Hedge funds and private equity offer unique investing opportunities, including the possibility for diversified and excess returns. Yet, current federal securities regulation effectively prohibits the public offer and purchase in the United States of these hedge fund and private equity 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, hedged mutual funds 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 non-U.S. markets and engendered the creation of U.S. private markets. 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 likely harmful to U.S. capital markets. These are external costs inherent in the current regulatory scheme which the SEC has not recognized. The SEC should consequently undertake a thorough costbenefit analysis of its hedge fund and private equity regulation. Based on the available evidence, such an analysis is likely to conclude that the benefits of a regulatory scheme permitting the public offer of hedge funds and private equity funds as a component investment of a diversified portfolio not only exceed its costs but is superior to current regulation.

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