Are hedge funds dodging the Dodd-Frank?

That may be putting it a bit strongly, but certainly more and more hedge funds are looking to convert to ‘family offices’ – vehicles that are less exposed to the rigors of regulatory compliance. True, these are mostly funds that have a substantial chunk of their funds owned by the fund manager or his family themselves, but the fact remains that the advantages of ‘privatizing,’ so to speak, outweigh the prospects of returning all the public monies.

Hedge Funds

Giant loophole

According to this article on ValueWalk, a crucial Dodd-Frank rule (under Section 409 of that Act) exempted family offices from registration under the Advisers Act. A “family office” is an entity providing investment advisory services that also meets each of the following criteria:

– Its only clients are “family clients” (family members and certain alter-ego entities formed for tax, charitable, or estate planning purposes).

– It is wholly owned by family clients and controlled by family members.

– It does not hold itself out to the public as an investment adviser.

Taking advantage of this “giant regulatory loophole,” billionaire hedge fund managers such as George Soros, Carl Icahn and Stanley Druckenmiller swiftly made the transition to family offices. Rumors abound that Steve Cohen-run SAC may also adopt the same route.

Other advantages

Shelter from regulatory scrutiny may not be the only advantage. Other payoffs include the increased flexibility and autonomy in investment decisions, better financial, estate and tax planning for the family funds, more bargaining power opposite prime brokers to obtain pricing breaks, financing and rebates, and a saving in overhead costs.

But there is an interesting flip side to this – a view that often comes up in the context of Steve Cohen’s SAC. Apparently, contrary to market expectations, Cohen is really not interested in converting to a family office because he runs an army of traders – “a huge organization in order to insulate himself while encouraging his traders to do whatever it takes to make money,” according to this Forbes article. Another angle could be that Cohen himself benefits from this massive infrastructure because a large part of the costs are in effect borne by the public investors.

Hedge funds to go the family office route

As of now, however, more and more hedge funds that have a considerable proportion of their funds invested by the founders, and do not have a need for public investment in order to sustain themselves, are likely to go the family office route.