Fri, 18/05/2007 - 07:00
Ernst & Young's Michael DeStefano and Karen Vejseli outline the benefits and challenges of listing hedge funds in the US market.
Hedge fund companies have enjoyed considerable investor attention in the past few years. Recently, these alternative investment firms have garnered even more of the spotlight by making hedge funds available to individuals and institutional investors through initial public offerings (IPOs) of the management companies and, in certain cases, the funds themselves.
In February, Fortress Investment Group, a U.S.-based hedge and private equity fund firm with approximately USD 26 billion in assets under management, went public on the New York Stock Exchange. The stock initially jumped 89% before closing at USD 31 a share, for a first-day gain of 68%. This offering, the first listing of its kind in the U.S., is sparking interest in such IPOs. The trend toward publicly traded hedge funds has already taken off in Europe: in July, Goldman Sachs' Dynamic Opportunities Ltd. debuted on the London Stock Exchange, and in December, Marshall Wace LLP's MW Tops Ltd. raised USD 2 billion in its IPO on Euronext Amsterdam.
Such firms choose to go public for the same reasons that most traditional companies go public: to raise permanent capital, to provide key talent an incentive to remain on board, to allow founders to monetize their investments, or to help the firm sustain and attract new business. Going public could also serve as an exit strategy for principals or provide a chance to solidify an organization's enterprise value by diversifying its
A recent move by regulators only makes it more appealing for hedge fund firms or the funds to go public. In December, the U.S. Securities and Exchange Commission (SEC) proposed rules to increase the minimum net worth needed for individuals to invest in non-public hedge fund products. Under current rules, an individual must have at least USD 1 million in net worth to qualify, but the new rules bump up that figure to USD 2.5 million. IPO investors in hedge fund firms, including those investors who do not qualify to invest in the non-public funds that the firm manages, will be buying into the management and incentive fees earned by the firm which provides them access to a piece of the non-public funds' return.
Navigating uncharted waters
Besides the obvious business advantages of going public, however, hedge fund managers have other considerations. Since hedge funds traditionally have been averse to revealing too much about their business and trading practices, the disclosure requirements involved in going public might present a whole set of new challenges. There are a number of challenges that alternative investment firms must overcome in entering the relatively new territory of public trading. The most important issues are the following:
Time and money drain: Preparing for listing requires a significant investment of time and money. Required registration documents such as the S-1 usually take four to eight weeks to complete, not including receipt of and response to comments from the SEC. The firm preparing for listing must also amass and circulate information about its principal shareholders, certain transactions, capitalization, dividend policies, and risk factors, among other data. In addition, management's discussion and analysis (MD&A) must be written, agreed upon, and approved by management and legal counsel.
Auditing considerations: Besides the S-1, other documents that must be provided include a comfort letter from an independent auditor about financial information in SEC registration statements that is not covered by the auditor's opinion. The comfort letter is not filed with the SEC, but is typically required by underwriters. Furthermore, a firm looking to go public must prepare three years' worth of SEC compliant financial statements (including related footnotes and disclosures), unaudited stub-period financials for the shortened current year and comparative prior year, and, in certain instances, pro-forma disclosures under Regulation S-X.
The firm must also ensure that the independent auditor is registered with the Public Company Accounting Oversight Board (PCAOB) and has been independent (e.g., has not performed prohibited services) according to SEC rules going back three years. It is not sufficient for the auditor to adhere to just the rules of the American Institute of Certified Public Accountants (AIPCPA), as auditors of private companies do.
Governance structure: The right corporate governance structure is essential for dealing with audit, legal, compliance and other ongoing requirements. Hedge fund firms must consider whether they have adequate infrastructure and expertise to implement new policies and systems for maintaining an effective control environment.
They will need the capability to form a corporate board structure that includes nominating, audit and compensation committees; a board of directors with two or more independent directors and at least one financial expert; an internal audit function; the resources to monitor auditor independence; and reportable event monitoring. Also essential is the creation of compliance policies and compliance monitoring mechanisms to handle such matters as code-of-ethics violations, conflicts of interest, whistle-blowing, and insider trading.
Regulatory scrutiny: Once listed, a hedge fund firm is subject to the same regulatory scrutiny as any other public company. Regulatory oversight is not a one-time consideration during the listing period but an ongoing fact of life for public companies. A new emphasis on corporate governance makes it essential for company officers, directors, and principals to understand their responsibilities and legal obligations in a rapidly changing regulatory environment. In addition, the proliferation of rules and regulations has made compliance and disclosure much more complex, time-consuming, and costly.
Public companies must file timely reports with the SEC about their operations; their officers, directors, and certain shareholders (including salary, fringe benefits, and transactions between the company and management); the financial condition of the business, including statements audited by an independent registered public accounting firm; their competitive position; and the material terms of contracts or lease agreements. Public firms are also subject to SEC review of financial statements and publicly available receipt of and response to SEC comment letters.
Requirements under the Sarbanes-Oxley Act include: implementing controls at the entity and process levels, providing management's attestation that such controls are in place, have been tested and are effective, and supplying the results of auditors' testing of the controls. Management certification of financial statements is also mandatory. Furthermore, public companies must routinely pass rigorous examinations to prove that they are meeting all regulatory requirements.
Handling disclosure requirements
A hedge fund firm's challenges do not come to an end after its listing on a stock exchange. It must provide investors with information on a regular basis, offering insight into its operations, including inflows and outflows, trading income, and, above all, risk exposure. Since hedge funds are known for their short-term investments using vehicles such as futures trading and credit-default swaps, and practice investment strategies like short-selling and commodity hedging, they will need to carefully determine the extent of disclosures about the investment strategies that are so crucial to their competitive advantage.
Once a company goes public, it must also supply other information that offers investors visibility into its operations. Requirements include filing management-certified quarterly financial reports with MD&A, announcing press releases and/or responding to analyst and investor communications and scrutiny, and administering proxy voting on corporate matters.
In addition to conducting an annual shareholder meeting and filing quarterly and annual reports, public firms must file a 'current report' (Form 8-K) with the SEC to disclose major events that shareholders should know about. Examples include material agreements, financial obligations or off-balance-sheet arrangements, material impairments, certain unregistered sales of equity securities, auditor changes, certain accounting errors, the appointment or departure of officers or directors, and amendments to codes of ethics.
Outlook for IPOs
Historically, the unique structure and success of hedge fund firms has been built on the premise that value can be maximized through the flexibility that comes with being outside the scope of the supervision of any regulatory body. Although many hedge fund firms are now registered as investment advisors with the SEC, the level of regulatory oversight heightens once the firm is in the public market through an IPO.
Therefore, while going public offers great potential reward for a hedge fund firm and IPO investors, it also presents significant challenges to the firm, primarily related to regulatory issues. (Please see 'Tightening Up: Hedge Funds Prepare for Greater Scrutiny' in this issue, page 18.) Those hedge fund firms that are prepared for the challenges of the IPO process as well as those of being a public company, and being subject to SEC scrutiny, will endure the IPO process and thrive in the aftermath.
Michael DeStefano is a partner in the Americas Asset Management Center within Ernst & Young's Financial Services Office. Karen Vejseli is a senior manager in the Asset Management practice.
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