essentially 10 from the trading activity that -- 11 MR. LINDSEY: Well, compensation for a prime broker 12 can come from essentially three -- four areas. 13 One could be execution, commission type of flow, 14 if, indeed, the prime broker is associated with the 15 executions. 16 And the other would be essentially -- I've 17 classified them as three separate ones, but that's 18 essentially income derived from margin balances, short 19 balances, and credit balances -- so debits, credits, and 20 shorts. 21 There may, in many cases, also be a processing or 22 transaction fee associated with processing a trade, 23 particularly if that trade is done someplace else. 24 MR. ROYE: How about in promoting the hedge funds, 25 roles prime brokers -- 1 MR. LINDSEY: I don't know of any prime broker that 2 promoted hedge funds. 3 MR. ROYE: Okay. Capital introduction services? 4 MR. LINDSEY: Capital introduction services are 5 services that amount to essentially, you have a clientele 6 that may be interested in meeting institutions. All of our 7 capital introduction is involved with institutional. 8 And you have institutions that are qualified 9 investors that indicate that they are interested in hedge 10 funds, and what we do is, we provide a venue where they may 11 meet, so those venues typically consist of what I'll call 12 conferences, so -- where you have a number of hedge fund 13 managers that may talk, a number of investors that have come 14 into the room, and do that type of thing. 15 As Robert, I think, said earlier, the investing 16 process today is a very long process, particularly with more 17 institutionalization of the marketplace. 18 Those investors may look at hedge fund managers for 19 anywhere between, you know, nine months to a year-and-a-half 20 to two years. They'll see them at a number of different 21 prime brokers' capital introductions meetings. They'll see 22 them at a number of outside conferences. They'll see them 23 perhaps one-on-one in their offices. 24 But they go through a very long and detailed and 25 rather slow process of deciding whether or not they're going 1 to invest. 2 I think that I would say that the capital 3 introduction process is a little bit akin to the fact that, 4 you know, your next-door neighbor's son is looking for a job 5 and asks you whether or not you know of any jobs that are out 6 there, so you take, you know, his resume and you pass it to a 7 few places that may have some jobs that you know of, and say, 8 "I don't know the person particularly well, but indeed, you 9 know, if you have a position that meets it, please interview 10 them and see if there's something there." 11 MR. ROYE: So you're not really functioning in the 12 role of placement agent/broker for the client investing in 13 the hedge fund? 14 MR. LINDSEY: No. No. And that's, I think, our 15 practice, and I believe the practice of at least all of the 16 major prime brokers, is to disclaim that, disclose that in 17 every interaction with the investors and with the hedge fund 18 managers. We try to make that abundantly clear. 19 MR. NEUS: I would just add on that, is that we 20 make sure that, if we're participating in such conferences, 21 we ensure that the prime broker tells us that all the 22 investors that are there are qualified to whatever degree is 23 required within our funds. 24 CHAIRMAN DONALDSON: Can you comment on how the 25 prime broker relation unit within the firm is organized in 1 terms of other units within the firm -- the trading desk, the 2 research department, salespeople, et cetera, et cetera? 3 MR. LINDSEY: Well, I think it varies a little bit 4 from firm to firm. 5 In our firm, it's actually a separate broker- 6 dealer. All of our clearance business is in a separate 7 broker-dealer, completely isolated from the trading 8 activities, analysts, from any -- from basically the rest of 9 the company. 10 So either all of the prime brokerage personnel are 11 separated, also all of the people that process and handle 12 trades, see positions, et cetera. 13 Part of that is to provide comfort to our clients 14 that, indeed, other parts of the firm cannot access it. 15 Other firms are organized somewhat differently. 16 Sometimes prime brokerage falls within the institutional 17 equities division of the firm. It's really a matter of 18 individual firm structure. 19 MR. ROYE: Joel, how about the role of auditors in 20 the hedge fund context? You've alluded, I think a couple of 21 times, to some of the services. 22 But how would an audit of a hedge fund, say, differ 23 from a mutual fund, if at all? 24 MR. PRESS: Trying not to put everybody to sleep, 25 I'll make this very quick. 1 A mutual fund audit is really a controls-based 2 audit, and it dictates off of internal controls. Most of the 3 administrators have a SAS-70, and you can do a controls-based 4 audit. 5 Hedge funds are a substantive approach, so it's 6 testing, and hedge funds really have three major investments. 7 It's capital, broker balances, and of course, valuations. 8 Mutual funds require 100 percent valuations at 9 December 31st, or at their year end. 10 Hedge funds, you are allowed to do testing when you 11 think appropriate, and use that for your audit opinion. Most 12 auditors in the hedge fund world do most substantive testing 13 and valuation procedures at year end, but it is not required 14 to do 100 percent. 15 Financial reporting, there's a 100 percent 16 requirement disclosure. There is a proposal for mutual funds 17 for positions greater than 1 percent. 18 Hedge funds have SOP-95.2, which requires a 19 disclosure greater than 5 percent. 20 Filing requirements must be within 60 days. Hedge 21 funds, if it's CFTC, is 90 days. Otherwise, there are no 22 filing requirements. 23 One of the key things for hedge funds on auditing 24 is getting out the K-1s. People want to file their return, 25 as much as possible, on time, and that's another part of 1 where hedge funds work hard to get those K-1s out, and 2 accountants work hard to get them done. 3 Compliance: auditors for mutual funds will review 4 compliance procedures, are not required to do that in hedge 5 funds. 6 Basically, in short, those are the major 7 differences between mutual fund auditing the hedge fund 8 auditing. It could go on in little details, but I don't 9 think it's critical for what we're talking about. 10 MR. ROYE: So the audit requirement is largely 11 driven by what is in the private placement memo -- 12 MR. PRESS: The private placement memo -- 13 MR. ROYE: -- that the funds will agree to have an 14 audit once a year? 15 MR. PRESS: All hedge funds that I've ever been 16 associated with in my 35 years in the business have a 17 certified audit all at the year end, and obviously get out 18 their tax information and report to the partners. 19 Some hedge funds reports give a capital letter, 20 which shows information with regard to the personal capital 21 letters. CFDC, in certain instances, requires that. But 22 everyone gets a financial certified statement and tax 23 information. 24 MR. ROYE: And time constraints in terms of 25 delivering that information is as outlined in the private 1 placement memo? 2 MR. PRESS: The private placement memo normally 3 defines it will be out in 75 or 90 days, could take longer. 4 Funds of funds will take longer because, until you gather all 5 the information, depending on the size of the hedge fund, 6 what strategy, it takes a longer period of time, and in that 7 case, almost always, the tax information is well after April 8 15th, but that's disclosed to the investors, also. 9 Offshore funds also are audited under the same 10 requirements as domestic hedge funds, but we will report. 11 There is the board, a William indicated, in offshore hedge 12 funds, and there will be a board reporting. 13 And we're seeing a small movement to audit 14 committees on some of the larger hedge funds, where we will 15 report to an independent board, even in domestic hedge funds 16 on the larger size, and in offshore. 17 MR. ROYE: How about procedures like confirming 18 account balances for hedge fund investors? Is that something 19 that's typically done as part of a check? 20 MR. PRESS: There's rigorous testing on 21 reconciliation of broker balances, confirmation of positions, 22 verification of location, custodianship, and so forth. 23 Hedge funds don't -- are not required to use a 24 third party custodian, mostly use prime brokers. To the 25 extent there's executory contracts or derivative contracts, 1 there's an elaborate confirmation procedure, but again, not 2 required to do 100 percent testing on a controlled testing 3 basks. 4 MR. ROYE: Okay. I just wanted to touch on sort of 5 the use of hedge fund indices. 6 A number of you construct indexes of hedge funds. 7 You gather information from hedge funds. Information is 8 reported to you. 9 What level of confidence do you have in that 10 information that's reported to you, the performance numbers, 11 the information that you get from the hedge funds that 12 report? 13 MR. SCHULMAN: It's not audited. It's audited, as 14 Joel just said, at the end of the year. 15 It is directionally correct. We think it gives 16 very good information for someone who is interested in how 17 the industry has done. 18 There are two types of indexes. One, your 19 capitalization weighted indexes, like the S&P 500. You have 20 non-capitalization weighted indexes, like the Dow Jones. 21 There is some move afoot from people like S&P and 22 CSFP to launch products that track these indexes, with some 23 degree of success relating to the launching of that. 24 I think they're indicative of how the market does, 25 and I think they're a reasonable benchmark and a much better 1 benchmark for the hedge fund business. The indexes and the 2 sub-indexes are much better benchmarks because they're 3 absolute return benchmarks, and that's the way you should 4 measure absolute returns in the marketplace. 5 As Charles said earlier, when the market was going 6 up 30 percent a year and hedge funds were doing 18 and very 7 proud of it, they had nothing to compare to. 8 When the market was going down 30 percent a year 9 and hedge funds were doing 10, they had nothing to compare 10 to, but were still very proud of it. 11 These indexes give us a chance to have some 12 reasonable institutional benchmarks and some reasonable 13 retail benchmarks, so that someone has some idea of what a 14 good outcome is versus a bad outcome. 15 Are they perfect? Is every manager pure in the 16 style in which they're included? No. 17 Are they directional, are they statistically 18 accurate, are they directionally correct? Yes, they are. 19 MR. ROYE: Charles? 20 MR. GRADANTE: I think Bob answered the question. 21 You know, the only thing I can add to it is that, you know 22 hedge funds do take that heir performance fees, so it 23 behooves them to have accurate numbers, and the internal 24 auditing procedures centered around that are very rigorous, 25 from what I've seen. 1 MR. NEWTON: There's a fairly widespread 2 misapprehension, particularly in some of the media that goes 3 out there, is that the numbers that we're using -- I believe 4 this is correct at Bob's shop -- we are reporting net 5 performance figures. We occasionally get a cunning little 6 manager who says, "Oh, I didn't understand that," but they 7 normally get smacked fairly hard when we find them, and, you 8 know, given the overall weightings. 9 But the numbers that are going out there are net, 10 so it's after the management fee -- 1, 2 percent -- it's 11 after the performance fee -- 20 percent, 30 percent, whatever 12 it is. 13 So you're seeing a very -- you know, you're seeing 14 the actual return that the investor gets, and I think that's 15 something very important to keep in mind, because obviously, 16 we all know that in the mutual fund area, you don't see that. 17 MR. SCHULMAN: And it is more complex than it 18 sounds, because of something that was talked about when we 19 talked about administration, which is there isn't one correct 20 number when you're the administrator of an offshore and 21 onshore fund. It depends on when the investor came in. 22 Our policy is, we track someone as if they had 23 invested fresh on January 1st. The numbers you see in our 24 database are a fresh investor on January 1st, not making up a 25 high water mark, not necessarily suffering from whatever 1 happened in January and February. 2 That's just a matter of policy, and we state that 3 when we publish the task database. Other databases take 4 slightly different approaches, but we're all trying to get an 5 accurate read as to what an investor gets. 6 MR. PRESS: And the investors get monthly or 7 quarterly performance information, and many of the investors 8 today get these databases and look at them and go back to the 9 funds and say, "Are you within reason, or if you're out of 10 that strategy, why are your numbers slightly different?" 11 There's comprehensive review by investors and the 12 managers to maintain accuracy of their performance 13 information. Then, of course, the audit information provides 14 performance information, which then gets put into the 15 databases, also. 16 MR. SCHULMAN: And if you're a qualified investor, 17 you can get that information directly off half a dozen 18 different web sites, at no expense, at a zero charge; so you 19 can check your own results against the results that are 20 published by the manager. 21 So you have all those investors out there who are 22 our control and who are the managers' control as to where 23 those numbers might be very different. 24 COMMISSIONER CAMPOS: Is there any need or would it 25 be possible to have indices by hedge style, in terms of the 1 different matters that -- you know, because we're talking 2 amalgamating everything that may be a hedge fund in these 3 indices, I suppose. 4 MR. SCHULMAN: We do produce -- 5 MR. GRADANTE: Earlier, I mean, we have 23 6 different sub-indices to the indices, so yeah, there is. 7 MR. SCHULMAN: And we have 11, and again, they're 8 all up on the web sites. People can see them. 9 MR. GRADANTE: You know, we even go as far as 10 having, you know, sector indices, like Latin America, 11 technology, telecom and media, and things like that. 12 CHAIRMAN DONALDSON: We've got a few more minutes 13 left for our panel, and I think maybe it might be appropriate 14 to conclude by asking each of the panelists, really, to talk 15 about sort of the state of the hedge fund industry as they 16 see it. 17 You know, we see a lot of institutional interest in 18 hedge funds today. We see funds being created. You know, 19 the industry has changed. I guess it might be described as a 20 fairly young industry, even though hedge funds have been 21 around since 1949, at least. 22 But I wonder if maybe each one of you could kind of 23 give your assessment of where the industry is, and trends, 24 and where you see it going? 25 COMMISSIONER GLASSMAN: Paul, can I just add one 1 thing to that question? 2 As you answer that, if there are any problems or 3 issues in the current industry that you think the SEC needs 4 to deal with, that would be helpful. 5 MR. PRESS: I guess I'll start. 6 I think the industry is just a growing, dynamic 7 industry with tremendous opportunity. 8 There have been three studies, one by Putnam 9 Lovell, one by Greenwich, and one by DeutscheBank, talking 10 about growth in the next five to 10 years in excess of $1 11 trillion, potentially 9,000 new hedge fund market funds, and 12 it's clearly a growing industry for entrepreneurs with great 13 opportunity. 14 I think one of the things we didn't talk about is 15 the technology support that prime brokers, developments that 16 allow for valuations and reporting has improved dramatically 17 in the last five years, and the changes in the next three 18 years are just tremendous for helping in terms of valuing 19 difficult instruments and the derivatives as we grow. I 20 think it's a great class, obviously. 21 And issues -- one of the concerns, as an auditor, 22 is technology and fraud, in terms of the ability for 23 technology to make fraud a little bit simpler today and more 24 difficult to find. 25 We've seen it in the commercial markets, whether 1 it's massive fraud at an Enron, or a Michael Berger in a 2 hedge fund industry. These are issues, of course, all 3 accountants and all people in the industry, whether prime 4 brokers or not, are all concerned about. 5 But in general, this industry has had, I think, a 6 lower percentage of issues, and I think it just has 7 tremendous breadth and potential. 8 MR. SCHULMAN: Okay. Joel covered everything. No. 9 Average life of a hedge fund, because it was one of 10 the questions that we had talked about, is about six-and-a- 11 half years. 12 The business is moving from an entrepreneurial 13 business to a smaller number of very large players who have a 14 lot more bells and whistles and a lot more controls, who look 15 a lot more institutional. 16 So the entrepreneurial zeal is there, and some 17 people agree to stop growing when they reach the 18 entrepreneurial constraints of what they can do with a few 19 people, and there are a few large organizations that have 20 gone out to build what we would call mega-hedge fund 21 organizations relating to the number of funds they run and 22 the amount of money that they run. 23 We have some performance challenges in the hedge 24 fund business, not because the markets are bad, because 25 people expect hedge funds to perform less well when the stock 1 market does less well, but performance equally is tied to the 2 level of rates and the level of volatility in the market 3 across the hedge fund universe of strategies, and with lower 4 rates and lower volatility, you probably will see continued 5 sub-part hedge fund performance, which, by the way, does not 6 mean negative performance. It means sub-part relative to 7 what hedge funds have done historically in the strategies 8 that are not long, short, equity. 9 You're beginning to see specialty structures 10 develop, where guaranty products are finding their way into 11 the United States, whereas they've been a big feature in 12 Europe and they're now becoming a way of packaging this to 13 the qualified investor that's going to become more popular as 14 time goes by. 15 You're also beginning to see leverage offers to 16 high net worth investors that allow them to take these sub- 17 par returns and, at their own risk, in a fully disclosed 18 basis, leverage them up to take advantage of it. 19 You're seeing the financial institutions -- not 20 hedge fund financial institutions, but traditional financial 21 institutions -- get behind the idea of making those loans as 22 relatively safe, securable loans for them to make in the 23 practice of their business, which is making loans. 24 The other big feature that's going on in the 25 marketplace as the market becomes institutionalized is you're 1 seeing a move towards risk transparency, as, in addition to 2 having to get registered, more funds are being pushed down 3 the road or going down the road of becoming transparent in 4 what their portfolios are, at least to a third party player, 5 so that it becomes practical for financial intermediaries, 6 whether they be administrators or fund of fund operators or 7 institutional advisors, to deliver them an understanding of 8 what the risk of the portfolio is, without delivering them an 9 understanding of what the positions in the portfolio is, 10 which would be considered death in the industry -- death to 11 the opportunity to perform well would be to disclose 12 positions. 13 So they're kind of going halfway down the line and 14 saying, "We'll tell you what the risks are," which probably 15 are more important than the positions, from a disclosure 16 standpoint. 17 MR. KEUNAN: I guess I just wanted to echo Joel's 18 point, that it's a continually and continuously evolving 19 industry, and as such, it's a joy to work in it. 20 But we see different cycles in a hedge fund, in the 21 evolution of a hedge fund. There are small hedge funds; 22 there are medium-sized hedge fund; and there are large hedge 23 funds, and it's our challenge, and we partner together with 24 the auditors, the prime brokers, and the lawyers, and 25 obviously, the investment advisors, to ensure that the 1 process is appropriate for the type of hedge fund that we're 2 servicing, and that's the challenge. 3 And the bottom line is that it's a learning curve 4 for us all. We don't pretend to be the experts in all of the 5 securities that the investment advisors invest in. 6 Otherwise, we wouldn't be administrators. But we do, I 7 believe quite successfully, as an industry, develop a 8 methodology that is appropriate for each fund, and as such, 9 we act from that methodology. 10 MR. NEUS: I think that the two main themes that 11 have come out today are institutionalization and 12 retailization, and both of them from both the investor 13 standpoint as well as from the process of the investment 14 advisor. 15 On institutionalization, I think that's a good 16 thing for the industry, both with respect to the investors 17 coming in being more institutional, having a greater degree 18 of understanding of the products, and frankly, having a 19 greater muscle in ensuring that they get the level of 20 information that they want. 21 In terms of hedge fund managers, I think you're 22 continually seeing entrepreneurs who come out and think 23 they've got a better mousetrap, and that they're going to 24 come out with something new, but where the industry is 25 evolving is that some of that is occurring in startups as 1 part of broker-dealer/mutual fund complexes or larger 2 institutionalization of hedge funds. 3 And while you will never have a situation where 4 there aren't pure startups -- you know, two guys in a garage 5 who are hiring a prime broker and administrator -- I think 6 because the support network has evolved around startups, that 7 you're seeing a greater degree of professionalism within the 8 industry as a whole. 9 With respect to retailization, I think there are a 10 couple notes there. 11 One is that the media inquiries tend to focus on 12 the fact that now there are registered funds of funds and 13 that hedge funds have gone down market, and I think if you 14 actually parse through what's happening, what you'll see is 15 that retail fund of funds has lowered the bar to entry into 16 individual hedge funds by aggregating them, so that you would 17 have an investor who invested in a hedge fund fund of funds, 18 and the fund of funds then may invest in 20 different hedge 19 funds, and the individual may only have to put as low as 20 $25,000 into the hedge fund of funds. 21 However, to my knowledge, all registered funds of 22 funds currently require the investors to be either a credited 23 investor, qualified purchaser, or qualified clients under the 24 Advisors Act, and so the concept out there is that hedge 25 funds are going down market and are retail, but the reality 1 is that it's the same qualification of the investors who can 2 invest in a single hedge fund are investing in a basket of 3 hedge funds, and I don't necessarily think that's a bad 4 thing. 5 That being said, I think there are specific issues 6 about retail investors going into individual hedge funds, and 7 per Commissioner Glassman's request to point out things that 8 the Commission should look at, I think where you have a 3- 9 C(1) standard of a $200,000 income, $300,000 with a spouse, 10 or $1 million net worth that's 20 years old is something that 11 the Commission should look at. 12 The second thing I think the Commission should look 13 at is in overall education. 14 I would say, anecdotally, 80 percent of articles I 15 read on hedge funds use somewhere the adjectives "shadowy," 16 "mystique," "offshore." 17 I think that what really happens, and hopefully, 18 you've had a sense for it today, is that it's a highly 19 professional, highly organized industry which, because of 20 restrictions on advertising or holding yourself out to the 21 public, we are not capable of sharing with the general public 22 what we do, and I think the fact that the Commission is doing 23 both a hedge fund sweep and these panels is extremely 24 laudable, and I think that's something that will help dispel 25 some of the myths around the industry. 1 MR. ROYE: Charles? 2 MR. GRADANTE: With respect to the retailization of 3 hedge funds, from what I gather, you know, in the hedge funds 4 or in the arbitrage business, many of them, there seems to be 5 a feeling that there's a regulatory arbitrage going on 6 between mutual funds and hedge funds, and the best thing to 7 do is to close that loophole. 8 The belief that mutual funds and hedge funds should 9 be on the same playing field may be misguided, but let me 10 clarify that. 11 We do not think that the capital markets are best 12 served by regulating all hedge funds as mutual funds. Only 13 those hedge funds that want the retail market should go 14 through the registered public offering process. 15 We should not interfere with the freedom of hedge 16 funds to determine how best to meet their objectives. 17 Perhaps the degree of regulation should be a function of the 18 market needs. We need to protect the retail investor, and at 19 the same time, allow capital formation to meet other investor 20 needs, whether they be hedge funds, venture capital, or 21 private equity. 22 It would not make sense to permit investors to have 23 ownership in a startup venture capital company through an 24 unregistered private placement, but not allow a similar 25 investment in a hedge fund. 1 MR. VAUGHN: I think we've had pretty good coverage 2 already of where the industry stands today, but I would like 3 to add one thing, which I think is probably not directly in 4 what we've been considering here today the hedge fund 5 industry, the unregistered fund industry, but a related 6 development in the industry, which I think goes to some of 7 the discussions we had here. 8 That is these registered funds that are engaging in 9 strategies that are similar to or sometimes the same as what 10 hedge funds traditionally have engaged in. 11 There are registered funds out there, both directly 12 managed and now the funds of funds products, where they offer 13 investors, maybe not pure retail investors but accredited 14 investors on a larger scale, investment strategies that are 15 -- that had been only available to institutional investors 16 and high net worth individuals to allow them to diversify 17 their portfolios. 18 I think that's a positive development, especially 19 in the context of the registered funds with these more 20 retail-type investors, where they have Commission oversight, 21 registration, the limitations of the Investment Company Act. 22 They're simply engaging in strategies now, because those 23 strategies are thought to be good for diversification, that 24 had traditionally been the purview of hedge funds. 25 Now, they're not as leveraged. They don't go short 1 as much as hedge funds. And, you know, maybe that's right. 2 Maybe at the margins there maybe could be an adjustment or 3 two. 4 But in general, that gives the investors who don't 5 qualify to go into the traditional hedge funds at least an 6 ability to get some exposure in their portfolio to similar 7 strategies without giving up the protections that the more 8 retail investors have come to rely on and benefit from. 9 MR. LINDSEY: Almost everything has been said, but 10 I'll repeat some of it, maybe. 11 One of the things that maybe hasn't been entirely 12 made clear is that I think the hedge funds, the bigger, 13 biggest ones are actually getting bigger, and they're not 14 getting bigger in the fact that more assets are being 15 deployed within each one of those strategies, but rather, 16 their organizations are growing as what I'll call umbrella 17 organizations of hedge funds. 18 So those large hedge fund families that have the 19 infrastructure, the legal support staff, the compliance 20 structure, the trading capabilities, are seeding new hedge 21 fund managers. They are kind of growing within their 22 organization a diversified strategy of hedge funds. 23 And sometimes, we kind of lump that all together 24 and talk about a hedge fund of a particular size, and a lot 25 of times, of course, the hedge fund itself isn't of that 1 size, it may be in eight, 10, 12 hedge funds of much smaller 2 size aggregated under one umbrella. 3 So that's important, and I think that will continue 4 to happen as this industry matures and becomes, in and of 5 itself, a little more institutionalized in the way that it 6 runs. 7 In each case like that, they try to preserve that 8 entrepreneurial attitude, because that's really what makes 9 these individuals successful. 10 Robert said earlier that there were really two 11 types of hedge fund managers, and I agree with that, that 12 there are really hedge fund managers that are traders. They 13 have some extra synapses in their brain that somehow allow 14 them to trade and do very well at it. 15 And then there are hedge fund managers that are 16 essentially people that do very strong and very fundamental 17 analysis of either trends or financial statements of 18 corporations, et cetera. 19 We derive, in whole, in aggregate in the financial 20 marketplace, a great deal of benefit from these individuals, 21 and I'll hearken back to a little bit of economic theory, 22 that in our economy we talk a lot about efficient markets, 23 and we talk about the value of disclosure, and we talk about 24 the value associated with the filings that corporations make 25 with the SEC. 1 Well, a large part of what happens in the hedge 2 fund world is that people spend an enormous amount of time, 3 effort, energy, and talent into looking really deeply into 4 those numbers, looking at the bond covenants to decide 5 whether or not this bond versus that bond has some arbitrage 6 opportunity. 7 That reflects itself, in the end, in the efficiency 8 of prices in the marketplace. It reflects itself in the end 9 in the overall efficiency of how our markets work. 10 So there's a huge value that should not be 11 discounted by this you know individual of entrepreneurial 12 activity. 13 I would also say that the investors are becoming 14 more and more institutional and more and more sophisticated. 15 The last thing I think that any institutional investor wants 16 to do is go before the committee of their institution and 17 say, "I lost money in this hedge fund." They aren't paid 18 well enough to try to do that, and in general, they try to 19 avoid it, so they do an awful lot of due diligence and expend 20 effort. 21 The other thing is that we have to keep things in 22 perspective. Even if we roughly double, and we take the size 23 of the hedge fund industry to $1 trillion, which, you know, 24 there are some forecasts of that, at $1 trillion, hedge funds 25 still represent a small fraction of the overall financial 1 marketplace and the overall investable assets. 2 There is a lot more activity that goes on than the 3 hedge fund activity. It gets a lot of press. It makes -- 4 you know, because some people seem to think that they're very 5 mysterious or very secretive or very whatever, that it makes 6 nice things to write about. 7 But there's more press about hedge funds than there 8 is financial activity in the marketplace by hedge funds, so, 9 you know, we should try to keep that perhaps in perspective. 10 I think that when I look at any of the things that 11 have gone wrong in the hedge fund world over the last decade 12 or so, if there was anything that was illegal, it was already 13 illegal, that there is not, you know, a need for additional 14 qualifications. 15 You know, fraud, at least when I worked here, was 16 illegal. I think it still is illegal. And, you know, a lot 17 of times, it's a matter of making sure that we enforce the 18 things that happen when things happen. 19 MR. ROYE: Greg? 20 MR. NEWTON: I will just very quickly say I think 21 everything, you know, has obviously been covered, but I think 22 the important thing, and we've just alluded to it in a couple 23 of speakers along here, about the fact that hedge funds have 24 been perceived as being relatively secretive. I think they 25 are relatively secretive, but the regulatory regime under 1 which they work exacerbates that condition. 2 Speaking as a media person, we're generally in the 3 business of, wherever possible, casting light, and anything 4 that goes to removing this, you know, this almost ethereal -- 5 the words, you know, mysterious, shadowy, offshore, et 6 cetera, are sort of hyphenated when hedge funds appear in the 7 general media, and it's not justified. 8 And I think that I would just, in closing these 9 part of my remarks, say that I believe that this process 10 which the Securities & Exchange Commission has been running 11 for the last 12 years -- it's 12 months, I believe, I'm 12 sorry. It just seems like 12 years. 13 (Laughter.) 14 CHAIRMAN DONALDSON: More for the staff, I think. 15 MR. NEWTON: Like this panel. 16 (Laughter.) 17 MR. NEWTON: But, you know, I think that the 18 process, you know, I think the process, certainly for 19 educating the regulators, which is never a bad thing, and 20 also for just educating the people in the webcast out there, 21 is going to be extremely valuable in the long run for this 22 business and this great nation's financial services sector. 23 MR. ROYE: Well, we've gone over our time. We're 24 going to take a 10-minute break, but I'd like to thank our 25 panelists for an excellent discussion starting off our 1 roundtable. 2 We're going to return in 10 minutes with a 3 discussion on distribution and marketing of hedge funds. 4 (Applause.) 5 (A brief recess was taken.) 6 MS. OSTERMAN: My name is Elizabeth Osterman. I am 7 an assistant chief counsel in the Division of Investment 8 Management. And this is a panel on hedge funds marketing and 9 distribution. Before I start, just one sad note, recently 10 one of our former directors of corporation finance passed 11 away and some of our panelists will be leaving to attend his 12 funeral, which is this afternoon. 13 We are going to, as I said, be discussing marketing 14 and distribution of hedge funds and funds of hedge funds. 15 Let me start off by introducing the members of this panel. 16 Starting from my far left is Craig Russell. Craig is the 17 managing director and global head of sales and marketing for 18 Deutsch Banc Absolute Return Strategies. Craig is the global 19 head of sales and marketing for DB's hedge fund products, 20 including their registered fund of hedge fund product that 21 went effective last year. 22 Seated next to Craig is Michael Tiedemann. Mike is the 23 president of the Tiedemann Investment Group Domestic and 24 chief operating officer of Tiedemann Investment Group or TIG. 25 TIG manages a number of hedge funds. 1 Next to Mike is Leroy Cody. Leroy is the managing 2 director of the Alternative Investments Unit of American 3 Express Asset Management Group. Leroy heads a team dedicated 4 to the distribution of his firm's proprietary hedge funds. 5 Between Leroy and me is Michael Butowsky. Michael is a 6 partner at the New York Law Firm of Mayer Brown Rowe & Maw. 7 Michael serves as counsel to various members of the hedge 8 fund industry, including investment advisors, hedge funds and 9 prime brokers. 10 On my far right, jumping a bit, is Judson Reis. Judd is 11 the founding partner of the Sire Group of Partnerships, Sire 12 Management Corporation. Judd is primarily responsible at 13 Sire for Sire's funds of hedge funds. 14 Next to Judd is Clark Hooper. Clark is the executive 15 vice president of regulatory policy and oversight at the 16 NASD. Clark is responsible for directing regulatory 17 activities relating to advertising and investment companies 18 issues at the NASD and is particularly interested in 19 suitability issues as they relate to the sale of hedge funds 20 and funds of hedge funds. 