While the hedge fund industry agrees that $50 billion in assets is a reasonable threshold for determining when a hedge fund or other non-bank financial company should be deemed systemically significant under Dodd-Frank, it is important that the threshold be adjusted over time to account for the effects of inflation and the growth of capital markets. In a letter to the Federal Reserve Board, the Managed Funds Association said that without appropriate adjustments over time the threshold will become outdated and capture additional firms whose size relative to the size of capital markets has not increased. The MFA noted that it has consistently urged Congress and the SEC to raise investment thresholds to address the effects of inflation and to prevent hedge funds from becoming accessible to retail investors.
The MFA also asked the Board to clarify the calculation of assets for asset managers and the investment funds they manage. It is also important for the Board to maintain the privacy of any list of significant nonbank financial companies, to avoid unintended market effects on firms that meet the definition.
The structure of investment advisers and the private investment funds they manage is fundamentally different from the holding company structure typical of other types of financial institutions. The MFA is concerned, however, that the proposed consolidated balance sheet test does not appropriately account for these important differences and, thus, could be overly broad with respect to investment advisory firms. This is because GAAP may, under certain circumstances, require the assets of client investment funds managed by an adviser to be consolidated onto the balance sheet of the adviser.
In the MFA’s view, this accounting treatment does not reflect the reality of where the at-risk assets are located and would provide a misleading view of the size and interconnectedness of investment advisory firms. The hedge fund association urged the Board to specifically exclude client assets under management from the consolidated balance sheet test for investment advisers, regardless of the accounting treatment with respect to such client assets.
A review of the basic structure of investment advisers to private investment funds illustrates the appropriateness of excluding client assets under management from an adviser’s consolidated balance sheet. Advisers to private investment funds typically do not have substantial assets. Although the principals of the adviser often have personal capital invested in the funds they manage, any losses to such capital do not affect the safety and soundness of the investment adviser entities. It is the funds that hold the financial assets, that transact with trading counterparties on a collateralized basis, and to which investors commit capital.
The risks and rewards of the funds’ investment portfolios are borne by a diverse group of underlying sophisticated investors, institutions or ultra-high net worth individuals, who typically invest in private investment funds as part of a diversified portfolio. The adviser entity is not liable for the obligations of the investment fund, nor does the investment fund have responsibility for the liabilities of the adviser entity. For these reasons, the MFA believes it would be inappropriate and misleading to include fund assets under management when determining whether an investment adviser meets the $50 billion asset threshold
The MFA also asked the Board to clarify that separate investment funds managed by the same adviser should not be consolidated for purposes of the definition of significant nonbank financial company solely because the funds are managed by the same adviser, regardless of accounting treatment. The association noted that different funds managed by a common adviser do not typically have the kind of intercompany loans or transactions that can create intraconnectedness and tie the risks associated with one company to other companies in the same ownership structure.
Unlike bank holding companies, hedge funds and other private investment funds generally engage in one distinct business. For these reasons, analyzing private investment funds on a fund-by-fund basis provides a realistic view of the size and interconnectedness of those investment funds. It is this economic reality and not the accounting treatment of investment funds that should be the basis on which the Board considers whether an investment fund is significant.