This article dissects both the origins and resulting harms of what the author terms the "hedge fund conundrum," in which institutional investors, such as pension plans and endowments, have consistently increased hedge fund allocations over the past decade despite pervasive evidence of excessive fees and subpar returns. It then utilizes an historical institutionalist lens to examine how lawmakers may have enabled a conundrum of this magnitude. By and large, this phenomenon is a symptom of regulatory loopholes that have permitted the private hedge fund market to increase in "publicness" through its expanding access and subsequent harm to retail investors. Such investors are now indirectly exposed to hedge funds through pension plans and endowments, without receiving the investor protection guarantees under the federal securities laws. Subsets of historical institutionalism, such as "conversion" and "drift," provide useful rubrics in analyzing how the law has evolved in this regard. In terms of conversion, lawmakers initially converted concepts of publicness through administrative regulations and court rulings that expanded indirect retail investor access to private investments. With respect to drift, lawmakers then failed to update these amended definitions to accommodate evolving notions of publicness brought about by financial innovation and changing market conditions.
An examination of this nature is novel in this area of the law and it provides a useful guidepost for exploring well-tailored solutions that concede the unlikelihood of subjecting hedge funds to direct regulation. Such a solution would therefore rely on conversion to effectively create a regulated market for "hedge-fund-like" strategies. This would entail loosening (but not eliminating) the section 18 capital restrictions that currently apply to mutual funds. Loosening these restrictions would allow pension plans and other institutional investors to access essential opportunities for wealth maximization, particularly during declining markets, in a transparent market that is subject to extensive regulation. If, however, pension plans and other institutional investors continue to allocate to hedge funds in an inefficient manner, Congress should then consider more drastic measures, such as completely excluding such investors from accessing private investment funds by amending elite investor definitions provided under federal securities laws.
Cary Martin Shelby, How Did We Get Here? Dissecting the Hedge Fund Conundrum through an Institutional Theory Lens, 74 Bus. Law. 735 (2019).