21 Next to Clark is Alan Beller. Alan is the director of 22 the Division of Corporation Finance here at the Commission 23 and senior counsel to the Commission. Alan is responsible 24 for administering our laws relating to the offer and sale of 25 all securities and to our full disclosure program and in 1 developing policy with respect to those laws. 2 Finally, next to Alan is James Hedges. Jim is the 3 founder, president, and chief investment officer of LJH 4 Global Investments. LJH Global Investments is a hedge fund 5 advisory firm with a global presence. His firm helps 6 investors navigate the complexities of hedge fund investing. 7 I hope that this panel is going to pick up and 8 explore a number of the topics that were identified and 9 briefly mentioned, sometimes more than briefly mentioned at 10 this morning's first panel. These issues are particularly 11 interesting in the environment that we are today where a 12 number of people are now raising above the standards that 13 traditionally have related to investors who may invest in 14 hedge funds and also in the new products that are available. 15 Hedge funds operate under a regulatory regime that 16 assumes that investors in hedge funds can fend for themselves 17 and don't need the general protections of federal securities 18 laws. Because of rising incomes, inflation, and new 19 products, more and more investors are now investing, both 20 directly and indirectly, in hedge funds. Our job today is to 21 determine or consider whether those investors, like hedge 22 fund investors from years past, continue to be able to fend 23 for themselves or at least are getting regulatory protection 24 so that the same protections available before, the same 25 sophistication that played into hedge fund investors before 1 still continues to exist. 2 As you know, hedge funds are marketed and 3 distributed in ways very different from registered investment 4 companies. They are prohibited from offering and selling 5 their shares to the public. This traditionally limited the 6 types of investors who may invest in hedge funds. And I am 7 looking forward to hearing from the panelists this morning as 8 to whether these limitations make sense in today's 9 environment and economy. 10 The prohibition against public offers and sales of 11 hedge fund shares also limits the amount and type of 12 information generally available about hedge funds. Hedge 13 funds may not, as we all know, engage in any form of general 14 solicitation or general advertising. This has always been 15 problematic for the hedge fund industry. But the 16 Commission's attention has been redrawn to this prohibition 17 in light of the ever-increasing use of the Internet by hedge 18 funds to keep their investors informed and also by the 19 increasing use of the public to gather information about 20 everything, including hedge funds. 21 Some hedge funds are sold through traditional 22 broker distribution channels, raising traditional suitability 23 issues. More often, hedge fund managers turn to other 24 channels to attract investors. Hedge funds frequently rely 25 on a network of personal associations and existing investors' 1 recommendations to obtain new investors. They also are 2 hooked up with investors through third-party intermediaries, 3 such as the consultants, some of whom you have heard speak 4 today, and prime brokers, who may perform other services for 5 the hedge fund manager. 6 Judging by various reports, interest in hedge funds 7 has been on the rise and sales of hedge fund shares are 8 booming, and it is not institutions or the King or Queen 9 Midases who are getting in on the action today. Inflation 10 has caused many investors to qualify as investors in these 11 products, although they would not have qualified even a few 12 years ago. As I mentioned before, I am very interested to 13 hear from the panelists today whether this new pool of 14 investors has moved hedge funds as an investment opportunity 15 to a group of investors who perhaps should not be investing 16 in hedge funds. 17 Inflation and higher incomes are not the only 18 reasons for increased accessibility of hedge funds to 19 investors. Many fund complexes now offer or are in the 20 process of offering a relatively new investment product. 21 This product is known, as we have discussed already today, as 22 a fund of hedge funds. As its name implies, it is a fund 23 that invests in a pool of hedge funds. The Commission is 24 seeing a rise in the number of these funds who work their way 25 through the registration process and then are offered to the 1 public. As a publicly offered product, these fund of hedge 2 funds raise an entirely new set of concerns that did not 3 exist 10, or maybe even two, years ago. Among other things, 4 this panel will discuss the conundrum that this new product 5 creates: Investors, who are prohibited, from directly 6 investing in hedge funds but may invest indirectly in the 7 hedge funds through this new product. 8 With that, I would like to start by asking Alan Beller 9 and Michael Butowsky to explain and comment a little bit on 10 the eligibility requirements for investors in these hedge 11 fund products. 12 MR. BELLER: Thanks, Liz. One has to think about 13 eligibility requirements for hedge funds in sort of 14 categories of types of hedge funds, I think some of which 15 were discussed a little bit in the first panel. Most large 16 hedge funds are established pursuant to an exemption under 17 the Investment Company Act under Section 3(c)7. And that 18 dictates a particular type of sales restriction that I think 19 I am going to ask Michael to chat about for a couple of 20 minutes. 21 MR. BUTOWSKY: Oh, all right. Well, as Alan 22 mentioned, there are -- I guess just to describe 3(c)1 and 23 3(c)7 generally. There are two exclusions from the 24 definition of the Investment Company Act within the 25 definition of an investment company, under the Investment 1 Company Act of 1940. And those exclusions -- and it is an 2 important distinction that they are not exemptions from the 3 40 Act, they are exclusions from being defined as investment 4 companies. One is 3(c)1. One is 3(c)7. 3(c)1 being one 5 that is very old. It has been around I think since the 6 beginning of the Act. And 3(c)7, I think being around since 7 '96. 3(c)1 is an exclusion that is available for funds that 8 have 100 or fewer beneficial owners other than owners of 9 certain short-term securities. 3(c)7 was adopted under the 10 premise that wealthy people don't need the protections of the 11 40 Act. And to qualify, to buy a qualified purchaser fund or 12 a 3(c)7 fund, there are various different categories of types 13 of people that meet the standards of being a qualified 14 purchaser, essentially individuals who have $5 million or 15 more in investments. There are family companies that have $5 16 million or more in investments, corporate entities or other 17 vehicles that are managed by a money manager or invest for 18 themselves that have $25 million or more in investments. And 19 there are a few others, including qualified institutional 20 buyers under 44A. 21 I think, Alan, I guess I will turn it back to you, the 22 point about on the 33 Act side, how those are actually 23 offered though. 24 MR. BELLER: Right, that is fine. The premises of 25 the two exclusions, as Michael points out, are very 1 different. The 3(c)7 exclusion is premised on the category 2 of wealthy investors that can presumably get on without the 3 protections of the 40 Act. The 3(c)1 exclusion, which is 4 50-plus years old, was really designed to draw a ring around 5 small, private investment companies that didn't rise to the 6 level of a regulatory interest justifying registration, I 7 think would have been the original justification. 8 There is no restriction under the 40 Act itself 9 with respect to who can buy one of these funds, hedge funds 10 or other funds limited to 100 beneficial owners. That takes 11 you back into the Securities Act, which proscribes offering 12 restrictions for sales of securities generally. The 13 restriction that would be applicable in terms of these small 14 funds is actually quite a bit less restrictive than the 15 restriction with respect to so-called 3(c)7 funds. The 16 restriction is on offers and sales to so-called accredited 17 investors. They are defined to include most institutions, 18 institutions with assets of $5 million or more of various 19 sorts. The definition also includes individuals. 20 Individuals who are accredited investors are those who have 21 with their spouses $1 million of net worth or those who have 22 $200,000 of income in the last two years and a reasonable 23 expectation of that in the current year or $300,000 together 24 with their spouse. Those tend to leave you with a quite a 25 bit larger category of potential investors than the qualified 1 purchaser exemption of 3(c)7. 2 And I do think that one of the issues that 3 confronts the staff and the Commission in thinking about 4 marketing is whether that accredited investor definition is 5 where it should be. It is a definition that applies across 6 the spectrum of the securities laws so that offers in -- 7 private offers and sales completely outside the hedge fund 8 context are also in certain circumstances governed by the 9 accredited investor limitation. And that has raised a number 10 of issues over the years, including things like small 11 business capital formation, which is presumably outside the 12 purview of this group but it is one of the things that has 13 complicated approaching the accredited investor definition. 14 I want to mention one more thing about offerings 15 here, which is generally applicable and which I think is very 16 important, especially as Liz mentioned it in the Internet 17 context. All offerings of these unregistered funds, other 18 than the offerings of registered funds of funds, has to be 19 done under the general private offering rules under the 20 securities laws. And, in particular, they have to be 21 accomplished without what is referred to as general 22 solicitation and general advertising. That is a limitation 23 on publicity outside the universe of eligible investors, and 24 indeed outside the universe of eligible investors who have 25 been in some sense pre-qualified as accredited investors. 1 And one is the reason that under our rules, as we believe 2 they should be interpreted, there really should not be 3 publicity about hedge funds and offerings of hedge funds. 4 And there is an important point in there. If you are an 5 operating company, let's say you are a car manufacturer, we 6 don't view your advertising of cars, if it is the sort of 7 advertising that always in the ordinary course is done, as 8 necessarily conditioning the market or as necessarily 9 impermissible publicity for an offering by that car 10 manufacturer. But in the context of hedge funds, and I know 11 Michael has thought a lot about this and may want to chime 12 in, in the context of hedge funds, they are not in the 13 business of doing anything other than offering securities and 14 managing a portfolio. And therefore there really isn't an 15 exception, at least that we have been able to identify for 16 kind of ordinary course communications in the hedge fund 17 context. And that does complicate the life of hedge funds 18 when it comes to general solicitation and general 19 advertising. 20 The use of Internet, and then I will stop for a 21 minute because I think we will get back to that later, the 22 use of the Internet, you have to think about particularly in 23 the context of the restriction on general solicitation and 24 general advertising, a web site that does not have some 25 protections against anyone from the public or anyone who is 1 not pre-qualified as an accredited investor getting on to 2 that site where that site includes communications about hedge 3 funds that might be construed as either an offer or as 4 publicity amounting to general solicitation is problematic. 5 And we will talk some about that later. But that kind of is 6 the general universe of restrictions on offerings other than 7 registered offerings of registered funds of funds. 8 MS. OSTERMAN: And, Alan, you are right. I hope to 9 get back to that point because that is an incredibly 10 important point, and one that I hear come up time and time 11 again is how funds are brought through the Internet to the 12 public if they are. 13 I would like to move back a little bit before we go 14 there to the qualifications of investors who invest in these 15 hedge funds. One thing I think -- Michael you wanted to 16 raise one interesting perhaps point about the 3(c)7 funds. 17 MR. BUTOWSKY: Yes, I just wanted to point out, I 18 didn't mention this before, when you look at the two 19 exemptions or the two exclusions, the 3(c)1 has the 100 20 person limitation. Technically, under 3(c)7, there is no 21 limitation at all on the number of people that can invest in 22 them. Sometimes people in the industry, you will hear them 23 talk about a 499 investor limit but actually from a statutory 24 point of view there isn't any limit. What there is though 25 under the Exchange Act, there is a point at which you have 1 enough investors that you have to actually register the 2 vehicle under the Exchange Act and start doing public 3 reporting. So I think it is a self-imposed industry 4 standard, that people limit the qualified purchaser funds to 5 499. 6 MS. OSTERMAN: I have heard a lot of discussion and 7 I have seen a lot of paper on the qualification standards, 8 the accredited standards. And, Judd, I wonder if I could ask 9 you to talk a little bit about your views on what the 10 accredited standard means and how it works and whether it 11 does work? 12 MR. REIS: Well, I think it works in the sense that 13 it certainly limits the number of people to that group. Now, 14 as Alan points out, that group of people who are accredited 15 may be a lot larger than it was five or 10 years ago. And I 16 think somebody this morning referred to the fact that the 17 million dollar net worth or the $200,000 and $300,000 income 18 test were devised 20 years ago. So you could argue just with 19 the way the world has changed or with inflation that maybe 20 that test ought to be somewhat higher to get back to the 21 level in an economic sense that was intended 20 years ago. 22 And I can't speak for others, I know speaking for our 23 business, it really wouldn't make any difference. It might 24 make a difference on some of these registered products, which 25 I am not really an expert on but there are others here who 1 are. But I can't think of anybody who doesn't adhere to 2 those tests very carefully, who doesn't knowingly go to 3 people who wouldn't be qualified. I think everybody I have 4 seen in the industry is careful about it. We all have 5 documents that require people to sign off on that. Certainly 6 in our case, we know so many of our partners, we sort of know 7 they are there anyway. But it is not that hard to ask them 8 for a couple of references, a bank reference, a tax 9 accountant reference if you think there is some problem 10 there. But most of us run most of our lives most of the time 11 assuming that people we deal with are honest and if they fill 12 out the forms, they are doing it correctly. So I think it 13 works. If you are worried that there are some people now who 14 couldn't qualify 20 years ago, I don't think it would hurt to 15 change it a little bit. 16 COMMISSIONER GLASSMAN: Can I just ask a question? 17 When you say it doesn't make a difference, are you suggesting 18 that most people are well above those minimums so it is 19 irrelevant, so it doesn't matter or that it really doesn't 20 matter if the standard is a little higher? 21 MR. REIS: No, I am saying it doesn't matter if the 22 standard is a little higher. 23 COMMISSIONER GLASSMAN: Okay. 24 MS. OSTERMAN: Of course, one of the things we have 25 been focusing on over our last year of investigation is the 1 so-called retailization of hedge funds. And I wonder if any 2 of the other panelists have an idea about your views on this 3 phenomena where inflation or whatever other economic effects 4 are raising people's net worth and making them eligible for 5 these products and if you want to comment on that? 6 MR. RUSSELL: Yes, I think I have two comments. One is 7 if you look at the industry, and again I think Judd is 8 correct when he says that people today who are participating 9 in the industry I think are paying a lot of attention to the 10 status of investors and who is eligible for which products. 11 But I think if you look particularly at the larger players, 12 and I think that would fall into the bulk of the industry, if 13 you do the math on funds that are offered as 3(c)1 funds, as 14 an example. And you pick a minimum investment then someone 15 would typically see, perhaps a minimum on a fund like that 16 might be $100,000 or $500,000, certainly we see them higher. 17 And you are limited to 99 investors and you think about the 18 economics of running a fund that size. You open a fund with 19 $100,000 minimum, it is 3(c)1 fund. You could find yourself 20 running a $10 million fund. And I don't really think if you 21 look at the industry and the size of numbers that we are 22 talking about today, that the bulk of the industry is out 23 offering accredited investor funds in reasonable size 24 minimums because you basically limit the size of your fund, 25 which is going to have big impacts on you as a manager and 1 also investors. 2 So typically, and again I think somebody brought it 3 up in the last panel, the bulk of the industry has been done, 4 I don't know if there are some statistics that talks about 5 it, certainly more than half comes from offshore where you 6 don't have these investor account issues. But when you look 7 inside the U.S., the majority of funds that we see are 3(c)7 8 funds that typically have much higher minimums. The much 9 higher minimum standard as a definition almost drives the 10 typical investor up off the accredited investor standard. If 11 you look at the accredited investor standard either being -- 12 call it an income test or a net worth test, net worths have 13 obviously been driven up by real estate values and coasts and 14 things so a lot more people clearly qualify in the last 20 15 years that didn't before, but typically looking at the 16 minimum investment size of the fund is going to drive the 17 sort of status of that investor far higher I think than the 18 accredited investor standard. I don't think any small change 19 in that is going to have a big impact on the majority of 20 investors who are invested in this space. 21 MR. HEDGES: I would like to touch a little bit on 22 the accredited investor status because from my perspective I 23 do believe that is anachronistic, that it is not necessarily 24 a standard that is reflective of where the industry might 25 need to require people to be today in terms of financial 1 sophistication. But I would also rather decouple the notion 2 of financial sophistication and education from net worth 3 standards. It is my feeling as an investment manager and an 4 investment advisor in the hedge fund space, that we also 5 operate, whether it is on a self-regulating basis or in terms 6 of best practices, we operate as fiduciaries. We have to 7 help our clients get educated about not only the category but 8 also the product. Keep in mind that this Commission itself 9 has been working over a year to educate itself on the 10 category. And so I think there are monumental steps that 11 have got to be taken for investors in terms of suitability. 12 It is not just $200,000 or $300,000 of annual income. It is 13 the ability to be educated the different strategies and the 14 different types of risk and return parameters that are out 15 there. It is the ability to differentiate products. And 16 maybe most importantly for investors, it is the ability to 17 have realistic expectations. So how that ties back into 18 accredited investor status is a little sticky because there 19 is no test for whether or not your investor has got realistic 20 expectations. But I believe part of that onus lies with the 21 advisor who is serving as a fiduciary and counsel to 22 investors in looking at these investments. 23 MS. OSTERMAN: I would like to explore that issue 24 of suitability in perhaps a layman's term a little bit. 25 Before we go there, I am interested by something, Judd, you 1 said, and perhaps everyone could jump in, which is something 2 that also came up in the course of our investigation. And 3 that is the standard and the way that people selling hedge 4 fund products make sure that an investor actually does have 5 the ability or the qualifications that they say. So 6 frequently we were faced with the answer to the question of, 7 well, who is doing the due diligence on the investor buying 8 into the fund? And we were answered with, well, they sign a 9 piece of paper that says I am accredited. And I would truly 10 like to have your views on how that works and why you think 11 that is an appropriate way of policing -- self-policing that 12 particular point? 13 MR. TIEDEMANN: I think if I could take stab at 14 that. I think the process when the hedge fund launches 15 generally starts with a 3(c)1. As they grow, they then 16 launch a 3(c)7 fund. While they are in the 3(c)1 stage, and 17 really from the inception, they are gathering friends and 18 family money, people they know quite well. And I think 19 echoing what the first panel mentioned, much of the growth, 20 if not the bulk of the growth in the industry has been 21 institutionally driven, pensions, endowments, foundations, 22 and fund to funds. So the retailization is I think possibly 23 a major issue going forward, thus far has been less of an 24 issue. 25 The one thing I think -- the two changes possibly, 1 raising the million dollar standard and the income standard 2 is something that should be considered. I think the other is 3 possibly forcing managers to see brokerage statements or 4 actual proof of income from the investors. Currently, if I 5 ask for that from a potential investor, there is no chance 6 that they would give that to me. But if we were forced to do 7 that by regulation, possibly that would open up another 8 avenue to really regulate the investments. 9 CHAIRMAN GLASSMAN: Can I ask a question here? 10 Just a couple that are related to this. One is my assumption 11 is that the income standard was intended to be a proxy for 12 suitability in some sense. So is there another proxy that is 13 relatively objective if the income standard isn't 14 appropriate? And the other part of the question is what is 15 the investor's responsibility, if they are signing that form 16 saying they are accredited, what is their responsibility? 17 MR. TIEDEMANN: I would like to take a stab at the 18 suitability because I think that is a broad issue, as Jim 19 mentioned. Suitability in terms of percentage of liquid 20 assets that an individual has that is invested within a 21 certain strategy, then that brings on the whole issue of what 22 is that strategy, is it long/short equity, is it fixed income 23 arbitrage, and down the line, is that suitable? Is it a tax 24 inefficient strategy that returns anywhere from 8 to 12 25 percent a year, but in a bull market when the equity markets 1 are returning 30 percent a year, is that suitable? I think 2 there are a variety of ways that can convolute the issue on 3 the suitability issue. And so I think that is why we are 4 sitting here today. But ultimately I think the economic and 5 really the easiest thing to focus on is the percentage assets 6 of an individual that is investing in the fund. 7 MR. BUTOWSKY: I just want to add a point to that. 8 I guess about 20, 30 years ago, there was once in Reg D a 9 minimum investment standard and it was dropped. So a lot of 10 issues relating to minimum investments in funds has been sort 11 of bantered about as an issue about whether or not a certain 12 lower level would constitute retail. And people have talked 13 about that with raising issues about, well, does that mean a 14 really, really rich person can't invest a little in a fund? 15 That is one question. 16 And the other thing I think, in answer to Liz's 17 question about who has got the duty, I think you have to look 18 to who is actually involved in selling the fund. While I 19 agree with these gentlemen here that a lot of the large 20 institutional -- a lot of the growth has come in the 21 institutional side, there you have brokers and you have to 22 look at the NASD rules and the issues on that side. But 23 there are many funds that are sold directly by the general 24 partners of the funds, taking advantage of what is viewed as 25 an issuer exemption. And for them there is a question about 1 whether or not there is a suitability obligation at all. 2 There, I think the issue really turns on whether or not the 3 person who is running the fund is otherwise acting as an 4 investment advisor to those people that are coming to invest 5 in the fund. If somebody comes along who has a relationship 6 with the general partner and asks to invest in the fund, does 7 that somehow create a fiduciary duty on the obligation of the 8 general partner to do a suitability analysis on the investor. 9 It is an interesting question because there may not have been 10 an advisory relationship created by virtue of that. 11 MR. CODY: Well, just to add to what Michael 12 mentioned before. I think the financial standards, the 13 income or net worth test of some sort is a good starting 14 point. Whether it is suitable or not, I don't think it takes 15 away from the need for the hedge fund or the fund to funds to 16 determine suitability on the basis of a number of different 17 levels. But it is certainly a reasonable starting point to 18 start qualifying. 19 The other item that I would mention is I don't 20 think we have talked about having pre-existing relationships 21 and kind of knowledge of the investor ahead of time, before 22 really offering the product or making it available to them. 23 I think that is an important part to mention as well. 24 MR. REIS: Can I maybe take a slightly different 25 tact on that and that is that I don't think it is our 1 responsibility to determine suitability of all our investors. 2 I think it is our responsibility to give them the information 3 where they can make the decision as to whether it is suitable 4 or not. And I think that is a very important distinction as 5 who is ultimately responsible for that individual's 6 investment, he or she or us? And I would say very strongly 7 it is he or she who is making the investment. But in 8 fairness, they ought to have what they need to make a 9 reasonable choice. 10 MS. HOOPER: It is really interesting to me to sit 11 back and listen to all of this good conversation because it 12 is quite apparent that there are very disparate levels, if 13 you will, of the way these vehicles are being sold. And, 14 obviously, at the NASD we are focusing on what our members, 15 the broker-dealers, are doing in the course of selling "hedge 16 funds." And I say that in quotes because one of the things 17 we have found is that there are variety of different types of 18 investments that are sort of generically being categorized as 19 hedge funds, should be of some concern and interest to the 20 people who are marketing and constructing bonafide hedge 21 funds, I might add. But to the individual investor, who is 22 after all the person that we are trying to protect and make 23 sure they are educated, to the individual investor, a lot of 24 those distinctions are transparent. And what they are 25 hearing from their stockbroker, the intermediary that is 1 generally selling them the fund, as opposed to the types of 2 investors that have been alluded to here, that are being 3 dealt with directly with the funds, they are from the 4 feedback that we have gotten to date, not as clear on the 5 issues involving hedge funds and whether or not they are 6 suitable to them. Jim, I thought for a minute that you might 7 have worked for the NASD at some point, as you were saying so 8 many of the same points that we have dealt with. 9 If I could just take a second here and talk about 10 some of the positions that we are exploring. And they really 11 came out of issues that were raised with us by our members 12 who were finding materials and sales promotional pieces in 13 the industry, self-regulation at its best, you might say. I 14 think competition had a lot to do with it because these are 15 investments that were being described in such ways that 16 almost categorized them as mutual funds but when one got 17 through the rhetoric, we realized that was not what we were 18 dealing with. And actually we first started addressing this 19 last summer when we issued an investor alert because we found 20 that some of the information that was being disseminated 21 simply did not clearly educate the investor, and worse fear, 22 that the people who were disseminating it were not educated 23 either about the investment. 24 As you are probably aware, we issued a notice to 25 members in February of this year that was really just sort of 1 a heads-up to our members, saying, hey, look, these are the 2 obligations that you are under. You have a heightened 3 obligation as a matter of fact when dealing with a certain 4 type of investment that involves a higher degree of risk. 5 And we were really focusing on a couple of areas. One of 6 them is in the disclosure area, the fact that a lot of the 7 materials that we were seeing were lopsided. They were 8 focusing on the potential for growth. I mean this is after 9 all the beauty, if you will, of such investments is that they 10 are offering an opportunity in a bad market condition to give 11 investors something to cling on to and hopefully have their 12 investments grow. But at the same time, if they are not 13 balanced with obviously the more opportunity there is for 14 growth, the more opportunity there is for risk. And we are 15 adamant that our members distribute materials that make it 16 clear that these investments are indeed full of risks, 17 illiquid, that they aren't necessarily required to provide 18 any kind of periodic pricing, and that they aren't first and 19 foremost subject to the same regulatory requirements, for 20 example, that mutual funds are. 21 The other thing that we are particularly looking 22 for concerns this whole issue of suitability. And at the 23 NASD, we have requirements that our members make certain that 24 there are two prongs of suitability that are met. One of 25 them is a reasonable basis, that there is a reasonable basis 1 for assuming that is a suitable product or investment for the 2 investor. And the other one is that it is suitable for that 3 individual or that particular investor. So we are looking 4 for these things. 5 We did a sweep, we are still in the process of 6 doing that sweep. We have gotten about 1,000 pieces of 7 material. We have found that approximately 50 percent of th 8 firms submitting materials, a little more are getting 9 comments back. The biggest problems are in balance and 10 disclosure. And as a result of that sweep, we have actually 11 taken an enforcement action against one of our members. I 12 might add that that member was selling both private and 13 public funds. So I think that there is no way to categorize 14 this as a problem that is affecting one area more than 15 another. If the group that is selling the product to the 16 investor is so inclined, then they can misrepresent I think 17 by over-simplifying the investment, by not clarifying the 18 amount of risk involved, and even by perhaps alluding to the 19 investment in such a way that it would lead the reader to 20 think it is a different type of an investment than it is. 21 MR. BUTOWSKY: Clark, if I could just ask one 22 question relating to the notice to members. 23 MS. HOOPER: Sure. 24 MR. BUTOWSKY: I think a lot of the people that I 25 deal with in the industry on the broker side were a little 1 concerned that -- I think the industry has pretty much taken 2 the view that when it comes to selling a fund to somebody who 3 is an institutional investor, that for an institutional 4 investor they don't really need to do a customer-specific 5 suitability analysis, that they distinguish institutional 6 investors from retail investors in that regard. And I was 7 just wondering if you could comment on what I understand some 8 people have been saying that the notice to members can be 9 taken to be interpreted that the NASD doesn't see a 10 distinction? 11 MS. HOOPER: Well, I guess my answer to that, my 12 response to that is that certainly we see a distinction 13 between institutional and retail investors. However, having 14 said that, it doesn't mean that one isn't accountable for 15 ensuring that the investment is suitable, whether it is to an 16 institution or whether it is to a "retail investor." One 17 cannot simply find a safe harbor in a definition of investor 18 and dismiss the need for assuring that it is a suitable 19 investment. 20 MS. OSTERMAN: Leroy, I wonder if you could comment 21 on your practices with respect to making sure that 22 investments are suitable for the investors that your firm 23 attracts? 24 MR. CODY: Okay, I think the first thing I will say 25 is that, like many of my colleagues here on the panel, is 1 that our business is focused on institutional investors. 2 That is where our hedge funds, first hedge funds were spawned 3 really, from the institutional asset management end of our 4 business. That has been our focus and the overwhelming 5 client base growing from that. And that is where the 6 dollars, the bulk of the dollars are coming from. But I 7 would agree with Clark that because we are dealing with 8 institutional investors who are sophisticated and are savvy 9 and are doing their own levels of due diligence, doesn't in 10 our mind really absolve us from responsibility to make sure 11 that we are having conversations with those investors about 12 certainly understanding what our product is and how it fits 13 in, does this fit in with what they are trying to accomplish 14 in their particular fund. 15 But, generally speaking, I would say there are 16 probably about five areas that we are going to focus on with 17 investors to determine suitability, and that is overall 18 financial status, assets that they may have, and what their 19 investment objectives are, also a lot of focus on their 20 individual risk profiles, is it really suitable for -- are 21 they willing to take more risk, do they have the stomach for 22 more risk? And sometimes even institutional investors will 23 have difficulty with that, believing that they can swing for 24 the fences and then finding out with the first hiccup that it 25 is uncomfortable for them. Third, liquidity -- fourth, 1 liquidity. And that is that there are lock-ups on most of 2 these products and they have to be able to live with that. 3 And, again, just back to the whole concept of understanding 4 what it is that we are doing. Our best clients are those 5 that really do understand what we are trying to achieve in 6 our investment strategies, can understand it, can get their 7 hands around it, and understand that there are times when we 8 are going to do well and times when we might not do quite so 9 well. And are comfortable with how that fits in with their 10 overall investment objectives. 