Hailed as the most sweeping overhaul of the pension system in decades, the Pension Protection Act of 2006 is touching all facets of the financial services community–including hedge funds. The Act modifies the Department of Labor's (DOL) plan asset regulation by allowing hedge fund advisors to accept more money from pension programs.
In essence, what the pension law does is enable hedge fund advisors to pull in more pension fund money "in terms of the percentage of the [hedge fund's assets] before tripping DOL rules," explains Michael Tannenbaum, a partner at New York law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP. Once a fund has more than 25% of its money in pension plan assets, it becomes subject to DOL rules. However, under the new pension law, when a hedge fund computes the 25%, it would be required to include those plans that are subject to ERISA, individual retirement accounts, and Keogh plans, but the fund "no longer has to consider government or non-U.S. pension plans," he explains. As a result, "it will take a longer time to get up to that 25% [threshold], which is favorable."
Tannenbaum believes that the Act's modification to the plan asset rule is just another sign of the trend toward more hedge funds seeking pension investor assets. More and more hedge fund advisors are voluntarily registering with the SEC so they become more attractive to pension funds. "Pension trustees are fiduciaries and they have certain responsibilities, one of which is to be prudent in selecting managers," Tannenbaum says. "So you'd want to choose a manager that's registered with the SEC."
On the issue of registration, in response to the D.C. Circuit Court of Appeals' decision in Goldstein v. SEC, which struck down the SEC's hedge fund manager registration rule, the SEC decided not to challenge the ruling and instead issued a no-action letter in August announcing that hedge fund advisors may withdraw their registrations if they do so by February 1, 2007. As of mid-September, 84 hedge fund advisors had de-registered, according to an SEC spokesman.
In testimony before the DOL Advisory Council in August, John Gaine, president of the Managed Funds Association, said that while the plan asset rules within the pension Act are "a good first step" to encouraging more pension funds to invest in hedge funds, he believes the plan asset rules should be modified further in order to "enhance the investment opportunities available to plans," and to eliminate confusion in some areas. The current lack of guidance, he said, "Causes hedge fund managers to incur unnecessary compliance costs, which are ultimately passed on to all investors in a fund." Gaine said there are currently more than 8,000 hedge funds with $1.2 trillion in assets under management.
For instance, Gaine said hedge funds need clarity regarding how the plan asset rules apply to them, which would help "minimize the administrative burdens and expenses that hedge funds face when they choose to accept ERISA investors." Gaine also said that changes that would treat hedge funds like venture capital funds and real estate funds–which are generally not subject to ERISA– and "would provide ERISA plans greater flexibility with respect to their investment options."
Mainstreaming = Regulation
While the plan asset rules within the Act are a definite loosening of the pension rules as they apply to hedge funds, John Rekenthaler, VP of research at Morningstar, says that the fact that hedge funds are seeking more money from public, private, and government pension funds is a sign that hedge funds are going more "mainstream." This is precisely why regulators are zeroing in on hedge funds, he says, warning that further regulatory changes reining in the industry may be inevitable. "Where there is a loosening [of regulation] there will also be a tightening," he says.
The new plan asset rules are mainly good news for large single funds as well as funds of funds–not the mid-sized single funds that Morningstar interacts with, Rekenthaler notes. Indeed, Gaine said in his testimony that while pension plans may invest directly with a hedge fund, most plans gain access through a fund of funds arrangement because it gives the plans "a chance to learn about hedge fund before investing in them directly, access to individual hedge funds that are closed to the broader community, and a tailored investment strategy."
Gaine noted in his testimony that as it stands now, investors in hedge funds are mainly public pension plans, university endowments, or other large institutions, and wealthy individuals. However, some large pension funds, including those of General Electric, General Motors, and Verizon, include hedge funds in their portfolios, he said. Defined benefit pension plans, too, have become increasingly interested in hedge funds, he said, "due to the diversity of the investment styles available to help such plans meet their benefit obligations." But statistics show that only about $71 billion in pension fund assets (both corporate and public) were invested directly in hedge funds as of January 2005, he pointed out, compared to the more than $1.8 trillion held by corporate defined benefit pension plans at the end of 2004.
