Successfully launching and running a hedge fund is daunting. It requires multidisciplinary skills such as developing and maintaining a positive track record that outperforms its competitors and benchmarks, hiring a talented supporting cast and attracting capital. As the hedge fund industry has matured, it has become increasingly difficult for hedge fund managers to distinguish themselves from other managers and, as a result, attracting capital has become more challenging.
The amount of assets under management by a firm is one of the critical factors for many institutional investors that have moved from making indirect investments through a fund of funds to direct investments. Hedge fund managers, more than ever, should approach capital raising with two focal points: Identifying the message that they would like to communicate and determining the mode of delivery. Seems simple but it’s not. Both the message and the means of communication not only require commercial knowledge, but both must also comply with a labyrinth of laws, not only within the United States but abroad.
During the last several years, hedge fund managers have increasingly been getting their message out by speaking at conferences, writing white papers, conducting interviews with the media and even using social media. For managers using these methods of communication, it is important to keep in mind that most managers of hedge funds rely on Rule 506(b) under Regulation D of the Securities Act of 1933 to avoid registering their offerings with the Securities and Exchange Commission (SEC).
The rule prohibits general advertising of the fund, such as placing an advertisement through television, newspaper, radio and publicly available websites seeking new investors—this is referred to as the “prohibition against general solicitation.” Some notable exceptions to the prohibition are: An offer to a prospective investor with whom the manager or its agent has a substantive pre-existing relationship or the dissemination of factual business information excluding opinion, predictions or projections as to the valuation of a security or the fund’s past performance.
Prior to using television, radio, Internet or social media to share their message, hedge fund managers know they have to consult with legal counsel. Yet, as with all professions, different lawyers may reach different conclusions. Legal guidance is based upon understanding the factual scenario and thorough research and interpretation of the laws which apply to the facts. Violating the prohibition against general solicitation has severe consequences. While it may result in prosecution by the SEC, the loss of the private placement exemption is often more concerning. Without the exemption, the hedge fund manager and its employees may be personally liable to investors who, in the event of a loss of capital, may seek to recover their investment, interest and attorney fees.
In July 2013, the SEC approved final rules in connection with The Jumpstart Our Business Startups Act (JOBS Act). Rule 506(c) of the JOBS Act enables hedge fund managers to engage in general solicitation provided that such funds only accept investment from accredited investors and that managers take reasonable steps to verify the accredited investor’s status. However, the previously customary method of self-certification via subscription documents does not satisfy Rule 506(c)’s requirements.
Nevertheless, the JOBS Act may ultimately prove useful to both small and large hedge funds. Managers of smaller funds operate their businesses at a competitive disadvantage against managers of larger funds with mature distribution channels or investor relations teams. Provided that they comply with the law, smaller hedge funds may be able to use the Internet to reduce this disadvantage. Larger hedge funds may consider operating pursuant to Rule 506(c) not only in connection with distributing their product, but also as a prophylactic protection against an unintended breach of the prohibition against general solicitation.
As of today, the effect of the JOBS Act does not appear significant. Based upon filings of Form D with the SEC reflecting Rule 506(c) and the scarcity of advertisements by hedge funds, both emerging and established fund managers have made limited use of new opportunities afforded under Rule 506(c).
Ultimately, hedge fund managers perpetually compete against other hedge fund managers, alternative mutual funds and traditional asset managers. Given the challenges of raising capital, managers should continue to explore all available distribution channels including those that are newly developing.
We anticipate that for the near future few hedge funds will embrace the JOBS Act as the benefits to managers appear to be outweighed by a number of concerns, primarily the fear of increased scrutiny by regulators, as well as diluting and invariably harming the manager’s brand. However, if first movers have any success, expect a quick shift in other managers’ approach.