11 MR. ROYE: Liz, can I ask the panel a general 12 question and that is as we get overseas and attract money 13 from overseas, there are aggragators overseas who are 14 "institutions." And my question is have people on the panel 15 had experience dealing with those aggragators and what is the 16 responsibility to go beyond the aggragator to the ultimate 17 customer and see what difficulty have you had doing that? 18 And is this an area that the SEC should be looking at? 19 MR. CODY: I will take a stab at that because over 20 time a large percentage of our investors have been non-U.S. 21 And we have been careful to try to abide by the letter and 22 the spirit of our regulations. And it has been frustrating 23 in many, many cases where there are barriers to really 24 knowing who that end investor is. So we have gone to great 25 lengths to try to get at stations really from those 1 administrators or others that are the fiduciaries that we are 2 dealing with directly, that they know who the investors on 3 the other side are and that they can attest that they are 4 accredited to the best of their knowledge. 5 MS. OSTERMAN: I think that raises an interesting 6 point that I have been trying to get at, which is, Leroy, you 7 are mentioning how hard you push back at that aggragator to 8 find out the composition of the pool of money that you are 9 getting. Why is it that there isn't more push at the 10 individual investors, perhaps it is just a prior knowledge of 11 your investors, you have known someone for a long time, or 12 maybe it is something else. But I would really like to hear 13 someone talk a little bit more about pushing at your 14 qualified, maybe not so qualified, investor? 15 MR. RUSSELL: Yes, I think one thing that hasn't 16 come up here, I think all of us who work in this business who 17 have been in it for a while recognize that the Patriot Act 18 has changed the landscape tremendously among managers and how 19 much they know about their investors. I think we are going 20 places we never went before, and I think that is a good 21 thing. And I think the attention being paid to the sources 22 of capital, who is bringing the capital, obviously both on- 23 shore and offshore in the last couple of years, has changed 24 dramatically from where the industry was. 25 I think that we are honing in on this distinction, 1 and I just want to touch on it for a minute. Honing in on 2 this distinction between individual hedge funds, that may or 3 may not be registered, going directly to investors versus 4 typical intermediary channels that operate in the business. 5 And there is a little bit of -- it sounds like a little bit 6 of a mismatch. I think it is an interesting topic, the topic 7 of the institutionalization of the hedge fund business, as 8 well as the retailization. And, obviously, as a registered 9 investment advisor and having a registered fund to funds in 10 the market, the reality is that the retailization of the 11 market is being done by registered investment advisors. In 12 general, I think Bob mentioned on the last panel, maybe the 13 number of funds that are being offered out there and how they 14 are being distributed. They are primarily being distributed 15 through broker-dealers. The sort of small entrepreneurial 16 firm with four employees or 15 employees is not going to 17 adequately cover the investor spectrum and draw thousands of 18 barely accredited investors. It can't be their business 19 model. Their business model which we are hearing is going 20 toward institutional investors. So I think there should be 21 some comfort taken that particularly on the registered fund 22 side, number one, they are expensive to launch. Number two, 23 they are going off to a broad-based audience and the way they 24 are doing it is through intermediaries who I think in my 25 experience and what I see in the industry is almost all 1 broker-dealers, which put investors subject to the 2 suitability test. So we are focusing in on one sliver but 3 the reality of the retailization is it is really focused on 4 places where suitability is in place. 5 The last thing I would mention is that in terms of 6 suitability, I think there are also two levels. And I heard 7 this distinction on the last panel between single managers, 8 single-strategy funds and diversified fund to funds. And 9 often what we see and what we do in cases is testing 10 investors, like an example would be that not more than 10 11 percent of their liquid assets be invested in a single 12 manager fund and a threshold of say 30 percent being invested 13 in a diversified fund to fund. So there is probably, in 14 terms of risk and suitability, a distinction should be made 15 between a diversified fund to funds versus a single manager 16 fund. And we do that. 17 MR. BUTOWSKY: I just wanted to add one thing to 18 what Craig said on the Patriot Act. We are seeing more and 19 more in our practice, the impact where many times investors 20 who are coming through an intermediary perhaps, that the fund 21 or the broker for the fund isn't familiar with, if they can't 22 obtain information concerning the underlying investors, those 23 investors are being rejected because the intermediary perhaps 24 isn't deemed someone that the fund feels comfortable relying 25 on. So many times the investors coming through an 1 intermediary, where you can't get all the information related 2 to the underlying investors, will only be accepted if the 3 intermediary is deemed reliable. 4 MR. HEDGES: I don't know if it is fair to split or 5 stratify the conversation along these lines. But it sounds 6 to me as though there is a bit less concern about 7 institutional investors in that they appear to have an 8 additional layer of oversight and regulation, ostensibly a 9 larger asset base and a degree of professional due diligence 10 and risk management that is really institutionalized or 11 systematized. And I sense that there is a greater degree of 12 concern with the individual investor. 13 And the way I was thinking about this conversation 14 evolving is there is the direct access, be it for a fund to 15 funds or a hedge fund, to the high net worth or retail 16 investor. And I believe that, at least it is my position, 17 that the manager, the advisor, the consultant has a 18 responsibility to ensure that there is proper suitability and 19 education and realistic expectations, as I said before. I 20 think one of things that is less clear though is when there 21 is an indirect relationship, as we were talking about before. 22 Our firm is in the business of oftentimes building funds of 23 hedge fund products, which are then constructed and managed 24 by us but then sold through intermediaries, like on- and 25 offshore private banks, broker-dealers, registered investment 1 advisors, commercial banks. And so we have a number of these 2 indirect relationships at our firm. 3 What has not been mentioned here today, which I 4 think is a substantial gating factor to the sales process, is 5 that those intermediaries, again whether it is an offshore 6 private bank or a NASD-registered broker-dealer, these are 7 intermediaries who are taking your product to their best 8 clients. Their best brokers are offering this client, the 9 corner office broker to the best clients. And there is a 10 tremendous amount of concern, reticence, and care that is 11 taken at these organizations to line up. Not to say that, as 12 you point out, Clark, that a lot of the documentation 13 requires commentary and what have you. But we find that 14 there is a very active dialogue about what is the appropriate 15 type of messaging to give to properly train the sales force, 16 the intermediaries, those that are assessing suitability, and 17 then what standards do they apply on the ultimate investor. 18 MS. HOOPER: And I think it is really critical that 19 that occur because we have seen this in other segments of the 20 industry as well. All you need is one or two bad instances 21 that can smear the entire industry. You don't want that to 22 happen. And therefore when we find situations where there 23 really are egregious violations of good faith, if nothing 24 else, then you know that we need to look at these things and 25 put something in place, which is actually the reason we 1 started out with our notice to members, to make people aware 2 of what is expected of them and what high standards they are 3 being held to. It is complicated a bit by the fact that in 4 competition with hedge funds or the managed commodities 5 pools, for example. And, once again, I think the 6 distinctions are often transparent to the investor except for 7 the fact that there is a difference in the underlying 8 investment. But the requirements, for example, of what kinds 9 of performance can be presented are quite different among the 10 different types of securities. And yet there are some 11 things, for example, that we would outright prohibit. And we 12 have actually taken action against some of this whereas in 13 other instances, other regulators are requiring certain types 14 of information. These are the kinds of inconsistencies that 15 unless explained, and I think that is the critical point is 16 making sure that people understand that they are educated 17 both from the seller's perspective as well as the buyer's 18 that can lead to the confusion and the unsuitable investment 19 ultimately. 20 MR. BELLER: It seems to me that one of the things 21 that this last colloquy demonstrates is that there really are 22 two related but separate issues. One is suitability 23 determinations and being comfortable you are talking to the 24 right kinds of investors. And the second is the disclosure 25 obligation. And what Clark is talking about I think in terms 1 of being education, making sure that the investor understands 2 what he/she/it is getting into is a matter of disclosure. 3 And both have to be dealt with adequately. You can't 4 overcome bad disclosure with good suitability determinations 5 and vice versa. 6 MS. HOOPER: Right. 7 MR. REIS: Let me take the other side of that for a 8 second because I think if you give an investor fair and 9 meaningful disclosure, suitability is very easy to determine 10 at the extreme. Somebody is sitting with a huge bond 11 portfolio that is generating more income than they can 12 possibly spend a big pile of cash, illiquidity shouldn't be 13 an issue. Somebody who has $100,000 and they say to you, 14 "Look, I may this in the next three months," illiquidity 15 becomes a huge issue. But in between those extremes, 16 suitability becomes looking in the rear view mirror because 17 if you said to somebody in March of 2000, "These hedge funds 18 are risky." They would have said to you three years later, 19 "They were really suitable. I lost 40 percent of my money in 20 a tech fund." And, likewise, if you said to that same person 21 in the beginning of 1994 or 1995, "We have got a fund here 22 for your risk money that is going to 8 percent." And he 23 looked back five years later and said, "I could have earned 24 35 percent a year in the S&P, what do you mean that is 25 suitable?" So I think on the extreme suitability is an issue 1 and then after that disclosure does play an important part 2 because it lets the investor decide whether it is suitable. 3 MR. BELLER: If you give the best disclosure in the 4 world to an investor who can't read it -- 5 MR. REIS: Well, we will assume that our investors 6 are literate. 7 MR. BELLER: -- or completely doesn't understand 8 it. No, Judd, I think you can fairly assume probably that 9 your investors are in a category where this issue is largely 10 irrelevant. I think as you particularly get into the kinds 11 of funds where intermediaries do the principal marketing, I 12 don't think it is a frivolous concern. 13 The other thing I guess I would say -- 14 MR. REIS: I didn't say "frivolous," Alan. 15 MR. BELLER: That is fair. The other thing I guess 16 is we have been talking about investor experience in terms of 17 suitability. I think it is worth noting at least that pull 18 it back to the exemption notion, we have these exemptions 19 based on net worth and income as really as surrogates for 20 sophistication. We don't have direct exemptions based on 21 sophistication, which I think is probably too hard to define 22 an exemption around. But it is interesting to note that 23 there are some jurisdictions, and I think the UK is the 24 principal one, the UK has an exemption from our equivalent of 25 registration for offerings to investors with a demonstrated 1 degree of investment experience without regard to their 2 income levels, without regard to their asset levels. And it 3 is worth noting that that is out there, it seems to me, as a 4 different or an alternative approach to the exemption issue, 5 not just to the suitability issue. 6 MS. OSTERMAN: I am going to take a leap and jump 7 to a different issue for a minute because, Alan, I know you 8 are going to have to leave us very soon. If we could talk a 9 little bit about the use of the Internet and public 10 solicitation, that would be great. And I don't know, Alan, 11 if you would like to start off? 12 MR. BELLER: I think probably we are all better off 13 if Michael starts off. 14 MS. OSTERMAN: Okay. 15 MR. BUTOWSKY: Okay. Well, I guess there is a bit 16 of confusion out in the industry obviously about the use of 17 the Internet because there is quite a bit out there on the 18 Internet about funds in general. And it just adds on to the 19 point that Alan was making before. I guess as a premise, as 20 a requirement to both 3(c)1 and 3(c)7, you need to make sure 21 that you are not conducting a public offering or proposing to 22 conduct a public offering. And there is a wide amount of 23 interpretation as to exactly what that means. And when you 24 look on the Internet, you will see a wide variety of 25 different types of references to funds out there, both 1 proprietary sites and non-proprietary sites. But I think it 2 is widely viewed as an offer is really deemed to occur when 3 you are either making a direct offer or possibly 4 incentivizing people to come to you to ask more questions 5 about a vehicle. And when you take a look, you will see on 6 the Internet that there is, like I said, a wide diversity of 7 different types of references out there. And people just 8 have to be very careful as to whether or not they are 9 crossing the line between an offer and providing information. 10 But there are also broad questions, as Alan mentioned before, 11 about whether or not by virtue of having information on the 12 Internet as opposed to an operating company, a fund 13 technically isn't really advertising a product that whether 14 or not it is conducting something that it shouldn't be. 15 MR. BELLER: I guess I would say there are two 16 elements that one has to be careful about in terms of using 17 of the Internet or any other form of publicity with respect 18 to hedge fund activities. One is kind of the general 19 publicity issue. You can't put up a billboard on Time Square 20 and say, "We have a new hedge fund but please understand that 21 unless you are an accredited investor, don't call." There is 22 a school of thought that so long as you restrict the sales to 23 accredited investors and are adequate about policing the 24 people to whom you sell, it shouldn't matter if you put a 25 billboard up in Time Square. That is not the law today. 1 That billboard in Time Square or equivalent or much lesser 2 amounts of publicity are inconsistent with our views of a 3 private offering. 4 The second part that is very important is the 5 notion of pre-existing relationships, and this has been 6 mentioned a couple of times on the panel already. Even 7 targeted means of publicity to offer to persons to whom or 8 with whom the advisor or the other intermediary seller does 9 not have a preexisting relationship can also raise general 10 solicitation questions, especially as that targeting becomes 11 less targeted, if you will. You send out an e-mail or make a 12 website generally available and say, "You can buy this but 13 only if you are an accredited investor" and people with whom 14 you don't have a preexisting relationship have access to that 15 page, that itself can be problematic under our current rules. 16 I think it is fair to say that the kind of the 17 costs, the benefits and burdens of the rules have been 18 subject to a good deal of thinking over the years, both in 19 the 40 Act context and in the general offering of securities 20 contexts generally. It is an issue that has been taken up on 21 and off I think since at least the mid-90's when the Wallman 22 Commission started thinking about it in general terms, much 23 of the general thinking is translatable to the hedge fund 24 context, should there be more focus on sales, should there be 25 less focus on general solicitation? 1 I do believe that -- I don't know if SEC staffers 2 are speaking only for themselves generally on this panel but 3 I am certainly speaking only for myself on this particular 4 point, and that is I do think there is a connection between 5 the relatively low level of the accredited investor 6 definition and the concern about -- the desirability of 7 maintaining some level of restriction on the offering side. 8 I think the two points are not unrelated, and I think that is 9 an area that is worthy of some consideration as well. For 10 example, to go out of the investment company context for a 11 moment, general solicitation is arguably a lot less of 12 concern when you are selling only to qualified institutional 13 buyers, that is $100 million-plus institutional investors, 14 which again is not a subject for this panel. But when you 15 are selling to individuals with $200,000 or $300,000 of 16 income, I think it is more of an issue. 17 MS. HOOPER: The problem is the more broadly 18 disseminated that general solicitation is, the more difficult 19 it is going to be to limit your audience to restrict it. 20 MS. OSTERMAN: Alan, because of time constraints, I 21 would like to push if I could a little bit and have you think 22 about funds of hedge funds and the possibility that more 23 information, and not less, is better for those investors who 24 are making that choice to get into that particular product. 25 MR. BELLER: I suppose one solution to that issue 1 is, of course, on the registered side. I assume you are not 2 really talking about registered funds of hedge funds where we 3 have got public offerings and prospectuses and where my view 4 would obviously be more disclosure is better, and I don't 5 think there is an particularly regulatory obstacle to it. 6 MS. OSTERMAN: Well, I guess suppose you have the 7 investor in the funds of hedge funds who wants to do a little 8 of their own due diligence on the underlying product. And so 9 they are trying to find out more information about the 10 underlying hedge funds that their fund has invested in and is 11 that a better thing, if there is that information available 12 to them? 13 MR. BELLER: I think presumably that is a better 14 thing, both in the registered and the unregistered context. 15 It points up one of the real I think conundrums of funds of 16 hedge funds, both in terms of investor due diligence on the 17 offering side, where I would agree with you, more is better. 18 But you come up against some restrictions that I think others 19 on the panel are much more qualified to talk about than I am 20 in terms of the practicalities of getting that access. I 21 think it is also a conundrum in terms of something that 22 really falls more into the investment management area, which 23 is regulating registered funds of hedge funds where their 24 portfolio consists of securities where there is not a lot of 25 public access of it -- there may not be a lot of access to 1 the board of directors of the registered fund, to us as 2 regulators of the registered fund. And I think that that 3 maybe is a related but different question from the investor 4 question. I think it is important in both those areas. 5 MR. HEDGES: I would like to take a step back and 6 differentiate between funds of hedge fund investments and 7 hedge fund investments. I believe that fund of hedge fund 8 investing is dramatically, dramatically safer for the 9 investor. I also believe that it has been, and will continue 10 to be, a primary conduit for capital in the hedge fund 11 business. There are lower investment minimums. Therefore, 12 investors have less at risk individually. There is arguably 13 a professionalized due diligence and oversight process. 14 There is an ongoing risk management and portfolio inspection 15 process. There is the diversification. Most fund to funds 16 out there probably have 20 to 40 different hedge funds within 17 their portfolio. So there is a high degree of 18 diversification and then there is also an economy of scale 19 and cost savings associated with spreading one's bets over a 20 larger pool of capital. Ubiquity doesn't equal safety with 21 hedge funds, meaning that just because these things are 22 growing, there are more hedge funds out there all the time, 23 doesn't mean that the industry is getting safer. I think the 24 likelihood of the individual investor picking that hedge 25 fund, which is precisely appropriate for that individual is 1 very, very low without an advisor. I think that to the 2 contrary fund to funds offer a much more secure diversified 3 lower cost entry, lower feed entry, although there is an 4 additional management fee for fund to funds, but lower cost 5 structure with professionalized diligence that I think 6 warrants suggesting that those standards -- those vehicles 7 should be looked at differently. 8 The issue of doing due diligence on the underlying 9 hedge fund managers within a fund to funds portfolio, I think 10 is really not necessarily the right question. Because when 11 one invests in a fund to funds product, you are hiring not 12 somebody to give you access to these 10 managers, and you are 13 getting a flow through, you are hiring that individual to be 14 in the business of due diligence, professional risk 15 management, and transparency, and all of those types of 16 issues. That is what you are paying for. And so looking 17 into the underlying portfolio of 40 funds, I don't know that 18 that is particularly meaningful. We don't necessarily go and 19 look inside of our mutual funds individual security holdings 20 and ring up our mutual fund manager and say, "I don't like 21 the fact that you own Enron in the portfolio." Why then 22 would we also be in a position to call up and look at a 23 portfolio of 40 hedge funds and say, "I don't like that you 24 own XYZ Fund in this portfolio." So I just wanted to split 25 that discussion between hedge funds and funds of funds. 1 MR. TIEDEMANN: Can I just make a comment going 2 back to the Internet discussion. As an unregistered fund, 3 obviously we are not allowed to, and I think that should not 4 change, I think marketing hedge funds over the Internet would 5 be a terrible proposition. I do think though that once there 6 is an investor and a qualified investor in a fund and once 7 they have seen and been given all the appropriate 8 information, and I have another comment about that, I think 9 that the use of the Internet is an exceptional way, given the 10 password and log in and all that, to give updated, timely 11 exposure of what a fund is investing in, whether it be at the 12 sector industry level, overall risks within a portfolio. And 13 it really helps both parties because as a hedge fund manager, 14 you are not fielding calls all day explaining your portfolio. 15 And if you are lucky enough to have a technology platform 16 that can automate that process, more power to you. 17 I do think, just going back to information 18 disclosure, offering memorandums or obviously legal documents 19 are complicated to read as an investor, certainly as an 20 unsophisticated investor, I think you would be hard-pressed 21 to really get too much out of it if there is a lot of 22 complicated legal terminology. I would suggest possibly 23 having a standardized due diligence document, which focuses 24 on what I think is as important as anything, the operations 25 and business risks of the funds, as well as the investment 1 risks. Because I think they are often overlooked, less so 2 now than it was four or five years ago, the business 3 practices of a fund, their operational practices, their 4 ownership, et cetera, et cetera, as well as the investment 5 practice. But have it more in layman's terms that possibly a 6 less sophisticated investor could understand. 7 MR. REIS: Michael, you can do that now if you 8 want. 9 MR. TIEDEMANN: Yes, I know you can do that but if 10 it was a matter of practice and really forced upon the 11 industry, then -- 12 MR. REIS: Well, if it is a matter of practice and 13 it is good practice, it will sort itself out. 14 MR. TIEDEMANN: I don't think it is a matter of 15 practice. 16 MS. HOOPER: The only thing you have to be cautious 17 about, and we have seen some disclosure sheets, some sort of 18 generic disclosure sheets that try to hit on the different 19 items. But if there are issues or concerns that are taken 20 out of context from the rest of the materials being 21 presented, you have got to be extremely careful to make sure 22 they are connected to the particular things they are trying 23 to explain, just to staple or insert a disclosure sheet 24 doesn't always fully educate the investor about which areas 25 you are trying to explain. So you have to be cautious about 1 that. 2 MR. RUSSELL: Okay, one comment to Alan. I think 3 one of the challenges that is clearly a conundrum is the 4 issue that I think investors are struggling to get 5 information about the business and that is difficult. If you 6 pick up popular press and you search for the top 10 articles, 7 they are always the articles of some flaming failure of some 8 guys who has three jets, it is a terrible thing. You rarely 9 pick up the cover of popular press being, look, the last 10 three years have been a difficult market for a lot of 11 investors, here is something that has offered them some 12 diversifications to their portfolio in a balanced way. The 13 conundrum being that we spend a lot of our time with 14 intermediaries. I can't tell you how much time I have spent 15 over the last five years educating intermediary groups and 16 individual investors and really in a way demystifying hedge 17 funds, telling them that they are not all shooting for 90 18 percent returns, that on balance if you looked at a 19 diversified portfolio of hedge fund returns over the last few 20 years, they have been albeit positive but modest. And 21 getting that information across is very difficult obviously. 22 So one of the benefits obviously of creating some more public 23 information being available is that people would have a 24 better context for which to view an industry that is clearly 25 growing and people want to get access to. Obviously, there 1 are registered funds out there and literally, I don't think 2 it would be fair to say for everybody, I don't think 3 registered fund sales are exploding and they are not running 4 away, partly because there is a big de-mystification and 5 education that needs to happen. And the access to 6 information for investors, really true information, comparing 7 performance, like you see in traditional investments, is very 8 hard for investors to get access to today. 9 MR. BELLER: I want to say two things then I do 10 have to run, both I think in response to these last comments 11 and Mike's comments in particular. One, on the use of the 12 Internet, clearly an incredibly powerful tool that can be 13 used for the benefit of investors. And that is why we have 14 in fact been spending a lot of time thinking about it. With 15 things like password protection, it is a way to get 16 information to your investors that is much more efficient 17 than paper or anything else that seems to be available. So 18 there is certainly no regulatory interest in reducing the 19 appropriate use of the Internet. If anything, exactly the 20 opposite. It is just that things like password protection 21 are appropriate devices to do that within the rules. 22 Secondly, on disclosure. I think the hedge fund 23 industry probably suffers from the same malaise that 24 disclosure generally suffers from, which is that in one 25 sentence the way I describe what you were talking about is 1 too much disclosure is written to avoid liability as opposed 2 to inform investors. And just as the operating companies of 3 America would do well to spend more time thinking about how 4 to inform investors, I think probably the same thing is true 5 of the hedge fund industry. Judd is absolutely right. There 6 is no obstacle, indeed I think there is nothing but 7 regulatory encouragement for the kinds of practices that the 8 two of you are talking about. And I think it requires a 9 determination to do it and do it in the right way. 10 MR. BUTOWSKY: Alan, I just wanted to react to one 11 thing that when you and Judd were talking, going back and 12 forth before about the suitability, just one point. It was 13 interesting that you mentioned to Judd that the question 14 about whether or not people, if they have the information, 15 can they understand it. And just thinking, when you look at 16 the NASD rules on 2310, the suitability rule and one of the 17 interpretations under it, it talks about in the context of 18 institutional investors, that really the duty of a broker is 19 to evaluate whether or not the investor has the ability to 20 evaluate on their own as a first measure. And then second 21 are they making the decision on their own. So ability to 22 evaluate and independence. And so at least in the 23 institutional context, it at least focuses on that area. 24 MS. OSTERMAN: I would like to talk a little bit 25 about consultants and their roles in connecting investors to 1 hedge funds. This is generally considered to be outside of 2 the brokerage area. These are people who are not -- who are 3 frequently not registered as brokers. And I would like to 4 talk a little bit or have you all talk a little bit about the 5 connections that are made and what distinguishes those 6 practices from brokerage practices, what suitability tests 7 those consultants do or are responsible for doing in 8 connecting investors to hedge fund products. Jim, if you 9 have any reaction to that? 10 MR. HEDGES: Okay, I think the question regarding 11 consultants needs to be addressed in the context of what the 12 business model of the consultant is. Lots of different types 13 of business models exist in the hedge fund landscape, maybe 14 in the investment landscape where people are "advisor" or 15 "consultants." Ultimately, it is the revenue model of the 16 business that determines where potential conflicts of 17 interest lay and therefore what sort of positioning should be 18 taken in terms of evaluating the efficacy and the 19 responsibilities of that particular advisor. So, 20 simplistically, there are "consultants or advisors" who are 21 compensated merely on fee only basis in exchange for "X" 22 dollars or in exchange for "X" percent of assets under 23 management. We will tell you what to do with your money. 24 Arguably, that is about education, asset allocation, and then 25 ultimately opining upon managers and helping the investor 1 invest in managers. That represents what one might call a 2 sort of Ivory Snow or 99 percent pure business model of being 3 purely aligned with the investor. 4 Then there are consultants, advisors who receive 5 compensation in the form of directed commission dollars 6 through various types of broker-dealer relationships with the 7 investment managers. That is also a mechanism which may or 8 may not represent a complete alignment of interest. It is a 9 different business model but nonetheless one that has got a 10 certain set of caveats in terms of the way it is positioned 11 to the client and the way in which it is positioned with the 12 investment manager. 13 Then there are finally investment managers, 14 advisors, consultants who operate product themselves, 15 investment management product, whether it is a fund to funds 16 or a hedge fund product. And, again, there is a different 17 axe to grind if we are in the business, if one is in the 18 business of selling a fund to funds as opposed to simply 19 "advising" somebody on how they should invest their capital 20 for a fee only type of relationship. So the point being 21 made, you really can't I think generalize about what 22 consultants are doing, how they are doing it without really 23 drilling down and looking at the revenue model and how these 24 organizations are structured because that ultimately tells 25 where the agenda is. 1 MR. BUTOWSKY: Jim, aren't the vast majority of the 2 consultants compensated by the investment advisory clients or 3 the investors? 4 MR. HEDGES: I don't know the numbers of it. I 5 know that all of those models exist. I think of consultants 6 that are paid through directed commissions, that get fee- 7 only, that charge asset-based fees, and that also are what I 8 think of as effectively glorified contract marketers or 9 third-party marketers. So I can't speak to the breakdown of 10 the number of players out there but I think there are a lot 11 of different business models out there. 12 MR. RUSSELL: I think one thing that is not 13 mentioned here, which is worth mentioning also, is there is 14 clearly a large consultant community in the institutional 15 asset management space that is not sort of completely focused 16 on hedge funds but clearly have clients who are coming to 17 them asking for hedge fund advice and there are some who 18 focus more on endowments and foundations who have a great 19 deal of hedge fund expertise and there are other investment 20 consulting firms who have very little expertise. And it 21 really runs the gamut. They are clearly in the advisory camp 22 but that is a growing portion of people in this business who 23 are gaining expertise and making asset allocation and manager 24 advice to clients as we see it. 25 MS. OSTERMAN: I know that we are running over a 1 little bit. I would like to spend just a little bit more 2 time on fund of funds. It is an area that we have been 3 focusing quite a bit on in our investigation and thinking 4 about. And I would open up to the panel, we have talked 5 about who buys the fund to funds, and I think generally what 6 we have seen in our disclosure office is that a registered 7 fund of funds is a product that currently sells to accredited 8 investors and that the lowest minimum investment is about 9 $25,000. I think that is the lowest I have seen at least. 10 That is still a pretty big -- that is still a pretty big 11 investor for these products. As we all know, however, there 12 is no legal requirement on funds that makes them stay with 13 these requirements except for everyone's general concerns 14 about who is getting into these products. We do hear people 15 pushing at these limits. We hear people asking questions 16 about should these products be open to any investors 17 regardless of their net worth? Should they be open just as 18 any closed-end product? Should they be sold just on a 19 constant basis to anyone who comes in? And I am very 20 interested to hear what people think about lowering the 21 limits so that these funds of hedge funds, with as Jim was 22 talking about, their professional management at the middle 23 level between them and the actual hedge fund, if those are 24 really good investment products? 