What Drives Dodd-Frank Act Compliance Cost for Private Funds?

Wulf Kaal

Are Dodd-Frank Act compliance costs forcing smaller private investment fund advisers out of the market?  Several policy makers have suggested that Dodd-Frank Act compliance costs affect smaller firms more than larger firms and many financial studies have shown that an inverse relationship exists between the size of a regulated firm and the per-unit cost of compliance. If the administrative and compliance costs created by Title IV of the Dodd-Frank Act should disproportionally affect smaller private fund advisers, it is conceivable that over time smaller fund advisers could get forced out of the market or merge with other funds. Private fund advisers who are contemplating a startup may not enter the market. A disproportionate effect of Title IV of the Dodd-Frank Act on startup private funds and smaller advisers could create barriers to market entry and precipitate a trend toward consolidation among smaller private fund advisers. A surplus of larger private fund advisers with correspondingly larger amounts in AUM, in turn, could increase systemic risk.

Title IV of the Dodd-Frank Act and Securities and Exchange Commission (SEC) rules implementing the requirements under Title IV created a paradigm shift for the regulation of private funds in the United States. The new regulatory framework for private fund advisers in the United States requires private fund manager registration in combination with enhanced disclosure of sensitive proprietary information (Dodd–Frank §§ 401, 402). Some of the more controversial requirements include disclosure obligations that require the reporting of, among other things: positions held by the investment adviser, strategies and products used by the investment adviser and its funds, counterparties and credit exposure, risks metrics, performance and changes in performance, financing information, percentage of assets traded using algorithms, and the percentage of equity and debt.

This study makes an unprecedented contribution to the literature because it relies on a dataset of compliance cost estimates (N=94), collected in the aftermath of the enactment of mandatory registration requirements for the private fund industry. I show with two independent datasets that the number of funds managed by private fund advisers is associated with Dodd-Frank Act compliance cost. However, the size of registered private fund advisers as measured by assets under management (AUM) is not associated with the per-unit cost of Title IV compliance and other independent variables as proxies for cost. The linear and non-linear regression results are significant and consistent across all independent variables. Smaller firms in the sample of this study have, in the aggregate, larger Title IV compliance costs than larger funds. The results affirm other studies, finding that regulatory compliance cost can bring increasing returns to scale.

The findings of this study have several implications. If Title IV compliance cost bring increasing returns to scale because the cost of Title IV compliance favors larger firms, it seems possible that Title IV at least contributes to the creation of barriers to entry for smaller private fund advisers. This affirms other studies that find barriers to entry can result from financial regulation. Barriers to entry can also mean that smaller private fund advisers could get forced out of the market or consolidate with other private fund advisers. Consolidation of smaller private fund advisers may contribute further to an already existing trend towards private fund adviser consolidation. Ironically, while Title IV of the Dodd-Frank Act was intended to curtail systemic risk (Dodd-Frank §404(2)(b)(1)(A) 2012), the consolidation of the private fund industry is likely to increase the number of larger private fund advisers with correspondingly larger amounts in AUM. Larger AUM can heighten the systemic risk posed by the private fund industry.

The preceding post comes to us from Wulf Kaal, Associate Professor at the University of St. Thomas School of Law. It is based on his recent article, which is entitled “What Drives Dodd-Frank Act Compliance Cost for Private Funds?” and is available here.