July 28, 2006
ERISA and Hedge Funds
Posted by Victor Fleischer

This W$J article notes how the pension bill going through Congress would make it easier for pension funds to get into hedge funds.  Sounds scary and risky, right?  It shouldn't.  Under current law, if an investment fund takes more than 25% of its money from pension funds (and isn't a "venture capital operating company" or VCOC - long story), the hedge fund becomes an ERISA fiduciary, which apparently is a pain in the behind.  The bill would exempt public employee and government pensions from counting against the 25%. 

I think this makes sense -- public employee pension funds (think CalPERS) are usually big powerhouse players who can figure out which funds are better to invest in, and the 25% rule can make it difficult for pension funds to get into the best funds.  A few questions, though:

1 -- Instead of drawing a line based on public employee vs. private pension funds, why not draw a line based on the size of the pension fund?  Presumably size is a better proxy for sophistication than govt vs. private. 

2 -- Couldn't Congress turn the rule around to look at the percentage of assets that a pension fund invests in a given hedge fund rather than the the percentage of money in a hedge fund that comes from pension funds?  I'd be concerned if my pension were all invested in one hedge fund, but not if 15% of my pension money is spread across five different funds. 

3 -- Why do we think hedge funds are more dangerous than venture funds?  I think the purpose of the rule here is to discourage pension fund managers from pushing their fiduciary obligations off onto other passive investment managers who aren't ERISA fiduciaries.  VC funds can fit into a different policy box because they actively exercise management rights.  They aren't passive investors.  (I think a lot of private equity funds also manage to fit into the VCOC box, but I'm not sure.)  As hedge funds become more active investors, then maybe the right policy choice here would be to loosen the VCOC rules a little, not change the 25% rule. 

If that's not the rational for the VCOC exception, then what is?

Anyone know of a good law review article that talks about these rules? 

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