25 I guess this morning we heard about, I think 1 Commissioner Campos said, "So this should be a product open 2 to everybody because it is low risk, no risk." Is that 3 really true? 4 MR. RUSSELL: I would say that given some standards 5 around what the definition of a registered fund to funds 6 would be. I think that the appropriateness for this 7 investment is not determined by whether someone is an 8 accredited investor. I think someone brought up the concept 9 of is there some other measure. Clearly, if you go outside 10 of the U.S., retail investors not defined by credit investor 11 rules have access to these funds in lots of jurisdictions 12 around the world and they are sold in quite large size. 13 There was some mention that they may be hybrids but retail 14 clients well below accredited investor status are getting 15 access to these funds outside of the United States. 16 My view is that these funds are applicable for 17 investors as long as you take into account the issues that I 18 think a lot of people brought up, the risk of loss of their 19 investment, tax issues, liquidity, does it fit into their 20 asset allocation mix. But within that context, I think it is 21 applicable for a lot of investors. Another way to look at is 22 I think if a lot of investors who did fit the criteria that a 23 type of an investment like this would make sense for and had 24 the ability to invest over the last several years, I think 25 that would have been a very good situation for a lot of 1 investors. And I think it is also worth noting that in a 2 fund to funds product, we don't see people making -- there 3 are clearly investors globally who have large portions of 4 their portfolios in hedge funds. I think all of us can cite 5 examples of clients we know that. But traditionally when we 6 see investors making initial investments in hedge funds, we 7 are talking about maybe 5, 10 percent of their investable 8 assets on the outside. So our view is that for clients who 9 it is appropriate for, I think it should be available to 10 investors who are below accredited investor standards. 11 MS. HOOPER: And I might just add that I believe 12 from our perspective, regardless of whether the investor is 13 an accredited investor or retail investor, we would still 14 hold the broker-dealer subject to suitability requirements. 15 So if the investment is suitable for the investor, whether 16 the investor is accredited or whether it is a retail 17 investor, if it is a suitable investment, then that is what 18 we would be looking to as the criteria. 19 MS. OSTERMAN: Well, I would like to end this panel 20 the same way Paul did and open up the floor, if I could hear 21 from everyone on the panel about any concerns, thoughts or 22 points that they think haven't been made in this panel. 23 Again, we have talked about marketing and distribution, 24 suitability issues, fund to funds. Give everybody a deep 25 breath and starting from my right, Judd, would you like to 1 start off? 2 MR. REIS: Sure, I think one of the most 3 interesting issues is the prohibition on advertising 4 marketing communication in some sense, which is 5 understandable, and yet from an investor's point of view 6 maybe not totally desirable in that most investors who don't 7 have direct access, either to good fund to fund managers or 8 directly to hedge funds, really rely on the press for their 9 education about hedge funds. Now there are some books and 10 the diligent investor can find out a lot more from 11 publications but you will tend to get it from the Wall Street 12 Journal or local newspaper or some of the financial 13 magazines. And they tend, as the press does, to focus on the 14 sensational. It is not a very article, somebody mentioned 15 earlier this morning, to say for the last three years if you 16 had earned 5 percent, you would have outperformed the S&P by 17 55 percent. Don't you wish you had some? I think I would 18 say sure but it is much more sane to talk about a burger 19 flaming out or a beacon hill losing 50 percent of its 20 capital. So I think it is an interesting issue for the 21 Commission to wrestle with, as to what people ought to be 22 able to say. Personally, I have no axe to grind. We don't 23 care about advertising. We don't want to go on the speaking 24 circuit. But I can why a lot of investors would like to 25 legitimately learn more than we can tell them now. 1 MS. HOOPER: Just building on that. I think one of 2 the things we are hearing is the rather broad extent under 3 which these investments seem to be categorized. They run the 4 gamut from being appropriate for multi-million dollar 5 institutions. And we are looking at whether or not they are 6 also appropriate for retail investors. If you want to build 7 on that, and it seems to me that if it is a good investment, 8 and by "good," I mean an appropriate investment, then the way 9 I think to do that is to provide the investor with as much 10 information and education about that as possible. That is 11 not to say a standard disclosure statement, I believe there 12 is a former director of the Division of Investment 13 Management, who once said that, "A prospectus should be read 14 carefully before you invest or send money because it will be 15 used against you in a court of law." And I think that is 16 exactly the kind of disclosure we are not looking for. So in 17 terms of getting information out and making these securities 18 as they grow in popularity, they will be of more interest to 19 more of the lower level, if you will, retail investor. And 20 they have simply got to understand what is being offered to 21 them. 22 MR. HEDGES: A few conclusions. About a year ago 23 the Commission announced that they were putting out what I 24 viewed as a few hypotheses. We are concerned about the 25 pricing of the liquid securities, about conflicts of 1 interest, about fraud, and there were a number of issues that 2 they discussed. My sense is that the industry is, as Joel 3 Press was very articulate in saying in the previous panel, 4 highly-professionalized and organized, an industry that has 5 got a great deal more depth and process and 6 institutionalization than lay people have historically 7 understood. I think that is now getting articulated 8 publicly. And these issues, like the incidents of fraud, I 9 think is very low in this industry. The incidents of 10 illiquid securities being improperly priced in portfolios 11 only applies to a relatively small number of strategies, 12 effectively only a small number of managers. 13 So I think a lot of these hypotheses are not 14 necessarily the headline issues. Ultimately, to me the 15 headline issues are if you have an industry that is going to 16 attract this institutional capital, professionally advised 17 capital, intermediated capital, then that is an industry that 18 is espousing that institutionalization. And I think we are 19 seeing the industry mature constantly there. I think where 20 our concern lays is on that retailization or 21 pedestrianization of the industry and what about all these 22 suitability disclosure issues. 23 Well, ultimately, it is my sense that the lion's 24 share of the hedge fund industry is actually not interested 25 in the retail investor. More hedge fund managers that I talk 1 to than not have no interest whatsoever in selling their 2 product in a retail channel. They like being privately 3 placed to accredited or qualified purchasers. They like the 4 freedom that that enables them to have. And they are not 5 interested in getting into a different type of construct in 6 order to target the retail investor. 7 We keep talking about pedestrianization and these 8 registered fund to funds or registered hedge fund products 9 but, again, I would underscore that these apply to accredited 10 investors for the most part and the actual number of 33 Act 11 open-end fund to funds products I think you can count on your 12 hands and your toes. It is a very, very small number of 13 products out there and a number of products that I frankly 14 don't see growing dramatically in the near future. 15 MR. BUTOWSKY: I would just say that I think you 16 hear a lot of times out in the press people calling hedge 17 funds lightly regulated. And for those who work in the 18 industry who are very familiar with the laws in the area, 19 they understand that in truth when you have got a hedge fund, 20 when it is run by an unregistered advisor, it is very, very 21 regulated. I would say that probably 90 percent, 95 percent 22 of the Investment Advisors Act applies to unregistered 23 advisors as well as it does to registered advisors. The 24 general anti-fraud prohibitions apply. And that is an 25 important thing to keep in mind because across the industry 1 there is a wide disparity as to the level of understanding in 2 the industry as to what people are subject to and what they 3 are not. Obviously, the larger people, the larger 4 institutional funds, they are always dealing with lawyers and 5 they are very, very familiar with what they are supposed to 6 be doing. 7 And the reason I raise this point is I think as we 8 go down this road in considering if there is anything that 9 needs to be done in the industry, I think one of the things 10 that I would encourage the regulators to do is to think about 11 rather than regulating through maybe a broad series of 12 enforcement actions, which people usually read and try to 13 interpret all sorts of things from, instead to come up with 14 maybe some sort of concept releases or something that 15 brutally and clearly tell people what hedge funds, whether 16 they are run by a registered advisor or not a registered 17 advisor are subject to. And go into the marketing point for 18 one second, the subject of the Internet. Like I said 19 earlier, it is all over the place. And it is a facts and 20 circumstances analysis and many people aren't in a good 21 situation to try to figure out exactly what they are supposed 22 to be doing. 23 MR. CODY: I will echo a little bit what Jim said 24 and I think Craig brought it up as well and that is what I 25 see as a bit of disconnect because I do believe that most of 1 the business models for hedge funds and fund to funds are 2 really focused more on very accredited investors, 3 institutional investors. And I am sure there will be those 4 whose models are going to drill down a little bit somewhat 5 below that. But certainly from an economic standpoint, you 6 want to build a business model that has an ability to attract 7 some more dollars and stable dollars and people who 8 understand your product and understand what your strategy is 9 supposed to be about. 10 MR. TIEDEMANN: One of the true issues in my 11 opinion in the industry that wasn't mentioned explicitly in 12 the first panel are here is capacity -- everyone talks about 13 the dollar growth of the industry and it is obviously very 14 impressive. It obviously comes with job growth, which no one 15 likes to point out which has been the terrific saving grace 16 for the financial services industry. But every capacity, and 17 I think if you ask the asset allocators at this panel and in 18 this room, if their assets doubled next year, would they be 19 able top with conviction place those assets and managers that 20 they think could manage them properly and still have the same 21 return stream. That is a major issue. The more the assets 22 that flow into this industry, the more efficient it becomes, 23 the less opportunities potentially there will be to make the 24 returns as we know them. 25 Regarding registering or not registered, we are 1 unregistered hedge fund group. Our decision to register 2 would be based on one of two things: if Chairman Donaldson 3 told us to or if we based on a business decision wanted to go 4 after more ERISA money or registered fund to fund products. 5 I think there is enough capital that will find its way to you 6 without advertising if you are superb manager in your space 7 over time if you are superb manager in your space over time, 8 which is probably the proper way for it to come to you 9 anyway. 10 My only concern about the outcome of this 11 conference or potential outcome is that a barrier to entry 12 through regulation could potentially be created, which would 13 really be too high of a hurdle for less capitalized, smaller 14 entrepreneurials to enter in the space who have good 15 intentions, who do not want to grace the covers of 16 publications but that want to develop a culture and run a 17 business and co-invest with their investors. That would be 18 my only concern as an outcome of the conference. 19 MR. RUSSELL: Liz, I was hoping you were going to 20 start over here and go that way but this is the sweet spot of 21 going around the table. Clearly, there has been a lot of 22 mention about issues around suitability and appropriateness. 23 And in my view those are key, and I think we are all spending 24 a lot of time on those, particularly as a broader set of 25 investors get exposures to these type of investment vehicles. 1 Topics that I think are important for clients, and I think it 2 has a lot of things -- we mentioned the Patriot Act has 3 changed the assessment of investors greatly over the last 4 couple of years. Transparency has increased tremendously in 5 the business, not only to professional advisors but also 6 investors and registered funds who get to see who they are 7 invested in. Due diligence has been raised to a different 8 level. The first panel mentioned from a client perspective 9 that people are spending a lot more time on operations issues 10 and valuation and accounting and that is key. 11 To us, the value of investing in hedge funds is 12 compelling. I think Bob mentioned in the last panel you can 13 slice it and dice it, you can look at academic research, it 14 is a compelling proposition. And I think one of the biggest 15 challenges that we have as a business is finding a way within 16 the sort of suitability appropriateness framework to get that 17 information out properly to investors. And I think that is 18 one of the biggest challenges we face as a large manager and 19 also as a firm that is an intermediary in the business is 20 getting that information out in a way that is obviously 21 proper and credible at the same time. And right now we are 22 doing that on foot but it would be great if we could do that 23 as an industry. 24 MS. OSTERMAN: Thank you all for your comments and 25 for your participation in this panel. 1 (Whereupon, a luncheon recess was taken.) 2 MR. PLAZE: Good afternoon, and welcome to Panel 3 3 of our roundtable on hedge funds. 4 I'm Bob Plaze. I'm the associate director in the 5 Division who will be the master of ceremonies, at least for 6 the next hour-and-a-half here. 7 Our topic this afternoon is disclosure, 8 transparency, and performance fees -- three topics -- and 9 with me this afternoon is a distinguished panel of experts in 10 the area, who will be offering their opinions. Let me 11 introduce them. 12 Starting from my far right, Mr. Peter Bernard is 13 chief financial officer of the RiskMetrics Group. Peter has 14 been at RiskMetrics for over three years, and during that 15 time, he's had responsibility for operations of the company's 16 strategic planning and senior client relationships. 17 RiskMetrics offers risk analysis that clients of 18 hedge funds will use to evaluate the risks associated with an 19 investment. 20 George Hall is president of the Clinton Group, an 21 SEC-registered investment advisor with approximately $5.7 22 billion in hedge fund assets under management, both onshore 23 and offshore funds. 24 David Hsieh is professor of finance at the Fuqua 25 School of Business at Duke University. Professor Hsieh has 1 conducted extensive research in the area of hedge funds. 2 He's won numerous awards for his work, including the Fisher- 3 Black Memorial Foundation's 1999 Robert J. Schwartz Memorial 4 Prize for the best paper on hedge funds, which he co- 5 authored. 6 Professor Hsieh holds a Ph.D. in economics from the 7 Massachusetts Institute of Technology. 8 Jean Karoubi is president and founder of the 9 LongChamp Group. He provides managerial and financial 10 advisory services, specializing in hedge funds, asset 11 allocation, to high net worth families, and they have about 12 $300 million of assets under management. 13 To my left, Larry Simon is president and chief 14 executive officer of the Ivy Asset Management Corporation, 15 another SEC-registered investment advisor. 16 Through its funds and advisory relationships, Ivy 17 manages over $7 billion of investor funds. 18 Next to Larry is David Swenson. He is chief 19 investment officer at Yale University, where he is 20 responsible for more than $10 billion in Yale endowment 21 assets and several hundreds of millions of dollars of other 22 investment funds. 23 In 1990, Yale became the first institutional 24 investor to pursue absolute return strategies as a distinct 25 asset class. 1 He is the author of Pioneering Portfolio 2 Management, an Unconventional Approach to Institutional 3 Investment, published in 2000, and prior to joining Yale in 4 1985, Mr. Swenson spent six years on Wall Street. 5 Finally, to my left, Michael Tannenbaum, our lone 6 lawyer on the panel this afternoon, heads the financial 7 services hedge fund group of the New York City law firm of 8 Tannenbaum Helpern Syracuse & Hirschtritt. 9 He has over 30 years of industry experience in U.S. 10 and non-U.S. hedge funds' structured finance arrangements. 11 Mr. Tannenbaum is also director of the Hedge Fund 12 Association. 13 Welcome, gentlemen all. 14 Again, our topics today, disclosure, transparency, 15 and performance fees. 16 The first two topics may not be obvious, the 17 distinction, but I'm going to draw a distinction for purposes 18 of this discussion, disclosure being the information an 19 investor obtains or perhaps needs to obtain before making an 20 investment in the hedge fund; and transparency, information 21 the investor obtains or needs to obtain to assess his risk 22 and exposure with respect to a continuing investment in a 23 hedge fund. 24 If you're a securities lawyer, you might 25 distinguish this between the '33 and '34 Act, which, of 1 course, don't directly apply in this situation. Nonetheless, 2 we're going to talk about them today. 3 Just to kick off, the current disclosure regime 4 requires delivery of a private placement memorandum to an 5 investor before the initial investment, but investors feel a 6 need to do extensive due diligence on an investment in a 7 hedge fund. 8 A recent DeutscheBank survey reported that 60 9 percent of hedge fund investors surveyed take between two and 10 six months to complete due diligence and make a hedge fund 11 investment. Many feel the need to hire a consultant, and 12 even sometimes a private investigator, to uncover and verify 13 information before making an investment. 14 Mr. Tannenbaum, the private placement memorandums 15 I've read describe what the hedge fund manager will do -- 16 e.g., event arbitrage -- but as I think alluded to earlier 17 this morning, they then typically allow him to make just 18 about any other kind of investment he wants or deems 19 appropriate as the general partner of the fund. 20 Is this typical, and does this explain perhaps why 21 private placement memoranda are not particularly useful or 22 used by investors? 23 MR. TANNENBAUM: Thank you. Everything was fine 24 until to got to the "not particularly useful" phrase. We 25 would differ as to that. 1 First, let me say that investments of this sort -- 2 and by that I mean hedge fund type investments -- are 3 typically run, almost virtually always run by opportunistic 4 entrepreneurial folks who basically are retained in the first 5 place in order to find investment opportunities, and have a 6 broad mandate, so as to perform well in virtually all 7 markets. 8 There is no question that the documents are, in 9 fact, drafted very broadly, and that's intended, and I would 10 suggest that that's favorable to the investor. 11 They are drafted in a way that permits the manager 12 to react to changing market conditions, which I think is 13 crucial; they're drafted in such a way as to allow the 14 manager to react to a situation that perhaps didn't exist at 15 the time the document was originally drafted, and it's that 16 very flexibility that's, I believe, a cornerstone of the 17 industry. 18 That's the reason why these funds tend to be so 19 flexible, so that the lawyer in me, of course, and other 20 lawyers in the room, and those not in the room, of course, 21 draft these documents in a very broad way, and that's very 22 much intended so as to permit that flexibility. 23 MR. PLAZE: Do you ever have any concerns that an 24 investor who, say, isn't a lawyer, reading these documents, 25 might not appreciate that last sentence in the two-paragraph 1 description of the investment objectives and policies? 2 MR. TANNENBAUM: It's always a concern, and the 3 concern is where you draw the line between what needs to be 4 disclosed from a legal standpoint -- and there's plenty to be 5 disclosed -- and how that is to be written in a way that is 6 meaningful and legal and artful, and how you make the 7 documents readable, sufficiently readable so that investors, 8 a wide range of investors -- admittedly some have more 9 experience in this asset class than others -- are able to 10 react in a meaningful way. 11 What we do, and what I think most lawyers in this 12 industry do, is to have a summary section which tends to be, 13 as the name suggests, more of an executive type summary of 14 the transaction, followed by many pages of explanatory 15 material that backs up the summary, and I think that's 16 somewhat unavoidable at this point. 17 MR. PLAZE: Professor Hsieh, you've described, in 18 one of your writings, private placement memoranda as, at 19 best, cursory and involve technical descriptions. 20 Do you have any suggestions as to ways that they 21 could be improved to be more useful to investors, or would 22 your advice for directors be not to rely on them? 23 MR. HSIEH: Well, I think that it would be useful 24 to get some summary information of what the funds are exposed 25 to, but I've read some of these disclosure memorandums 1 myself, and I think that it's, for a typical investor, it is 2 very hard to go through and see all the details. 3 MR. PLAZE: Mr. Swenson, do you rely on them at 4 all? 5 MR. SWENSON: I guess I would be in the category of 6 not particularly useful in terms of the disclosure documents. 7 I mean, what we really care about when we're making 8 investment decisions is, first and foremost, the quality of 9 the people, and there's no way that you can look at 10 somebody's disclosure document and figure out if the people 11 that you're invested with have the character, the 12 intelligence, the integrity, the creativity, and market savvy 13 that you want to have in a partner in this arena or any other 14 investment arena, for that matter. 15 When you look at disclosure documents, it might 16 tell you what the proposed deal structure is, but on the 17 other hand, if we don't like the deal structure, we'll talk 18 to the manager and try and negotiate a set of terms that we 19 think would be fairer; so what's disclosed there may or may 20 not be relevant to us. 21 Finally, there's probably some information on 22 historical track record, but that's all backward looking, and 23 what the returns were or what the volatility of those returns 24 were don't really tell you much of anything about what they 25 might be. 1 And what's interesting to us what are the 2 fundamental positions that were taken, security positions, 3 long, short, or otherwise, that contributed to the record 4 that was created, not the pure return numbers or the risk 5 numbers associated with that. 6 So the disclosure document touches on two of the 7 things that we care about, but doesn't really address them in 8 a comprehensive way, and the disclosure document misses the 9 most important fundamental thing that we care about in making 10 investment decisions, and that's the character and quality of 11 the people. 12 MR. SIMON: I'd just like to point out that the 13 private placement memorandum is more end of process than 14 beginning of process. 15 For those of us that are registered, we are 16 basically selling a security, and therefore, you cannot 17 basically offer a document unless a client asks for it, et 18 cetera. 19 Most clients, whether institutional or high net 20 worth, tend to have this towards the end of the process. 21 They want to do their due diligence, they want to know about 22 process infrastructure, they want to know about returns, 23 track record, which is usually filled with informational 24 material. 25 The second visit or second request may then ask for 1 the private placement memorandum. 2 So no client should receive a private placement 3 memorandum on a first visit, unless they ask for it. 4 MR. PLAZE: Mr. Tannenbaum. 5 MR. TANNENBAUM: The disclosure process, this 6 initial legal disclosure process, as opposed to the 7 transparency side, which is the distinction you made, is 8 really, in and of itself, two, really two disclosures. 9 There's an initial -- there's a type of a 10 disclosure that would satisfy the investors in terms of, you 11 know, what the deal is about, what the strategy is, what the 12 risk parameters are, fee structures, those kinds of things 13 that, for lack of a better phrase, are purely business 14 oriented, and therefore exceedingly important to the 15 investor. 16 There's another type of disclosure, again for lack 17 of a better phrase, which is the legal disclosures -- pages 18 of tax materials; pages of materials about the USA Patriot 19 Act, our new money laundering statute, of course; materials 20 about the CFTC futures disclosure; descriptions of qualified 21 eligible participants, which is the 4.7 rules; description of 22 qualified purchaser, qualified client. 23 I guess the question is, what do I leave out? You 24 know, what does a lawyer leave out of that mix and still 25 satisfy the needs to make sure that the full disclosure is 1 made? And I would suggest it's difficult to leave any of 2 that out. 3 MR. PLAZE: The one item I might notice is the 4 conflicts of interest disclosure. That's an important part 5 of that document, and I would think, Mr. Swenson, as an 6 investor, that's one area you would look at very carefully. 7 MR. SWENSON: Well, I do look at the conflicts of 8 interest, usually for amusement, because it's an easy way to 9 eliminate funds from consideration, but aside from that, I'd 10 like to actually address the issue of using the disclosure 11 document description of investment strategy as a starting 12 point. 13 I mean, the lawyers draft these so broadly that 14 they're useless. They take great care to make sure that an 15 investment manager can do absolutely anything without running 16 afoul of any strictures that might have been placed on the 17 manager in the disclosure documents. 18 So the only way to really find out what a manager 19 is doing is to sit down and take a look at the portfolio and 20 go through it position by position. 21 I think that, because of the legal nature of the 22 disclosure process, the documents tend to be pretty close to 23 useless, although I will put a little asterisks by it for the 24 conflicts of interest, because sometimes those are amusing. 25 MR. PLAZE: I was just going to say that it is one 1 thing in the way of disclosure to have the market power to 2 take a look at position by position, and that's exactly what 3 one should do if they can. 4 The further one gets away from the manager, the 5 less one can do that, and there I would suggest disclosure 6 has got to put a greater emphasis on what are the processes 7 that the intermediary has gone through to put a portfolio of 8 hedge funds together, what they have done in the way of due 9 diligence, and I think there's quite a lot that can be done 10 that isn't being done today on that score. 11 MR. BERNARD: I'm -- oh, I'm sorry. Go ahead. 12 MR. PLAZE: I was speaking because I didn't sense 13 anybody else was. 14 MR. BERNARD: Well, one thing I wanted to point 15 out, I think listeners may get an improper impression. I 16 think private placement memorandums vary from one hedge fund 17 to another, and as we've said before, there are thousands of 18 them. 19 You know, the ones that I'm most familiar with, 20 obviously, are my own, but certain other ones that I've read, 21 they're very specific in terms of what asset class the 22 investor -- the hedge fund manager can invest in, what they 23 can do to hedge it. 24 Now, there are some that are very general, and 25 that's because certain hedge fund managers are generalists, 1 and they should have the opportunity, and investors want them 2 to have the opportunity to change from one strategy to the 3 other. 4 But in general, I think specialists that have a 5 particular niche that they focus on, that's pretty well laid 6 out in the private placement memorandum. 7 That's not to say that that's enough information to 8 make a decision. Obviously, due diligence, looking at track 9 record, and getting a feeling for the manager and so forth, 10 is important. 11 But I think it would be wrong to leave listeners 12 with the impression that private placement memorandums are so 13 general that you can't get a grasp on what the strategies 14 are, because I don't think that's universally true. 15 MR. PLAZE: Let me just ask this question to the 16 group. How important a role do the consultants play in 17 ferreting out specific information for investors? There are 18 large questionnaires, I understand, that are submitted to you 19 regularly, so that you must have some people spending quite a 20 bit of time answering them, from what I've seen. 21 MR. BERNARD: Well, that's driven by the investor. 22 If the investor wants to hire a consultant to do this due 23 diligence, then the consultant will do it, and certain 24 investors do the due diligence on their own, and all 25 investors, they tend to have different things that are 1 important to them. 2 Some information is relevant to one investor, and 3 it's irrelevant to another, and it's up to hedge fund 4 managers to answer all these questions that they're willing 5 to answer as accurately as possible, and the information that 6 they're not willing to answer, such as positions in the 7 actual portfolio, then that should be, I think, uniform among 8 all investors. 9 MR. PLAZE: That's a good segue. Mr. Simon, you 10 noted that different investors have different disclosure 11 needs. Why? How does that work out? 12 MR. SIMON: I think this was something we discussed 13 recently. 14 They shouldn't, in reality, have different 15 disclosure needs, but by the nature of the client, whether it 16 be an institution looking to place significant money or a 3- 17 C(7) investor who has investible assets of a certain size and 18 may have a gatekeeper or asset allocator or accountant or 19 lawyer who helps make the decision, to the 3-C(1) accredited 20 investor who may be sold by brokerage house or investment 21 bank or someone, they all have different reasons for 22 disclosure. 23 So if you start with the institution, as was just 24 stated, you'll be put through a tremendous amount of 25 questions, because there's a fiduciary responsibility for 1 most of those institutions that either the trustees are 2 looking to protect or basically delegate that responsibility 3 to the hedge fund manager or the fund of funds manager. 4 Same thing with high net worth families. The 5 accredited investor in a 3-C(1) fund is basically buying 6 performance, pedigree, strategy, and is not going to be, 7 unfortunately, as thorough as the other two categories, et 8 cetera. 9 So clearly, it should be important to every one of 10 those classes, but it's going to vary by individual 11 personality and their desires. Institutions are looking to 12 make long investments, three to five years. Unfortunately, 13 high net worth investors may be chasing performance. 14 So it's going to vary, and therefore, disclosure 15 may mean different things to different audiences. 16 MR. PLAZE: There are investors who want different 17 types of information, but there are also situations in which 18 investors can get different types of information, depending 19 upon their market power, their ability to band and extract. 20 I notice with interest there are some guidelines 21 published by the Alternative Investment Association. It's a 22 European organization. Jean is our designated European 23 representative here. 24 MR. KAROUBI: I need to make a correction here. I 25 have been in the U.S. for 26 years. 1 MR. PLAZE: Okay. 2 MR. KAROUBI: My children are born in New York, my 3 wife is American. I have been investing in hedge funds in 4 the U.S., in the U.S. mostly, for about 24 years. I know 5 very little of European. 6 One thing you can say is that -- 7 MR. PLAZE: I said the wrong thing. 8 MR. KAROUBI: He said that you had those guidelines 9 made in the U.S. in year 2000 by the Managed Futures 10 Association, and the Europeans copied them. 11 MR. PLAZE: Oh. 12 MR. KAROUBI: But the difference is that the 13 regulatory authorities in the U.K. in general, I believe -- 14 again, it's my belief, because I'm not sure of what I'm 15 saying there -- more seriously and took more attention about 16 this set of guidelines, that possibly it was done here. 17 But in terms of disclosure, which in a way these 18 guidelines address, first we talk about, you know, Larry 19 talked about using the PPM as an end, as a beginning, as a 20 start. 21 I think it's something which is extraordinarily 22 useful. It's kind of quite fun to use the PPM as a base to 23 ask questions and to see how the manager will react. 24 "You are the manager? How come you are not the 25 director yourself of your offshore fund?" The answer of most 1 of the managers is, "Because my lawyer told me I should not." 2 And of course, don't forget who wrote the PPM. The lawyer, 3 paid by the manager. 4 So it is totally normal that the PPM will not 5 protect the investor. It's protecting, obviously, the 6 manager. 7 It's up to the investor to use that format to ask 8 questions detailing, piece by piece what the manager actually 9 does, what are their actual conflicts of interest, which are 10 real, and some of them which are so large not to be clear, 11 and quite frankly, having looked at and read personally, 12 because as a so-called small investor, I don't have a battery 13 of lawyers to do for me, read several hundred of them, we 14 came to a very simple format to dissect out of it what 15 questions to ask the manager. It's not that hard. 16 And the manager, most of them, the overwhelming 17 majority of them is absolutely willing to go far beyond what 18 their lawyer has written to limit himself into exactly what 19 he or she is doing. 20 MR. PLAZE: The question is that -- we mentioned 21 that the guidelines indicate that if a manager gives someone 22 information, he should provide it available, make it 23 available to all the investors, the information, and the 24 question I was going to ask is, should we adopt similar 25 guidelines in the United States, in terms of -- it's a 1 fairness question. 2 MR. KAROUBI: What do I know? I can only talk 3 about my own experience. I am not here to regulate the SEC. 4 MR. PLAZE: Oh. 5 (Laughter.) 6 MR. PLAZE: Anyone else have any views on this? 7 Before we leave, any suggestions on things that 8 could be done to improve this disclosure process by which 9 investors make decisions, very important decisions involving, 10 sometimes, a lot of money. 11 MR. ROYE: Hey, Bob, can I jump in and just ask a 12 question about the extent to which the greater institutional 13 interest in hedge funds, how has it shaped or influenced the 14 disclosure process, or does that really go more to the 15 transparency issue? 16 MR. BERNARD: I think they bleed into each other, 17 in my experience. The institutions in their due diligence 18 exact promises on what they will have access to on an ongoing 19 basis, and that's one aspect of the decision making process. 