This week we welcome back HBG Senior Researcher Kenny Tavares to the blog. Earlier this year, Kenny and fellow HBG senior researcher Elizabeth Roma shared their extensive research on family offices in a podcast. In this week’s article, Kenny shares more about the legislation affecting hedge funds and family offices, and how this could impact the philanthropic landscape.
With Halloween approaching, the time is right for a scary topic! Pull up a chair and let me tell you about the Dodd–Frank Wall Street Reform and Consumer Protection Act, aka Dodd-Frankenstein. Wait, no, sorry. I meant Dodd-Frank.
Since it was passed in 2010, this controversial financial regulation overhaul has drawn screams and groans from those both for and against the legislation. Despite efforts to glom on spare parts, repeal or reduce its effectiveness, like Frankenstein, it lives… IT LIVES!!
But seriously, as fundraisers, we shouldn’t fear Dodd-Frank – in fact, we should learn about and embrace it, because it helps us to gain a better understanding of our donors, particularly those who are investors.
In an effort to provide more transparency to the public on the financial industry, Dodd-Frank has served as a catalyst to emerging trends that we need to know about. Let’s get started with a primer on some of these developments.
First, a quick review
- The Dodd–Frank Wall Street Reform and Consumer Protection Act is a collection of federal regulations that primarily affect financial institutions and their customers.
- It was passed in 2010 in response to events and practices that caused the financial crisis in 2008.
- The goal of Dodd-Frank was to reduce risk in parts of the U.S. financial system.
- It is named after former U.S. Senator Christopher J. Dodd of Connecticut and former U.S. Representative Barney Frank of Massachusetts, who made significant contributions to its creation.
- Dodd-Frank created new agencies to monitor the performance of companies and created new rules to protect consumers.
Now, that wasn’t too scary, right? Okay, let’s look at how this law has affected investors.
The Effects of Registration and Regulation on Private Fund Advisers
In a podcast on family offices earlier this year, Helen Brown, Elizabeth Roma and I discussed the new trend of large hedge funds returning money invested by outsiders (non-family members) and converting the fund into family offices.
While there are many reasons why this trend has gained momentum, Dodd-Frank’s new standard for reporting was a primary motivator. Here’s why:
As a result of Dodd-Frank, hedge fund advisors with assets of $100 million or more are required to register with the Securities and Exchange Committee (SEC).
These larger hedge funds are also required to establish compliance programs in order to meet new standards and to participate in systemic-risk reporting. These regulations and the extra cost of compliance have led some organizations to convert their hedge funds to single-family offices.
So: In order to become a single-family office, these hedge funds:
- must return “outside” funds to non-family investors
- be wholly owned and operated by immediate family members; and
- not market themselves as an “investment advisors”
The bad news: now we prospect researchers will not be able to find assets under management (AUM) for family offices like we could for hedge funds.
However, the good news is that you can assume that a prospect with a single-family office is managing at least $100 million, which is believed to be the minimum needed for the office to make financial sense.
More good news: many families behind these new family offices are incorporating philanthropy into their broader financial strategy, taking a more sophisticated, deliberate and purposeful approach to giving.
What else has Dodd-Frank wrought?
New registration and reporting requirements also apply to private equity funds with more than $150 million in assets. How much and how often they have to report depend on the size and type of fund.
Widespread abuse found
General partners in these funds must also register as “private equity investment advisers” with the SEC and report on their operations and finances. The requirements are less stringent than for publicly-traded companies, so some don’t believe in the effectiveness of this rule. However, since the new rules have been established, the SEC has found widespread abuse among advisers, including:
- manipulation of a portfolio’s value,
- avoidance of their fiduciary responsibility, and
- collecting transactions fees from their portfolio companies without first registering as broker-dealers
…all of which are violations of the current law.
As a result of these scary revelations, private equity firms are quickly reversing course on these practices. These changes will benefit private and institutional investors as well as portfolio companies in the form of reduced transactions fees and increased monitoring of their investments. This may have the effect of slowing the explosive growth of compensation for those in the private equity industry.
Regardless, an ongoing examination of these rules changes, as well as how the private equity industry perceives them, is imperative. As more and more individual investors create family offices, these regulations and their impact on the private offices could affect a prospective donor’s perception of their wealth – and therefore their philanthropic giving.
The Rules About Accredited Investors
Under the terms of Dodd-Frank, the SEC adjusted the definition of the term “Accredited Investor,” a person or institution capable of participating in sophisticated higher-risk investments.
Under the old rules, an Accredited Investor (AI) must either have had income that exceeded $200,000 for the current and two previous years OR a net worth of $1 million or more. In 2011, the SEC changed the rule by excluding an AI’s primary residence from the calculation of their net worth, and a recent proposal has suggested changing the income level to $450,000 and the AI’s net worth minimum (minus their primary residence) to $2.5 million.
Dodd-Frank also requires the SEC to revisit its definition of “Accredited Investor” every five years, and establishes a minimum which advisers can charge performance-based advisory fees.
These rules are meant to protect the consumer. Their side impact could be to reduce the number of eligible investors by 60%.
What does this mean for nonprofits?
The people impacted by these proposed changes would include our most top level donors, board members and volunteers, including partners at start-up companies, hedge funds and venture capital firms. Newer hedge funds could be squeezed, too, since they would have to rely on larger investors, including single-family offices, whose leverage can be used to reduce administrative fees. Knowing what is tops on the list of concerns for our key donors is an important part of donor-centered fundraising.
What’s in store?
To date, five of the eight rules in Dodd-Frank that directly affect financial advisors have been finalized. On the horizon is:
- the creation a self-regulatory organization to help the SEC oversee advisers,
- the creation of a uniform fiduciary standard for all advisers and broker-dealers, and
- creation of new rules about compensation that aim to avert reckless financial behavior that could harm investors.
There’s no telling what the future will hold, especially with the upcoming presidential election. That’s why knowing these regulations now (and where they might be headed) will help you to understand your donors’ financial situation when the rules change.