Tuesday, October 15, 2013

The JOBS Act and Private Placement Advertising

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

As per rules adopted in line with the 2012 Jumpstart Our Business Startups Act (JOBS Act), hedge funds and other private placements can now advertise to the general public.  We have been covering this issue extensively here on the blog.  While many sources suggested that this would unleash an immediate flood of new marketing, several sources have noted that there has in fact been remarkably few hedge fund advertisements so far.

Why?  There could be several reasons.  The first is that while the SEC has relaxed their rules, other regulators have not.  For example, the Commodity Futures Trading Commission still prohibits general solicitation for hedge funds that use derivatives extensively -- which could be a large fraction of the market.

It has also been suggested that hedge funds might be weary of increased SEC scrutiny should they choose to advertise to the general public.  The SEC's 2013 Examination Priorities (PDF) notes that:
Marketing and performance advertising is an inherently high-risk area due to the highly competitive nature of the investment management industry.  Aberrational performance of certain registrants and funds can be an indicator of fraudulent or weak valuation procedures or practices.  The [SEC] will also focus on the accuracy of advertised performance, including hypothetical and backtested performance, the assumptions or methodology utilized, and related disclosures and compliance with record keeping requirements.
Several hedge fund sources quoted in the financial media propose a third reason.  They claim that advertising is seen as a sign of weakness amongst funds.  One source in the Financial Times stated that big hedge funds are unlikely to advertise as "they think it is gauche and déclassé."  Instead, by these accounts it is the smaller and less established funds that are most likely to use general solicitation to increase their investor base.  If true, this bias towards smaller funds may lead to an equilibrium where the riskiest and least established funds are those that market most heavily to unsophisticated investors.

As we discussed over a year ago, a major concern with allowing general solicitation of private placement investments is that such investments tend to be highly speculative.  As an example, we have found that sponsors of a private placement real estate investment called a tenants-in-common agreement (or TIC) tend to use aggressive and unrealistic assumptions in their return projections.  These products also tend to involve the largest selling commissions, leading brokers and advisers to 'push' them on investors.  This combined with the lifting of the general solicitation ban could lead to a proliferation of unsuitable or fraudulent investment schemes.

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