Hedge Funds & You

John Mauldin | Thoughts from the Frontline
May 11, 2001

In today's e-letter I want to briefly give you an overview of the hedge fund and private offering industry and to show some of you how you may be eligible to participate in this investment arena. If you know what and where to ask, you can get information on private offerings, such as hedge funds, which may be of great interest to you.

What triggered this letter was some work I have been doing this week. I have been researching hedge funds for a new project, and also preparing a presentation I will be giving in May in New York at the annual IIR Hedge Fund Forum. They charge about $1500 for the conference, so they want the speakers to provide them with their material in advance so they can put it in a manual. Presumably this makes the attendees feel they got something for their money.

I have spoken on a variety of topics at a number of hedge fund and private investment conferences over the years, both in the US and abroad, and attended scores of conferences that deal with the world of private investing and hedge funds, and have sat on industry committees. I only say this to show that I do have some base of knowledge about the industry, as my previous writings would not indicate such familiarity.

So what can I tell you about the investment potentials I learn from these conferences? The reality is very little, which is sad because I often find some very interesting opportunities. However, the rules for private offerings are very strict about what you can and cannot say in a public forum like my e-letter.

Let me (briefly) explain the rules. In general, private offerings are exempt from Securities and Exchange Commission (SEC) registration and regulation if they:

1. Limit their investors to 99 or fewer;

2. If they only accept money from certain types of investors;

3. Do not advertise or allow the general public to get information about the offering. You really MUST keep a private offering private.)

Who can invest will change from offering to offering, but in general the limits are to those investors who have a net worth of $1,000,000, including your home and real estate; or have made $200,000 or more per year for the last two years. These higher net worth individuals are known as "accredited investors."

(To my lawyer friends I KNOW I have greatly simplified a complex and arcane topic. My purpose here is not to go into the dozens of exceptions and variations, but to give some general understanding. To the rest of you, I will show you where to get more precise information in a moment.)

This million dollar designation was made in 1933 by Congress when they created the SEC. Congress did not want to outlaw private investment, but they did want to protect smaller and supposedly less sophisticated investors from being taken in by promoters. Back then, a million dollars was a lot more money than it is today. Basically, they decided that if you had $1,000,000 you either were capable of analyzing an investment or could afford to hire someone to do it for you.

I should point out that it is not the SEC that makes the rules. They merely enforce what Congress passes. I believe we need regulation in the investment community. The number of frauds and problems we currently have would multiply dramatically without that oversight. I do wish that Congress would change the rules somewhat, however, to allow smaller investors to participate in the hedge fund arena and to allow for information to flow more freely about these investments.

The hedge fund industry has evolved over the years to cater to the investment needs of higher net worth individuals. I think it is fair to say that if these higher net worth individuals did not think that the opportunities to meet their investment objectives in hedge funds were not better than those represented in mutual funds, they would not be turning to hedge funds in ever increasing numbers.

They certainly would not pay the fees associated with most hedge funds if they did not think there was value added. It is quite typical for a fund to charge a 2% management fee and also take 20% of the profit. If a fund manager made 30% in his fund, the total fees would add up to 8%, reducing the client's gain substantially! Why would any sophisticated investor pay such a seemingly outrageous fee?

Because they believe they are getting a good value for their investment. Hedge funds can do far more than can traditional mutual funds. Mutual funds are limited by law in what they can do. Hedge funds can do whatever they want to in an effort to provide profits for their clients. The variety of hedge funds is far greater than that of mutual funds. Some are highly leveraged and try to make as much as they can and are VERY volatile and risky. But then, many investors have found technology mutual funds to be more volatile and risky than they previously thought.

The hedge funds and private offerings which seem to be of most interest lately are those that are designed to provide a specific level of return coupled with lower risk. There are funds which make a very steady 12%-15%-18% a year with very little or no drawdowns. I know from talking to many of you that you would love to have the opportunity to invest in these funds. But most have million dollar minimums and other restrictions.

As I mentioned, the rules governing private offerings were essentially written in 1933. Very little has changed. These rules were fine at the time, but they have become out-moded today. I think it is essentially unfair that just because an investor does not have a net worth of $1,000,000 he is precluded from investment opportunities he would rationally make if given the opportunity. In my mind, it is rank class discrimination, and differs very little from discrimination by race, sex or religious belief.

Let me quickly comment on the three characteristics of private offerings mentioned above, show how they affect you and how they should be changed.

The 99 Investor Limit

As long as a private offering has 99 or fewer investors, a private offering is not required to be registered. But if the fund takes just one more investor, they must, by law, register. Why is it that 99 or fewer accredited investors are deemed sophisticated enough to not need oversight but 101 need government protection?

What this rule means is that private offerings typically have a high minimum investment because the managers know they can only take 99 investors. If these funds want to grow (and most do) they know they must get the maximum amount they can from the limited number of investors they are allowed. High minimums mean that even if you do have a million to invest, you cannot adequately diversify your portfolio.

This rule has been partially responsible for the creation of a niche of hedge funds called "hedge fund of funds". Basically, they cater to "smaller" millionaires who would like to invest in a portfolio of hedge funds, and they take smaller minimums, sometimes (though not often) as little as $100,000. This is an exploding investment arena. One list I have seen has over 250 such funds on it, and more are being added every month.

I think the 99 rule should be thrown out. Logically, you would do away with it altogether. I mean, at what number should we consider a group of otherwise sophisticated investors to become collectively brain-dead? Politically speaking, it is more likely for the number to be increased somewhat than for it to be done away with. There are efforts to change this number, but it has aggressive opposition from the mutual fund industry, who justifiably fear they would lose customers.

