Donald A. Steinbrugge (Feb, 2010) via HedgeCo : The SEC has changed its position with regard to third party marketing firms and is exploring legislation that indicates that the SEC is apparently willing to reconsider its recommendation that all third parties be banned from soliciting government business.
SEC Director Andy Donahue has asked FINRA's Robert Ketchum for help in crafting legislation that is designed to curb pay for play activity while protecting the role of third party marketing firms. The SEC changed course, at least in part, because of an outcry of response from a wide spectrum of investment professionals, that articulated the positive role that third party marketing firms play in the industry.
The SEC had originally signalled 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 original course of action completely ignored the positive impact that third party marketing has on the investment decision making process. Based on numerous complaints that the SEC received that articulated the positive impact that third party marketing firms play throughout the investment process, the SEC reversed course and asked for FINRA’s help in crafting legislation that would curb pay for play activities, but protect the role of third party marketing firms.
As you may recall, in early 2009, David J. 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.
Following the indictment, New York state Attorney General Andrew Cuomo promised to eliminate the use of third-party marketers in the public pension allocation process. As the nation’s third largest pension plan, the Common Fund wields significant influence in the pension industry. Unfortunately, the initial debate regarding third party marketing firms was framed in part by the Common Fund and others who committed wrongdoing, who chose to deflect blame from themselves and their deficient internal governance practices onto others.
I am delighted that during its due diligence the SEC has listened to the outcry from investment professional and now recognizes the important role that third party marketing firms play in the industry. If the SEC had followed the New York State Attorney General's recommendation to ban third party marketing, the marketplace would likely sustain far-reaching negative consequences without resolving the breach of fiduciary duty and public trust that is alleged. I will go into greater detail regarding the benefits that third party marketing firms bring to the process later in the discussion.
While I applaud the SEC’s decision to reconsider its course of action, I would encourage the SEC and FINRA to adopt a series of measures.
First, I would require all marketing professionals that call on public funds to be registered with FINRA, whether they are employed with third party marketing firms or employees of alternative investment firms.
This measure will level the playing field for everyone soliciting business with public funds. Second, I believe that greater transparency including fee disclosure be required of all third party marketing firms. THIRD, I would also suggest a ban on political contributions from third party marketing firms and all alternative investment firms seeking to do business with public funds. Finally, I would expect that strict policies regarding Travel and Entertainment Expenses of all third party marketing firms be enforced by FINRA. Effective legislation combined with rigorous enforcement will protect the positive role that third party marketing firms bring to the table and protect the broader interests of all market participants.
The State of New York Common Retirement Fund pay for play disaster serves to remind us that we have no outright protection from fraud and unethical behavior in our society. However, we do have powerful regulatory bodies capable of enacting and enforcing laws that promote ethical and responsible behavior. I am encouraged that the SEC has solicited feedback and is apparently willing to be thoughtful in its approach to third party marketing firms.
The value that third-party marketers add to the allocation process is manifold. 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. Third party marketing firms are paid a fee for their efforts, typically a percentage of assets raised or a percentage of all fees generated by the investment in the future. The elimination of third-party marketers would likely cause many of these alternative investments 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. Many small and medium-sized hedge funds and private equity firms provide seed capital to start-up and small businesses and are an integral part of the global economy's shadow banking system. Small businesses represent a significant portion of our country’s job growth and are the backbone of our nation’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 market.
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, which would negatively impact market efficiency. 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 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.
All of the reasons articulated above suggest that the SEC is wise in its most recent efforts to explore a framework of rules and regulations that protect third party marketing firms and market participants.
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 is managing member of Agecroft Partners LLC, a Richmond, Va.-based consulting and third-party marketing firm specializing in hedge funds and other alternative investments.