The Financial Power of Impact Investing

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For many years the divide between instruments of philanthropy and investing has been clear cut. Investing strategies typically did not involve social organizations focused on non-governmental organization (NGO) concerns. However, the advent of millennial investing power, the rise of social enterprises, and the need for further asset diversification have blurred the line between both industries. Environment, Social, Governance (ESG) investing, informally known as impact investing, is on the rise with both active and passive investors. For example, ESG assets under supervision at Goldman Sachs have grown from US$3.8bn in 2015 to US$6.5bn end of fiscal 2016. As Goldman Sachs poignantly stated, ESG investing is now mainstream even within the pension fund and insurance sectors.

Even though financing social causes has overlapped between philanthropy and ESG investing, by no means is the latter non-profit seeking. First, while impact investing may dive into sectors once thought as solely philanthropic, let us make it clear that the investing strategies used to generate returns do not veer from tradition asset management practices. Specific return objectives are set, even if the companies that are in the portfolio may comprise all social enterprises. In fact, Goldman Sachs recommends that investors should be even more aggressive with risk/return analyses when it comes to ESG portfolios, to ensure even more accountability. Traditional sectors tend to put the bottom line first by nature, so it is of utmost importance to hold for-profit social enterprises accountable for revenue and profit estimates.

U.S. Trust’s “Impact Investing: A Guide To Doing Good While Also Doing Well” gives an excellent overview of impact investing. According to the U.S. Trust, managed U.S. assets committed to impact investing in total grew from US$640 billion in 1995 to US$6.57 trillion at present. Impact investing can be broken down into further categories of socially responsible investing (SRI), faith based investing, green investing, and values based investing (VBI). For example, an investor who is against tobacco use but is not necessarily pro-environment may seek investment in an SRI portfolio, but not a green portfolio. As with traditional ETFs and mutual funds, diverse social investing asset classes are available via equities, bonds, REITs and even private equity. Investment funds including these ESG options in have indeed increased from 55 to 925 within the last two decades. In particular, U.S. Trust’s ESG investor pool jumped 23% from 2015, with a whopping 93% of millennial investors who have added ESG components to their portfolios!

ESG investing is an excellent mechanism to be considered by shareholders through engagement and by Board of Directors through guidance and governance. Rick Scott, Vice President of Finance and Compliance at the McKnight Foundation, gave great insight as to the need for adding and monitoring ESG components to investment strategic directions at the Board level. The McKnight Foundation has allocated 10% of its US$2bn portfolio strictly to impact investing with a focus on US clean water and carbon footprint. Scott enlightens that the Board must call for a “triple bottom-line for financial, programmatic, and learning return.” Boards must have an investment or risk committee assigned to give oversight on risk/return objectives specific to the triple bottom line, and with C-Suite determine the healthy mix of ESG and traditional components for portfolio investments. We have said time and time again that clear internal corporate governance goals and procedures, in this case adopting a “triple bottom line” approach, is the most pertinent form of corporate social responsibility an organization can practice.

While global institutional investors have now become ESG investing stalwarts, retail investors, individual private investors, and minor shareholders may still need direction in how to effectively embark on the ESG investing journey. In addition, the ESG investing sphere has been known to be have quite a few ‘greenwashers’ with more public relations talk than actual profit generating. As with any investment vehicle, extensive research is recommended. Global investment firm Cambridge Associates has developed the Impact Investing Benchmark which comprises 51 private investment closed-ended funds dealing strictly with the intent to generate social impact. From this data, Cambridge Associates created and MRI Database, and uses ImpactBase extensively as well. U.S. Trust as well has developed benchmarks via an IMPACTonomics™ program, which has specific in-house and third party impact investing platforms such as the Breckinridge Sustainable Bond Strategies and IMPAX Global Environmental Markets Fund.

