Private fund Performance After the Dodd-Frank Act – Evidence from 2010 to 2015

Wulf Kaal

Does the Dodd-Frank Act lower the earnings of the private fund industry? For much of its history, the private fund industry has viewed private fund adviser registration and the disclosure of proprietary information as a threat to its profitability. Title IV of the Dodd-Frank Act introduced the most significant regulatory change in the history of the private fund industry in the United States – requiring mandatory registration for private fund managers with over $150 million in assets under management and increasing the disclosure requirements pertaining to confidential and proprietary information. Implemented under Title IV, the controversial disclosure obligations in Form PF require private fund adviser to report risk metrics, counterparties and credit exposure, strategies and products used by the investment adviser and its funds, performance and changes in performance, financing information, the percentage of equity and debt, trading practices, the amount of AUM, valuation policies, side letters, the use of leverage, and other information deemed necessary and appropriate to avoid systemic risk.

Evidence exists that mandatory private fund adviser registration under the Dodd-Frank Act affects the cost structure of the industry. However, the registration and increased compliance requirements under the Dodd-Frank Act increase the cost structure of private funds only marginally. Registration and disclosure requirements under the Dodd-Frank Act do not seem to affect the returns of private funds. Rather, compliance costs associated with the Dodd-Frank Act appear to affect mostly the profitability of private fund advisors’ investment management companies.

In a new study, Barbara Luppi, Sandra Paterlini and I assess the impact of Title IV on private fund performance. We use data from the Morningstar Private Fund Database, Inc. on monthly private fund earnings (measured in US dollars) reported by about 7,000 private funds and more than 3,700 private fund advisers. The data set contains information on individual private fund advisers and their managed funds (SEC identification number, name of the private fund, inception date, domicile) including monthly reported assets under management and monthly reported earnings. Due to missing data and the presence of outliers, we extract a sample of 887 private funds that report all the monthly earnings data and monthly AUM in each period from January 2010 to August 2014.

Our findings support the private fund industry’s claims that increased supervision and disclosure mandated in the Dodd-Frank Act have a negative effect on private fund earnings. A discontinuity exists at the threshold value of $150 million AUM, above which private fund adviser registration under the Dodd-Frank Act becomes mandatory. While the relevant estimates are not significant and the discontinuity is not persistent and dissipates in the subsequent months after the registration effective date for private fund advisers, our results do support the private fund industry’s claims that increased supervision and disclosure via the Dodd-Frank Act affects its profitability.

Several theories could help explain a negative effect of the Dodd-Frank Act on private fund earnings. First, we do not see higher compliance cost, identified by Kaal as the primary effect of private fund managers registration under the Dodd-Frank Act, as a contributing factor. Kaal shows that higher initial compliance cost usually would have been incurred once, when managers and their compliance officers learn how to prepare and file the required information. For each subsequent reporting period, the compliance costs are substantially reduced. We also reject the claim of the private fund industry that lower earnings could result from taking managers’ time away from their core management duties because they had to address heightened legal and disclosure requirements under the Dodd-Frank Act. Kaal shows that compliance and legal functions are largely separated from management and would generally not burden management.

Lack of data does not allow us to evaluate several theoretical explanations for a negative effect of Dodd-Frank registration and reporting requirements on private fund adviser earnings. While it seems theoretically possible that fund managers changed strategy and positions or otherwise changed the management of their funds after consultation with their legal and compliance officers about the requirements imposed by the Dodd-Frank Act and SEC implementation rules, due to lack of data, we cannot evaluate a possible feedback effect between compliance reporting and the fund managers’ strategy, its positions, and diversification. If perceived or actual biases in the Dodd-Frank Act regime, communicated by legal experts, did not directly affect managers’ investing behavior, it seems possible, yet again untestable, that managers, without direct input from legal experts, desired to appear less risky or avoid additional regulatory scrutiny and changed their managerial conduct accordingly, remedying pre-Dodd-Frank Act concerns about their strategies and corresponding positions in markets. We also cannot examine if managers who could have been employing questionable practices addressed perceived issues with portfolios or strategies in light of enhanced reporting obligations in the aftermath of the Dodd-Frank Act.

Our data does allow us to evaluate the impact of strategies and the level of activity of fund managers on our results. Anecdotal evidence suggests that managers could have changed the portfolio composition post Dodd-Frank because of concerns about SEC supervision related to particular strategies and corresponding positions. We examine a possible bias within Dodd-Frank mandated registration and disclosures and possible targeting of certain strategies and positions by adjusting our research design to include an evaluation of strategies employed by the private fund managers in our sample. Recent industry publications and academic literature have shown that the performance of actively traded funds lags behind far less active management styles and strategies.  By identifying strategies in our dataset that are more prone to active trading, we examine the performance of actively-traded private funds and the possible impact on our results.

We do not claim that we sufficiently evaluated all relevant theoretical explanations for our findings. Because of lacking or insufficient data, several possible theoretical explanations for a negative effect of Dodd-Frank on private fund performance cannot currently be examined. Further evaluation of the research questions examined in this study may be possible in the future as more data becomes available.

The preceding post comes to us from Wulf Kaal, Associate Professor at the University of St. Thomas School of Law. It is based on a recent study done by Wulf Kaal, Barbara Luppi, Università degli studi di Modena e Reggio Emilia – Faculty of Business and Economics, and Sandra Paterlini, Professor at EBS Business School and Chair of Financial Econometrics and Asset Management, which is entitled “Did the Dodd-Frank Act Impact Private Fund Performance ? – Evidence from 2010-2015” and is available here.