By CHUCK JAFFE
The one thing that might have allowed convicted felon Bernie Madoff to run his phony hedge-fund business even longer in the face of an eroding stock market is successful advertising.
With his reputation -- which was sterling right up to the moment it was tarnished -- the public would have beaten a path to his door if Madoff had been allowed to roll out the general welcome mat as his crisis was coming to a head.
You could also argue that public advertising would have led to scrutiny which might have uncovered the whole scam sooner.
It's a hypothetical debate with real consequences, because a largely unnoticed provision of the Jumpstart Our Business Startups (JOBS) Act signed April 5 by President Obama allows hedge funds to market themselves to the portion of the general public that qualifies to invest in private-equity pools.
Markets and marketing
Hedge funds and other private investment vehicles are not required to provide the same kind of disclosures -- or adhere to the same risk restrictions -- as traditional mutual funds. The trade-off for that freedom is they were not allowed to do any real marketing and could only work with experienced, high-net-worth investors.
The provision in the JOBS Act presumably was approved because investments in hedge funds can help to fund businesses that will create new employment opportunities. It's also why the new law changes rules over micro-financing done through a process called "crowd funding" that makes small-scale private-equity deals available to a much wider section of the public.Read more about concerns over crowd funding here.
Hedge funds still won't be for the masses, as they will still be a haven only for "accredited investors" -- currently defined as people who can prove they make more than $200,000 or have at least $1 million in investible assets (those rules will be revised again in 2014).
These funds will, however, be much more accessible. Currently, many hedge fund managers won't even allow basic details on their own websites -- much less talk to the media or discuss investment strategies -- for fear that anything they say can be seen as a solicitation and, thus, against the rules.
But advertising changes the hedge-fund game.
While average investors think of hedge funds as high-powered vehicles for the rich, the truth is that many hedge funds fail every year. That's not surprising, because the hedge-fund structure is slanted to the manager -- who typically takes 2% off the top and keeps 20% of the profits the fund generates -- so much that shareholders have little patience when an issue falls short of expectations. It is common to reach the end of a lock-up -- hedge fund investors typically must stay with the fund for a certain period and can only withdraw funds at set or specified times -- and shareholders demand their money back and basically shut down the fund.
Critics of the new law are concerned that marketing to the general public will attract people to investments that carry too much risk for the average person with sufficient wealth to qualify for entry.
Truthfully, the best hedge-fund managers most likely won't have much reason to advertise. Private funds operate with a limit on how many shareholders they can have -- though the JOBS Act also expanded that number -- and they would rather attract big-dollar institutions than millionaire-next-door types.
But advertising takes many forms. While the public thinks of it as general media, it can be different; the relaxed rules mean that broker-dealers at investment banks will be able to openly pitch a private equity firm's latest hedge fund, complete with glossy pamphlets (and maybe lunch).
That's where the concern is, that consumers who are interested in using hedge funds will fall for a slick sales pitch, especially from funds with unproven track records and the greatest need to attract new cash.
"To get to the great hedge fund managers, you have to be a significant player," said Geoff Bobroff, a fund industry consultant in East Greenwich, R.I. "Those managers don't need to advertise to attract money and, if they do, it would make you wonder if they were in trouble."
With that kind of advertising, investors will be best served by ignoring what they see.