Many have the misconception that impact investing precludes investing in traditional industries, such as the fossil fuel and mining industries. Absolutely not! The smart and savvy investor must see diversification opportunity in line with tailored return objectives. There is financial power in such comprehensive asset management. The end point is return on investment, whether from most profitable traditional, social, and technologically advanced companies in the market. A gold mining company with a strong, proven corporate responsibility background can share the same portfolio as a profitable microfinance company that lends globally to small entrepreneurs. Again, the crux of investing in any asset class lies with return objectives. ESG investing, like smart technology, is no longer the niche market. As Rick Scott and Goldman Sachs put it, the point is to find the “right tools for the right time.” The time is right to consider impact investment vehicles in tandem with traditional market portfolios.

SOURCES

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Chinese Investments in U.S. Real Estate – Challenges, Opportunities and Policy Recommendations

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As the world’s second largest economy, China’s influence on the global economy is expanding at a furious pace, thanks in part to the surge in outward foreign investment. In the United States, China is now a major source of foreign investment with capital flowing into virtually every industry and market. For many Chinese firms and individuals, the United States is a prime destination for their investments because the prospects for stable returns are high.

 Policy makers, business leaders, and the general public in the United States still do not have a comprehensive understanding of the patterns and implications of Chinese investment in the United States. While foreign investment has been a critical piece of this country’s economic success, the recent boom of Chinese capital flowing into the United States has stoked fears of job loss and disruptions to local and regional economies and markets, and even threats to national security.

 Chinese investment into U.S. real estate, in both the commercial and residential sectors, stirs up these misgivings and sparks debate about the domestic costs of these investments. Concerns range from anxieties over the potential inflationary effects of deep-pocketed firms and investors in the residential real estate market to more pronounced anxieties over property acquisitions that can endanger national security. The reality, as this landmark study makes clear, is much more complex.

 Chinese investment around the world surged in the past decade, expanding from an early focus on natural resource extraction and energy in developing countries to broader industries and advanced products and services in developed markets. In 2014, Chinese outward FDI flows totaled $116 billion, and approximately $18.1 billion flowed into the United States. In 2015, Chinese outward FDI flows totaled $118 billion, and Chinese foreign direct investment flows into the United States increased to $22.3 billion. Still, China accounts for less than 10% of all foreign direct investment in the United States.

 Chinese direct investment in U.S. real estate was negligible until 2010 but has since grown dramatically and visibly. In 2015, China ranked third in U.S. commercial real estate acquisition volume, trailing only Canada and Singapore and tied with Norway. Chinese developers are building multi-billion-dollar projects in several major cities. A Chinese insurance firm bought the prized Waldorf Astoria hotel in New York City in 2015 and struck a $6.5 billion deal for Strategic Hotels & Resorts in early 2016. Chinese investors dominate an immigrant investor program known as EB-5, and in 2015, China overtook Canada as the biggest foreign buyer of U.S. homes.

 This anecdotal portrait reveals the rapid and widespread entry of Chinese investors, both firms and individuals, into the U.S. real estate market, but it also underscores how real estate differs from other investment sectors. It defies the traditional definition of foreign direct investment – ownership of at least a 10% stake in a U.S. company – with a broad range of entry points. Buying a home, for example, does not have an analogue in the technology industry but is critical in painting a full picture of Chinese capital flows into the U.S. real estate market. Furthermore, in addition to the unique channels of real estate development and EB-5 capital, Chinese investors are also increasing investment in portfolios of U.S. assets through real estate investment trusts and private equity funds.

 These real estate investments come on top of China’s position as the biggest holder of mortgage-backed securities issued by U.S. government-sponsored enterprises such as Fannie Mae and Freddie Mac. Like U.S. Treasuries, these bonds are important investments for Chinese government finances, because they allow for recirculation of dollars gained by the trade imbalance, and for the U.S. housing market, because they help ensure liquidity and mortgage rate stability. Chinese banks have also become major sources of debt capital in the U.S. real estate market, primarily for U.S. firms. To fully understand the role of Chinese capital in the U.S. real estate market, it is vital to look beyond direct investment. More than any foreign investor other than Canada, China stands out for the breadth, depth, and speed of its participation in the U.S. real estate market.