Minimum Net Worth Standards

Let me state it very plainly. The idea that being a millionaire makes you a sophisticated investor is patently ludicrous. I have clients who are millionaires who are remarkably naive. I also have clients who have only small savings who can and do teach me a thing or two. While I admit that those with more money on average have more financial sophistication than those who do not, it is not because they have money but because they have taken the time to educate themselves.

If the goal of minimum net worth standards is to keep unsophisticated investors away from risky investments, then the rule is a failure. What minimum net worth standards apply to Janus Funds or other technology mutual funds? There were a lot more mutual funds which lost 50% last year than hedge funds which lost 50%.

And how many small investors lost 70%-80%-90% on technology and internet stocks which are regulated? A lot of technology hedge funds made money on the way up and on the way down. Some of them made scary numbers, because they did so well as the market dropped. Not without their own significant volatility, but not any more, and in some cases much less, than did technology stocks and mutual funds.

Once again, the only significant opposition to lowering or eliminating these standards is the mutual fund industry. They are afraid of losing business. The reason for minimum net worth standards made sense in 1933, but in the Information Age are simply anachronistic rules which now serve only to protect the mutual fund industry's market share.

The No Advertising Rule

Getting information about hedge fund and private offerings is difficult, even for me. There are several sources for hedge fund and private offering information, but the data is often incomplete or inaccurate. You have to check everything. Some sources are very good at certain things, but leave a lot to be desired in other areas. As you might imagine, the best sources are expensive.

The result is that the industry, while starting to change, is still one in which personal relationships and knowledge are very important. Because knowledge is so hard to come by, those firms and individuals who do manage to collect reliable information are sought after and are able to charge significant fees for their services. Of course, they have significant expenses in gathering the information, so they earn their money the hard way. They have to work for it.

There are some associations of investors who get together to share information, but to my knowledge these associations are generally composed of investors worth $50,000,000 or more, or institutional investors. Typical is an association of "Family Offices" (families, often heirs, who have a very high collective net worth and hire money managers to oversee their investment portfolios.)

Since funds are private, the amount of due diligence required before investing is much more extensive than what one would do before investing in a mutual fund. Because there is no central source of information, each investor must do his own investigation. This is time consuming and a huge duplication of effort.

The Solution

We need legislation authorizing a new class of investment company that is a hybrid of mutual funds and hedge funds. These hybrid funds would be allowed to operate as they do now, but would also be allowed to advertise under the same rules and restrictions as mutual funds. They should be allowed to take as many investors as they choose and to set their own minimum net worth standards.

To qualify for this status, they would have to allow for thorough inspection by the SEC of their accounting and operational books, and would have to provide full disclosure of everything but proprietary trading information.

At a minimum, the 99 limit needs to be significantly increased, the net worth requirement significantly lowered and the advertising rule relaxed to allow for reasonable flow of information.

I can find no compelling reason for Congress to keep these old and arcane rules which, at a minimum, are an insult to smaller investors and at worst, keep smaller investors from investment opportunities enjoyed only by those who are arbitrarily considered wealthy.

What can we do today?

All that being said, without a significant political push and a large and active grass roots investor campaign, the likelihood of any significant changes are small. I often harbor thoughts of trying to start such a campaign, and then I come to my senses. One man cannot do that alone. Even though I now have 12,000 readers, and know some of you would be willing to get involved, it would take a lot of collective effort from a lot of you.

I am not a political novice. To effectively lobby Congressmen and Senators would take a group of political activists from nearly every state. As many of you know, I have been seriously active in political circles in Texas, and can lobby our representatives, but a congressman or Senator from Maine doesn't really care about me, unless I bring a check. Voters in his state are who he or she cares about.

It would also require a very large database of investors who would sign petitions and write their Congressman and Senators, and that means people who will work to get hundreds and thousands of participants. I think there would be some participation from other investment writers and newsletters, and there are hedge fund associations who would appreciate the help.

If you are an accredited investor, where can you get more information?

Last year, I wrote a Special Report called the Accredited Investor Membership Guide. You can access this report from my web site or click here. It goes into much more detail than the material above and offers some guidance on what questions to ask about private offerings. If you are an accredited investor, I urge you to take the time to read it. That report is available to anyone who is interested, as it does not mention any specific private offering or web site.

I can do something for those of you who do meet the standards of being an accredited investor: $1,000,000 net worth (including your home and real estate) or $200,000 per year income for at least 2 years. I have been asked by another organization to do a monthly letter for accredited investors. I have agreed to do so only if I can offer it for free to my own readers who are accredited investors as well.

But to do so, I must meet some very strict rules. To get on the list, you must sign a document verifying that you are an accredited investor. Then we have to have a brief talk on the phone.

I will send you the form by email if you write and ask, then you can fax or mail it to me and we will set up a time for an initial brief conversation. The form simply says you affirm you meet the standards to be an accredited investor. You do not have to provide balance sheets or income statements. I am allowed to trust you.

As you are reading this, I am on a much needed vacation with my wife in Hilton Head. It is our anniversary. It is good to get away and to take time to remind ourselves that our real "net worth" is not in money or houses. When it comes to wives, I am an extremely High Net Worth investor. Some wise man once said something about the value of a good wife is far above rubies or gold.

Of course, I will slip away for a few afternoons and once again try to break 100. Then I am off to yet another conference in Denver and will be back the middle of next week.

By the way, writing this other letter will not interfere with this e-letter.

Your 29 handicap analyst,

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