Hedge Fund Inquiry Will Slam Small Funds

The latest push for greater regulatory scrutiny of hedge funds will likely be a boon to the biggest, most established hedge funds and a blow to smaller fund managers.

Nearly four years ago, the federal courts struck down the attempt by the Securities and Exchange Commission to force hedge fund managers to register with regulators, ruling that the SEC had overstepped its legal authority.

Now Financial Crisis Inquiry Commission may have found a way around the ruling. The commission demanded the information from the Managed Funds Association, threatening a subpoena if the hedge fund lobbying group didn’t comply. The MFA provided information on its more than 2,600 members as well as information on funds that are not members.

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While requests for information may seem harmless enough on their surface, they create serious legal and compliance costs for hedge funds. Bigger hedge funds and those owned by banks such as Citigroup or JP Morgan Chase can easily bear these costs. They have teams of in-house lawyers and relationships with big law firms ready to handle these issues.

It’s the smaller funds that will feel the sting of FCIC scrutiny. The additional costs make it harder for smaller funds to compete with the big players and create barriers to entry for new funds.

“The DC Court of Appeals' decision struck down the original SEC rule requiring hedge fund registration as arbitrary. Indeed, the rule seemed mainly aimed at protecting banks and big funds from the competitive threat represented by hedge funds rather than targeting a need for investor protection,” University of Illinois law professor Larry Ribstein tells CNBC.

The irony is that the anti-competitive effect may cause further consolidation in hedge funds, perhaps creating funds that—like our behemoth megabanks—are too big too fail.

Witness the news today that the London-based hedge fund Man PLC is acquiring GLG Partners to create a $63 billion hedge fund. This consolidation is occurring just in advance of likely European Union regulations that will require hedge funds to be licensed by national authorities, and subject the licensed funds to risk-management and trading oversight. Greater regulatory oversight seems to be pushing even the biggest funds to get bigger.

But if the cost is less competition and greater consolidation, what good will backdoor hedge fund registration do? Probably not much, according to Ribstein.

“It is far from clear that the benefits of registration and public disclosure outweigh the costs in terms of exposing hedge funds' proprietary information and reducing their incentives to scout out new information. Consider this: Bernie Madoff was one of the fund operators who elected to register with the SEC after the registration rule was struck down. This didn't do his investors a lot of good,” Ribstein says.