 Our findings are that from a modest base in 2010, China was the source in aggregate of at least $350 billion in U.S. real estate holdings and investments by the end of 2015. This figure includes the direct purchase of real property and indirect investment through the purchase of agency mortgage backed securities and provision of debt financing, among other channels. In addition, we estimate that Chinese entities managing U.S. real estate operations and individual investment through vehicles including the EB-5 program may have created or sustained 200,000 jobs. For commercial and residential real estate, China has been an important source of capital as the U.S. economy recovered from the recent financial crisis and Great Recession.

 Chinese investment in U.S. real estate is a recent development with considerable growth potential. While it is not as politically sensitive and does not directly impact national security as does Chinese investment in U.S. technology or telecommunications, real estate affects more people and communities and involves policy makers at multiple levels.

 This report aims to objectively present the following:

  • Sources of Chinese capital flowing into U.S. real estate;
  • Motivations and drivers for various Chinese investors;
  • Benefits and impediments posed by this wave of investment;
  • Analysis and projections of the sustainability of Chinese investment in commercial and residential property; and
  • Recommendations for U.S. and Chinese investors, policy makers, and stakeholders to keep investment channels open.
  •  Combining information from public records, reports, and trade groups – based in part on gathering of data and interviews with industry sources – this report assembles a unique information set, providing the first comprehensive analysis and understanding of Chinese inbound investment into all facets of U.S. real estate.

 This reported investment data are not perfect, a result of the combination of the particulars of real estate investment avenues and the ability of government and third-party sources to accurately measure capital flows. Furthermore, a significant portion of investment from offshore locations, including China, comes in the form of minority interests in projects sponsored by U.S. entities and is not directly traceable to the capital country of origin.

 Our study is focused on investment from mainland China, but the flow of capital through intermediary destinations sometimes necessitates the inclusion of capital from Hong Kong, Macau, or Taiwan. Moreover, the task is complicated by the multiple channels for investment, ranging from purchases of homes and apartments to business investment in commercial assets to development and construction, as well as through provision of debt to both residential and commercial property investors. The myriad ways in which to record real estate ownership can also obscure the true country of origin of the buyer. With this in mind, this report presents the data as minimum investment volumes. While acknowledging these data limitations, we have made every effort to compile data and insight that provide a more complete reflection of actual Chinese investment activity across the entire spectrum of the U.S. real estate market than previously published. This includes enhancing investment volumes reported publicly as well as confirming the reported data via industry participants.

 The investment flow has come into the United States through several channels:

 

• Residential property: Between 2010 and 2015, Chinese buyers spent at least $93 billion on homes, including condominiums, for occupancy and investment. Spending rose at an annual rate of 20% and provided important demand in many local markets hit hard by the housing crisis. Chinese buyers paid substantially more, on average, per home than other international buyers because of their concentration in prime neighborhoods in California and New York.

 • Commercial property: Between 2010 and 2015, Chinese investors acquired at least $17.1 billion of existing office towers, hotels, and other commercial buildings, representing an annual growth rate of 70%. Half of that investment came in 2015 alone. The buyers were mainly large Chinese companies, including real estate firms and institutional investors.

 • Development: By the end of 2015, Chinese-funded projects under construction or planned totaled at least $15 billion. These range from multi-billion-dollar mixed-use projects in Los Angeles and the San Francisco Bay Area to smaller-scale developments in secondary markets. These investors include Chinese developers, builders, and construction companies, some of which have set up U.S. offices, creating local jobs for ongoing operations beyond the construction phase.

 • EB-5 visa program: Since 2010, Chinese nationals have been the most numerous investors in the EB-5 U.S. visa program. The program enables a foreign national who invests at least $500,000 in projects that create a minimum of 10 jobs to receive a U.S. visa and, on completion of the project, a green card for permanent residency status. Detailed data on these investments and the actual number of jobs created are not generally available. But based on the minimum investment and job creation requirements, and assuming all investments are successful, Rosen Consulting Group estimates that since 2010, nearly 20,000 Chinese EB-5 investors have generated at least $9.5 billion of investment capital and contributed to the creation of 200,000 jobs.

 • Residential mortgage-backed securities (RMBS): Chinese government entities began purchasing U.S. government agency-backed RMBS in the early 2000s to diversify beyond U.S. Treasuries. As of June 30, 2015, China held $207.9 billion in agency-backed mortgage bonds, more than any other country, according to preliminary U.S. Department of the Treasury data. These holdings contribute to enhanced liquidity in the U.S. housing finance market.

