The JOBS Act has failed to ignite a mass market, capital-raising boom in the United States, chiefly because the de-regulatory ambition of the measure is contradicted by a host of other regulations, including regulatory reporting obligations.
Amid an unceasing diet of re-regulation, one measure offered hope rather than threat. This was the Jump-start our Business Start-ups Act (the JOBS Act). Unfortunately, it turned out not only to be irrelevant to those managers which invested it with hope, but to actually add to the burden of regulatory reporting of the few tempted to try it.
The Act, put into effect under the supervision of the Securities and Exchange Commission (SEC) on 23 September 2013, appeared to offer alternative managers an opportunity to raise capital from retail investors. By amending Regulation (d) of the 1933 Securities Act, the legislation lifted a prohibition on private funds marketing funds to the public.
So far, next to nothing has happened. The 2014 survey of 198 hedge fund managers running over $1 trillion by consultants Aksia surveyed found just one manager in a hundred intended to advertise to the public in the wake of the OBS Act. Nearly a quarter told Aksia they would “wait and see,” while most of the rest (73 per cent) said they would definitely not make use of the rules.
A Preqin survey of 150 private equity and hedge fund managers produced a similar verdic t. 77 per cent of private equity firms and 63 per cent of hedge funds told Preqin they would “never” or “not at this time” market under the JOBS Act. So far, an estimated 4 per cent of hedge funds and 5 per cent of private equity firms have registered with the SEC to market funds under the JOBS Act.
This collective disinterest reflects the continuing belief of alternative managers that they are better advised to build lasting relationships with sophisticated institutional investors than to mass market their strategies to the public. The costs of mass marketing are significant, and regulators of mass market funds will not look kindly on managers that charge them to the fund.
Managers marketing funds under the JOBS Act also incur onerous compliance and reporting obligations. All marketing materials must be shared with the SEC, increasing the risk of a regulatory examination. SEC rules insist marketing materials do not mislead investors in any way - particularly on performance, where the regulator has also disdained to offer concrete advice on presentation, - and include robust anti-fraud provisions.
Managers must submit Form D - the brief notice explaining the fund, which is necessary to claim the exemption from the 1933 Act - to the SEC at last 15 days in advance of their first “general solicitation,” and amend it for each new offering. “The SEC has warned managers taking advantage of the JOBS Act that they will be the first firms subjected to regulatory audits,” says Steven Nadel, a partner at Seward & Kissel in New York. “Compliance officers need to carefully review all marketing materials and fund documentation to ensure they are not fraudulent or misleading.”
Fund managers are also obliged undertake rigorous due diligence on prospective investors. The SEC is inevitably sensitive to criticism from consumer protection groups, state regulators and trade unions that unsophisticated investors will be fleeced by unscrupulous managers pursuing high risk or fraudulent strategies.
So it is demanding that managers ensure any investors recruited under the JOBS Act are properly “accredited.” An accredited investor, as presently defined by regulators, is someone earning more than $200,000 a year or with a net worth in excess of $1 million (excluding the value of their primary residence).
Obtaining this kind of Know Your Client (KYC) data entails engaging with auditors, brokers and lawyers already acting for an investor. There is a possibility that the current definition of an accredited investor could change by the end of this year - Section 413(b)(2)(A) of the Dodd-Frank Act requires the SEC to re-examine the definition of “accredited investor” every four years – but the last change, back in 2010, was not encouraging: it was then that the SEC decided to exclude primary residences from the calculation of net worth.
Steven Nadel is not expecting the 2014 review to be rich in liberalising measures. “It is quite possible the SEC could increase the threshold from the $200,000 per year as applied to income to up to $500,000, and the $1 million net worth threshold to more than $2.5 million,” he says. “While this is unlikely to impact large scale fund managers which solicit institutional investors writing substantial tickets, it could have a significant effect on smaller managers who are setting up and are devoid of seed capital and therefore reliant on cash inflows from friends and family.”
Another compliance risk to managers distributing funds under the JOBS Act is the difficulty of controlling the distribution network. Under Rule 506 of Regulation D of the 1933 Securities Act, which implements Section 926 of the Dodd Frank Act, offerings are disqualified if anybody associated with it is a “bad actor.” A “bad actor” is someone with a relevant criminal conviction, or regulatory or court order or other disqualifying event that occurred on or after 23 September 2013, when the exemptions came into effect. This obviously applies a fortiori to directors of the fund.
