Monday, 8 February 2016
Last updated 8 min ago
Feb 16 2010 | 9:45am ET
By Donald A Steinbrugge -- The SEC is re-evaluating its position with regard to creating regulation that would ban third party marketers from soliciting business from public pension funds in the United States.
This issue has received a lot of publicity since early 2009, when David Loglisci, former chief investment officer of the New York State Common Retirement Fund, and Henry Morris, former chief political adviser and chief fundraiser for former New York State Comptroller Alan Hevesi, were indicted on 123 charges, including enterprise corruption, securities fraud, grand larceny, bribery and money laundering. This followed a campaign by New York Attorney General Andrew Cuomo to have third party marketers banned from calling on public pension funds in the State of New York as well as other states. The campaign with other states received significant pushback, as many high profile public funds came to the defense of the third party marketing industry by articulating the value they add to their organizations. New York also advocated to the Securities and Exchange Commission to force other public funds from utilizing third party marketers through new legislation. Once again this legislation received significant push back during the feedback period from large public pension funds, institutional investment consultants and alternative investment firms. As a result, the SEC is considering changing its position to allow third party marketing to call on public pension funds if they are registered with FINRA, and if FINRA agrees to establish procedures to prevent pay for play practices. This was recently highlighted in a letter from SEC Director Andrew Donahue to FINRA’s Chairman and CEO, Robert Ketchum.
By way of background, third party marketing firms in the United States that represent hedge funds are already required to be registered with FINRA, although those that represent private equity and long-only strategies historically have not been.
While I applaud the SEC’s decision to reconsider its course of action, I would encourage the SEC and FINRA to adopt a measure that would require all marketing professionals that call on public funds to be registered, not just third party marketers. I would also suggest a ban on political contributions from third party marketing firms, investment management firms and their employees to officials that can influence the decision making process at public funds. Finally, there should be strict policies regarding travel and entertainment expenses for all organizations that market to public pension funds. The SEC’s new position is positive for the vast majority of third party marketing firms that ethically approach their business because it will level the playing field and encourage all to play by the rules.
The proposal is also good for the industry as a whole because of the many benefits the third party marketing industry provides to public pension funds and the citizens within their jurisdiction.
Following is a brief overview of third party marketing and benefits it provides.
Third party marketers act in the role of an investment bank by raising capital for many private equity firms, hedge funds and other organizations in the alternative investment arena. They are paid a fee for their efforts, typically a percentage of assets raised or a percentage of all fees generated by the investment from the investment managers. There should not be any incremental expense to the investor.
Third party marketers have represented many of the top alternative investment firms in the world as well as small and mid-sized firms. The elimination of third party marketers would likely cause many of these smaller firms to close their doors, while simultaneously creating a higher hurdle rate for new managers considering entry into the business. It would also disproportionately harm minority- and woman-owned firms, which tend to be smaller. Furthermore, many of these small and medium-size hedge funds and private equity firms provide seed capital to start-up and small businesses. Small businesses represent a significant portion of job growth in the United States and are the backbone of the US’s economic competitiveness on a global scale. Retarding the growth of the nation’s shadow banking system, during a time when traditional banks and lending institutions are less active, will likely have negative consequences for the residents of the US in terms of less jobs and lost tax revenue. In sum, third party marketers contribute to the health and existence of the alternative investment arena, which in turn provides capital for the global economy and increases market efficiency.
Banning third party marketers from the investment process would also shrink the opportunity set for investors and speed the migration of investor’s capital to the largest hedge funds and private equity firms, who can afford large marketing infrastructures. Many would argue that compared with their smaller brethren, larger organizations are not able to generate the same returns as their smaller, more nimble competitors, and that would further harm pension plan participants. Given that small and mid-size hedge funds and private equity firms have the potential to generate a significant amount of alpha, any legislation that impacts their existence should be carefully considered.
Hedge funds can choose to build their own sales teams, outsource the fundraising effort to a third party marketing firm, or blend a combination of the two. 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 including: retention of all marketing documents; monitoring of all firm correspondence by a compliance officer; off-site storage of all electronic communication; and periodic review by the regulatory bodies for compliance. Most hedge funds are not regulated and their internal sales people in many cases are not licensed. As it now stands, hedge fund 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 will likely choose to focus their efforts on the other managers they represent. Conversely, members of an in-house sales force are captive to their manager and face the prospect of losing their jobs if they are unable to generate sales.
I am pleased that the SEC has listened to the marketplace and recognizes the value that third party marketing adds to the investment process. The SEC’s appreciation of the role that third party marketers play and its request for help from FINRA to create rules that will level that playing field for all of us is welcomed.
Donald A Steinbrugge, CFA is managing member of Agecroft Partners LLC, a consulting and third-party marketing firm specializing in hedge funds and other alternative investments.