 • Real estate loans: In recent years, Chinese banks increased activity in lending for real estate acquisitions, recapitalizations, and construction and development. The banks have amassed at least $8 billion in loans and have become a major source of funding for large commercial real estate projects. This loan portfolio extends beyond Chinese investors and projects with Chinese partners, as leading Chinese banks are active competitors with U.S. and international banks and private sources of capital in the commercial property market. Residential mortgage lending by Chinese banks in the United States is more limited, but growing.

 OUTLOOK

We believe China’s economic turbulence will create a short-term speed bump for real estate investment overseas, including in the United States. In the near term, a 6- to 24-month temporary period of increased capital controls is likely – either formally via policy announcements or informally through administrative processing – until the Chinese currency can be re-aligned with that of global partners. However, this does not mean investment will cease during this period. Furthermore, the long-term investment drivers remain: strong U.S. demand for capital; a widening and deepening pool of Chinese investors, many of whom have not ventured into U.S. real estate; increasing global appetite by Chinese developers and construction companies; a $1.6-trillion insurance industry that has become active overseas but invested just a fraction of funds available for real estate projects; and new Chinese investment vehicles, such as private equity funds, which have only recently become a factor in the U.S. market.

 We project that Chinese direct investment across existing U.S. commercial real estate assets and residential purchases, excluding new development projects, could total at least $218 billion, cumulatively, from 2016 through 2020. In the short term, capital controls will likely slow individual purchases of U.S. homes, the biggest component of Chinese real estate investment, and slow the growth rate of commercial property acquisitions. Chinese-backed development projects are likely to remain a substantial component of the commercial real estate market even as the economic cycle in the United States slows the overall pace of new development announcements. Beyond 2020, Chinese investment in U.S. real estate could accelerate further.

 RECOMMENDATIONS

These large capital flows, accelerating substantially in a short period of time, do not come without challenges in both countries.

In the United States, several policy areas will need attention in the next several years:

 

1. Rationalization of taxes affecting foreign investment: The Foreign Investment in Real Property Tax Act (FIRPTA), while perhaps well intentioned at inception, is an onerous structure that creates an impediment to international investors in real estate. Every effort should be made so that there is a level field for taxes on foreign investors regardless of their domicile.

 

2. Continuation of the EB-5 program: While the program was extended through the summer of 2016, renewal is by no means a certainty. It has been a successful bridge builder, bringing capital into the marketplace, growing or retaining jobs in the United States, and allowing Chinese citizens and families access to visas and residency. The EB-5 program will likely undergo reform, but it should not be altered so dramatically as to cut off access to international capital and immigration, including those from China.

 

3. Continued implementation of existing security policy: Offshore investors are understandably screened for security risks and legitimacy of capital sources. So far, such concerns have not been an impediment to investment in U.S. property, as it has been in technology platforms, manufacturing firms, or natural resources extraction and processing. Any proposal to restrict U.S. government occupancy, including those of certain government contractors, in foreign-owned buildings – as is being discussed in congressional circles – should be carefully monitored.

 

On the Chinese side, the issues that deserve attention include the following:

 

1.Continued development of legal and financial rules to encourage private sector investment in overseas property: Chinese companies and individuals can benefit themselves and the Chinese economy by diversifying assets globally. It is critical that China develop a robust domestic legal framework for foreign investment, as many countries expect reciprocal treatment of foreign investors. Likewise, reforms that reduce bureaucratic bottlenecks and expedite outward investment should continue.

 

2. Enhanced transparency in capital ownership: The United States and other global financial centers are increasingly monitoring the identities of foreign investors and business operations. While China is not the only country that raises concerns, Chinese businesses historically have been less open regarding origination of capital and ties to government or military officials. Continuing progress toward the transparency required by international agencies – many of which are welcoming China as a significant participant – will be an important step.

