Cutting the global hedge fund industry down to size

A welter of proposals for regulation and controls suggests that the era of free-wheeling hedge funds might be coming to a close. That in turn is likely to rein back an industry that has produced above average returns for wealthy investors and institutions.

The spectre of systemic risk, where the failure of one part of the financial system spreads outwards to the entire entity, haunts regulators of this $1,200bn industry.

An attempt by the UK Financial Services Authority (FSA) to slip in some regulation through the back door showed the industry the direction the national authorities were taking to extend their reach. This regarded rules governing the disclosure of ‘side letters’ (documents that selectively favour one investor over another). In fact, an industry revolt was mounted and the regulator retreated. But the writing of regulation was on the wall.

A further initiative to clip the wings of the managers was launched in the middle of December 2006 when the European Central Bank started to campaign for an international “highly leveraged institutions” credit register containing centralised information on the exposures of “all significant regulated firms” to hedge funds.

Concern about regulatory creep is present in the American community, where the Securities and Exchange Commission (SEC) passed a regulation significantly tightening the law concerning the registration of hedge fund managers. Again, intense industry feeling prevailed, in this case through the conduit of a successful appeal to the courts by Phillip Goldstein, a New York-based hedge fund manager. This struck down the SEC’s new rule.

Regulatory fightback

The SEC made clear that it would not take the Goldstein ruling lying down. SEC chairman Christopher Cox insisted after the judgment: “The commission is moving aggressively on an agenda of rulemaking and staff guidance to address the legal consequences from the invalidation of the rule.”

Mr Cox is proposing a new anti-fraud rule under the Investment Advisers Act that would have the effect of “looking through” a hedge fund to its investors. Mr Cox says: “This would reverse the side-effect of the Goldstein decision that the anti-fraud provisions of the act apply only to ‘clients’ as the court interpreted that term, and not to investors in the hedge fund.”

Mr Cox also says the SEC is considering an increase in the minimum asset and income requirements for individuals who invest in hedge funds.

For all the regulatory bluster, evidence that the industry is at serious risk of meltdown is sparse. The failure of Long-Term Capital Management (LTCM) in 1998, when the value of investments collapsed, raised fears that the entire banking system would be damaged. Regulators went into a tail spin and the Federal Reserve was forced to support the banking system. It facilitated the private sector recapitalisation of LCTM by the creation of a ‘consortium’ of 14 creditor banks and securities firms.

The system was recently tested by a major loss at the hedge fund called Amaranth Advisors. This is reported to have lost $6bn in a week, after a bet taken on natural gas-based commodities went wrong. The speed of the loss and the apparent deviation from the fund’s claim to be a debt-based investor shocked regulators in the sector.

Absorbing fall-out

But again, internal controls were sufficient to keep the system working efficiently. The industry prides itself on the comparative ease with which it has absorbed Amaranth’s losses. One observer notes that Amaranth’s losses left funds, on the other side of the transaction, enjoying profits. According to the Alternative Investment Managers Association: “Any major fund running into difficulties is unhelpful but Amaranth’s losses had a relatively small impact on the market, which is a reflection on the size and maturity of the hedge fund industry. While Amaranth’s investors made losses, others subsequently made gains on the same positions, so there was an element of balance about the whole process.”

Darren Fox, a partner at London-based law firm Simmons and Simmons, says: “Amaranth shows that when something goes wrong, there is no real crisis. There were still assets there after the natural gas assets have been settled. Investors didn’t get back much of their investment but it wasn’t insolvent and the market coped.

“A lot has happened since LTCM. The biggest concern is that if a fund gets into trouble, there will be a massive sale of assets into the market and that depresses prices on collateral sold and other firms go bust. A death spiral occurs. The evidence of Amaranth is that doesn’t happen.”

London regulators take a sanguine view of failure risk. Andrew Shrimpton, the FSA manager responsible for hedge funds at the FSA, says: “We are not a zero-failure regime. Our remit is to ensure they have the controls to deal with their risk.

“We regard hedge fund investors as being more sophisticated than retail investors. The volatility of the funds is not a regulatory issue. There are certain strategies where the valuation of complex or illiquid instruments poses a greater risk to our objective. It’s not the FSA’s job to stop investors losing money. That’s not our remit.”

The top 25 UK hedge funds are subject to surveillance from the regulator. The FSA says it has relationships with these funds where it sounds out responses to its new recommendations and rules for doing business. Such relationships are inevitably respectful. The FSA would be loath to jeopardise this industry, which employs many tens of thousands of highly qualified and wealthy UK taxpayers.

London has created a very attractive base for managers of $317bn in June 2006, some 80% of total European assets under management and a quarter of the world’s total market. The economic fall-out from a major flight of funds offshore would be dramatic.

While more managers are based in the US than in London, the FSA believes that the US has been losing market share to London.

London’s style seeks to avoid confrontation. Mr Shrimpton says: “We are in a position where we are raising the game in London. We are not having to raise the game a long way with this good practice guidance. Most of the firms were doing most of the points already. We are seeking to raise the level of compliance.”

The regulatory soft-touch was demonstrated in 2006, when London hedge funds mounted their first industry uprising over efforts to rein back an accepted industry practice. This told the hedge fund world that London funds would fight for their secrecy and privileges, even while the rest of the hedge fund world was suffering regulatory intrusions.

City snooping

The confrontation occurred when the FSA sought to open up the privileged relationship that the hedge fund offers its key investors. These privileges take two forms. First, investors may be offered a reduction in fees they pay the manager. Second, they may allow the investor a right to override constraints on the timing for redeeming investments. For example, many funds permit redemption only every three months, but some investors may be allowed to redeem every month. This allows them to respond more quickly to adverse events, such as the departure of a key manager.

