‘Nothing Systemic Here’

T he Securities and Exchange Commission (SEC) released a new proposed rule on January 26, seeking to substantially change reporting requirements for private funds of capital — that is, private equity, private debt, hedge funds, and other asset managers.

While the proposal did not capture a lot of press attention, it should have. The scope and implication of the proposed rule ought to concern defenders of free enterprise and coherent capital markets.

Form PF is a basic form that investment advisors to private funds are required to file with the SEC. So far as financial red tape goes, it is standard-fare obnoxiousness (64 pages long, cumbersome calculations and minutiae, etc.), but its mere existence isn’t cause for recoil. The proposed changes, however, transition the “inconvenient” to the “dangerous” and do so under a completely unacceptable premise.

Should the proposed rule change be adopted, the definition of a “large” private fund (such as a hedge fund or private-equity manager) will shift from $2 billion in assets under management to $1.5 billion under management — a revision that would capture over 440 private-equity managers alone. For our purposes, I will ignore the fact that no one in their right mind would believe that $1.5 billion in management is “large” in the context of the private-equity sector, a $4.2 trillion industry responsible for $1.2 trillion of deals done last year alone. But beyond that silly definition, the most troubling aspect of the new rule is at its center: that “large” private funds must report to the SEC within one business day “certain triggering events,” specifically:

• Extraordinary investment losses over a ten-day period

• Significant increase in the use of margin or collateral

• Default by a counterparty around the use of margin

• A change in prime brokers

• Various events concerning redemptions and withdrawals

To its credit, the SEC does not pretend that this information is necessary to protect the investors in such funds. The SEC acknowledges that current-investor requirements demand investors have a $5 million or greater net worth, an aggressive tolerance for risk, and a fully documented awareness of the relative illiquidity of their investment. These investors can, of course, lose money. But the SEC is rationalizing these demands around the “systemic risk” that such events could represent across financial markets. Essentially, the justification for this is based on the notion that this would assist the Financial Stability Oversight Council (a relatively new body established, among other tasks to identify — as its name implies — risks to U.S. financial stability.) Thus the language referring to the “reporting of events that could be relevant to financial stability” and “timely information to analyze and assess risks to investors and markets more broadly.”

The attempt to include both hedge funds and private equity within the scope of the new rule is, itself, a sign of disingenuity on the SEC’s part. But before explaining the private-equity side of this, let’s see the hedge-fund proposal through.

How does investment inside a hedge fund represent systemic risk? Investors can lose all their money, I suppose, but even the SEC would not pretend that the reporting of an investment loss can change the loss itself. Hedge funds for “qualified purchasers” are the ultimate “buyer beware” investment from a regulatory standpoint, and for an agency whose plate is full dealing with real bad actors inflicting real harm on mom-and-pop investors, it would stretch the imagination to believe that the SEC would go to these lengths to protect the wealthiest of investors and their institutional counterparts.

No, the rationale here is that the leverage in the system when a hedge fund (where private equity is involved, the issues involving leverage are different and ought not to represent anything “systemic”) incurs large capital losses could mean broader financial-system risk. Okay, so now we are getting somewhere. But wait a second! How is the hedge fund’s investment loss the source of systemic risk? Isn’t the lender’s capital that funded the leverage the heart of the matter? And didn’t Dodd-Frank (a law, incidentally, enacted long after the Long-Term Capital Management debacle) provide the strictest capital requirements on our investment banks and commercial banks in history? Is the SEC claiming that the train has left the station and that lending endeavors by our largest financial institutions are now out of the view of regulators? Can we not trust stated capital ratios? Are the Fed’s capital and liquidity tests flawed? Have the thousands upon thousands of Fed and banking regulators who sit atop the balance sheets of our nation’s lending institutions lost the plot?

There is risk for the equity side of a hedge-fund investment — the risk that what one buys can go down — and that risk is borne only by the investor. Moreover, the risk is capped at 100 percent of his or her own capital in the investment, which is to say, it is the textbook definition of being “not systemic.”

There is also risk for the debt side of a hedge-funding investment — that is, the lender providing the debt capital used to leverage up the equity — and that risk is borne by the lenders. That risk is either part of the most comprehensive regulatory apparatus in world history (Dodd-Frank), or it is borne by non-bank lenders. And once again I ask, where is the systemic risk if non-bank lenders take losses? Their principals could lose principal capital. Investors could lose risk capital. But how can non-bank lenders with isolated capital pools connected to specific hedge-fund investments be considered “systemic”?

The reality is that we are talking about two different things here, and the SEC knows it.

Most leverage provided to hedge funds comes from their prime brokers — namely, large investment banks heavily, and I mean heavily regulated by Dodd-Frank.

And most leverage provided to private-equity managers comes from non-bank lenders — that is, pools of capital that simply do not represent any systemic risk should their senior-secured, first-lien position become impaired.

The reporting of losses and various activities inside a trading strategy is the ultimate suicidal self-fulfilling prophecy. The mere reporting of a bad event guarantees the snowballing of that bad event as other highly sophisticated actors pile on and exploit the investor’s weak hand. The secrecy and privacy of complex and opaque trading strategies is often at the very heart of an asset manager’s strategy. Again, bad news does not get better with reporting. I recognize that bad news does not often get better with age, either, and it may very well be that a deterioration event will remain an impairment in that hedge fund’s quarterly or annual results. But that is between that hedge fund and its investors; the forced reporting of the leverage levels, the trade details, the collateral circumstances, and all other material information is like throwing red meat into a lion’s den and hoping it will calm the animals down. 

This is aggressive overreach overloaded with unintended consequences. The SEC’s argument is that the sheer size of private equity and hedge funds necessitate greater disclosure. But the disclosure of losses within hedge funds is between the general partner, the fund, and its investors. Giving regulators who don’t have skin in the game visibility to such things within 24 hours is unhelpful, abusive, and if anything, a closet confession that the regulators do not think they have a command of the debt exposures falling within their actual regulatory purview.

It’s very likely that an important catalyst for this rule was the collapse of the Archegos family office last year. But that case does not offer a rationale for the SEC’s position. On the contrary, it supports mine. Private actors took a lot of risk. They lost a lot of money. And their lenders responded by covering their losses where they could, and one of them largely exited the prime brokerage market. Lesson learned. All risk their lenders had was within their own regulatory capital allowances. Markets didn’t blink. Mom-and-pops lost no money whatsoever. Some very rich and smart people got poorer and markets worked just fine.

The SEC would be wise to remember the lesson of 2008. The hedge-fund community and private-fund world served as a source of liquidity and capital allocation to a regulated world that had lost its mind. Capital markets work best when risk is left where it belongs. Our regulatory apparatus ought to preserve this.