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The Next Hedge Fund Asset Bonanza

A proposal passed by the House could unleash billions of dollars in pension money.

The U.S. House of Representatives recently passed a little-noticed bill that could make it a lot easier for hedge funds to attract money from pension plans. The consequences could be meaningful, as pensions are by far the largest investors in hedge funds.

"It's a significant proposal. It would make it easier for hedge funds to raise substantial amounts of capital from pensions," says William A. Schmidt, a partner at law firm Kirkpatrick & Lockhart Nicholson Graham. "It is perceived as very good news by the hedge fund industry."

Although only a few hedge fund institutions lobbied for the bill, most are very supportive of it, another lawyer says.

The bill would also apply to funds of funds.

"No doubt the bill, if passed into law, will have the potential to increase the size of the hedge fund market. It would change the financial markets altogether," this lawyer says.

Under the proposal, a hedge fund that has less than half of its assets sourced from U.S. corporate pension plans wouldn't be subject to the stringent Employee Retirement Income Security Act (Erisa) of 1974, a set of rules that protect workers' retirement assets by limiting the flexibility of fiduciaries in how they manage the money. Today, the threshold is 25%.

The bill, called Pension Protection Act, was passed by the House Dec. 15. It was sponsored by Rep. John Boehner, R-Ohio, chairman of the House Committee on the Education and the Workforce.

This legislation is still pending because the Senate and House have yet to reconcile it in conference. A conference committee could meet as early as February, says one Washington official who is familiar with the bill. But some lawyers speculate that the committee will be pushed off until early spring. "I heard different things. At this point, it's anybody's guess," one lawyer said.

The bill sponsors want to raise the threshold over which hedge funds are subject to Erisa rules to 50% because they viewed 25% as low and restrictive, says the Washington official.

Other restrictions would also be relaxed. Under current law, pension plans that are not subject to Erisa -- such as government, state or foreign plans-- count toward the calculation of the 25% test, making it difficult for investment managers to stay below the threshold. As a result, most hedge funds have limited the amount of pension money they take in.

For example, let's take a billion-dollar hedge fund with a total of $250 million in pension assets. About $10 million of the pension assets come from

General Motors

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plan governed by Erisa and $240 million come from

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, a foreign plan. Since the combined amount is $250 million, the manager is treated as a fiduciary for the General Motors money, meaning he is subject to Erisa.

The bill proposes to exclude from the calculation of the new threshold those plans that are not subject to Erisa. In the former example, only 1% would be counted toward the 50% threshold.

Raising the percentage test to 50% from 25% and easing the Erisa calculation would make it much easier for managers to accept pension assets.

For hedge funds, that would be big news. Although pensions don't allocate as much to hedge funds as foundations and endowments, their massive volume of assets represents a sought-after market. A typical first foray into hedge funds may be as high as 10% of the pension's assets. With pension plans controlling hundreds of billions of investable assets, the stakes are huge for hedge funds and funds of funds.

New doors would open -- doors that have so far remained shut.

"Hedge funds do whatever they can to avoid Erisa," says a veteran industry executive.

"Hedge funds have held less than 25% of their assets in pension money in order to avoid being subject to the Erisa rules," says Don Carleen a partner in the executive compensation and employee benefits group of Fried, Frank, Harris, Shriver & Jacobson.

It is not uncommon for managers to allow pension assets to rise to 24.9% of their total. "They don't want to be bothered. Especially the well-established and top hedge funds will reject pensions," says another attorney.

So what's the problem with Erisa?

First, Erisa rules prohibit fund managers from conducting transactions with third parties involved with the plan. For instance, a pension may be dealing with several brokers. The hedge fund is prohibited from doing business with the brokers. The tracking of those third parties can be a due diligence nightmare for hedge funds, especially if they have several pension investors and if the parties are brokers.

Another way hedge funds have avoided Erisa, although it is less common, says Carleen, was to take on only non-Erisa money, such as public pension plans and foreign pension plans.

But whether they capped pension money to 25% or eliminated Erisa plans altogether, the result was that pensions grew more and more frustrated as they were being denied access to some pretty powerful hedge funds or funds of funds.

"A lot of pension plans view hedge funds as a very appropriate means of investing, and a lot of pension money has been looking for ways to invest in hedge funds. But so far, those rules have prevented them to invest in hedge funds," Carleen says.

Indeed, more often than not, consultants recommend that their pension plan clients diversify and hedge their portfolio via alternative investments.

"This bill will be beneficial for the industry all across the board," says the head of a multibillion-dollar fund of funds.