September 5, 2007
Black Market Capital
Last Friday, the Wall Street Journal ran an interesting article on the large number of individual investor comments the SEC is receiving for its pending rule proposal to raise the wealth requirements for investment in hedge funds and private equity. Apparently, the bulk of these comments criticize the SEC for depriving these investors of the opportunity to invest in hedge funds and private equity. These investors rather want unrestricted access to these investments. The article was fortuitously timed as I have just finished up my summer writing project -- Black Market Capital -- which touches upon this subject and argues for just such investor access (download the article on the SSRN here). I'll be presenting parts of this article to the securities reg. section meeting at AALS in January. Here is the abstract:
Hedge funds and private equity offer unique investing opportunities, including the possibility for diversified and excess returns. Yet, current federal securities regulation prohibits the public offer and purchase in the United States of these investments. Public investors, foreclosed from purchasing hedge funds and private equity, instead seek to replicate their benefits. This demand drives public investors to substitute less-suitable, publicly available investments which attempt to mimic the characteristics of hedge funds or private equity. This effect, which this Article terms black market capital, is an economic spur for a number of recent capital markets phenomena, including fund adviser IPOs, special purpose acquisition companies, business development companies, structured trust acquisition companies, and specialized exchange traded funds all of which largely attempt to replicate private equity or hedge fund returns and have been marketed to public investors on this basis. Black market capital has not only altered the structure of the U.S. capital market but has shifted capital flows to foreign markets and engendered the creation of U.S. private markets such as Goldman Sachs' GSTrUE. This Article identifies and examines the ramifications of black market capital. It finds this effect to be an irrational by-product of current hedge fund and private equity regulation, one that is likely harmful to U.S. capital markets. A solution is to restore equilibrium in U.S. markets and enhance their global competitiveness by amending the Investment Company Act and Investment Advisers Act to permit public offerings of hedge funds and private equity funds. Though further study is warranted, the economic benefits of such a regime prospectively outweigh objections previously raised by regulators and others. Current market volatility and distress does not affect this conclusion. Black market capital is also an example of the unintended effects of regulating under the precautionary principle and difficulty of regulating in an era of market proliferation.
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