 

3. Avoidance of capital controls: China’s economic growth rate has slowed, and its currency is re-aligning with that of other major economies. Chinese concern over capital outflows is understandable, but a hard capital-control regime could negatively impact the financial institutions the government nurtured over the past two decades.

 China is a powerhouse the US cannot discount. Prosperity and free flow of capital between the 2 nations is the only way to go.

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A Case For US Infrastructure

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US infrastructure policy has failed dismally over the past two decades. The nation’s decision makers must agree that American roads, bridges, plumbing systems and public buildings are falling apart. A trip to most of American urban centers leaves all in shock and wonderment at the failure of prior US governments to upkeep basic infrastructure needs of the American people. President Trump’s intention to pump US$1 trillion into America’s failing infrastructure is by no means an overestimation!

The US Congress’s dire inability to legislate on funding to support both new and retrofitted roads, bridges, public buildings and general physical transit communications has landed America in this mess. The majority of transit and road retrofits have stalled because the US Congress has managed only temporary funding for infrastructure maintenance, sometimes lasting for a matter of months. It is only from December 2015 that Fixing America’s Surface Transportation (FAST) Act was passed for a US$305bn to highway and transit maintenance over 5 years. From 2005 the US Congress depended mainly on funding extensions, nearly depleting the Highway Trust Fund. This lack of oversight has left America closer to third world status when it comes to infrastructure development.

US infrastructure should be a bipartisan issue and will be made priority over the course of the Trump administration. President Trump and his team proposed to immediately increase private sector spending on infrastructure projects with US$137bn in tax credits. The Federal gas tax has funded America’s infrastructure to date. However, this tax has not been increased, or adjusted for inflation since 1993. And since 1993 US politicos over various administrations have complained and whined on the need to come up with money for failing US infrastructure, without even considering basic economics such as an inflation adjusted gas tax rate. Due to this mismanagement, we will need more than pure fiscal spending to solve this maligned infrastructure funds drought.

The Canada Pension Plan Investment Board’s (CPPIB) US$18bn global infrastructure portfolio is a strong replication to follow for infrastructure investment outside of tax revenue. The CPPIB’s fund invests US$375m to US$1.5bn in single projects. In this sense, the fund has blanket management oversight in the project. According to Mrs. Hogg, Managing Director of the CPPIB, the Fund has gen­er­ated annual re­turns for the port­fo­lio of 12.8%, consistently for a five year period. While the CPPIB invests globally, we invite US institutional investors such as US public pension funds to actively step up and invest heavily in the nation’s infrastructure projects, and to also take a management oversight approach in investing where possible. Thus far, US pension funds such as CalPERS have made investing strides in domestic highway projects. This trend must continue if we are to have the funds America needs to both maintain and develop our infrastructure.

Private infrastructure funds will have a crucial part to play as well. According to Preqin’s 2016 Infrastructure Fund Outlook, while the majority of capital raised for infrastructure needs comprised a minority of global funds, 51% of private sector infrastructure investors are motivated to provide capital to first-time funds due in part to the US’s renewed infrastructure focus. Most infrastructure investors are interested in both global and boutique funds that are backed by businesses with long-term commitments from a healthy mix of public and private infrastructure projects.

We have a healthy rebound in mutual funds and ETF funds that are primed towards infrastructure companies and industrials. Morningstar has reported the asset base of such funds to be well over US$10bn. Capital concentration for unlisted infrastructure funds have almost skyrocketed from 2015 to present. Preqin’s Infrastructure Capital Concentration report for first quarter 2017 states that total fund size for unlisted infrastructure funds jumped by 73% from 2015 to 2016. These unlisted funds raised US$59bn in 2016. We can attribute such a jump in capital concentration in part to strong investor expectations regarding the Trump Administration’s infrastructure policy.

Suggestions and Recommendations:

  • The inability of US Congress to stand by infrastructure funding has failed America’s infrastructure in the past. We need bipartisan support on Federal infrastructure laws, acts, and bills that are introduced.
  • State legislature needs to step up to the plate when it comes to state enforcement of laws, acts and bills to strengthen funding for depleted infrastructure. This is not only a Federal issue.
  • Infrastructure projects will need to focus more on user fees and revenue. Both Federal and State projects have only focused on steady toll revenue on major highways within the past 5 years. User fees offer funds for maintenance, and projects with user fee projections are much more attractive to institutional and private investors.
  • Funds such as the Highway Trust Fund may need more private sector input on their Advisory Boards to ensure that the funds are well managed with consistent returns.

