Hedge Funds Find An Escape Hatch

The loophole: Locked-up funds don't require oversight. That means more risk for investors

Securities & Exchange Commission Chairman William H. Donaldson recently accomplished a major feat when he got the agency to pass a controversial rule forcing hedge fund advisers to register by 2006. Unfortunately, just weeks after the SEC announced the new rule on Dec. 2, many hedge fund managers have already figured out a simple way to bypass it.

The easy out is right on page 23 of the new SEC rule: Any fund that requires investors to commit their money for more than two years does not have to register with the SEC. The SEC created that escape hatch to benefit private-equity firms and venture capitalists, which typically make long-term investments and have been involved in few SEC enforcement actions. By contrast, hedge funds, some of which have recently been charged with defrauding investors, typically have allowed investors to remove their money at the end of every quarter. Now many are considering taking advantage of the loophole by locking up customers' money for years.


Securities lawyers say phones are ringing off the hook with questions from hedge funds considering circumventing registration. Some firms have already held small seminars packed with hedge fund managers discussing the potential cost and hassle of registering. Analysts estimate there are over 7,000 hedge funds, with roughly $1 trillion in assets; many may be looking for an out. Lindi L. Beaudreault, an attorney at Washington-based law firm LeClair Ryan estimates that "one third of unregistered hedge fund advisers are seriously considering locking up their investors' money for two years" to avoid registering.

Hedge funds seeking to skirt SEC registration raises troubling questions given their recent track record. In the last five years, the SEC has authorized or brought 51 cases against hedge fund advisers for allegedly defrauding investors of over $1 billion. And some SEC officials are already conceding that the exemption could be problematic. "If we see a significant evasion of the rule, we'll have to rethink," says Paul F. Roye, director of the division of investment management at the SEC.

The SEC did anticipate that some hedge funds would try to take advantage of the loophole. It concluded that investors would have the smarts to steer clear of any fund trying to evade the rule. But it may be tough for investors to distinguish between funds that are lengthening their so-called lockup periods simply to avoid registering, versus those with legitimate reasons for a longer investment horizon, such as a strategy based on turning around troubled companies. Already, investors in 5% of hedge funds with more than $1 billion in assets, many of which had voluntarily registered before the rule was introduced, have agreed to funds' demands that they hand over their money for two years or more, according to Chicago-based researcher Hedge Fund Research Inc. Still, if hedge fund exceptions become the rule, Donaldson's coup might turn out to be a Pyrrhic victory.

By Emily Thornton in New York

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