20 So if they will have access to position level data 21 in the future, if they will have access to risk statistics, 22 if they'll only have access to one conversation per quarter, 23 and a one-page letter, those are factors in the due diligence 24 process that speak to the openness of a relationship between 25 the investor and the manager going forward. 1 MR. PLAZE: Mr. Hall, do your documents explain 2 what you will be providing, ongoing information, in that 3 respect? 4 MR. HALL: In the private placement memorandum, I 5 don't believe it provides for ongoing information. That's 6 more informal, more outside of the documents. 7 But one thing I wanted to mention, this goes back 8 to the question that Commissioner Campos asked this morning, 9 when he said that everything sounds great with hedge funds, 10 why don't we just open the floodgates and let everyone 11 invest? 12 I think the question was somewhat rhetorical, but 13 not fully answered. 14 The point there is, I think the institutions, the 15 fact that historically, more sophisticated investors and 16 institutions have invested in hedge funds, they have driven 17 this -- you know, I think hedge fund managers, they do the 18 right thing, they try to disclose accurately. I think they 19 have a great level of integrity, by and large. 20 But the fact that institutional investors and 21 sophisticated investors have driven this market in the past, 22 they've caused hedge funds to disclose at, I think, an 23 appropriate level. 24 If it does get opened to retail investors, they are 25 not going to be as sophisticated, and that's probably 1 something that needs to be considered, that over time, the 2 quality of disclosure that's demanded by institutional 3 investors may actually slip downward. 4 MR. PLAZE: As a result of retail investors? 5 MR. HALL: Well, I think, by and large, the world 6 of hedge fund investors now is more sophisticated than the 7 world of retail investors, if you just took the average 8 sophistication across both segments. 9 So I think as the sophistication goes down, you 10 know, all the things that were pointed out that I had agreed 11 with this morning on the first panel about the positives of 12 the hedge fund and their ability to self -- not self- 13 regulate, but to do these things of their own volition, that 14 potentially, those thresholds could slip a little bit, as it 15 penetrates a less sophisticated investor group. 16 MR. PLAZE: Any thoughts? 17 MR. SWENSON: I'd actually like to take a little 18 bit different tack on that particular question. 19 I think that hedge funds are unsuitable investments 20 for unsophisticated investors. It doesn't matter how much 21 disclosure there is, how much access they have. If you have 22 a group of unsophisticated investors, they're likely to have 23 a very, very high degree of failure in the hedge fund world. 24 If you look at the individuals' experience s mutual 25 funds, we've got thousands and thousands of mutual funds. On 1 average, the experience of individual investors is quite poor 2 there. They would be far better off with an index fund than 3 with the high cost active management that they've got in the 4 mutual fund world. Of the thousands of mutual funds, there 5 are probably several dozen that are worthy of investment. 6 Now, the thing that you've got in the mutual fund 7 world that is a benefit is that at least the investor gets 8 the asset class exposure, so if they're in an equity mutual 9 fund, they get the wind at the back from owning equities over 10 long periods of time, or if they're in a bond fund, at least 11 they have exposure to the bond market. 12 If you go to the hedge fund world, there's no wind 13 at the back. There's no asset class exposure. It's all 14 active management. It's all about being partners with 15 managers that can identify and successfully exploit 16 inefficiencies in the marketplace. 17 So the likelihood is that if you get a group of 18 unsophisticated investors, they're going to end up with a 19 group of managers that are going to produce poor results and 20 they're going to pay extraordinarily high fees for the 21 privilege of getting the poor investment results, and that's 22 just a terrible combination. 23 So I would think that it would be best for the 24 investment world to have extraordinarily high hurdles in 25 place in terms of allowing unsophisticated or smaller 1 investors to participate in the hedge fund world. 2 MR. KAROUBI: The world of investment in hedge 3 funds is twofold. 4 Either you invest directly in a hedge fund -- and I 5 agree with you, David, on what you said right now. It's 6 pretty difficult to select Hedge Fund A versus Hedge Fund B, 7 and someone with little means first doesn't have really 8 access to an ability to analyze those strategies. 9 But Larry here has provided a number of investors 10 very quality funds of funds. We do the same in a way for our 11 own family and other investors, where by buying other 12 people's expertise into combining strategies and putting 13 together investment in hedge funds, it does work in retail 14 format, so far. 15 I think the danger of developing hedge funds is 16 simply too much money going to strategies, and wherever this 17 money comes from. I think the danger comes more from the 18 people who are copying you, David, and realize that you have 19 done so much better than they have done. 20 And the pension fund, the endowment, the foundation 21 is big money. I was stupefied recently, being on a small 22 group of investors, including $50 billion pension fund, who 23 needs to provide at least 6 percent return, some others, 8 24 percent return. 25 They are desperate to find the yield, to find the 1 return, any which way, and they are trying to get into a 2 hedge fund as if hedge fund is going to give a sure way to 3 get them this kind of return; and this is so much more money 4 into an industry who may not have the capacity, the retail 5 investor. 6 MR. SWENSON: I mean, I don't think that a fund of 7 funds is the answer for lack of sophistication. I think that 8 it exacerbates the problem, because the unsophisticated 9 investor is going to be attracted by performance, and if you 10 judge an investment only by performance, you're going to end 11 up in the soup, eventually. 12 The only way that you can do an intelligent job of 13 judging investments is to understand the fundamentals, and 14 the unsophisticated investor, by definition, doesn't 15 understand the fundamentals, doesn't understand what the 16 managers are doing. They're simply responding to 17 performance. 18 So if these unsophisticated investors pool their 19 money in a fund of funds, and they are looking only at 20 performance, there's a patch of bad performance, they'll pull 21 the money away, creating instability and creating bad returns 22 for themselves; so that's not an answer. 23 I think the answer is that this is an arena for 24 sophisticated, highly qualified investors, and there's no 25 simple way to allow the unsophisticated to play. 1 MR. SIMON: I just would like to add for the 2 record, since I seem to be caught between two gentlemen 3 talking about fund of funds, and since that's the business 4 I'm in, it's certainly not retail. As a number of counselors 5 out in the audience can tell us, it's their lawyers that we 6 utilize. 7 The minimum investment in the fund of funds that we 8 run is $1 million and the minimum investment for 9 institutional account, private label, is $100 million. I 10 don't think that's retail. So I just want to put that on the 11 record. 12 MR. HSIEH: Can I add something to that? 13 From the evidence that I have seen, sophisticated 14 investors also chase performance. They chase it just like 15 the retail investors. 16 (Laughter.) 17 MR. HSIEH: My main concern, if we think about 18 opening these types of investments to the general public, is 19 that we now have very illiquid, typically, very illiquid 20 investments. We have now a lot more hot money chasing 21 performance. 22 It will really exacerbate the problem, and then 23 you'll end up, at the end of the day, if investments go bad, 24 the retail investor is going to be asking the question, "What 25 happened, because I can't get out of these funds," and that's 1 really something that we should be concerned about. 2 But I don't think anybody in the industry is really 3 strongly advocating for opening it to the retail investor. 4 MR. PLAZE: These are issues regulators all over 5 the world are struggling with, and coming up with different 6 answers, I might add. The U.K. decided not to. 7 But Hong Kong, a mature market, decided to make 8 them available to the retail investors, because, "If they're 9 so good, why shouldn't a great number of people have access, 10 in at least a percentage of their portfolio?" 11 One could also argue that, of course, there are 12 some mutual funds that are offered in the retail area that 13 involve risk, extraordinary risks, also. This is a 14 fascinating debate. 15 One of the issues, of course, ongoing, and one of 16 the issues we have on our topic schedule today, is 17 transparency, and I know a great many of our panelists have 18 an interest in this issue. 19 Once the decision to invest in a hedge fund is 20 made, it's important to investors to be able to assess the 21 ongoing risks of an investment, particularly if the 22 disclosure documents are written so broadly, I would suggest, 23 and particularly an investment that involves substantial, or 24 could involve substantial leverage. 25 The President's Working Group on Long-Term Capital 1 Management, one of the few recommendations that dealt with 2 the management side, the securities side of the issues, as 3 opposed to the lending that's dealt with, recommended greater 4 transparency of hedge fund financial positions, a 5 recommendation that required legislation to effect, and that 6 was introduced but never passed by Congress. 7 Recently, the same issue has arisen in mutual fund. 8 The Commission has sought to improve the transparency of 9 mutual funds by requiring, instead of twice a year, four 10 times a year disclosure of portfolio holdings, and there have 11 been suggestions, mostly made, I think, in the press, that 12 hedge fund transparency requires position reporting. Others 13 argue that investors need only a quantifiable risk 14 measurement to assess the risk. 15 But there's no, I think, agreement on measuring 16 risks, so far. At least there's no standardized measurement 17 of risk. 18 I wondered what kind of transparency do hedge funds 19 typically provide ongoing, and is it uniform, and has it 20 changed over years as a result of large investor pressures? 21 I think, Paul, that was your question coming up 22 around here. 23 Mr. Simon? 24 MR. SIMON: I don't know if there's an advantage in 25 sitting next to you, but -- 1 (Laughter.) 2 MR. SIMON: -- it's a very interesting question, 3 but it really is strategy dependent. 4 I've been in this business for 19 years, around it 5 since 1965. We use three core strategies, so let me address 6 it from that perspective. 7 Clearly, for long/short/equity managers, we tend to 8 use managed accounts, for a number of reasons, because it 9 offers us liquidity, transparency, the ability to basically 10 cut and leave if some manager has style drift or basically is 11 no longer the star our due diligence thought they were. 12 So we will get, every single night, a prime 13 broker's report of all the positions for those managers. 14 So, for instance, if we have hired a technology 15 manager -- and again, since this is webcast, I have to offer 16 apologies to the Bank of New York, but if one of those 17 managers bought Bank of New York stock, that clearly is going 18 to set a bell off as to how is that technology, et cetera? 19 So with long/short/equity managers, there's a very 20 high percentage of transparency if you tend to use managed 21 accounts. 22 That said, in special situation investing and in 23 what I call multi-strategy managers, and other event-driven 24 approaches, over the last 19 years, we've seen a marked 25 improvement of managers willing to share more information, 1 but not necessarily full transparency. 2 We are given most of their 15, 20 top positions. 3 If it's our player we tend to ask those questions. Some will 4 give us a portfolio at the end of a quarter. I'm not sure 5 that's of any value as you move into a quarter that has just 6 passed, and it changes. 7 The cachet of institutional money coming in 8 strongly, many of these managers like the cachet of having a 9 state pension plan, an insurance company, a Taft-Hartley 10 plan, whatever it may be, and are willing to offer more and 11 more. 12 Their letters are going from one page to 10 pages 13 in terms of what they do, how they do, what the allocations 14 are for their various strategies. 15 So sort of the long/short answer to your question, 16 again, it's strategy dependent, but we have seen a tremendous 17 amount of movement of more transparency over the last five, 18 10 years as the institutions have come into this arena. 19 I'll be candid with you and tell you that the 20 majority of the high net worth investor does not ask for 21 transparency, as an institutional client will ask for more. 22 MR. PLAZE: Mr. Hall, is that your experience? 23 MR. HALL: Well, if I may, can I go back a second 24 to the President's Working Group, which you alluded to, which 25 I actually have an excerpt here. 1 They mention comprehensive measures of market risk, 2 parenthetically value at risk and stress test results, 3 without requiring disclosure of proprietary information on 4 strategies or positions. 5 So let me contrast that to the mutual fund 6 business, where most large, particularly large cap mutual 7 funds, they've got liquid stocks, large cap stocks. Many of 8 them, the majority of them are common to the index that 9 they're competing against, so there are really no great 10 secrets; so full transparency is really not a detriment to 11 their operation. 12 Hedge funds are a different approach to making 13 money in the financial markets. They tend to traffic in 14 securities that may be less liquid, so it's proprietary what 15 they're doing. They may not necessarily want other people to 16 see what they're doing. 17 One of the things that I think was well understood 18 during the long-term capital debacle was that as people 19 sensed what their positions were, that they were trying to 20 unwind, that there was front running going on, it actually 21 caused spreads to move out even further. 22 So position level transparency could be detrimental 23 to the performance of a hedge fund, because their ideas are, 24 in some sense, secretive, they're proprietary, they've worked 25 very hard, done a lot of research to come up with things, and 1 they need to keep it somewhat to themselves. 2 The other point about transparency is that position 3 level transparency is basically meaningless, I think, to most 4 investors. 5 The fact of the matter is, hedge funds tend to 6 participate in strategies that may be more complex, they may 7 be more quantitative, more model driven, and so forth. 8 They're more complicated than just buying a portfolio of 9 stocks. 10 Now, whether that's good or bad is a different 11 issue, but the transparency is not going to help, and I think 12 if you look at most of the well-known blowups and problems 13 that have happened, first of all, transparency wouldn't have 14 made investors get out of those investments. 15 In many cases, investors were somewhat familiar 16 with what they were doing and they thought it was great until 17 it didn't work out. 18 So, you know, I don't think providing transparency 19 of positions is going to help. 20 Now, transparency of risk analysis, which there's 21 no standardized way to do that, and, you know, I'd love to 22 hear some of your opinions on that, but providing information 23 about risk and exposures, whether it's to interest rates or 24 to the stock market or currencies, whatever it happens to be, 25 is important, and I think investors are forcing managers to 1 be more informative about what the risks are, and I think 2 that's appropriate. 3 MR. PLAZE: That's a good segue into our next 4 topic. 5 How does one go about preparing for offering risk 6 analysis? 7 MR. BERNARD: Thanks for the lead-in, George. I'd 8 agree that position reporting is unwieldy, at best, and 9 unhelpful and misleading to most investors at worst. So 10 what's the alternative? 11 There are certainly -- it certainly doesn't boil 12 down to a single statistic, a single measure across all hedge 13 fund styles, across all hedge fund managers. I think that 14 there are three components of what might constitute an 15 appropriate risk disclosure, ongoing risk disclosure kind of 16 practice. And those three elements are all, I think, 17 designed to educate, to communicate and those in order to set 18 expectations. 19 What we're really talking about in terms of 20 disclosure either before or transparency after is to help the 21 investor understand what he's in for. What can he expect in 22 return and what can he expect in terms of the variability of 23 that return or a worst case return in a crisis environment 24 from that investment. 25 The three components that I think make some sense 1 are one, some element of risk bucketing, understanding where 2 the bets are placed, how concentrated the bets are. And this 3 works in a long/short equity funding works in a merger out 4 fund. 5 The percentage of positions, however defined -- I'm 6 not particularly that interested in getting down to the 7 precise definition, but what percentage of a portfolio is in 8 the top three positions or the top one position. What 9 percentage is in a particular geographical area, what 10 percentage is in a particular sector in a long/short equity 11 fund. Those are kinds of one easy element. 12 The second is, I think, any system of risk 13 practices or risk disclosures needs to have a what-if 14 element. George mentioned a value of risk measures that have 15 been discussed. That is one approach, a statistical 16 approach, to a what-if question. 17 Stress testing is a second approach to a what-if 18 question. Back testing. What has a particular risk system 19 said about what the returns would be and how do those actual 20 returns match up to what the system said? That's a what-if 21 aspect and reasonably valuable. 22 The third element is really -- speaks to 23 consistency. I think that we should all be probably less 24 concerned with what distributions are at play, what 25 algorithms are at play, what statistics are put out there 1 than the fact that the same -- on a particular fund manager 2 -- he ought to be producing the same statistics month after 3 month. 4 George mentioned the long-term capital anecdote. 5 We had some involvement what the banks post-September 1998 6 and what was clear is that whatever system one used, their 7 system, our system, anybody else's system, the firm was 8 taking significantly more risk in July 1998 than it was 9 taking in January 1998. 10 It's an interesting fact that maybe the investors 11 might have wished to know and I think that the consistency of 12 approach is far more important than the actual algorithm or 13 distribution in play. 14 MR. PLAZE: Professor Hsieh, you've written 15 extensively on this subject. 16 MR. HSIEH: Yes. I've been studying hedge fund 17 strategies and risks since 1994 and this morning I heard that 18 there's a call for some of the academic research for the 19 Commission and I am very happy to provide at least a short 20 summary of this work here. 21 Let me start, clearly there's no way to present in 22 a few short minutes the work of over -- almost a whole 23 decade, but let me just give a vision of what we would like 24 to achieve and a quick assessment of where we are. 25 The vision that we would like to achieve, I'd like 1 to take it back to something that you looked at, equities. 2 Now, in the equities market, the kind of risk model that 3 academics look at are things like the capitalize of pricing 4 model and the pricing theory. 5 The idea for those models is that you decompose the 6 risk of a security, a stock, into two parts, one part that is 7 related to the systematic part or common to a large number of 8 securities, and the other part that is idiosyncratic, which 9 means that it is very specific to that one security. 10 And the reason why I say that is that at a 11 portfolio level for an investor of hedge funds, again, if you 12 have a portfolio of hedge funds, you're really interested in 13 the common sources of risk across these hedge funds, not so 14 much the individual single hedge fund that might blow up on 15 you. 16 So the goal of this research is really to try to 17 figure out what are the common sources of risk across hedge 18 funds. If we can figure that, then I think we go a long way 19 to what's understanding for an investor what -- the risk they 20 face in their portfolio. 21 We do this in two steps. First, we look at returns 22 of a large number of hedge funds and try to extract common 23 components and then we try to link those common components to 24 observable market prices and how they move. Sometimes 25 they're option prices, sometimes they're interest rate 1 spreads, sometimes they are different spreads between 2 different kinds of equity like small cap stocks versus large 3 cap stocks. 4 Now, we have been trying to do this for a number of 5 different styles and I have written papers on at least two of 6 those styles and hopefully there will be more to go, but let 7 me give you a quick assessment of how far we have come. 8 If you take the average return of fund of funds as 9 a proxy for a large portfolio of hedge funds and you ask how 10 much of the return variation can we explain using the risk 11 factors that we have identified so far, we have something on 12 the order of 70 percent of the return variance can be 13 explained by the risk factors that we have identified in the 14 research to date. And as my research proceeds forward, 15 hopefully we can bring that percent even higher. 16 What does this say about disclosure and 17 transparency? I think at a minimum someone, either the hedge 18 funds or the consultants, should provide with investors these 19 exposures of the funds to these risk factors and then the 20 investors can then aggregate up at the portfolio level to 21 understand what the risk factors are. 22 And then we can do all kind of what-if scenarios 23 that Peter was talking about. If we know these risk factors, 24 we can actually see in history what these risk factors have 25 done and then we can go back and ask what would the hedge 1 funds have done in the market environments that we haven't 2 observed, because we only have about 10 years of good data on 3 hedge funds and that covered a very short period of time. We 4 could not look at that data directly and say what would have 5 happened in the '70s. We didn't see it. We didn't see what 6 hedge funds did in the '70s. But if we know what the risk 7 factors are and we can go back and look at what they did in 8 the '70s, we can have a good idea. 9 Now, I'm not saying that we can quantify them 10 exactly but for a typical investor, that's not what you 11 really need. What you really need is some idea of how these 12 funds would perform in your portfolio. And I mean the 13 investor, even for a sophisticated investor. That's really 14 what they're looking for. They're not looking for an exact 15 distribution of returns. Of course, for certain purposes, 16 you can generate that as well. 17 That's sort of a quick summary. 18 MR. PLAZE: This morning we learned that the 19 average life of a hedge fund is six-and-a-half years. How 20 did you deal with survivorship bias issues? 21 MR. HSIEH: Well, what we try to do is to group 22 funds that have similar trading strategies together and keep 23 all the ones in the sample, keep all the new ones, keep all 24 the ones that have dropped out, and try to extract a common 25 source of return across all of them and then try to identify 1 what this common source of return is. 2 So this method is also less sensitive to the kind 3 of survivorship bias that you would encounter if you just 4 take a standalone portfolio of existing hedge funds because 5 that would have some survivorship problems. 6 MR. HALL: The only comment I would make to that, 7 which goes back to what we were talking about before about 8 the flexibility allowed to hedge fund managers if they change 9 their strategies, and strategies evolve over time, so despite 10 whatever you can do statistically, I think it's almost 11 impossible to predict how a hedge fund manager would have 12 performed in any other environment, be it the '70s or the 13 '80s. 14 A lot of the success of the hedge fund is -- it's 15 not that a hedge fund has a strategy and in various markets 16 will make that strategy work or make that strategy fail. The 17 hedge fund manager is evolving that strategy, modifying that 18 strategy, getting in and out of the strategy at different 19 times, so a lot of it is a qualitative assessment of the 20 manager's ability to do that, not something that statistics 21 can handle. 22 That's not to say that I don't admire all the work 23 that's being done and I think there's a lot of value to these 24 stress tests and value at risk if it's in the hands of people 25 that understand their limitations, but I would be careful 1 about doing this type of analysis and giving investors a 2 false sense of security about what their risks are because I 3 think over time it will prove that any statistical test may 4 give certain comfort that it will fail in market environments 5 that we haven't seen yet or when we get outside of the normal 6 market conditions. 7 MR. PLAZE: So, for instance, would you agree this 8 is hard to translate into, say, disclosure to a hedge fund or 9 fund investor? 10 MR. HSIEH: From a single fund to a funds or -- 11 MR. PLAZE: Right. No, for that type of investor, 12 say, a registered product to understand -- deal with the -- 13 MR. HSIEH: Oh. I think that this will not be a 14 single number or something like that that is standard 15 disclosure. It might well be that you need to tailor these 16 to the specific investor, but let me come back and respond to 17 George's point. 18 I agree that hedge fund managers change a little 19 bit what they do and I would call that sort of looking at the 20 hard to explain part or the idiosyncratic part of a single 21 fund's return. 22 But for my analysis, there is style consistency in 23 the sense that people who do the same strategies end up 24 generating the type of returns that I would expect to see on 25 exactly those environments that I expect to see them, and 1 that's all that this analysis is really going to be used for 2 is to ask questions like in different environments, what 3 would you expect to see. 4 And I do see quite a lot of consistency in this 5 type of analysis. And if I don't live up to this type of 6 consistency check, I wouldn't be advocating doing something 7 like this. But of course a manager can change styles 8 completely. Now, that would mean that the historical 9 analysis conducted on that manager may not work going 10 forward, but if they do the same thing, they tend to generate 11 similar types of returns. 12 MR. SWENSEN: I would take an even more extreme 13 position than George on this. I think qualitative 14 considerations are overwhelmingly important in the manager 15 selection and monitoring and evaluation process and that 16 historical returns and historical variances and historical 17 correlations are almost useless in making an investment 18 decision. 19 I mean, I think it's interesting for a lot of other 20 reasons but if you're making an investment decision, what 21 happened in terms of returns and risks and correlations 22 really isn't helpful. I think if you look at long term 23 capitals numbers before they blew up, or David Askin's 24 Granite funds before they blew up, or the Piper Mortgage 25 debacle in 1994, on a risk return basis, backward looking, 1 everything was fine right before it came a cropper. 2 MR. HSIEH: No, I don't agree with you on that. 3 MR. SWENSEN: And I think if you took a qualitative 4 assessment or, you know, wrapped your arms around what these 5 people were doing, you wouldn't have given the money. 6 MR. KAROUBI: I would disagree as well. You give 7 example of totally opaque funds which we are provided no 8 information on risk, capturing any kind of alpha out of being 9 exposed to any specific kind of -- 10 MR. SWENSEN: The numbers weren't opaque. You 11 could -- 12 MR. KAROUBI: The monthly number, what do they 13 mean? They mean nothing. 14 MR. SWENSEN: Well, that's what I said. 15 MR. KAROUBI: Yeah. But you are talking of mapping 16 the picture of risk and one should remember what is the 17 objective there. The objective -- there are two kinds of 18 objective. One is figuring out do we have ongoing good 19 manager. When we hired the manager, we believed he was good. 20 We have done all sort of due diligence, all sort of 21 qualitative analysis and the amount of time with his company 22 and as a manager. 23 Then he is getting -- his lifestyle may change, he 24 may be less focused. How to monitor -- that's what we're 25 talking about now, transparencies, monitoring. If we get on 1 a monthly basis the type of risk that the manager 2 systematically gets exposed to month after month after month, 3 we try to capture some type of alpha to make money some way. 4 And suddenly, as we say, we see that type of risk or the 5 level of risk changing, there are questions to ask. 6 I think exactly what you said it in terms of risk 7 factor, we can map the risk of a manager if we get this type 8 of information and we can monitor them. 9 MR. HALL: Well, let's look at a simple example 10 from '95 until the middle of '98. If you were long credit 11 spreads you'd earn positive carry and you'd earn capital 12 gains because credit spreads tightened. And then certain 13 manager -- compare two managers. 14 One may have decided, okay, credit spreads are 15 getting tight so we're going to get out, or there seems to be 16 too volatility so we're going to get out, and other managers 17 may say no, I'm going to stick with it. One, in August of 18 '98 and thereafter will experience huge losses and one won't. 19 That's not going to be in the numbers. 20 They may have historically had the same exposure to 21 credit spreads. So in terms of transparency to a fund of 22 funds or to a consultant or so forth, the consultant may 23 decide that they want to get out of the credit market and 24 then you're transferring the managing the portfolio from the 25 fund manager to the consultant, and that's up to investors on 1 who they want to make that decision. 2 But the decision to at some point in time say it's 3 time to get out of this asset class, it's time to sit on the 4 sidelines a little bit to me is impossible to really quantify 5 in the numbers. And that really comes down to the things 6 that Mark mentioned about the quality of the manager, the 7 discipline of the manager, the appetite for risk that the 8 manager has and so forth. 9 MR. PLAZE: What bout in deciding your particular 10 asset class? 11 MR. HALL: As a manager? Well, as a manager you 12 have to look at various asset classes and what gives you the 13 highest expected return relative to the risk that you're 14 taking. You have to look at trends, you have to look at if a 15 trend is -- you may have earned money on spreads moving in 16 one direction and then you have to make a decision on whether 17 they're going to continue to move in that direction or 18 whether it's time to get out. 19 MR. PLAZE: No, I meant from an investor in a wide 20 range of asset classes directly in stocks and bonds and a 21 portion of whose assets are in hedge funds. If one 22 understands the risk of hedge funds as an asset class, one 23 can evaluate the portion. 24 MR. HALL: Well, again, that depends on who the 25 investor is. I think part of this roundtable is about 1 retailization and so forth and I gave the simplest example I 2 could think of, which is credit spreads widening or 3 tightening and I'm not sure retail investors would have a 4 handle on that. 5 As the strategies get more complicated, it becomes 6 harder and harder to quantify what makes a manager successful 7 and what makes a manager fail and a lot of times it's just a 8 simple decision to set off the field and get on the 9 sidelines, and it's very hard to quantify. 10 I applaud the work that's being done. I think it 11 improves the information that people can have but what I'm 12 most concerned about is a false sense of security based on 13 statistics. 14 MR. BERNARD: The statistics don't provide answers. 15 They provide the basis for better questions. But the 16 comparison was made this morning between the hedge fund and a 17 proprietary desk in a big Wall Street institution. And I go 18 further. Fund to funds or a portfolio of hedge funds is a 19 portfolio of proprietary desks, looks an awful lot like a big 20 financial institution. 21 What do they do? They measure risks everyday and 22 they ask questions about what those risks look like. The 23 statistics are only some common way to take a look at risks 24 and exposures across desks, across asset classes, et cetera. 25 I think to suggest that it is not useful 1 information and is supplanted by only qualitative analysis I 2 think suggests that the two can't work together and in fact 3 we see on Wall Street everyday that they do work together and 4 I would suggest that the same model can be applied to the 5 hedge fund world. 6 MR. PLAZE: Okay. We're going to have to move on 7 to our last and third topic which is performing fees. One of 8 the defining characteristics of hedge funds is their fee 9 structure which differs substantially from mutual funds which 10 we here, at least at the Commission in the division of 11 investment management, are most familiar with. 12 Mr. Tannenbaum, could you briefly compare the two 13 structures and how they operate? 14 MR. TANNENBAUM: Sure. Be happy to. Generally, 15 performance arrangements in hedge funds divide along -- major 16 -- is a major fault line between U.S. funds and non-U.S. 17 funds. And I've been careful to say performance arrangements 18 as opposed to performance fees because there is a difference 19 between the treatment of this compensation onshore versus 20 offshore. This being a U.S.-oriented discussion, I guess 21 I'll stay with the U.S. markets. 22 Performance fees in the United States or 23 performance arrangements in the United States basically are 24 allocations. These are transfers of in most cases 20 25 percent, if that's what the fee structure calls for, 20 1 percent of the net appreciation generally in excess of a high 2 water mark. 3 That amount is allocated to the general partner's 4 capital account within a partnership or a limited liability 5 company structure, which is the most tax efficient for U.S. 6 taxable investors. And these are structures that essentially 7 have capital accounts. Each investor, including the general 8 partner, has its own capital account and monies flow in and 9 out of that account. So about 20 percent of that net 10 appreciation flows into the general partner's account. 11 To drill down a little further, you need to get 12 into the computation of net appreciation. In 30, 35 years or 13 so of factors, virtually every fund in our office treats net 14 appreciation as inclusive, taking into account realized gains 15 and losses, unrealized gains and losses, to get a true 16 snapshot of what the profit, so to speak, in a lawyer's terms 17 would be in the account. 