US infrastructure has lagged so far behind in build and maintenance over the past decades that it will take an intensive ground-war approach to getting prioritized projects up and running. We cannot afford to have stalling for even one year on proposed measures to begin fixing America’s roads, bridges, buildings, levees and all physical infrastructure systems. The Trump Administration has pledged full support in bringing US infrastructure up to standard. US political decision makers and citizens should stand by this pledge.

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The Symbiosis of Institutional Investors and Activist Hedge Funds

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Second quarter 2016 has waxed brutally for hedge funds in the realm of regulatory compliance. The Securities and Exchange Commission (SEC) has called on investigative authority over hedge funds such as RD Legal Capital LLC and Platinum Partners LP for full disclosure of investment vehicles and practices. Of late, Visium Asset Management has joined the growing list of hedge funds flagged for insider-trading. The Wall Street Journal recently cited SEC’s Director Andrew Ceresney as stating hedge fund “Valuation [to be] one of the core issues.”

As we pointed out in our prior article Hedge Fund Performance and Regulation hedge funds historically had greater leeway in choosing how to value and categorize the portfolio’s underlying investments, drawing on the Securities Act of 1933’s Regulation D safe harbor rules. We also stated that regulatory compliance dictates from the SEC should remain constant, and not increase as hedge funds are above all performance driven. There is deep reasoning behind support for hedge funds, especially activist hedge funds, in the investment world – reasoning that laymen may not understand, but which focuses on the benefits institutional investors derive from seemingly mutually exclusive activist hedge fund activity.

Activist hedge funds exhibit corporate control activism, which according to L. Bebchuk, A.Brav, and W. Jiang, Harvard Law Review authors of The Long-Term Effects of Hedge Fund Activism, can be categorized via three strategies. First, as shareholders of a potential acquirer company, the strategy involves taking high stakes in a target company to ensure full acquisition over competition. Second, as shareholders of a potential target, hedge funds may use blocking strategies to benefit target shareholders. Third, hedge funds have themselves taken aggressive positions in a portfolio of companies solely in order to become activist, rather than diversifying and becoming involved when companies are exhibiting non-performance. Although not widely publicized, traditional institutional investors such as large pension and mutual funds engage in shareholder activism mainly through SEC Rule 14a-8, forcing inclusion of shareholder proposals in the proxy statements of vested public companies.

Marcel Kahan and Edward B. Rock of University of Pennsylvania Law Review do a superb job of explaining the constraints of institutional investor activism and the ensuing need for hedge fund activism via Hedge Funds in Corporate Governance and Corporate Control. We examine the most poignant points:

Pension Funds

  • Governance changes through shareholder proposals have largely been a practice of public pension funds due to the sheer asset size and scope. We have seen a surge of shareholder engagement from pension funds from 2015 to present, with the plunge in global economic and business climates. However, while proxy contests from pension funds aid in activism, the activism is more post-event reactive to company performance than pre-event business structuring. As the authors put it, pension funds traditionally handle only the “motherhood and apple pie issues” of shareholder engagement.
  • Pension funds have political constraints that inhibit an aggressively proactive approach to shareholder activism. Many pension fund trustees tend to overlap between private and public sector duties such as “gubernatorial appointees or elected politicians.” Such positions may lead to a bias towards political establishment dictates as opposed to actively working with company Boards to ensure optimal investment returns. The authors cite CalPERS as a prime example of such constraints, as historically the pension fund has held a strong pro-union position and has widely held union representatives on the Board.

