Law closes in on hedge funds

Date: Sunday, April 22, 2007
Author: The Sunday Times

The US industry is courting politicians with donations to ward off stricter regulation, writes Dominic Rushe from New York

RUDY GIULIANI has Paul Singer, founder of Elliott Partners. Hillary Clinton has Lisa Perry, wife of Richard Perry of Perry Capital. Barack Obama has George Soros, although Soros is hedging his bets and may switch to Clinton.

Fund raising for the 2008 American presidential election is in full swing, and this time titanically rich hedge-fund managers are working overtime to push cash and contacts towards their favoured candidate.

With notable exceptions - Soros spent about $27m (£13.4m) trying to stop President George Bush’s reelection - most hedge-fund managers have been happy to ignore Washington as long as Washington ignored them. Now times are changing.

The lightly regulated hedge-fund industry has some powerful supporters in Washington. But as the industry gets ever larger and more high profile, so do the chances it will soon attract greater regulatory attention.

During the 2006 election cycle, executives at the 30 biggest hedge funds made $2.8m in contributions to political candidates or party committees, almost double the amount in 2000, according to the Centre for Responsive Politics (CRP), a nonpartisan group that monitors political donations.

“The hedge funds are increasingly concerned about the threat of regulation. What better way to preempt that than to give money to those that might regulate you,” said Massie Ritsch of the CRP.

Hedge funds have been in existence in some form since after the second world war. The latest and greatest chapter in their history started after the dotcom-led stock-market crash in 2000.

Last year, America’s financial watchdog, the Securities and Exchange Commission (SEC), estimated there were 8,800 hedge funds, with about $1,200 billion of assets in the United States.

“If this estimate is accurate,it implies a remarkable growth in hedge-fund assets of almost 3,000% in the past 16 years,” said SEC chairman Christopher Cox in testimony to the Senate committee on banking, housing and urban affairs.

Cox said that although hedge funds represent only 5% of all American assets under management, they account for about 30% of all American equity-trad-ing volume.

It’s a trend that has yet to find its upper limit. In the first three months of this year, hedge funds globally attracted $60 billion in new money, almost half the total amount they raised in all of 2006, according to Chicago-based Hedge Fund Research.

Traditionally, hedge funds have catered to the rich, but smaller investors can be exposed through the holdings of pension funds, and the lower tiers of the well-off are clamouring for a piece of the action - a phenomenon known as “retailisation”.

Many in the industry doubt retailisation will become a reality - the SEC is moving to block any such move. But few doubt that the vast holdings hedge funds have in everything from commodities and equities to currency and property mean they have a huge influence on the markets and the economy at large.

To date, they have managed to avoid burdensome regulation, but despite powerful allies in Washington, as the size and profile of the hedge-fund industry grow so does political scrutiny.

Already a number of pieces of legislation are being aimed at the industry. Congress is discussing limits on the amount that private-pension funds can invest in hedge funds, a move aimed at protecting pensioners from the potential fallout from a hedge-fund collapse.

The SEC has proposed a rule to increase the amount of money hedge-fund investors have at their disposal to ensure they are able to handle potential loss.

Last year, an SEC rule requiring hedge funds to register as investment advisers was thrown out by the courts. Republican senator Charles Grassley has been trying to reinstate it. He has also claimed the SEC is failing to root out illegal insider trading by the funds.

Other lawmakers are considering legislation that would raise the taxes on the profits that hedge funds earn on their deals.

No wonder the hedge-fund industry is increasingly interested in politics.

A year ago, the Managed Funds Association (MFA), a Washington-based hedge-fund lobbyist, had seven employees. Now it has 14. Jack Gaines, MFA president, said: “Five years ago, if I wanted to read a story about hedge funds I would have had to look it up on Google. Now they are on the front page.”

He said that the private nature of hedge funds had meant they had not always been keen on engaging politicians in debate. Now he said it was important that politicians were educated about the nature of the industry.

The hedge-fund industry has changed enormously since its beginnings.

