Hedge funds brace for tighter SEC regulation

The SEC is reformulating its regulation of hedge funds, forcing them to choose between the number of investors whose money they manage, and the degree of freedom with which they can manage that money.

In an earlier posting I described how hedge fund are only allowed to have 15 investors in order to justify the risks they take - shorting stocks and investing in other derivatives. Typically, hedge funds work around this limit by counting limited partnerships with their own base of investors – as a single investor. The reason this is possible is because the SEC defined an “investor” not as an individual, but as a “legal organization” like a limited partnership.

Now, however, the SEC has decided to prevent hedge funds from continuing to apply this definition of “legal organization.” Effective February 1, 2006, hedge funds will be required to “look through” the legal entities that they consider investors, and consider the individuals who compose that entity. The SEC estimates that between 690 and 1260 funds will be required to register under the new rules, and will thereby be required to limit their investing activities.

So far, I’ve yet to hear anything about how hedge funds prepare to deal with this contingency. A few options are available: ask certain investors to cash out (though this is hard to imagine): submit to limited investing activities (equally hard to imagine): or fight the SEC. Given the SEC’s history of capitulating to the demands of the financial houses, the latter option seems the most likely.