Last week the SEC officially changed its position, voting to adopt new rules concerning public pension funds’ pay-to-play practices. Donald A. Steinbrugge, CFA, Managing Member,
Agecroft Partners, LLC, examines the impact of the new rules.
The new rules permit managers to pay third party marketers that are registered as investment advisers or broker-dealers. In addition, the new rule “prohibits an investment adviser from providing advisory services for compensation — either directly or through a pooled investment vehicle — for two years, if the adviser, or certain of its executives or employees, make a political contribution to an elected official in a position to influence the selection of the adviser”.
“The SEC’s decision is good news for the industry and will level the playing field to allow registered third party marketers to provide valuable service to public pension funds based solely on merit”, says Doug Rothschild, Managing Director for hedge fund consulting and third party marketing firm Agecroft Partners.
The SEC originally signaled that it intended to ban third party marketing to public pension plans in the wake of the New York State Common Retirement Fund pay-for-play fiasco. While eliminating pay-for-play activities is laudable, the SEC’s first course of action completely ignored the positive impact third party marketing has on the investment decision-making process.
Last year, based on feedback they received from numerous sources including many high profile public pension funds articulating the positive impact third party marketing firms create throughout the investment process, the SEC reversed course, requesting FINRA’s help in crafting legislation that would curb pay-for-play activities, while protecting the role of third party marketing firms.
Public pension plans manage money for employees of state and local governments across the U.S. Public plans currently hold more than USD 2.6 trillion of assets, representing one-third of all U.S. pension assets It is very important to our society that these pension funds are managed by the highest quality investment firms in order to maximize risk adjusted returns. The services offered by third party markers are typically free to the public pension funds. Third party marketing firms receive their fees from the investment firm with out adding any incremental charge to the pension fund.
The SEC’s legislation is well written and will eliminate many of the pay-for-play practices that have hurt the industry in recent years. These practices included advisers, wanting to do business with public plans, making political contributions to elected officials in an effort to influence the decision making process. This new legislation benefits public pension plans, alternative investment firms and most importantly, pension plan participants by providing a process where advisers and third party marketers are awarded business based on skills and services.
Third party marketers contribute to the health and existence of the alternative investment arena by performing the role of an investment bank by raising capital for many private equity and hedge fund firms. The elimination of third-party marketers would result in many alternative investment firms closing their doors while simultaneously creating a higher hurdle rate for new managers considering entry into the business. The industry is dependant on a continual flow of new firms that will one day be the next industry leaders. For example, third party market firms raised capital for firms such as Moore Capital and Paulson &Co.
Hedge funds can choose to build their own sales teams, outsource the fundraising effort to a third-party marketing firm, or choose a hybrid approach. There are some important distinctions between third-party marketing firms and in-house sales staff. Third-party marketers are required to be licensed and regulated by the SEC and FINRA. These firms are heavily regulated and are required to follow all rules and regulations. Most hedge funds are not regulated and their internal sales people in many cases are not licensed. As it now stands, third-party marketers face a much higher degree of regulatory scrutiny than hedge funds that have not voluntarily registered with the SEC.
Another critical role played by third-party marketers is the screening of the manager universe. The best third-party marketers perform extensive due diligence before making the decision to represent a hedge fund. In some cases, third-party marketers represent less than 1% of the firms on which they perform due diligence. If one of the firms they are representing becomes less marketable for any reason, they have the option to focus their efforts on the other managers they represent. Where an in-house salesperson would need to either keep selling an uncompetitive product or find a new job.
The SEC’s reversal of their initial decision, demonstrates that the process works. They listened, collaborated, analyzed and came up with legislation that creates a fair and efficient environment for advisers and third party marketers while protecting the public pension plans and their participants.