The detail of these privileges are contained in ‘side letters’, which are additional to the standard fund agreement with its investors. Only the investors who receive the letters know they exist and know their content, but regulators have long sought to bring some light on the process. The side letter expressly favours one investor rather than another and thus concerns the regulator looking after the interest of all investors. So in March 2006, the FSA produced a document requiring fund managers to disclose the number of side letters they had in force.

The industry saw red. Mr Fox of Simmons and Simmons says: “The side letters issue is an example of how they got it very badly wrong.” He cites two key objections to the move. The first, and more important, concerns a breach of principle. The second alleges FSA naïvete in communicating the change to the industry. The FSA omitted it from its 2005 consultation document, but later included it in the final document.

The point of principle rests on the critical legal divide in a hedge fund’s structure between the jurisdiction of the fund itself, which is typically Cayman, and the jurisdiction of the managers, which is typically London, at least as far as an FSA-regulated fund is concerned.

Jurisdictional wrangling

The Cayman fund, which is subject to different legislation, issues the side letter to the investor. The extent of involvement by the London-based manager is a mute point, but lawyers say the FSA has no jurisdiction over its content or procedure involved in issuing side letters. The FSA was thus operating out of its remit in seeking to have the letters disclosed.

Mr Fox says: “The relationship between the fund manger and the investors in the fund is not a client relationship, for the purpose of FSA rules. It therefore falls out of the scope of regulation. The manager’s client is the fund, the underlying investors are not the client. FSA rules apply to the FSA-regulated manager and its clients. The investors are not clients. The fund is the client. This was an attempt to regulate the relationship between the fund manager and people who are not its clients, the investors. That is a worrying step.”

An industry rebellion was orchestrated by the Alternative Investment Managers Association (AIMA). This forced the FSA to modify its demand, and limit the disclosure requirement to those side letters “with material terms”.

Mr Shrimpton argues that managers and regulators have improved levels of practice as a result of the confrontation. “We have said that the non-disclosure of certain kinds of side letters, especially those giving preferential liquidity, is in breach of Principle One [the FSA principle of doing business which requires managers to act with integrity]. We have worked with the trade body to help managers to avoid breaching Principle One.

“The managers are disclosing whether they have side letters with material terms, so their investors can be aware of that and ask further questions. We are leading the world in our approach to this. It has been a successful collaboration to raise standards of collaboration to an appropriate level. Certain types of side letters with certain terms must be disclosed, in particular those that grant investors preferential liquidity terms or that grant preferential disclosure and allow you to act on that disclosure.”

Joe Seet, senior partner at Sigma Partnership, a hedge fund compliance and advisory firm, says the FSA acted legitimately in prising open a key conflict in the governance aspect of hedge funds, namely that between the London-based manager and the Cayman-based fund directors. “Some lawyers say it is an independent decision as to who issues the side letter, but everyone knows that is not the case. The FSA knows the investment manager has a contributory role to the side letter, although the decision is the ultimate responsibility of the fund directors and the FSA recognises it has no jurisdiction over offshore funds.

“The FSA is also very savvy, in that some fund managers are not as independent as they should be and may have disproportionate influence on the fund directors.”

The FSA’s light touch regime is not universally admired, even among hedge fund managers, who are its beneficiaries. One risk manager spoke on condition of anonymity about a welter of abuses that makes the hedge fund sector vulnerable to meltdown. He describes Ponzi schemes, mis-marking of asset values and parking of assets by hedge funds to protect their backs.

“An implosion is about to hit us, because of the leverage that is built into the system. There is a dangerous combination of credit and illiquidity. People are so driven by making money that they are throwing out all prudential criteria.”

Beware the meltdown

The behaviour of hedge fund managers who have investments in their portfolio listed on the Alternative Investment Market attracts his particular ire. Managers are remunerated by the value of their portfolio but when stocks are illiquid, valuation is prone to compromise and inaccuracy. The FSA estimates that some 20% of all stocks in hedge fund portfolios are illiquid. Third-party administrators serve as some safeguard but they have no mandate to produce an independent valuation.

According to this manager: “Valuations can be quite random. When you have an inherently illiquid instrument, you give it a daily liquidity and perhaps a monthly liquidity. There are so many funds out there that have net asset values [NAVs] which are based on inherently illiquid and inherently mis-marked assets.”

This manager calls for tighter regulation by the FSA of funds whose performance exceed expectation as well as those that under-perform. “When we make money, nobody questions us. My volatility is supposed to be 12% so I should make 0.75% in a day. If I make 5%, you should question me. When you make money, you should be questioned. When you lose money, everyone is over you like a cheap suit. If you don’t question people when you make money, you deserve to lose money when it blows up. Regulation will become a hot topic. The pendulum will swing from no regulation to over-regulation.”

This view of the industry is vehemently contradicted by Mr Seet. “Regulators are not responsible for monitoring a fund’s ‘style drift’ or volatility divergence. It is up to the fund directors and the investors to ensure the manager provides enough portfolio and performance details. A manager who actively trades his fund with daily profit and loss swings will not find his investors very tolerant.”

Mr Shrimpton confirms Mr Seet’s scepticism. “Window dressing is an accusation that has been made against the whole investment management industry and not just hedge funds. It is going to be for a very short period at the year end. We haven’t found evidence of that. It is only a temporary thing and would correct itself very quickly.”

The third-party administrator is a key control in ensuring Europe’s relatively freedom from scandal and abuse, says Mr Shrimpton. “The risk is that managers who are under-performing or feel under pressure may be tempted to overstate the valuations they provide to the administrator. We have had similar problems in the UK as in the US.

“They have had a number of scandals in the recent past, we have had hardly any, partly because we have independent third-party administrators.”