But fund distributors (or “solicitors”), placement agents, sub-advisors and even substantial investors (those who own more than 20 per cent of the fund) could all qualify as “bad actors” too. “Managers must conduct thorough operational due diligence on the funds’ distributors and solicitors and receive on-going representations that bad acts have not been committed and that no `bad actor’ is involved in the fund offering,” explains Emma Rodriguez-Ayala, general counsel at Mesirow Advanced Strategies, the $14 billion Chicago-based fund of hedge funds. “Managers should request an indemnity from the distributor or solicitor for any regulatory issues that the fund suffers as a consequence of the distributor’s or solicitor’s bad acts. If somebody involved in the fund offering commits a bad act, the fund must disassociate itself immediately from that individual and business. If a beneficial owner with more than 20 per cent of the fund’s voting securities becomes a `bad actor,’ the fund might force them to reduce their ownership share of the fund and waive their voting rights, in each case below the 20 per cent threshold.”
Another problem for global managers is potential contradictions between the liberalising impulse of the JOBS Act and the re-regulatory measures that have taken effect in Europe under the Alternative Investment Fund Managers Directive (AIFMD). Many managers based in the United States but open to European investors have chosen to rely on “reverse solicitation” - in other words, undertaking no active marketing, but responding to investors which approach the firm of their own volition - to escape the obligation to comply in full with the AIFMD.
To guarantee compliance with the AIFMD, lawyers and compliance experts have warned American fund managers to ensure their websites and other marketing materials cannot be viewed by investors based in the European Union (EU). Managers have duly taken note. 22 per cent of private equity managers told Preqin that inconsistencies between the JOBS Act and AIFMD were the biggest obstacle to embracing the opportunities created by the JOBS Act.
“While the JOBS Act does ease managers’ marketing restrictions, AIFMD opens up a whole can of worms,” explains Steven Nadel. “Managers in the United States are looking to rely on reverse solicitation but what if a hedge fund’s website or an interview with a trade journal was seen by a German investor? That could put the manager in breach of AIFMD’s national private placement rules.”
But the biggest obstacle to a post-JOBS Act marketing bonanza is another pair of regulatory contradictions: those between the SEC and the Commodity Futures Trading Commission (CFTC) in the United States. Firms that want to market their funds under the JOBS Act must register with both the SEC and the Commodity Futures Trading Commission (CFTC). Understandably, given the differences in the trading strategies of funds investing primarily in securities and those investing primarily in commodities or derivatives, dual registration tends to be uncommon.
Under Rule 4.13(a)(3) of the Commodity Exchange Act, firms trading a minimal level of derivatives are exempted from registering with the CFTC as Commodity Pool Operator (CPO) or Commodity Trading Advisor (CTA). A number of firms claim this exemption. However, under CFTC rules, this prohibits them from publicly marketing their businesses. Lawyers doubt the SEC and CFTC will reconcile this contradiction between the JOBS Act and the Commodity Exchange Act before 2015 at the earliest.
Steven Nadel of Seward & Kissel says settling the problem is not a priority at the CFTC. The regulator is short of money and staff, and buried in implementing the vast range of regulatory responsibilities conferred on it by the Dodd-Frank Act. Besides, managers affected generally conclude that I is not worthwhile to ditch their exemption, and incur the costs of registering with the CFTC, in order to claim the uncertain benefits of raising capital under the JOBS Act.
Given these multiple disincentives, risks, rules and restrictions, and the daunting complexity of complying with them, it is not surprising that the JOBS Act has failed to spawn a rush of mass market hedge fund offerings. But managers are not ignoring the JOBS Act altogether. It has encouraged managers to make more use of social media, enhance their websites, and speak more frequently at industry conferences and to the media.
Back in November 2013, Californian managers Topturn Capital became the first to advertise a fund on its home page. Dan Darchuck, co-founder and chief executive officer at Topturn Capital, says the response to the advertisement was overwhelmingly positive, adding the fund has grown assets significantly since the advertisement was released.
Marketing and advertising could also be of use to the increasing number of hedge and private equity fund managers adopting so-called “liquid alternative” structures, by which they mean mutual funds regulated under the 1940 Investment Company Act (“’40 Act”). Regulated funds can help diversify an investor base, especially into defined contribution pension plans (which hold over $5 trillion in investable assets), individual retirement accounts, annuity reserves, broker-dealers and registered investment advisers (RIAs).
An April 2014 study by Barclays Prime Finance – Developments and Opportunities for Hedge Fund Managers in the ’40 Act Space –reckoned assets invested in liquid alternatives grew by 43 per cent in 2013 to reach $137 billion in total. That rate of growth is almost three times the pace at which the classic hedge fund industry grew assets under management in the same period (15 per cent). Barclays predicts liquid alternative funds will be managing somewhere between $650 and $950 billion by 2018. Now sums of that magnitude are worth taking some trouble to attract. It is why mutual fund managers were among the most vociferous critics of the JOBS Act.