The economic consequences of hedge fund regulation: An analysis of the effect of the Dodd-Frank Act

In response to concerns about excessive risk-taking and misleading valuation practices in the hedge fund industry, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “DFA” or “Dodd-Frank”) in July 2010. Dodd-Frank is one of the most significant pieces of legislation ever affecting the financial sector and the hedge fund industry in particular. Broadly speaking, Dodd-Frank subjects most hedge funds to government inspections, registration with the Securities and Exchange Commission (“SEC”), and a number of disclosure and compliance obligations. Under the DFA, for example, hedge funds are required to maintain and report information on conflicts of interest, ownership structure, clients and officers, disciplinary history, assets under management, performance, risk exposure, and financing, and the funds also became subject to the Presence Exam Initiative – a comprehensive federal examination program of the funds’ valuation methodologies, allocation of expenses to investors, and other business practices.

The hedge fund industry criticized the DFA quite vigorously, claiming that the new compliance requirements were unnecessary (since hedge fund investors are relatively sophisticated) and costly. However, most hedge funds also claimed that they would absorb the new compliance costs and that, as a result, those costs would not affect the net profits going to investors (KPMG, 2016).

The tension between the hedge fund industry and public authorities over the passage of the DFA raises various questions. First, was Dodd-Frank associated with a meaningful reduction in profitability (and, if it was, what were the drivers of that reduction)? Second, if there was a decline in profits, was the decline compensated by reduced risk-taking (i.e., reduced return volatility)? And third, did the law lead to less capital formation (i.e., less resources being channeled from sectors with excess of liquidity to sectors in need of liquidity) because managers closed funds or launched less funds in response to the regulatory change?

In my paper, forthcoming in the Journal of Legal Studies, I examine these questions. The data show that, relative to a control group of funds that were already registered with the SEC or that were largely unregulated, the net profits going to investors in the funds that registered in response to Dodd-Frank decreased immediately after the implementation of the law. This decline could in fact be partially explained by direct compliance costs, but those costs do not seem to fully explain the results; rather, part of the decline seems to be driven by collateral effects of compliance, which include diversion of managerial attention from core business activities and/or adjustments to financial valuation or reporting practices that ultimately result in revisions of performance estimations. The data also show that risk-taking did not change significantly after the DFA, and that although fund managers closed funds and launched less funds in response to the law, that behavior did not result in less capital formation (as measured by total assets under management).

To the extent that part of the decline in profits documented in this paper can be explained by direct compliance costs and diversion of managerial time from a fund’s business, this paper documents an important cost of the DFA. However, since part of the decline could be explained by adjustments to valuation or reporting practices, then such part may in fact be a benefit of the law. These results in turn have more specific implications for the disclosure obligations of hedge funds and the desirability of mandatory private audits, which are discussed in the paper.

It is worth noting that some of the issues addressed in this paper have attracted the attention of other researchers, who reached different conclusions regarding the impact of the DFA on profitability and risk-taking (see Kaal et al., 2014; Cumming, Dai, and Johan, 2017). However, when those papers were written, it was difficult to distinguish between the funds that became subject to regulation under the DFA and those that did not because the key data source to identify the regulatory status of a fund (Form ADV) was not publicly available. With the availability of Form ADV today, however, it is now possible to estimate more precisely the effect of the law.

The paper is available for download here: https://ssrn.com/abstract=3541916.