Mutual Funds

  • Mutual Funds are generally retail investors.  The authors state that only TIAA-CREF has held what can be considered as an activist position in the industry. Mutual funds tend to take even a more passive position than pension funds in shareholder engagement.  Specifically, the necessary semiannual filing of all amounts and values of securities renders it difficult for mutual funds to take aggressive “pre-emptive strike” positions in a portfolio of companies.
  • SEC guidelines clearly stipulate the percentage of assets that all mutual funds can have in illiquid investments. In addition, mutual funds have requirements to redeem shares on short notice. These requirements put mutual funds in a passive shareholder engagement position.
  • Diversified mutual funds have major regulatory barriers and expenses that inhibit assertive activism. Unlike hedge funds, mutual funds for the most part do not charge performance based fees, and so depend on feed based on a fixed percentage of the of the mutual fund’s assets under management. Since activist investor proxy contests are costly, we find that most index mutual fund management would prefer to take a reactive position.
  • Most mutual funds have conflict of relationships due to affiliations with other non-activist financial institutions such as insurance companies and conservative pension funds. Many mutual funds have corporate pension plans as core business, and may not want to practice aggressive shareholder activism so as to not jeopardize client preferences.

Shareholder proposals from both pension and mutual funds are more a corporate governance wish list from shareholders, and fall more under the category of broad shareholder engagement than the activism partaken by activist hedge funds. Mutual and pension funds do not use the leverage that activist hedge funds employ to take the necessary positions for pre-emptive strikes to change company financial and operating structures.  As the authors rightly state, “hedge fund activism is strategic and ex ante: hedge fund managers first determine whether a company would benefit from activism, then take a position and become active.”  Hedge funds have become almost synonymous with activism. However, Kahan and Rock point out that only US$50 billion of the US$3 trillion global hedge fund assets under management are structured for shareholder activism. The point being that hedge funds are not solely formed to be activist investors. Yet, the small number of hedge funds that are activists truly pack a punch in active corporate governance.

The Columbia Law School’s Blue Sky blog’s article, Hedge Fund Activism: A Guide for the Perplexed has a bit of a mixed review when it comes to the activist hedge fund outlook. While there is an acknowledgement of activist hedge fund influence on company performance, the article takes an almost tongue in cheek approach to the effectiveness of activism, stating that  “institutional investors and knee-jerk academics…both believe that activists are doing the Lord’s work” as the champion of shareholder engagement, but in actuality hedge funds are by and large self-interested. From the points offered by Kathan and Rock on the limits of institutional investors to actively engage in pre-emptive structuring of companies to bolster shareholder interests, the industry must avow to the need for activist hedge fund activity, whether the motives are self-interested or otherwise. Regulatory dictates of the hedge fund industry may bring about transparency in valuations and curb insider-trading in the short term, which can be beneficial. However, a plethora of punitive regulatory barriers can seriously hinder effective shareholder engagement and corporate governance that may only be achieved through hedge fund activism.

REFERENCES

  • Bebchuk et al. 2015. “The Long Term Effects of Hedge Fund Activism.” Harvard Business Law Discussion Paper. Columbia Law Review. Pages 1064 – 1154.
  • Coffee, John C. Jr. 2016. “Hedge Fund Activism: A Guide for the Perplexed.”  The Columbia Law School Blue Sky Blog.
  • Copeland, Rob et al. 2016. “Scrutiny of Funds Grows.” The Wall Street Journal. Print Edition.
  • Kahan, Marcel, et al. 2007. “Hedge Funds in Corporate Governance and Corporate Control.”  University of Pennsylvania Law Review. Pages 1029 – 1069.

 

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Hedge Fund Performance and Regulation

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The hedge fund industry has taken quite a hit over the past year, leaving institutional investors fairly disappointed with ROI expectations. Preqin, the industry’s leading investment analytics company cited its 2015’s aggregate 2.02% return as the worst since 2011. Preqin further reported that 44% of fund managers reported failure to meet return objectives. The hedge fund industry is no lightweight; globally the industry accounts for over USD3 trillion assets under management. Poor hedge fund performance is a strong indicator of how unstable the overall financial system has become, even though the industry is not considered a market maker. Both large and boutique hedge funds that pursued single strategy objectives bore the brunt of poor performance. Hedge funds that focused on equity, macroeconomic, managed futures and relative value strategies had the most fund closures for last quarter 2015. Funds with multi-strategy, event-driven strategies and credit strategies had the best overall performance, and a larger number of fund launches. On a positive note, the entire industry saw an increased transfer of capital flows from family offices and high-net-worth individuals in 2015. Evidently, private wealth investors have waning confidence in public capital markets.