18 Some clients offset that gross amount with 19 operating fees so as to reduce the net a little bit before 20 applying the 20 percent. Some clients reduce that net amount 21 even further by the management fee that perhaps was assessed, 22 that's a net asset value fee, that 1 or 2 percent fee. I 23 don't think these are terribly material items but they -- it 24 is a slight distinction from manager to manager. 25 By the way, always fully disclose the document. 1 Unlike some of the other issues we've heard, transparency, 2 general disclosure and strategy, this is an exceedingly 3 simple thing to explain and it's a very easy thing for 4 clients to understand. They pay 20 percent of the profits 5 and there's a methodology by which profits is defined. So 6 that's pretty straightforward. 7 I mentioned high watermarks. Those are typical in 8 this industry. Profits go up to a certain level or go down 9 to a certain level, a fee is taken or not taken, as the case 10 may be, and then the fee is not taken again until you go 11 above that prior mark. 12 Again, to drill down a little bit further from what 13 was said earlier today, there are adjustments in the high 14 watermark area. For example, if there's a withdrawal from 15 the fund at a time when there is a loss carryforward, this 16 loss that needs to be made up before you get to the high 17 watermark number, typically that withdrawal so to speak 18 carries with it a piece of that loss. 19 So -- I'm sure my numbers will be off but I'll take 20 a stab at the example anyway. If you started with $1,000, 21 went down to $500 and then the investor took out $250, the 22 250 being half of the 500, half of that 500 deficit, so to 23 speak, half of that loss would disappear. And that's fair. 24 Obviously the capital has been cut in half and therefore the 25 ability to make up that loss has been diminished by that same 1 percentage so that there's an adjustment there. 2 I think the -- a couple of other key points. The 3 investment advisors who are registered in the United States 4 are not allowed to take performance fees under current 5 regulation unless the investor is what's known as a qualified 6 client. Qualified client is a defined term, a million and a 7 half dollar net worth or $750,000 in the transaction. If the 8 advisor is not registered, then that rule does not apply. 9 And the last point I want to make is the investment 10 manager's position in these funds is precisely aligned with 11 the interest of the investor in the fund. Not only is it 12 very often virtually always the case that the manager has 13 capital in the fund itself, but because of the allocation 14 process that I just described, the manager's general partner 15 account, assuming a profitable fund, is actually growing in 16 addition to their own capital growing. So not only are they 17 partners but there is a growth by virtue of this allocation. 18 Those funds are all being subjected to the strategy 19 and as a result, the investor's position is precisely aligned 20 with this. To quickly contrast this with the mutual fund 21 area, virtually always -- in fact, I don't know that I've 22 ever seen what is known as a fulcrum fee but there is a 23 fulcrum fee on the books under the '40 Act regulations, and 24 very simply put, the manager in a '40 Act fund chooses an 25 index, has a fee that actually increases as the manager beats 1 that index and has a fee that actually decreases conceptually 2 as the manager falls below the index. 3 It's very telling to me, looking at this through a 4 hedge fund lawyer's eyes, that hedge funds have performance 5 fees and do very well at them and for a reason the mutual 6 fund industry tends not to have fulcrum fees and primarily, 7 with all due respect, would be that they very rarely beat the 8 index. The index is very often -- exceeds the return, I 9 assume statistically of maybe 70 or 80 percent of the mutual 10 funds in the country. I would doubt very much that many 11 mutual fund managers beat the index that they would line up 12 again. 13 The last point relates to special situations. 14 These first few points related to liquid situations, very 15 easily measurable. When you have special situations, you 16 have illiquid arrangements so that those tend to be a little 17 bit more difficult to value and therefore you don't have the 18 ease of assessing a performance fee and typically you simply 19 wait until those investments liquify before you take the fee. 20 MR. PLAZE: Mr. Hall, the method of compensating 21 the advisor, it's simply not the effect on how he's 22 compensated but it has a profound effect on management also. 23 MR. HALL: Right. I think the performance fee 24 model is probably the most important aspect of the hedge fund 25 evolution, if you will. 1 Let me contrast that to the mutual fund business or 2 the traditional long only business. As you mentioned, 3 Michael, and John Bogle from Vanguard has spent a lifetime an 4 the academic research supports the fact that traditional 5 money managers don't beat the index and the ones that do in a 6 given time period aren't any more likely to beat it in a 7 future time period. So in terms of asset class exposure, it 8 would seem that index funds would be better. 9 Because of that, mutual funds have turned out to 10 be, in my view, marketing institutions and their single, most 11 important aspect in terms of their profitability is what 12 their assets under management are. So the market and they 13 have a diverse number of products and at certain times 14 certain products are better than others, and they raise as 15 much money as they can and that improves their revenues and 16 their profitability. 17 The hedge fund model is quite a bit different. The 18 most important driver of profitability for a hedge fund is 19 performance. The first thing, performance people say 1 and 20 20 or 2 and 20, for example. The management fee, 21 particularly in hedge funds that I think are doing the 22 appropriate building of infrastructure really goes to cover 23 costs. Very few -- there's very little profit, if any, in 24 the management fee. 25 So hedge fund managers really only get compensated 1 if they beat the index. So you've got a mutual fund industry 2 where as you've said roughly 70 percent don't keep up with 3 the index. Hedge fund managers really only get paid if they 4 keep up with -- or they beat a particular index. So their 5 focus is not on marketing as much. It's a focus on value- 6 added. It's a focus on generating profitability. 7 And to do that, the -- what I think hedge funds are 8 bringing to the money management business in general is a 9 strong emphasis on research, a strong emphasis on value- 10 added, a strong emphasis in being unique and looking for 11 niches and I think that's what this business needs. 12 MR. PLAZE: Let me just challenge one thing. A one 13 to two percent base plus a performance fee would be pretty 14 good money in a mutual fund world. 15 MR. HALL: Well, let me make an analogy. Mutual 16 funds, if you look at large public -- large cap mutual funds 17 -- in a hedge fund world we sometimes refer to them as closet 18 indexes. If you look at their portfolio versus the portfolio 19 of the index, there's a tremendous amount of overlap, 60, 70, 20 at times 80 percent. 21 So the real value added of the -- and that portion 22 of the money in an index fund could be managed virtually for 23 free. So the value added of the typical mutual fund is on a 24 very small portion of the capital and if you look at the -- 25 so the value added is stocks that aren't in the index they 1 may not have in their portfolio. Stocks that are not in the 2 index they may add to their portfolio. 3 And if you really break it down, the typical mutual 4 fund turns out to be an index fund for 60, 70, 80 percent of 5 its capital and then a long/short equity fund for a smaller 6 balance. In terms of fees -- and that's what the hedge fund 7 is. The hedge fund is a small amount of capital that's 8 strictly focused on value added. 9 Hedge fund managers don't put anything in their 10 portfolio that they don't think is going to make money and 11 add some value. They don't put securities in there to 12 maintain any index or to be sure they don't deviate from 13 index. So there's a much stronger focus on value added and I 14 think that's what the money management business really needs. 15 MR. PLAZE: Mr. Swensen, the hedge fund performance 16 fees would seem to be structured to reward risk taking and 17 that's why the fulcrum fee arrangements are required for 18 mutual funds. There is rewards on the upside and there's 19 penalties for the downside. 20 You have written about the need to structure an 21 investor's relationships with his or her money managers in a 22 way to align interests. Does this concern you at all in 23 terms of managing or someone managing to a particular risk- 24 adjusted return? 25 MR. SWENSEN: Yeah. I think you have to worry 1 about the 20 percent profits interest in the absence of other 2 important parts of the deal and the thing that we really 3 focus on at Yale, and it was something that Michael referred 4 to in his description of deal structure, was co-investment by 5 the general partner. 6 We care enormously about having the general partner 7 have a significant amount of money side by side with us 8 because that moves the equation away from giving the manager 9 an option, you know, if I win, I get 20 percent, if I lose, 10 it doesn't cost me anything, to a situation where if the 11 manager is side by side with us, if they win, they get gains 12 on their investment plus the 20 percent of profits and oh, by 13 the way, if they lose, they lose some of their own money. 14 So there is a much greater symmetry of interest 15 when the manager has a significant investment along with the 16 University. 17 I'd like to push back a little bit on something 18 that George said. He was talking about the notion that hedge 19 fund managers get paid for value added. We try very hard to 20 make that the case but I don't think it's the case in the 21 standard deal. 22 If you get 20 percent of the profits, 20 percent 23 above zero, that's more than 20 percent of the value added 24 because our money has an opportunity cost and the opportunity 25 cost of our money is not zero. So the profits interest ought 1 to come after the manager has given the investor a return 2 that's equal to the opportunity cost of funds. 3 Now, that's a difficult thing to measure. What 4 we've tended to do -- and most of these arrangements were 5 negotiated years ago with the U.S. Treasury was higher -- was 6 share profits after a return of the one year Treasury. Now 7 that it's barely visible with a magnifying glass, that's not 8 much of a hurdle but maybe it will be again some day in the 9 future. 10 MR. HALL: And I would agree with that but that's 11 just convention. I mean, an alternative to 20 percent would 12 be 22 percent over some hurdle. I mean -- 13 MR. TANNENBAUM: 20 percent over some hurdle. 14 MR. HALL: That's probably why we're not managing 15 any money for you. 16 (Laughter.) 17 MR. GLASSMAN: David, what are the typical co- 18 investment rates when you do that? 19 MR. SWENSEN: You know, it really depends on the 20 nature of the manager's financial circumstances. We're in 21 situations where the manager has a co-investment that's 22 larger than the University's and we're usually a pretty big 23 player. And there have been other circumstances where the 24 managers have essentially no net worth and they mortgage 25 their houses to make a co-investment. And there, tens of 1 thousands or hundreds of thousands of dollars is hugely 2 significant to them. In other cases, it's tens of millions 3 or even hundreds of millions of dollars of co-investment. 4 So the most important criterion for us is that it's 5 a significant amount of their net worth. Particularly in 6 instances where the general partner doesn't have substantial 7 means, we'll suggest that what they do is take any profits 8 interest that they earn and reinvestment it in the fund until 9 that becomes a material amount. 10 MR. PLAZE: Let's talk about conflicts for a 11 moment. The high watermark concept also raises some issues 12 there. For managers managing two funds, one of which has had 13 substantial losses so that there's no chance of a performance 14 fee, is there a concern or do you have a concern, Mr. Simon, 15 that the manager would be incentivized to spend all of his 16 time and energy and ideas on the fund for which there is an 17 opportunity to make a performance fee? 18 MR. SIMON: I think the question as you've phrased 19 it is really as a manager runs simultaneously two funds, one 20 that he sort of loses interest because performance is not up 21 to snuff and two, his other fund is -- from our perspective, 22 the way we run our money, that would not be a manager we 23 would choose. We want a manager that is focused and 24 committed to his strategy. 25 There are some managers that have gotten very large 1 that have basically lured away talent to offer other profit 2 centers within their organizations and if the due diligence 3 and monitoring says that the manager they've hired is a 4 quality manager, that would be okay but it's a different 5 thing than you've proposed. 6 We would basically not invest with a manager that 7 has simultaneous partnerships. The only kind of managers 8 that would have two partnerships, which you tend to see 9 today, is basically those that have onshore and pursue 10 offshore for different types of investment partners. 11 MR. PLAZE: So that they're managing basically on 12 the same strategy so you wouldn't see that situation where 13 you have one significant losses and the other up. 14 MR. SIMON: No. Now, I would say early in this 15 industry, and there maybe some on this table or not too many 16 that are of my age -- lucky for them -- there were managers 17 that would set up with a high watermark, fail to produce, 18 close down the partnership because they would never earn back 19 what they needed to pay back their investor, and reopen a 20 year later with a new partnership. 21 I think that is no longer something that is in 22 fashion. The institutions and fund of funds are far more 23 sophisticated today and there's a lot of talent to pick from. 24 That was something that was early on and I think it was best 25 demonstrated probably in '87 when most of the merger ops got 1 killed and reopened a year or two later in a new partnership. 2 But we don't see that anymore and I believe David you 3 probably don't see that anymore, either. 4 And I just also would like to say David is correct. 5 One of the due diligence questions of anybody that goes out 6 to make a manager selection is we want to see their 7 commitment, their fire, and most importantly, the majority of 8 their net worth alongside their investor's. Without that, 9 there is no reason to invest. 10 MR. PLAZE: Anybody -- of course, the other 11 conflict issue is side by side management of hedge funds with 12 mutual funds and other managed accounts that don't have those 13 types of performance fees and significant conflicts. 14 Now, there are some conflicts that are measurable 15 and discoverable by the regulator such as allocation of 16 trades but the type of conflicts in terms of allocation of 17 time and energy, that's very hard to measure and even harder 18 to bring enforcement cases against. 19 Any suggestions on how we, as a regulator of many 20 of these advisors now in this business, need to deal with 21 this issue or is it simply a disclosure matter to clients in 22 the mutual fund that this may in fact occur? 23 MR. HALL: Well, I don't have any particular 24 solution to that issue. I'm sorry if I interrupted. But I 25 think the first thing is disclosure. I mean, the question is 1 when someone invests with a management company, they're 2 investing with a specific portfolio manager or the company 3 and all its resources that it can bring to bear. 4 If the non-performance fee money has a portfolio 5 manager and there's a Chinese wall between the other 6 portfolio managers, that may be one solution but I don't 7 really have any particular solution to that problem. 8 MR. PLAZE: Mr. Karoubi? 9 MR. KAROUBI: First, while there are relatively new 10 and relatively small problem in terms of numbers and a lot of 11 companies who have tried to retain top quality traditional 12 traders by letting them run hedge funds on the side have very 13 often got very sorry to have done it because simply as a 14 hedge fund manager, if he -- once becoming a hedge fund 15 manager, being good enough, this manager generally is leaving 16 the company and creating his own company because he is 17 keeping that entire management fee which George says it's not 18 relevant but George, when you are 5 or $6 billion, I'm sure 19 that is little crumbs you can buy your shopping with at the 20 end of the day. 21 And very often, the fee structure is more I would 22 say prone to trigger entrepreneurship than to leave those 23 manager turn into quality hedge fund manager within the 24 mutual fund company and we have seen some of the best and 25 brightest hedge fund manager actually coming out of these 1 structure. 2 Disclosure certainly is there. I'm not a lawyer 3 but it was an intriguing question and since my name -- I call 4 my lawyer to ask what he thought of it and he said, you know, 5 I've heard of breach of fiduciary duty, reputation risk and 6 all sorts of issues linked to it. So I think that if a 7 manager start to divert the best long deals, the best 8 position into his hedge fund and deprive the traditional 9 investor from running in a way two different portfolio, the 10 profitable one within the hedge fund and the less profitable 11 one into the long only, I think this manager will be faced to 12 a very, very serious lawsuit by breach of fiduciary duty. 13 So I don't see how it is a real problem. Maybe it 14 is but I don't see it. 15 MR. PLAZE: Well, in addition to the allocation of 16 time and energy you have the ability within a leveraged 17 situation with a hedge fund to manipulate that market with 18 the long positions and the mutual fund by just a little bit 19 and cause the hedge fund to make a lot of money and the 20 manager to make a lot of money. And those are very subtle 21 things difficult to uncover and difficult for an investor to 22 uncover. 23 Now, some people have suggested two solutions, one, 24 which everybody is going to give me a Bronx cheer for, which 25 is eliminate -- subject hedge funds to similar restrictions 1 on performance fees as mutual funds are. The other is to 2 eliminate the restrictions on mutual funds and allow them to 3 be managed or performance compensation similar to that which 4 hedge fund managers have. 5 Any thoughts, comments on that -- those 6 alternatives? 7 MR. SWENSEN: Well, one of the huge problems in the 8 mutual fund industry is that fees are way too high. So 9 giving the mutual fund industry an opportunity to charge more 10 for the poor results they deliver I think is a terrible 11 solution. 12 (Laughter.) 13 MR. BERNARD: I think it would contribute to the 14 collapse of the mutual fund industry. I think that the 15 incentive fee is in part a very strong incentive to keep the 16 industry small. I think it is a huge barrier to growth in 17 the business and if mutual funds charge incentive fees, then 18 that industry would get smaller. 19 MR. PLAZE: Well, there's another school of thought 20 that if we actually did that, nothing would happen because so 21 few funds charge performance fees, even the ones that we have 22 that are allowed today, that it would be calling a party and 23 nobody arriving. 24 On that note, our time has expired and I'd like to 25 thank everyone for their participation today. I thought this 1 was a very interesting discussion. I hope you in the 2 audience and on the web enjoyed it as much as I did. 3 (A recess was taken.) 4 MR. SCHEIDT: The fourth panel today deals with 5 issues associated with valuation allocation, use of 6 commissions and personal trading. 7 I'll start out first by introducing myself. I'm 8 Douglas Scheidt. I'm an associate director and chief counsel 9 in the Division of Investment Management of the SEC. We have 10 a good group of panelists today and I'll introduce them 11 starting from my immediate left. 12 On my immediate left is Tony Artabane. He's a 13 partner at PricewaterhouseCoopers in New York and he leads 14 their global alternative investment management team. To his 15 left is Professor Andrew Lo. He's a professor at the MIT 16 Sloan School of Management and director MIT's laboratory for 17 financial engineering. 18 Next to Professor Lo is Richard Phillips. He's the 19 senior partner at Kirkpatrick & Lockhart and head of the 20 securities group in their San Francisco office. And to his 21 left is Robert Zack. He's a senior vice president and 22 general counsel of OppenheimerFunds in New York. 23 On my right is Steven Vine. He's a partner at Akin 24 Gump Strauss Hauer & Feld and he heads the corporate and 25 securities group in their New York office. Next to Mr. Vine 1 is Mike Dieschbourg. He's a principal of Silver Creek, LLC 2 an unregistered hedge fund. He also serves as an independent 3 director to a registered closed fund of hedge funds. 4 And to his right is Professor Bing Liang. He's an 5 assistant professor of finance at the Weatherhead School of 6 Management, Case Western Reserve University. 7 And at that, we will move to the panel. I'd just 8 like to say at the beginning, after listening to the first 9 panel today I was very struck by how all is well and fine in 10 the hedge fund industry and I figured that there was no sense 11 in continuing with the panel today, but since we're all here, 12 I thought we'd go ahead. 13 It seemed to me that we were sort of in a Lake 14 Woebegone situation where all hedge funds were achieving 15 above average returns relative to other hedge funds and all 16 hedge funds practices exceeded the best practices in the 17 industry so that there was really nothing to be concerned 18 about. 19 Well, the issues that we're going to talk about 20 today are issues as to which the abuses have occurred in the 21 asset management industry, valuation, allocation, use of 22 commissions, personal trading issues. This is where the 23 funny business is in the asset management industry and we 24 want to talk about some of these issues in the hedge fund 25 context and in the fund of hedge funds context. 1 So the first topic today that I want to discuss or 2 focus on is valuation and I want to start off by saying -- 3 making some points about why valuation is important. If the 4 valuations are inflated, then investors pay too much when 5 they invest in the fund or when they redeem, they get too 6 much to the detriment of the remaining investors. 7 If the values are too high, the manager's fee is 8 too high since the fees are tied to the assets -- the level 9 of the assets. And if the valuations are too high, then the 10 fund's performance will be inflated and investors who rely on 11 performance to invest will be misled. 12 There are several incentives in existence for hedge 13 fund managers to inflate the value of their assets. One, 14 they frequently calculate their own assets or their own 15 valuations and inflating their values will generally permit 16 them to receive higher fees. And inflating their assets may 17 allow them to earn their performance fees more easily. 18 It will also inflate the fund's performance which 19 makes it easier for the hedge fund manager to market the fund 20 and to raise additional money and to raise additional money 21 for other hedge funds. Inflating the values may also 22 discourage existing investors from redeeming their shares and 23 inflating the value may allow the manager the time to hide 24 losses temporarily, or perhaps permanently. 25 And so several factors contribute to overstatements 1 of valuation. One is the lack of transparency of the 2 underlying investments, lack of independent market prices for 3 many of the investments held by the hedge funds, lack of 4 independent pricing services to provide pricing for those 5 securities. Audits, if conducted at all, are only conducted 6 annually and auditors don't secondguess the valuations of the 7 hedge fund managers. 8 The managers aren't really required by law to value 9 their assets in any particular way except in a manner that's 10 consistent to their disclosure to investors, and valuations 11 may be provided to them by entities that may have a financial 12 incentive to ensure that the hedge fund manager is 13 successful, like a prime broker or others who have economic 14 relationships with the hedge fund manager. 15 So with that introduction, I'd like to get the 16 panelists to talk about how hedge funds value their interests 17 and how that differs from, let's say, how mutual funds value 18 their interest. 19 So start it off. Dick, do you want to talk about 20 mutual funds? 21 MR. PHILLIPS: Yeah. I'll start off talking a 22 little bit about mutual funds and how mutual funds as well as 23 other registered investment companies are required to value 24 their assets. 25 As you know, Doug, valuation of portfolio 1 securities is a focal point of regulation under the 1940 Act, 2 in significant part, because NAVs are critical to the pricing 3 process for sales and redemptions. But the Commission has 4 made clear that the same valuation requirements apply to 5 closed-end funds because, for the reasons you pointed out, 6 particularly with the hedge funds, NAV, proper pricing is 7 critical to the accuracy of performance figures and of course 8 it's used to determine fees payable to the managers. 9 Under the '40 Act, funds are required to value 10 securities by either using market value when quotations are 11 readily available and fair value when they're not available. 12 And fair value is as determined in good faith by a fund's 13 board of directors. 14 From a regulatory point of view, market value 15 determinations which are based upon information fed in by 16 pricing services have largely been trouble-free. The key 17 challenge is to develop a meaningful monitoring system to 18 monitor prices which are stale, out of line with the market 19 and to develop controls over portfolio manager overrides. 20 That's the issue in connection with market value 21 determinations. 22 Fair value determinations from a regulatory point 23 of view have been much more difficult and have received a lot 24 of attention. A fair value determination is not optional. 25 They're required whenever it's determined that market 1 quotations, reliable market quotations are not readily 2 available. 3 They're not readily available often for restricted 4 securities, illiquid securities, thinly traded securities, 5 securities, particularly foreign securities, where a 6 significant event has taken place between the close of the 7 primary market and the time that the NAV is calculated. 8 And there are other situations like significant 9 market fluctuations, et cetera, where fair value 10 determinations have to be made in order to comply with the 11 1940 Act. 12 The SEC has said repeatedly that fair value means 13 the price that a fund might reasonably expect to receive upon 14 current sale. Current sale means not intrinsic value, true 15 value, not the value that you might reasonably expect to get 16 when you expect to sell it. It's the price that you can get 17 upon current sale. Often, as a rule of thumb, current sale 18 means the price you could get if you can sell it within 7 19 days. 20 The Commission has also made clear that formulas do 21 not work with fair value determinations. Instead, there's a 22 lot of emphasis on consideration of all relevant factors, 23 whatever they are, fundamental as well as market factors. 24 Because fair value determinations require a lot of 25 judgment, the Commission and the Staff have focused on the 1 process and the process is far more important than specific 2 rules as far as understanding the valuation regulation under 3 the 40 Act. Some of the rules I and others of my colleagues 4 disagree with but what we don't disagree with is the emphasis 5 that the Commission and the Staff have placed on the process 6 for making these determinations. 7 Now, neither the statute nor the Commission rules 8 specify that a fund has to have a process, has to have rules 9 and procedures but over the years the Staff has placed 10 considerable emphasis on the existence of detailed policies 11 and procedures to valuing securities. 12 And in fact, they've said hey, Mr. Mutual Fund, the 13 statute says that securities must be valued at their fair 14 value as determined in good faith by the board of directors 15 and if the directors are not in a position to be on hand at 16 4:00 every afternoon to make the fair value determinations, 17 then they can delegate only if and only to the extent they 18 have approved detailed rules and procedures. 19 If the rules and procedures are not detailed, then 20 the amount of delegation is necessarily circumscribed. And 21 what this emphasis has done is to create within most mutual 22 fund complexes a discipline and a system of oversight. That 23 discipline is derived from the need for detailed policies, 24 procedures, rules which identify the situations when fair 25 value determinations must be made, which specify how they are 1 made and specify the controls that are placed on the making 2 of those determinations. 3 A primary control is to recognize that the 4 portfolio manager, while having the most expertise with 5 respect to a particular security which requires a fair value 6 determination has to be monitored, that portfolio managers 7 fall in love with their favorite securities and they can't 8 believe sometimes what the market, what the crazy market, 9 what the irrational market has done to those securities. 10 And so there has grown up within the fund industry 11 a system of using valuation committees, sometimes having a 12 membership that consists of at least one fund director and 13 the rest staff, that reviews fair value determinations 14 according to a detailed set of rules and valuation committees 15 have been a very important part of the controls. 16 In addition, the Commission keeps emphasizing that 17 boards of directors cannot delegate their responsibilities 18 even though they can delegate day-to-day administration and 19 therefore they have to continually review rules, they have to 20 receive reports of fair value determinations and act upon 21 changes in the rules when changes are required. 22 In addition to the board of directors and the 23 valuation committees, we have the auditors exercising 24 oversight at the time of the audit and you have very 25 importantly in recent years a relatively rigorous staff 1 examination process which occurs on a more or less regular 2 cycle for the larger fund complexes and usually looks very 3 carefully at the process for making fund valuations of 4 portfolio securities and if the process appears less than 5 adequate, then there's an extensive examination. 6 This combination of discipline and oversight and 7 accountability I think gives the fund industry and investors 8 in that industry a maximum degree of assurance that while 9 prices may not be perfect, at least there's a fair amount of 10 attention, a fair amount of intelligence and a fair amount of 11 discipline that goes into the process and therefore the 12 prices at which they buy and sell securities, the prices at 13 which or the numbers at which performance is measured, and 14 how the fees are paid represent a high degree of integrity 15 and consistency, and that's all investors have a right to 16 expect. 17 MR. SCHEIDT: So hedge funds don't have a lot of 18 those controls, do they? What kind of -- there's no board of 19 directors, there's no requirement for an audit. How does the 20 hedge fund industry -- how do hedge fund managers value their 21 assets? They frequently -- or some may not invest in 22 securities for which market quotations are readily available. 23 How is it that they value their assets and what controls, if 24 any, are in place? 25 MR. ZACK: Doug, that's actually a complex question 1 to answer because there are of course registered hedge funds 2 and those are the types of funds that OppenheimerFunds 3 currently offers. We also have a hedge fund affiliate, 4 Tremont Advisors, which offers other types of private hedge 5 funds. 6 Surprisingly, I think you will find that more and 7 more of the hedge fund industry is moving closer to the type 8 of model that the mutual fund industry has been using for 9 pricing and that I think most hedge fund managers do rely on 10 market quotations obtained from reasonable and reliable 11 sources to value their securities on a daily basis, if not 12 providing that information for daily net asset value 13 calculations. 14 And what we have done -- again, it's a model that 15 we have followed to try to provide a reasonable degree of 16 assurance and comfort to investors not only in our registered 17 hedge fund products but in the other hedge funds that are 18 offered by our affiliate. 19 To assure the quality of the valuation process, we 20 have used and are using and require underlying managers to 21 use a third party service to receive those daily valuations 22 from the hedge fund managers, to review those valuations 23 against market quotations and other valuations obtained from 24 the same sources that we price our mutual funds against, and 25 to compare those to see whether they meet certain stress test 1 limitations. 2 I don't think that's necessarily the answer for 3 everyone in the industry. I don't think that's necessarily 4 something that needs to be required by regulation. It is a 5 particular model that we have found a useful way and a good 6 way to deal with offering registered hedge funds and to 7 provide the necessary comfort for the underlying valuations 8 of those underlying managers. Additionally, that helps us to 9 meet our diversification testing requirements. 10 So I think that's one possible model, but I think 11 if you look at the hedge fund industry in general, there's 12 probably general agreement in this room that many of the 13 managers, certainly the larger managers are using market 14 quotations for their valuations of their portfolios. 15 MR. DIESCHBOURG: I would agree with that. Mike 16 Dieschbourg from Silver Creek. When you think about the 17 valuation process, we're an unregistered fund to funds and 18 it's important for us to get the proper valuation from our 19 underlying managers. But we use them not only from a 20 standpoint of proper valuations but that's also part of the 21 investment management and due diligence process. 22 We want to make sure that they're getting proper 23 pricing for the underlying securities, that they have a 24 process and procedure in place and as a fund to fund, it's 25 our responsibility to make sure that that's happening so we 1 can get the proper pricing. 2 And just as you have the opposite side of the coin 3 of wanting to have possibly the mispricing of securities, we 4 want to have securities properly priced because we want the 5 fees to be accurate. We want the volatility to be correct. 6 From a portfolio management standpoint, it's our 7 responsibility as fiduciaries to manage the portfolio from a 8 construction standpoint to the best of our ability and to our 9 investment objectives. 10 So there are a lot of things that we do, such as 11 having an audit since inception in our firm and having the 12 auditors actually review both the onshore and offshore funds 13 and seeing -- looking for discrepancies because you're 14 running them -- you have the CFO in the firm checking -- 15 making sure that they're independent of the portfolio traders 16 and the portfolio managers. 