Alfred Jones, a former Fortune magazine writer, is credited as the first hedge-fund manager. He left the magazine in 1948 and raised $100,000 to set up a fund that aimed to minimise the risk of holding long-term positions by short selling other stocks. Jones also introduced a 20% incentive fee for the managing partner. The idea was a success, and by 1968 there were 168 hedge funds in operation.

The number of funds and the amount of money they could attract really took off after an amendment to the Investment Company Act in 1995. Before Section 3(c)7 was introduced, hedge funds were allowed just 100 investors. The new 3(c)7 funds could attract as many qualifying investors as they liked to funds that were lightly regulated and could pay their managers huge performance fees.

Fund managers left big-name brokers and banks in droves, inspired by the likes of Julian Robertson’s Tiger Fund and its double-digit returns. Hedge funds had now become far more complex, using evermore esoteric strategies and investing in complex financial instruments, such as derivatives.

The most famous was Long Term Capital Management (LTCM) set up in 1994 by John Meriwether, former vice-chair-man and head of bond trading at Salomon Brothers. Myron Scholes and Robert Merton, who shared the 1997 Nobel prize in economics, sat on LTCM’s board, and initially all this brain power paid off with the company making annual returns of more than 40%.

Then, in 1998, as the markets turned, LTCM lost $4.6 billion in less than four months. Had the Federal Reserve Bank of New York not organised a $3.6 billion bailout, the bankruptcy of LTCM “could have potentially impaired the economies of many nations, including our own”, said Alan Greenspan, then chairman of the Federal Reserve.

In 2000, Robertson’s Tiger funds, which at their height had managed $22 billion in assets, were also shut down.

After the dotcom bubble burst taking the stock markets with it, many top financiers were attracted to hedge funds that, like the equally prosperous private-equity firms, were under far less scrutiny than the then troubled mainstream financial world. Low interest rates and poor stock-market returns proved a golden opportunity for the industry as money poured in.

But the latest batch of hedge funds have had their problems too. Last September, one fund, Amaranth, collapsed after losing $6 billion in a single week on gas futures. Among its losers were the San Diego County Employees Retirement Association.

In March the FBI brought charges against more than a dozen people, including former executives at four of Wall Street’s top firms, over improper trades with hedge funds.

With so much money at stake and so many firms competing, the incentive for wrongdoing is enormous, said David Chaves of the FBI’s securities fraud squad.

“That type of activity is very seldom discovered. How many other times and places has it gone on? This is a very slippy slope unless we get hold of it," he said.

David Tittsworth, executive director of the Investment Adviser Association, which represents SEC-registered invest-ment-adviser firms, said: “I’m amazed that hedge funds aren’t already more tightly regulated.”

“Hedge funds are becoming increasingly mainstream. I’ve had members tell me there is almost an ‘irrational exuberance’ among investors who want hedge funds as part of their investment strategy. It seems to me the evidence is clearly there to show they can have a negative impact on the economy as well as on individuals if things go wrong. Look at LTCM.”

Last February, the president’s working group on financial markets, set up after the collapse of LTCM, rejected further regulation and said the industry should instead follow voluntary guide-lines. Ben Bernanke, Federal Reserve chairman and a member of the working group, has also recently supported that view.

Tittsworth said he feared greater regulation would only come after a major disaster. “There’s some intent out there but no critical mass,” he said.

Gaines, too, said hedge funds feared regulation being thrust on them after a disaster, but argued that the industry was working hard to address its own shortcomings and weaknesses.

“It’s always a risk. I’d like to think we’ve been able to educate the regulators and Congress about the utility of alternative investments,” he said.

The danger, said Gaines, is that the industry could be punished for its success. Big pension funds are turning to his members for the returns they offer and are fully aware of the risks.

“Is that to say one can’t blow up and one day some pension fund is going to lose some money? No. If that didn’t happen I’d be surprised.”

He added that most hedge-fund investors are institutions and financially sophisticated individuals who know the risks. “Without risk there is no reward,” he said.