Key-Drivers-Hedge
Table 1: Key Drivers of the Hedge Fund Industry. Source: Preqin Hedge Fund Manager Outlook 2016.

While performance and handling market volatility are key drivers for the overall 2016 hedge fund outlook, Preqin cites the number one concern among hedge fund managers to be transparency and risk management, with the need to adapt to new regulations. Hedge funds face conflicting tasks of handling increased costs of improved business infrastructure, while remaining cost competitive with investor fees, in the face of industry regulation. In October 2015 the Securities and Exchange Commission (SEC) found via spot checks that certain hedge fund managers were breaching fiduciary relationships with investors. Fund managers were found to be personally profiting from trades before executing trading strategies, while shrouding performance numbers in performance reports. The SEC has promised further compliance enforcement for private equity and alternative investment firms in 2016, and now mandates hedge funds to provide strict standard data upon registration with the SEC. All private equity funds and investment advisers must file Form ADV to provide fund size and organization structure with the SEC. Funds with at least USD150 million assets under management (AUM) must file an annual Form PF to update leverage, liquidity and investment criteria, and investment fees. The SEC posts all aggregate private equity data derived from reporting publicly, thus satisfying Section 404 of the Dodd-Frank Act’s financial and risk reporting requirements.

Historically, hedge funds needed to meet only Section 4(2) of the Securities Act of 1933 and specifically, the Regulation D safe harbor rules. Hedge funds need to especially adhere to Rule 502, which prohibited general advertising through media and meetings; Rule 505, which exempts offering registration of USD5 million or less, and requires no more than 35 non-accredited investors to be vested in the fund; Rule 506, which allows the hedge fund to offer an unlimited amount of interests to investors. In addition, hedge funds need to file a state-specific “blue sky” filing with the SEC 15 days from the date of an investment into the fund. Under SEC Rule 12(g-1) hedge funds did not have to submit frequent reporting if the fund had less than 500 accredited and non-accredited investors. Hedge funds have been very vigilant in following exemption requirements to avoid over reporting and registration.

Columbia Law School professors Wulf Kaal and Dale Osterle pinpoint why hedge funds have been subjected to further regulation in their blog article, The History of Hedge Fund Regulation in the United States. Long Term Capital Management’s 1998 failure put hedge funds at the forefront of regulation. Prior to LTCM’s bailout by the New York Federal Reserve Bank, hedge funds were not considered as main influencers of systematic risk. However, the SEC began inquiries to regulate transparency and quantify reporting data in the alternative asset management industry. Kaal and Osterle cite the SEC’s failure to achieve all hedge fund registration in 2006’s Goldstein v. SEC case, by which hedge funds were able to deregister and return to the original registration exemptions under the Securities Act of 1933. However, as Kaal and Osterle explain, Title IV of the Dodd-Frank Act finally allowed the SEC to enforce stricture hedge fund regulation, and mandated that the SEC create and enforce rules requiring investment advisors, private equity and asset management firms to complete registration and annual data reporting. Data must include planned strategy disclosure; all risk analytics, credit limits, fund manager positions, and leverage figures must be included as quantifiable metrics.

Fund managers will have a veritable balancing act for the entire fiscal 2016 with continued regulation, and a call for further transparency within the extremely performance driven alternative asset management industry. While hedge funds may not be systematic drivers of the global financial economy in comparison to big banks, the industry’s USD3.2 trillion size is no laughing matter. In addition, sovereign wealth funds are significant players in funding emerging market debt, as we have seen recently with Argentina’s bond debt settlements. While continued regulation is necessary for transparency, fund managers need to have adequate reign in focusing on fund performance, especially in such a volatile macroeconomic system. Fund managers have taken it upon themselves to focus on risk and transparency. Thus, we expect that current data reporting based on Title IV of the Dodd-Frank Act continue with no additional punitive requirements, so as to give hedge funds room for performance improvement in 2016.

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