17 We have an investment committee so we're looking at 18 the prime brokers to get information when we do our due 19 diligence checks on these managers, are they pricing them 20 properly. We do have registrations with the various other 21 industries' organizations. We do have a third party 22 administrator for the offshore funds. 23 So when you think about what we're doing -- and we 24 also file under the fraud provision because whether you're 25 registered or unregistered, based upon the acts that are out 1 there today, there's plenty of regulations that if you're 2 creating fraud you're creating fraud. And all of us are 3 trying to run a good business and to grow our business and 4 whether you're registered or not, are subject to follow 99 5 percent of all the same laws. 6 MR. SCHEIDT: Well, Mike, how representative is 7 your situation and yours, Bob, where it appears from what 8 you're saying that the underlying hedge funds are willing to 9 provide you with information about the securities that they 10 are holding so that you can assure yourself that the actual 11 valuations for those holdings are in the ballpark? 12 What else -- what we've been hearing is that the 13 underlying hedge funds aren't willing to provide that 14 information to anybody in most cases so are your 15 circumstances different? Are they unusual? What are they? 16 MR. ZACK: Well, they may be slightly unusual in 17 the sense that this is a fairly new model but I think, again, 18 the underlying hedge fund managers don't provide us the 19 portfolio data daily to preserve their lack of transparency 20 for legitimate investing reasons. 21 Providing it to a third party, however, as a 22 condition of our -- in our due diligence process of using 23 them within our fund to fund structure, they are willing to 24 do that. That is one of the conditions of their 25 participation in the program and they have been willing to do 1 that. 2 The larger managers, even smaller managers, 3 managers who are willing to get onto the program, they have 4 to meet a lot of due diligence tests but they recognize that 5 this is the way the industry is gravitating, that degree of 6 transparency is something that you're going to see more of, I 7 think. Whether, again, it's the model that I suggest or 8 another model, I think that it's there. 9 As Mike said, it's also very key that the -- there 10 are very similar processes for compliance review at the hedge 11 fund level that are reviewed in the due diligence process by 12 us when we go in to select these managers. 13 Additionally, the auditors annually do audit the 14 portfolios just as they do with mutual funds. Mutual fund 15 auditors do not do an audit more frequently than once a year, 16 typically and they will go and test some of those securities 17 prices as well. So you have the same type of protection in 18 that sense from the audit process. 19 MR. PHILLIPS: Let me raise a question. If in fact 20 there are no valuation problems in the hedge fund industry, 21 then it raises a question whether there's a need for 22 valuation regulation in the mutual fund industry unless you 23 think that mutual fund managers are more prone to fraud and 24 abuse than hedge fund managers. 25 MR. VINE: Well, Dick, part of the answer to that 1 may be that the hedge funds have actually looked to the 2 mutual fund standards for their best practices. 3 MR. PHILLIPS: I think that's right. 4 MR. VINE: When we write the disclosure documents, 5 we will often lift out provisions from the statute, 6 provisions from the rule and build those into the partnership 7 agreements because this is an area in which I don't think 8 hedge fund managers regard being unregulated as providing any 9 particular license. 10 I think unlike performance fees, unlike avoiding 11 some of the leverage restrictions, valuation is not an issue 12 where they look at the regulated work as having inappropriate 13 approaches to the issues. 14 MR. PHILLIPS: I think the question is whether in 15 the absence of regulatory requirements there's enough 16 incentive for hedge fund managers to spend the money on the 17 compliance systems and the time it takes to set up and 18 administer those systems as you would do if it were required 19 as a matter of regulation. 20 MR. ZACK: Well, competition is a great driver of 21 integrity and I think that in order to get onto platforms 22 where managers have not been present before, they recognize 23 the need to do this and as Steve said, this is -- the model 24 that they're following is the mutual fund model. 25 I am missing a valuation committee meeting right 1 now as we're speaking, by the way, for my own complex so I 2 know these processes are very important in the mutual fund 3 industry. I don't want to see them removed. And I know you 4 were asking that as a rhetorical question rather than a -- 5 but I do think that the hedge fund industry does recognize 6 the importance reputationally also of providing good prices. 7 You don't want to go back after your audit to 8 discover that you've had significant pricing errors and have 9 to recalculate, redo -- delay further your tax returns, your 10 K-1s and everything else because of a pricing error that 11 occurred during the course of the year that shows up in an 12 audit. 13 So there's a tremendous reputational stake that 14 they have in the integrity of the pricing process as well. 15 MR. DIESCHBOURG: Part of that reputation risk is 16 also a business risk because we value the performance fee 17 structure and since a lot of us have a substantial amount of 18 our own capital invested in it, and we're actively protecting 19 that capital to make sure the valuation is proper and also 20 protecting the performance fee because that is an incentive 21 that drives the talent for the intellectual capital that 22 helps drive this business. 23 So we have an inherent value at stake which is our 24 own capital and our own integrity and our own reputation and 25 our businesses as we go forward. 1 MR. PHILLIPS: What controls do you find in hedge 2 fund organizations over portfolio manager determinations of 3 portfolio securities valuations and overrides of information 4 received from the pricing services? 5 MR. VINE: I think -- two-part answer to that. 6 Certainly, there's a distinction between the domestic arena 7 and the offshore arena. 8 In the offshore world, by and large pricing is done 9 primarily on an out source basis by third party 10 administrators so you certainly have some checks and balances 11 there. Domestically, I think the real distinction is between 12 the large organizations and the small ones. 13 The large organizations tend to have sophisticated 14 robust accounting -- internal accounting staff who report 15 directly to the proprietors of the firm. We're now seeing a 16 move toward having risk officers who are associated with that 17 function and who get actively involved in some of the 18 difficult pricing issues. We are not seeing that in the 19 smaller firms but I think in the larger ones, competition is 20 pushing in that direction. 21 MR. SCHEIDT: I was going to say there are issues 22 about side by side management of hedge funds and mutual funds 23 but this is an area probably where there's a benefit, where a 24 mutual fund manager enters the hedge fund business, has this 25 robust system, has this discipline that the '40 Act has 1 imposed on it and it will be sensitized to these kinds of 2 issues and hopefully will carry them over into the hedge fund 3 valuation. 4 MR. ARTABANE: I would just echo Steve's comments 5 and Bob's comments with respect to best practices and the 6 businesses evolving. It's very typical in larger 7 organizations where there is a dedicated focus, much like a 8 institutional traditional manager, if you will, in terms of 9 pricing, independent checks and balances on the pricing and 10 review by the manager. 11 So I think the standards are moving but the 12 industry is really bifurcated into smaller, middle and larger 13 players and the control systems for a very small hedge fund 14 may not be the same as in a larger hedge fund. 15 Having said that, as we heard early this morning, 16 if you look at the hedge fund industry, about -- I think the 17 number was about 35 to 40 percent is a long/short strategy, 18 equity strategy. And those are, by and large, readily 19 tradeable securities when there are market prices. 20 The prime brokers will usually see all the 21 positions in those types of strategies. They offer somewhat 22 of a check and especially if they extend margin leverage 23 because they're valuing the book for collateral purposes, if 24 you will. So there's some check and balance there. 25 And then because those securities are readily 1 available to price in most instances, the outside 2 administrators or the internal processes will be able to 3 validate that. 4 Now, is there a formal process of reject pricing, 5 you know, a manager rejects a price that comes up as in a 6 mutual fund? In the larger organizations, there are. In the 7 smaller organizations typically there is not, but that 8 usually is highlighted, that particular issue and what is 9 done. And managers by and large do not want to have a 10 problem either inter-month -- I'd say between months they are 11 redeeming or in their annual audit. 12 So oftentimes we will be contacted or the prime 13 broker or the administrator will be contacted on a particular 14 issue to get advice or counsel in Steve's case and I'm sure 15 he's had a lot of questions on fair value. So you have to 16 look at the industry in terms of the sophistication of the 17 people managing the money, the number of people and the other 18 systems. 19 When you get into a very complex strategy, that's 20 not a very easy one to price. There are no -- perhaps no 21 good market values for some of the strategies, the stress 22 debt, for example, or a sophisticated mortgage-type strategy. 23 So there has to be other controls built in and that's where 24 you get the question of how easy is it for someone to check 25 that price and validate that price. And, you know, you need 1 more robust controls so in most of those situations there are 2 more robust controls. 3 MR. SCHEIDT: What's the role of the auditor in 4 this process for hedge funds that do get audited? What does 5 the auditor -- 6 MR. ARTABANE: Well, it's a good question. It's 7 not merely not objecting to management, as you summarized, 8 but the auditor does not -- 9 MR. SCHEIDT: Second guessing. 10 MR. ARTABANE: Second guessing. Okay. We do 11 secondguess. We're objective and we secondguess. What we 12 don't do is substitute ourselves as an appraiser or an 13 appraisal expert. I don't put myself in the place of George 14 to try to understand and appraise a particular mortgage- 15 backed security, you know, very esoteric, IO Trust or 16 whatever, but I have to understand the process that the hedge 17 fund goes through and I have to determine that that process 18 is reasonable. 19 Now, the current audit guidance is audit guides of 20 investment companies and, see the word investment companies, 21 it covers '40 Act funds, it covers hedge funds. However, if 22 I don't believe I have the sophistication to understand a 23 particular model if a model is used, then I should consider 24 under other audit guidance, SAS-73, to be specific, using an 25 expert. And we, as the other big four firms, have global 1 risk management units that have people who used to trade with 2 George and understand the markets and that type of thing so 3 we will have them come in and look at the model to rely on 4 that. 5 So it's not simply accepting. It's understanding 6 the process, it's going through it, it's looking at the 7 documentation but if a judgment is made by management and 8 it's a matter of -- it's a relatively reasonable accepted 9 model or there's some discretion in the discounted cash 10 flows, if they're within a band of what are experiences in 11 the marketplace, we will accept that and make sure the 12 appropriate disclosures are made in the financial statements. 13 And sometimes there's push back and forth as to the 14 level of disclosure but it's very similar to a mutual fund 15 when you have a fair value issue. 16 But that's the process. So I don't want to give 17 the impression that it's passive. There is a process but we 18 are not going to evaluate as an appraiser. 19 MR. SCHEIDT: Do you check the valuation of 20 every -- 21 MR. ARTABANE: Well, that's a good question. Joel 22 I think gave a high level summary of the difference between 23 auditing a mutual fund and auditing a hedge fund. 24 You're required by the audit guidance -- and also 25 that's part of the regulatory requirements. I'm not sure at 1 what section of the Act that is required. But you're 2 supposed to, in a mutual fund audit, confirm the assets that 3 you're in 100 percent and value the assets that you're in 4 independently from the manager 100 percent. That's a 5 requirement of the law. That's what an audit does. 6 Having said that, the audit guide that was revised 7 and effective May 1, 2002 understands that the control 8 structures in funds, which is a typical fundamental principle 9 of auditing, is to understand the control structure and 10 design an audit sufficient so that you can gain comfort as an 11 auditor on the assertions of management which flow up into 12 the financial statements. So test sampling is a generally 13 accepted procedure when auditing. 14 In the mutual fund area, you're required by law to 15 do 100 percent at year-end, even if you test the systems and 16 determine that the systems are very reliable. 17 In the hedge area, recognizing that the requirement 18 is not regulatory driven, you do not necessarily need to 19 confirm 100 percent or test 100 percent of the prices but you 20 still have to evaluate the system and if your system is less 21 control-oriented, then you'll do more substantive testing and 22 that's the words Joel used this morning, just to describe at 23 a high level, they're more substantive in nature, audits of 24 hedge funds. 25 In many cases, auditors choose to confirm 100 1 percent of the positions. As a matter of fact, it's kind of 2 rare that you don't. It has to be an extremely well- 3 controlled environment. And again, these are my views, not 4 the views of PricewaterhouseCoopers. 5 But in terms of valuation, again, it may be very 6 efficient to test 100 percent. Frequently we test 100 7 percent of the prices, particularly in the more sophisticated 8 instruments and that is where you get into some of the 9 subjectivity where you have a complex instrument or an 10 illiquid instrument, where there are very few broker quotes 11 out there or perhaps a counter-party quote. And there is the 12 determination of, Dick, is it market price as defined under 13 the '40 Act, readily available market, or is it a fair value. 14 And that's typically the more complex securities in 15 the more complex areas so you have to look at what the 16 process is in place, test it and make sure that the 17 disclosure is reasonable. 18 CHAIRMAN DONALDSON: In a family of funds, we have 19 the auditor reporting to the family fund manager or do we 20 have a coordinated set of audits? 21 MR. ARTABANE: Yeah. Let's just -- to set the 22 guidelines, typically the U.S. hedge fund is a partnership in 23 form or an LLC so there's a general partner or a managing 24 member. There is not a board of directors. Offshore, there 25 is a board of directors generally because it's a corporate 1 format. 2 So in the partnership agreement, the investor in 3 the limited partner cedes to the general partner a wide 4 degree of authority and fiduciary responsibility to 5 administer the partnership's affairs. So the auditor will be 6 engaged by the general partner to audit the partnership and 7 the report will go to the general partner and the limited 8 partners. 9 Now, we don't send them directly. We give them to 10 the general partner in most cases and they'll make a 11 distribution probably along with the K-1s. They try to get 12 them together or shortly after. 13 So a formal management report, if it's necessary, 14 will be given to the general partner but the audit report 15 will be a distribution report free to limited investors. 16 CHAIRMAN DONALDSON: So if you have a family of 17 hedge funds -- 18 MR. ARTABANE: Right. 19 CHAIRMAN DONALDSON: -- is each particular hedge 20 fund getting audited in some respect or -- 21 MR. ARTABANE: Yes. Yes. Well, again, when I say 22 -- you're right. 23 CHAIRMAN DONALDSON: The auditor then is 24 coordinating those audits? 25 MR. ARTABANE: When I say yes, it depends on the 1 documentation because if the document says there will be an 2 annual audit, which in most cases it says -- that's typical - 3 - I think even today, the sensitivity, due diligence, it's 4 going to be very hard to sell a product without an audit, at 5 least an annual audit. 6 Steve, I don't know if you would -- 7 MR. VINE: Yeah. We don't see hedge funds being 8 formed without a requirement for an annual audit. 9 MR. ARTABANE: So to answer your question, 10 Commissioner, the audit requirement would normally apply to 11 each fund and each fund would be audited. If there is a 12 common control system, the auditor may take that into account 13 and do cross fund testing, if you will, but at each period 14 end there is some testing and perhaps 100 percent testing of 15 the verification of the assets by confirmation and the 16 pricing. 17 MR. SCHEIDT: I have a question about GAAP. If 18 these things are audited against GAAP or international 19 accounting standards, is there a fair value standard 20 inherent in those principles? 21 MR. ARTABANE: Well, yes. There is no one 22 recognized method of fair value. That's embodied in the 23 regulatory literature under Section 2(a)(41). I'm little 24 rusty on my mutual fund side. 25 But it's recognized there's no one way to do it. 1 The interpretive letter, which was very well written, 2001 2 interpretive letter, which Doug had a lot to do with on 3 valuation, recognizes that, too. But having said that, there 4 is a process. 5 There is guidance that the SEC had put out for 6 mutual funds and other investment companies in what were 7 accounting series releases 118 on valuation and illiquid 8 investments and 113 on restricted investments and then these 9 current interpretive letters in 1999 and 2001. 10 So there is a body of literature out there. The 11 audit guide has encompassed pretty much those standards in 12 terms of you look at various things, you look at the models, 13 you look at pricing. If it's a private security that's being 14 valued, you might look at a discounted cash flow, budget to 15 actual, third party potential second round financing and 16 competitor pricing. Things like that you would do in a 17 valuation. 18 And management will look at that. We would observe 19 what management did. We would look to see if it's reasonable 20 and then is it documented. That's part of the process. 21 Now, having said that, there is a GAAP standard but 22 there is a wide degree of applicability. However, the 23 offering document and partnership agreement govern whether 24 you get a U.S. GAAP report, an unqualified report, and if 25 it's audited in accordance with U.S. GAAS. That's the 1 typical requirement but there are some exceptions to that. 2 MR. SCHEIDT: And before we move on to the next 3 thing, I just want to -- audits only focus on the portfolio 4 as of a particular day in the year, isn't that right? So 5 audits don't necessarily reflect on how the hedge fund 6 manager has valued its assets throughout the year. 7 MR. ARTABANE: Doug, you have to -- you're 8 reporting on the balance sheet and on the profit and loss. 9 Now, because of the issue of capital subscriptions and 10 redemptions and the potential for dilutions as you had 11 explained earlier, you have to be sensitive to that as the 12 auditor and look at the controls so you may test 13 substantively the cash flows in and out, if you will, and you 14 may look at the process at an interim date if there is a 15 process, usually it's the same as of year-end reconciliation 16 to the prime broker, et cetera, and determine that the 17 process is reasonable to rely on those interim prices without 18 doing a lot of testing. 19 What you would consider, is there an independent 20 administrator, is there an independent unit within the group 21 that does the pricing, is there a very competent financial 22 staff that does that. And if you find that there isn't, you 23 ought to do more pricing which is the substantive nature of 24 the testing. 25 But before I leave fair value, the one thing that's 1 implicit is that these judgments are inherently subjective, 2 it's usually disclosed very prominently in the financial 3 footnotes that the fair value investments are subjective and 4 inherent and could materially change based upon the actual 5 factors that play out. 6 So it is quite possible that you have a good 7 structure, a good process in place, a fair value that's done, 8 and then, you know, perhaps because of market changes a month 9 later the market liquidity dries up. You have a very 10 significant depreciation when you go to sell those assets 11 similar to what happened in 1998. 12 Liquidity shrunk. It first started with the 13 Russian securities. Then it went to high yield. Long-term 14 capital happened, and then it went into mortgages and other 15 types of asset classes where the liquidity that was there 16 three months before wasn't there anymore, and pricing that 17 was reasonably valid at the time it was made became, you 18 know, substantial losses three months later. So I just want 19 to present that there are inherent subjectivities. 20 MR. ZACK: Right. But you have that in any 21 situation, Tony, and that points out the importance of a 22 process that would look at those fair valuations on an 23 ongoing basis. 24 One little footnote to your remarks on valuations 25 and the possibility of the effect of pricing errors at least 1 the hedge fund-to-funds model by the diversification that you 2 obtain in having a larger body of hedge funds, the ability of 3 that pricing error in any one hedge fund to materially affect 4 the valuation of the hedge fund-to-funds NAV is abated quite 5 a bit. 6 So that's another protection that makes those, 7 perhaps, a more palatable vehicle than was thought of in some 8 of the remarks earlier today. 9 MR. DIESCHBOURG: In addition, you also have 10 holdback provisions usually when people withdraw from a fund. 11 Unlike a mutual fund which has daily liquidity, in a hedge 12 fund-to-fund, you'll have a 10 percent holdback withdrawal so 13 that when you settle up based upon the audit at the end of 14 the year so that adjustments can be made. 15 MR. SCHEIDT: Well, we have the benefit of some 16 academics here. There have been several academic studies 17 that have called into question the accuracy of hedge fund 18 statistics and hedge fund data, particularly performance data 19 which is based on the valuation performed by hedge funds. 20 So if I could start with Professor Liang, you've 21 written several papers on this topic. Have you found 22 relationships between audits and the quality and accuracy of 23 hedge fund data? 24 MR. LIANG: Well, I'd like to mention a few points 25 here. The first point is some funds are probably easier to 1 calculate their asset value return than others. I think my 2 fellow panelists already mentioned this. 3 For example, on some unleveraged funds, you don't 4 use short selling. They don't borrow money. They don't 5 use -- positions. Probably it would be easier to calculate 6 the net asset value than the others. 7 And also, for some funds, investing in a variety of 8 regions, countries, you can imagine, you know, they use 9 different kinds of currencies. There's different kind of 10 trading times, and timings are different, so those funds 11 probably would be harder to calculate the valuations. 12 So there are differences across funds. I will not 13 say they're all the same. The other factor I would like to 14 mention is the manager efforts. You know, some funds they 15 probably will have more manager efforts. For example, if you 16 have your personal investing in that, you'll be more keen to 17 verify whether those numbers are more accurate for your own 18 sake or not. So that's one dimension. 19 The other dimension is, for example, fund-to-fund. 20 We talk about, you know, the managers could have more due 21 diligence in term of they don't do daily tradings, and they 22 probably will spend more time in double checking the numbers 23 are correct. 24 And also, there is a self-selection issue. 25 For fund-to-fund managers, they probably would choose some 1 well-established funds, large funds, effectively audited 2 funds. So we should expect fund-to-fund probably will have 3 some kind of accurate valuations than the others. 4 The third item is transparency. Some funds are 5 more transparent than the others. For example, some funds' 6 shares are traded on exchanges, like foreign exchanges, you 7 know, like European exchanges. So those funds could be more 8 transparent than the other funds. 9 And also, some funds are open to public investors 10 not only for the club members. So you can expect these funds 11 are more transparent than the other funds. So these are the 12 three dimensions I will like to mention when we consider 13 valuations, because that could put differences in term of 14 valuations across different funds. 15 And I've done a study about the accuracy of hedge 16 fund on returns in terms of auditing. The preliminary 17 conclusion is auditing will make a difference. I mean, 18 that's an obvious conclusion. Based on some 2,000 hedge 19 funds, I find vast majority of hedge funds have auditors, as 20 my fellow panelist argue. However, there are some hedge 21 funds they don't report auditing dates, which means we don't 22 know when they were audited or if they were really 23 effectively audited. 24 And that could raise a question. I mean, the 25 question is can we rely on these numbers over time or across 1 different databases? One way to check that is we know some 2 funds report to different vendors, so we can check a 3 particular hedge fund that returns on a particular month. 4 For example, let's say October '92 they should 5 report the same number to different vendors. If they're not, 6 then there's an issue here. So I do find for funds with 7 missing auditing dates some of them they will have some 8 inconsistent problem, which means they report one number for 9 Vendor A and then report another number to Vendor B. 10 MR. SCHEIDT: We might want to refer to people to 11 Enforcement for further inquiry. 12 MR. LIANG: And the other finding is for smaller 13 funds they tend to have more missing days than the larger 14 funds. I mean, that's expected because larger funds probably 15 they can afford to spend money to hire very good auditors. 16 Basically, a large fund they tend to have very good auditors 17 than smaller funds. 18 So the conclusion is larger funds tend to be more 19 effectively audited than smaller funds. So as an investor, 20 if you want to choose hedge funds or as a fund-to-fund 21 manager want to choose hedge fund, probably want to avoid, 22 you know, some smaller or less established funds because 23 there could be some minor issues. 24 But saying that, I will not say the issue is very 25 significant. Because they are smaller funds their market 1 shares are not so big, so probably the issue is not that 2 significant. 3 COMMISSIONER GLASSMAN: Doug, I have a question 4 going back to a comment that was made a few minutes ago. How 5 liquid are the investments in the funds of funds. If they're 6 more liquid than the investment in the underlying funds, 7 what's the implication of the holdback on the underlying 8 funds? Does that make sense? 9 MR. SCHEIDT: I'll try to answer the liquidity 10 issue. The underlying hedge funds usually are not very 11 liquid. They may allow the top tier fund of hedge funds to 12 get in and out on a quarterly basis or, perhaps, a semiannual 13 basis. There may be developments where the underlying hedge 14 funds may allow investors to get in and out on a more 15 frequent basis. 16 I think there have been rumors about having an 17 open-ended fund of hedge funds that would invest in those 18 kinds, but the practice now is quarterly at best. 19 COMMISSIONER GLASSMAN: In the underlying fund? 20 MR. SCHEIDT: In the underlying. 21 COMMISSIONER GLASSMAN: What about the fund-to- 22 funds? 23 MR. SCHEIDT: The fund-to-funds is going to be -- 24 the fund itself, the top tier fund, is going to be closed- 25 end, and it, too, would at best offer periodic purchases and 1 redemptions on a quarterly basis. 2 COMMISSIONER GLASSMAN: Okay. So it's pretty much 3 are in line with the underlying fund, so that not an issue. 4 Okay. Thanks. 5 MR. SCHEIDT: Well, it is for valuation purposes, 6 because if the top tier fund is getting investors in and out 7 at a time when it doesn't have pricing information, current 8 pricing information for the underlying hedge funds, then it 9 has got to fair value -- well, it has got to come up with a 10 valuation for those hedge funds. 11 And if the hedge funds aren't providing them with 12 the current information, what are they going to do? How are 13 they going to come up with a fair value? 14 COMMISSIONER GLASSMAN: So they don't have the 15 holdback that the underlying fund has -- 16 MR. SCHEIDT: No. 17 COMMISSIONER GLASSMAN: -- so then it may be an 18 issue? 19 MR. SCHEIDT: Yeah. Professor Lo, you've done some 20 academic studies, and you have some interesting points, among 21 others, about performance smoothing. 22 MR. LO: When I was an undergraduate thinking about 23 majoring in economics, somebody told me that an economist was 24 a person who knew the price of everything but the value of 25 nothing. It took me a while to really understand what that 1 meant, and I think that this hedge fund discussion highlights 2 that because I think there is a concern that there's a gap 3 between price and value, particularly when there is no price. 4 So I guess I'd like to just make two general points 5 before getting into the specifics of the research. The first 6 point is that valuation issues are not new. I think that the 7 venture capital and private equity community, real estate 8 investors I think have long understood that it's sometimes 9 very difficult to value illiquid instruments, but I think 10 that the reason we're focusing on this now is because the 11 hedge fund industry is growing rapidly both on the 12 institutional side and perhaps, to some degree, on the retail 13 side. 14 And so concerns about valuation that are not 15 particularly obvious to those investors I think have to be 16 made clear, and disclosure I think is critical. 17 The other point I want to make is that while 18 valuation issues are not new there is a very important 19 distinction between valuation in mutual funds versus 20 valuation in hedge funds, and that has to do with the fact 21 that mutual funds are required to have a daily NAV, but, in 22 many cases, hedge fund investors are looking for the kind of 23 opportunities that simply can't be obtained by managers that 24 have to strike daily NAVs. 25 For example, I think it's -- those of us who are 1 investing in exchange-traded securities like IBM, it turned 2 out that today IBM closed at 88 and 69, 88/75. That's a very 3 tight spread. We know what IBM trades at. 4 But if I ask the audience, "What's the price of 5 this building?" Well, that's a different matter. It's 6 actually pretty hard to come up with a price. I couldn't 7 figure out to within 5 or 10 or 20 percent what the value of 8 this building is, and yet there are many hedge fund managers 9 that add value by being able to come up with valuations 10 faster, better and in many ways superior to what can happen 11 out there in the marketplace. 12 So I think that one concern is that we really have 13 to understand what the purpose of valuation is and whether or 14 not the valuation process is something that is consistent 15 with the mandate of the particular investment vehicle. 16 In terms of the research that I've done, the way 17 that I got interested in this really was by looking at hedge 18 fund returns data, and I noticed something rather odd. The 19 odd thing was that for certain hedge funds the returns were 20 extremely smooth, that they didn't seem to bounce around a 21 whole lot and that positive months tended to follow positive 22 month, and negative months tended to follow negative months. 23 And this is particularly striking in comparison to 24 something like the S&P 500 where there's very little of this 25 kind of persistence. And so in digging deeper, it became 1 clear that part of the reason for certain hedge funds having 2 this kind of smoothness property is because of valuation 3 issues. That is that the returns that are being reported are 4 being reported either inadvertently or deliberately in ways 5 that make them look a bit more smooth than they otherwise 6 might be. 7 Now, I have to emphasize that there are many 8 different explanations for that most of which have nothing to 9 do with any kind of manipulation. For example, you can have 10 a hedge fund manager that requires brokers to provide them 11 with quotes on all of their securities on a month-end basis 12 and take the average of all the quotes, and if the brokers 13 are using simple formulas to try to extrapolate the prices of 14 the securities that are highly illiquid you'll get a rather 15 smooth set the returns. 16 That may very well be the best prices available but 17 nevertheless may mislead investors into thinking that the 18 returns are somewhat safer than they are. In particular, 19 when you have smoother returns, they look less volatile, and 20 that tends to make the performance on a risk adjusted basis 21 look better. 22 So from the research that we've done, I guess our 23 conclusion is that there's a great deal of heterogeneity 24 among hedge funds in this particular characteristic, this 25 kind of return smoothed property and that disclosure is 1 really the most important cure for this to make sure that 2 investors are aware that this kind of smoothness is very 3 often an indication of a highly illiquid investment and that 4 they need to act accordingly. 5 COMMISSIONER CAMPOS: Is this very different from 6 the mutual funds that have illiquid assets? 7 MR. LO: It's not different in principle, but it is 8 different in degrees, because hedge funds, given the nature 9 of their mandate, can invest in even more illiquid 10 instruments than the typical mutual funds can, so no. 11 In fact, there's a problem that mutual funds suffer 12 from which is stale prices. The stale price phenomenon is 13 where mutual funds use prices that have been set quite a 14 while ago to compute their NAVs. The problem with that, of 15 course, is that there are some outside investors that can see 16 this kind of staleness. They can forecast mutual fund price 17 movements and can game these kinds of prices to the point 18 where they, essentially, transfer money from existing 19 shareholders to new shareholders. 20 So it's very much the same type of problem. And, 21 in fact, in the study that we did, we found mutual funds that 22 had just as high a degree of smoothness as hedge funds. It's 23 just that it's a matter of degree. With hedge funds, there's 24 much more latitude. Investors are looking for that kind of 25 opportunity. For illiquid investments, you earn money in 1 many cases by bearing illiquidity risk. The key, though, is 2 really to disclose that to the investor. 