Vic (and other readers) check out my similar post on the ERISA implications of pension plans buying more hedge funds on Workplace Prof Blog (http://lawprofessors.typepad.com/laborprof_blog/)

Paul

RE the moral hazard problem, my impression is that the partnership agreements (or LLC operating agreements) often, if not typically, require a hedge fund manager to have a substantial portion of his or her net worth in the fund. So that might mitigate, if not solve, the "other people's money" problem.

I think hedge funds are a simple story--the best fund managers will thrive in an environment where they get paid only if they perform. So we see a migration of talent to that investment vehicle. From a regulatory perspective, there is nothing unstable or worrisome about this pattern beyond the retribution of wealth it augurs.

It is a separate question whether the best managers will be very interested in loading up on pension funds and potentially exposing themselves to ERISA regulation. The best manager should be able to negotiate a low-transactions cost fund (i.e., a staple of wealthy, patient, non-fickle investors with minimal regulatory baggage).

Thanks for the link, Paul.

Bill, you are right that some funds require the managers to have "skin in the game." I haven't seen enough agreements to know how much net worth these guys have locked up and if it is an adequate solution.

The ERISA question is tricky because we don't want pension fund managers to simply turn over the plan assets to somebody else to manage, which both weakens investor protection and incurs another level of fees and agency costs. On the other hand, if hedge funds really do provide value for pension funds by generating alpha, then we shouldn't let regulation get in the way.

So -- Which way do you come out? Should we allow hedge funds to have 50% or 100% pension money without treating the hedge fund assets as plan assets? Or stick with the status quo of a 25% limit?

"Why do hedge fund managers want to avoid being ERISA fiduciaries?"

If you are a plan fiduciary, you have a fiduciary duty to the plan and its beneficiaries, and you will be restricted by the prudent man rule. In the context of a large pension plan, putting a few percent of the assets into hedge funds may be a prudent diversification. However looked at in isolation the assets of any given hedge fund may be concentrated and too aggressive to meet the prudent man rule.

Managers typically have some money in their fund and sometimes a considerable portion of their net worth. It varies cosndierably from fund to fund.

Hedge funds generally want to avoid control and restrictions on what they do. I understand the prudent man rule, but if it were to restrict leverage (necessary to make reurns in some strategies) or require a diversified portfolio (hedge funds are more concentrated), I think it would dilute hedge fund returns.