3 MR. ZACK: But I think you have to go to the 4 idiosyncracies of the specific mutual fund, its investment 5 style and nature of its investments. For example, I can 6 think of high-yield bond funds that might have, you know, 7 fairly what are considered liquid securities. They don't 8 trade very frequently. We look at those prices even though 9 they don't move from time to time. So it's going to be a 10 little hard to game those types of prices. 11 You can look at municipal bond funds where a 12 manager may characteristically take all of the issues, very 13 small issuers in a widely diversified portfolio. They may 14 not be deemed to be terribly liquid securities, but at the 15 same time, and they're not going to move in price very much 16 either. 17 So you have to look at each of the different types 18 of circumstances to determine what is it that causes that 19 smoothing effect. 20 MR. LO: In fact, I would argue that the same holds 21 true for hedge funds. You have to look at the style of 22 investment to gauge whether or not the source of illiquidity 23 is genuine or inappropriate. 24 For example, distress debt as an asset class, the 25 way that managers make money from that particular strategy is 1 to identify securities that the public has said, "It's a 2 disaster. I want nothing to do with it. Get it out of my 3 portfolio." And they will buy at bargain basement prices. 4 Their valuation is different from the public's valuation, and 5 they make money from it, highly illiquid but highly 6 profitable. 7 MR. PHILLIPS: But they're not governed by the 8 current sale rule which mutual funds are, and therefore 9 they're not under the same pressure to keep varying the price 10 every day as the market turns because they're not -- they're 11 buying distressed debt, and they're going to hold it for a 12 while. 13 And therefore, they're not looking at an illiquid 14 market and trying to gauge what price they would receive upon 15 current sale. 16 MR. LO: Right. 17 MR. PHILLIPS: I happen to think that the current 18 sale rule does an injustice in the mutual fund world in some 19 situations like distress debt. 20 MR. LO: Well, the current sale rule is actually a 21 very interesting issue to take up for certain kinds of hedge 22 fund investment styles because I would argue that the current 23 sale rule is a very difficult standard to implement 24 particularly for highly illiquid investments. 25 I mean, anybody who has ever tried to sell a house, 1 can you imagine selling your house in seven days and what 2 kind of price you would have to get in order to be able to 3 make that sale in a seven-day period? That price is probably 4 very different from what you think your house is really 5 worth. 6 MR. SCHEIDT: Well, I would say that that current 7 sale standard is perhaps being misinterpreted. I would say 8 that on any current sale basis if you know that it's going to 9 take you an amount of time to dispose of the security you 10 should factor than in and say assume that I've gone through 11 the reasonable process of, if it's registering the security 12 or finding the willing buyer, and what would that willing 13 buyer find after that reasonable period of time, what would 14 that willing buyer be willing to pay me not on a fire sale 15 basis within seven days from the time I started but, having 16 going through the process, what would he pay me today for it. 17 MR. DIESCHBOURG: But has a hedge fund manager, 18 that's part of the opportunity for intellectual capital to 19 gain the market, not to game it but to actually gain an 20 opportunity for investment. 21 So one of the things you don't want to do for this 22 industry is you don't want to over-regulate it. There's 23 plenty regulation right now. And getting the daily pricing 24 and fair valuation gets that issue of too much information 25 takes away the opportunity to make money in this marketplace. 1 It's the intellectual capital that's bringing the -- 2 MR. SCHEIDT: Well, nobody's talking about taking 3 away value. If you buy distressed debt at what it's worth 4 today because you think intrinsically it will have more value 5 in the future, you shouldn't value it today at what you think 6 its value will be in the future. You should value it today 7 at what they should -- what it can go for. 8 And if you're right, your intellectual capital is 9 right, it will pay off, and the investors who want to stay 10 with you in the fund to bear that out will benefit, and those 11 that want to bail won't. So the value of current price and 12 current sale pricing is that it rewards those who go in for 13 the long haul, and it doesn't reward those who bail out. 14 So why should they get the benefit today when they 15 bail out of the future gains? 16 MR. ZACK: Another way to put that is that there's 17 a liquidity premium that investors, essentially, get paid for 18 for bearing that kind of illiquidity risk, and that's part of 19 the return that they're garnering from these kind of 20 investments. 21 We should also remind ourselves, too, that the 22 hedge fund industry does help provide a tremendous amount of 23 the liquidity in the market that helps assure the flow of 24 these types of securities through the market. 25 MR. LIANG: I would like to echo Professor Lo's 1 point. I think his point is illiquidity cannot be measured 2 by the traditional measurement like a standard deviation or 3 sharp ratios. For example, if some asset are illiquid, you 4 don't have a very active price on a daily basis, so probably 5 you can only use the past price, and then the price will be 6 flat. 7 A definition of "standard deviation" is the 8 volatility is zero. So you cannot use standard deviation or 9 regular volatility to measure the illiquidity. Then you'll 10 have to think about something else like odd correlations, 11 like a correlation between today's price and yesterday's 12 price and the day before to see what is the correlations over 13 time. So that's what we call the odd correlation. 14 So that's why we have to think about something 15 different from hedge fund managers, you know, than the mutual 16 fund managers. They're just different. One follows very 17 active trading strategies on a daily basis, and a mutual fund 18 probably will not trade that often. 19 So the traditional managers would be probably 20 questionable when we talk about hedge fund performance. And 21 especially I'm going to talk about a little different issue 22 here in terms of distributions. 23 When you look at the distributions -- because 24 somebody this morning used the term "skewness" and 25 "cartosis." I believe I can use that term, too. If you look 1 at all these terms, the skewness are kind of negative, which 2 means they're not center. They're probably heavy skewed on 3 the left side. The cartosis, basically, measure the fat 4 tails, which means hedge fund may have extreme events, 5 extreme losers and extreme gains, so they're not normal 6 distribution. 7 So all the traditional measures based on standard 8 deviation volatility, sharp issues should be probably 9 revisited. I think that's exactly Professor Lo's work on 10 smoothing and illiquidity. 11 MR. SCHEIDT: Let's move on to non-valuation 12 issues, some other conflict of interest situations that arise 13 in the operation of hedge funds that arise in the operation 14 of not only one hedge fund in relationship to another or one 15 hedge fund in relationship to a mutual fund that's also 16 managed by the same manager or private accounts managed by 17 the same manager. 18 There are issues related to allocation of 19 investment opportunities some of which were touched upon in 20 the previous panel, and there are various incentives for the 21 manager to, perhaps, favor one of its clients, one of its, 22 say, hedge fund clients over another client. 23 That could be the performance fee that that fund 24 might pay, the fact that that particular hedge fund might be 25 more in a position to pay the performance fee than another 1 either private client or another hedge fund and the fact that 2 if the manager is managing a fund or in a private account 3 along with a hedge fund, the manager has a lot of his own 4 personal investments in the hedge fund and would have a 5 temptation, if not more, to favor the hedge fund in the 6 allocation of investment opportunities. 7 And I'm not just talking about hot IPOs. I'm 8 talking about the best ideas or more valuable opportunities. 9 How do hedge funds deal with these conflicts of interest? 10 MR. ZACK: Doug, those conflicts exist actually not 11 just in the hedge fund industry but in any side-by-side 12 management situation in the asset management business. While 13 our shop, for example, does not have the type of hedge fund 14 where portfolio managers who manage retail mutual funds are 15 also managing hedge funds. As a matter of corporate policy, 16 we do not allow that, but we also only offer hedge funds of 17 funds, which precludes the arising of that type of situation. 18 But if you're managing wrap accounts, if you're 19 managing private assets through your institutional money 20 management arm, you have those same types of issues. One of 21 them -- 22 MR. SCHEIDT: But it's exacerbated in the hedge 23 fund -- 24 MR. ZACK: It is. It is. And one of the ways, 25 obviously, is disclosure to clients of the existence of those 1 potential conflicts of interest. You can do some things such 2 as isolation of trading desks, having trading allocation 3 policies and procedures in place to make sure that trades are 4 fairly allocated among different clients. 5 Those are, obviously, somewhat prophylactic in 6 nature. The most complete prophylactic, obviously, is to 7 have completely separate organizations and not allow the 8 conflict at all. 9 MR. PHILLIPS: I agree with Mr. Zack that conflicts 10 of interest are hardly raised by hedge funds and hardly novel 11 to the investment management in the street. Conflicts exist 12 any type a manager has two clients. Conflict exists when a 13 manager has one client, and he also trades for his own 14 account. Same kind of incentive in the latter situation as 15 in the hedge fund situation. 16 And the fact is that the investment management 17 industry over time has learned it has got to manage the 18 conflicts so that the management results in allocation of 19 investment opportunities and other trading opportunities pass 20 a basic test of fairness, and that's done by having a set of 21 rules and procedures tailored to the particular kind of 22 operation. 23 It makes a big difference the kinds of securities 24 that are being traded. It makes a big difference whether the 25 portfolio managers who raise the conflict are housed in the 1 same room or housed 3,000 miles away. A lot of different 2 factors affect the nature of your rules. 3 If you do have a focus on the issue, you do develop 4 rules and guidelines, practices and procedures, you do have a 5 system for monitoring the implementation of those rules, and 6 most of all you do have support from the top of the 7 organization for dealing with problems when they're 8 identified. 9 If you have that, then the conflicts can be 10 handled, and I think that's equally true of side-by-side 11 conflicts managing a mutual fund, a hedge fund, wrap 12 accounts, whatever. They have to be handled. They can be 13 handled, but take support from the top and the development of 14 a system of rules, policies and procedures and a system for 15 monitoring implementation. 16 MR. SCHEIDT: What level of assurance can you have, 17 though, about these issues in the hedge fund industry that's 18 not regulated, not subject to examination by the SEC, 19 allocation issues aren't considered by the funds' auditors? 20 Is it a you've got to trust me situation? 21 MR. PHILLIPS: I can tell you from my own 22 experience that since the SEC has been able to improve its 23 inspection staff with the formation of OSE there has been 24 much more focus within the mutual fund organizations on 25 compliance, allocation compliance as well as other conflict 1 of interest issues because they're aware that not this year 2 but maybe next year or the year following there will be an 3 examination, and they do not want to get long deficiency 4 letters that they have to explain to their boards of 5 directors. 6 MR. SCHEIDT: But you don't have that level of 7 deterrence in the hedge fund industry. And I'll tell you, 8 until the SEC started bringing enforcement cases against 9 registered advisors for fraudulently or preferentially 10 allocating investment opportunities you didn't have that 11 attention is my understanding. And, in fact, I heard because 12 the SEC first sued advisors to private clients that the 13 principles didn't really apply in the fund context. 14 And it wasn't until the SEC sued Dryfuss Funds for 15 preferential allocations that that message got through that 16 it did apply. So I'm personally concerned that the private 17 advisory managers don't fully appreciate their fiduciary 18 duties and don't fully appreciate some of the things that we 19 may take more for granted in the regulated industry. 20 MR. PHILLIPS: To the extent you've got a hedge 21 fund that has a sophisticated institutional base of 22 investors, you may find that there is some surveillance and 23 monitoring of the situations. To the extent they don't, then 24 you rely upon the personal integrity of the manager. 25 MR. ZACK: You also get that in the due diligence 1 process. If they have a family of hedge funds, how are they 2 going to allocate trades among those hedge funds? What are 3 the procedures that they use to monitor the personal trading 4 accounts of their staff members as well? 5 MR. SCHEIDT: And you'd probably look after the 6 fact that the relative performance of the different vehicles 7 to the extent that they're comparable to see if there are 8 major disparities in returns. 9 MR. VINE: Doug, I also think that as one of the 10 panelists in the last panel said, it's fairly unusual for a 11 hedge fund manager to be running a variety of different 12 products, and I think there is some correlation between the 13 size of a hedge fund firm and the number of products that its 14 able to run. 15 In the larger firms, from a compliance point of 16 view, do tend to look much more like the large mutual funds 17 in terms of having a culture of compliance and having the 18 tools in place to monitor that. 19 So I think in the hedge fund arena, the temptations 20 by and large don't exist for the garden variety hedge fund 21 manager. He has got one product, and he has got a lot of his 22 money in it. 23 MR. DIESCHBOURG: And also, for the fund-to-fund 24 shops, it doesn't exist because we're hiring individual 25 managers, and we're looking at their strategies. And if they 1 do have a dual strategy, or if they do have separate 2 accounts, we monitor that separate account versus a limited 3 partnership account that we might be invested in because that 4 creates another allocation issue, when you have a separate 5 account, how you're going to allocate. 6 MR. PHILLIPS: Let me ask you, when you do your due 7 diligence, how much focus do you place upon allocation, rules 8 and procedures and trading room rules and procedures to 9 prevent unfairness? 10 MR. DIESCHBOURG: Our CFO is very serious about 11 that process, so we go into a lot of detail. We actually go 12 back and talk to the prime brokers, too, and ask them about 13 various trades, get the book, look at it. It's a major part 14 of our process. We'll not hire great managers just because 15 we don't like their back office. They don't have a good 16 audit trail. They're not using a major firm or major law 17 firm. 18 So the operational and administrative side to the 19 business are critical to evaluate the business success, 20 because you're also investing in the small business, when you 21 think about this, for your fund. So from a fund-to-fund 22 standpoint, we are taking all those things into consideration 23 when we make those decisions, and we actually shy away from 24 funds that have separate accounts in addition to limited 25 partnerships because of that allocation issue. 1 MR. PHILLIPS: So what you're saying from your 2 experience is that the emergence of fund-to-funds whether 3 registered or not exerts a healthy pressure in developing a 4 compliance culture at the hedge fund level? 5 MR. DIESCHBOURG: Yes. 6 MR. ROYE: Question for Michael and Bob. How often 7 do you walk away from investing in underlying hedge fund 8 because you're concerned about those issues? 9 MR. DIESCHBOURG: A lot. We reviewed over 400 10 managers last year, and we only hired ten. 11 MR. ROYE: Yeah, but was that for performance or 12 some of the discussion we've heard so far, isn't it? Isn't 13 that a little inconsistent with some of the discussion we've 14 heard about earning problems? 15 MR. DIESCHBOURG: Well, it's a question of your 16 structure. We're looking for specific managers that have a 17 specific style, consistency of return. We don't like a lot 18 of leverage. We don't like securities that are too difficult 19 to value, obviously, and we're looking for shops that are 20 using major accounting firms that have an audit file. 21 So we're just going through that whole process. We 22 like older firms versus younger firms. There has been a 23 proliferation of new managers in the last couple years. Our 24 average manager has been managing for 14, 15 years versus the 25 new managers -- over the last, you know, 6,000 managers that 1 are out there today, 2- to 3,000 have formed the last three 2 years. 3 MR. ZACK: Paul, it would be a question of how all 4 of the factors fit together in the due diligence process 5 rather than you would go in and expect to find, you know, 6 blatant fraud that you've discovered in your due diligence on 7 valuations or on trade allocations. But you might not have a 8 comfort level about the overall operations, or it might not 9 fit the experience level. 10 I can't speak really for the folks in our Tremont 11 affiliate. They do this day in, day out. They have a huge 12 staff of people who go in and kick the tires, and they may 13 have a discomfort level about one aspect of a manager's 14 operations, but that didn't necessarily mean there is a 15 "problem" with that manager. 16 MR. SCHEIDT: What about conflicts with respect to 17 the use of the fund's commissions? The fund's commissions 18 can be used to benefit the fund. The fund's commissions can 19 be used to reimburse people who refer investors to the hedge 20 funds. It could be used to generate soft dollar benefits for 21 the manager. It could be used to generate personal expenses 22 paid for the manager. It could generate payments for capital 23 introductions. 24 How do hedge fund managers deal with use of 25 commissions and conflicts of interest, and how do they 1 satisfy their best execution obligations? 2 MR. ZACK: Well, again, since I'm looking at it 3 from the point of view of hedge fund to funds manager and 4 looking through the due diligence process of how we would 5 look at or how our Tremont affiliate would look at the 6 operations of the underlying managers and are they getting 7 best execution, how do they define it, what do they consider 8 and how do they test it, that is part of the process that 9 they will go through in the due diligence process. 10 It would probably be better to have someone who is 11 actually a hedge fund manager commenting on the actual use of 12 the brokerage allocations. To the degree that you're dealing 13 with registered investment advisors that are hedge fund 14 managers, and there are some out there, they're going to be 15 looking at 28(e). 16 They're going to be looking at the same 17 considerations under the Investment Advisor's Act, and 18 clearly that gives you a much greater level of comfort about 19 the allocation of brokerage commissions. 20 MR. SCHEIDT: I don't mean to put you on the spot, 21 but does your firm consider for investment a hedge fund whose 22 manager fully discloses that it can use brokerage commissions 23 to pay its business expenses or to reward people who 24 introduce investors to the hedge fund? Is that a 25 consideration? 1 MR. ZACK: Yes to the former and no to the latter. 2 MR. VINE: Let me jump in on this. One of the 3 first things that we talk about when we meet with someone 4 setting up a hedge fund is this very issue. What flexibility 5 do they want to have to use commission dollars, and what do 6 they want to use them for? And there is generally fairly 7 detailed disclosure in the private placement memos on this 8 issue. 9 What we see is that start-up managers do tend to 10 want to use soft dollars to the extent available to help them 11 get their business going. They are prepared to go outside of 12 the 28(e) safe harbor and, in general, I think the kinds of 13 investors who are interested in investing with fledgling 14 managers don't mind that. They understand the needs that the 15 manager may have to get going. 16 What we see is that as managers mature and get 17 larger, in general, they are living within 28(e), and I think 18 that's, to some extent, driven by investor demand. The 19 institutions tend to want to see that. To some extent, it's 20 driven by the fact that they are more likely to have an ERISA 21 account out there, and it's very difficult if you've got an 22 ERISA account and a hedge fund account to figure out how you 23 can use soft dollars for one and not the other outside the 24 safe harbor. 25 So I think we do see that kind of distinction, and 1 I think we actually find we spend more time than we'd like to 2 trying to interpret some of the boundaries on 28(e) I think 3 it would be helpful to hedge fund managers and others to get 4 some more guidance on some of the points that were left open. 5 MR. SCHEIDT: Do you have any thoughts about the 6 effect of eliminating the safe harbor of 28(e)? Congress has 7 expressed some concern in the mutual fund area about fund 8 fees and expenses and about use of soft dollars, and they've 9 thrown open the question if not directly then indirectly 10 about whether 28(e) is a good idea, whether it has produced 11 anomalies in the market that have prevented transparency and 12 have allowed managers through fine disclosure and a large 13 private placement memo disclose, basically, that they're 14 going to use the client's assets for their own benefit? And 15 is that a good thing from a policy perspective? 16 MR. VINE: Again, I think the hedge fund arena in 17 some ways has some built in checks and balances on it. The 18 fact that there's a performance fee, the fact that the 19 manager typically has a lot of his own personal net worth 20 tied into the fund means that the benefit of being able to 21 use the soft dollars is often outweighed by the detriment of 22 not getting best execution. 23 So I think there's some real advantages in the 24 hedge fund structure that may not exist in some of the other 25 areas of investment management. 1 MR. SCHEIDT: We're getting towards the end of the 2 program, and I've been asked to allow a little bit of extra 3 time here for the panelists to express their views, if they 4 have any, on the Commission's inquiry on the issues that have 5 been presented today about whether there's a need for 6 regulation in this area, whether it be registration of the 7 hedge fund manager at one end or registration of the hedge 8 fund itself whether under the 40 Act or under a 40 Act light 9 regime or anything in between, mandating that all hedge funds 10 in the United States must use an independent valuation agent 11 or limited the amount -- and this is way I don't know the 12 scope of this panel -- but limiting the amount of leverage 13 they could use. 14 Do any of the panelists have any thoughts on any of 15 those topics? 16 MR. ZACK: Well, Doug, I've never hesitated to 17 respond to your challenges on any panel we've been on 18 together. Actually, I think I want to say first that I do 19 really commend the Commission for holding this round table 20 and with the staff's efforts to gather the information needed 21 to evaluate the industry. 22 This is the way that the process really should 23 work, and it will result I'm sure in an intelligent and well 24 thought out response. 25 Having said that, I think that if we look at hedge 1 funds compared to other asset managed vehicles there is a 2 reason for their difference and distinction, and I would urge 3 caution in the adoption or consideration of rules unless 4 there is a clearly articulated need for regulation to deal 5 with a clearly articulated problem that has been identified. 6 I haven't yet heard today any problems rising to 7 the surface that suggest the need for regulation, at least of 8 a sweeping variety, and I don't think we want to make hedge 9 funds look like mutual funds. I think they are two very 10 distinct asset classes that serve a very vital, very vital 11 role in the liquidity of our markets and capital formation in 12 our markets. 13 MR. PHILLIPS: Let me chime in in this respect. I 14 don't think that the Investment Company Act is an appropriate 15 vehicle for regulation of hedge funds. It's much too 16 contradicted. In many respects, it's outmoded, and I think 17 that attempting to place hedge funds under the Investment 18 Company Act would dislocate a very important, increasingly 19 important industry in ways it could never recover and operate 20 and perform the service it does. 21 On the other hand, I have great difficulty in 22 understanding why if I have a half a million dollars to 23 invest and I go to a money manager and ask him to invest it 24 for me in a wrap account or a separate account, I can look 25 the person in the eye, I can negotiate the terms of the 1 contract, I can put restrictions on what he or she does, et 2 cetera, and I have a personal relationship, and yet I also 3 have the protections of the Investment Advisor Act. 4 I take that half a million dollars and put it in a 5 hedge fund, an impersonal mechanism, I have much less 6 negotiating ability, much less ability to -- much less 7 contact with the manager. I don't understand the 8 justification for not regulating hedge fund managers under 9 the Advisors Act. 10 In looking at the Advisors Act, there are only two 11 ingredients of the Advisors Act regulation as important. One 12 is the ADV mechanism of disclosure and, two, the Commission 13 examination. That would bring -- I don't think there are 14 large-scale problems of fraud and abuse in the hedge fund 15 industry, but regulation is not meant for the mainstream of 16 any industry. It doesn't work. It's meant for the margins. 17 And I would urge the Commission to consider an 18 unobtrusive system of regulations on the Advisors Act that 19 brings hedge funds within the Commission's radar through 20 registration of investment advisors, an ADV that's tailored 21 to the operation of hedge funds which requires that they put 22 their policies and procedures for handling conflicts, and 23 things like that, out on top of the table with disclosure and 24 a system of Commission examination that looks to see whether 25 those policies and procedures have been followed. 1 To me, that's a constructive regulatory move and 2 one that should not contradict 99 percent of the hedge fund 3 industry and over time will develop a compliance culture that 4 will be second to none if properly implemented. 5 MR. LO: Well, let me just comment on, sort of, the 6 broader questions that you raised regarding the need for 7 further regulation in the industry. Let me mention at the 8 outset, in the interest of full disclosure, that in addition 9 to my academic point I'm also a principal in a hedge fund. 10 And contrary to what you might think that kind of 11 conflict of interest might produce, I actually think there is 12 a need for additional regulation of a particular sort. I 13 think there are three outstanding issues that both this panel 14 and others at this conference are grappling with. 15 The three issues are investor education, risk 16 transparency and systematic risk exposures. And I think that 17 there's a need both in the industry as well as on the 18 regulatory side to provide better analytics, better 19 regulation to address each of these three issues. 20 And I know we don't have time to get into it, but I 21 just want to mention briefly we've talked about investor 22 education and the notion of a sophisticated or accredited or 23 qualified investor. I think that needs to be revisited. 24 Risk transparency. I think we've discussed in a 25 number of ways how hedge fund risks are, essentially, 1 different from the risks of more traditional investment asset 2 classes. And so additional tools and I and other academics 3 and people in industry are developing I think are going to be 4 important providing that risk transparency. 5 And the third issue which I don't think has been 6 mentioned at all today -- maybe it will be a topic for 7 tomorrow's conversation -- is the fact that every once in a 8 while we have a situation where a hedge fund blowup has 9 systematic risk exposures. Of course, I'm thinking about 10 1998 and LTCM. 11 I guess, following along the lines of the 12 president's working group on LTCM, I think that additional 13 measures need to be taken to deal with issues of systematic 14 risk. They're very rare, very unlikely to happen, but, 15 obviously, when they do, they're extremely important. And 16 there are additional things that I think the SEC and the 17 industry can do to ensure that these risks are minimized. 18 MR. SCHEIDT: Thank you. 19 MR. ARTABANE: Thanks. I would, I guess, agree 20 with the thought that the Investment Company Act of 1940 is 21 not the vehicle to regulate hedge funds. You can hardly run 22 many of the strategies in a good way. So I would agree with 23 that. 24 I think, though, that if Dick's view is undertaken 25 by the Commission and there is regulation of advisors that 1 you should look to make sure it's efficient and it's not 2 overlapping, because many hedge funds are already registered 3 with the CFTC as commodity pool operators, and you don't want 4 to get into a situation where there's too much regulation. 5 Having said that, I think the institutionalization 6 of the business is moving the standards up generally, and 7 that type of process that Robert has and that Michael have in 8 terms of their due diligence and the investor sophistication 9 is really raising the bar. 10 So I don't think it's broken. They're, obviously, 11 not to the standard of mutual funds because of the regulation 12 in mutual funds, and there are going to be some aberrant 13 issues given the fact that there are 6,000 managers there. 14 Some of them may be doing things that are not right. Some of 15 them may simply be taking on too much investment risk and 16 having a fund that's highly illiquid and highly leveraged, 17 you know, blow up as the markets go against you, but that's 18 part of the investment in the asset class. 19 MR. SCHEIDT: Thanks. Steve. 20 MR. VINE: Yeah. I'd echo what some of the other 21 panelists have said. I think we've seen very significant 22 consolidation in the industry in the past couple of years and 23 a very significant in-flow of sophisticated institutional 24 money. And what that has meant at the high end of the market 25 is that the firms are tending to look very similar from a 1 compliance standpoint. 2 The firms that are managing large sums of 3 institutional money can't really be distinguished in terms of 4 their compliance culture on the basis of whether or not 5 they're registered with the Commission. 6 Having said that, I think Dick Phillips raises a 7 good point, that it is hard to understand why an investor who 8 looks more like a retail investor should have a lesser degree 9 of protection when making a modest or relatively modest 10 investment in a wrap account versus a small hedge fund. 11 I think there really is a need to look at the 12 investor accreditation thresholds and see whether they need 13 to be adjusted to take into account that discrepancy. 14 MR. DIESCHBOURG: A lot of good things have been 15 said, and I do thank the SEC for having the round table, 16 because I think education not only for the regulators but 17 also for the press and for the people in the industry it's 18 important to let it grow. 19 And in growing that business, now I see 20 institutional players had a major impact on making it better, 21 but the fund-to-fund operators have been a major part of 22 making this industry better from a due diligence and from a 23 process standpoint and bringing the standards up in the 24 business, and these type of things really help that. 25 Becoming a registered investment advisor versus a 1 registered investment company would be a simple process, and 2 it's something that we good forward with should be done 3 simply and easily to identify the needs of our industry but 4 also shouldn't be restrictive enough that it stops the 5 entrepreneurial spirit of the people that go out there to 6 create these businesses. 7 The men and women that start these firms still need 8 to have the entrepreneurial edge to go out there and create 9 these businesses. So I just throw that out as a closing 10 thought, and thank you for giving us an opportunity to be 11 here. 12 MR. LIANG: Well, I think this industry is a new, 13 growing and very exciting industry. However, I do see there 14 are problems. If there are not, we won't be here today. And 15 the problems are -- we heard that from the street and the 16 problems with the long-term capital manager over-leverage 17 issues and systematic risk issues and also those non-auditing 18 issues. 19 But the question is are these issues representative 20 for the whole industry? If they are, then the question is 21 very significant. If the question is no, they're not, and 22 then we should do some kind of like a benefit cost analysis. 23 But leaving this industry alone like this probably will have 24 liquidity issues and will have innovations for financial 25 instruments will attract a lot of talented people these are 1 the benefit. And the costs are probably going to drive them 2 away. 3 So I think from the SEC's point of view, probably, 4 you know, this is a rough point here is doing some kind of 5 benefit cost analysis. That's my first point. 6 And the second point is we should distinguish one 7 fund from another. They're all different. There are 6,000 8 of them. They are not the same. They have different styles, 9 and they have different sizes, and they have different 10 organization structures. So we should treat them 11 differently. 12 For example, for large funds, they probably will 13 have some kind of large position issues, and currently they 14 are reporting to two different agencies for large position 15 reporting. And for smaller funds, probably they will have 16 technology issues, and they will have auditing issues. So 17 the issues are not the same. 18 We cannot say yes or no for the entire industry. 19 It probably is more complicated than that. We probably can 20 come to the middle of some positions. 21 And my last point is we're talking about hedge 22 funds and the mutual fund industry there's a, kind of, 23 conflict of interest issues. I will not say whether hedge 24 funds should be regulated or not, but I will raise a 25 question, and this question seems irrelevant to this round 1 table discussion, but I would raise it anyhow. 2 Mutual fund managers' hands and feet and tied too 3 tight to have enough freedom because we know there are old 4 securities laws governing mutual funds. So can we give them 5 more freedom other than tighten the hedge funds? I think 6 that's a relevant issue to this discussion between hedge fund 7 and mutual funds. 8 MR. SCHEIDT: Okay. Well, thank you very much, 9 everyone. That wraps up the first day of the round table, 10 and we hope to see you all tomorrow. 11 (Applause.) 12 (Whereupon, the hearing was adjourned at 5:34 p.m.)