Rise of hedge funds causes concern

Date: Monday, May 12, 2008
Author: Suchita Nayar, FT.com

Hedge funds are increasingly in the public eye. They are being called upon by regulators and lawmakers to explain their workings amid the widening global credit crisis triggered last summer by the unwinding of collateralised debt obligations linked to US mortgages. Tens of high-profile hedge funds have either liquidated or are suffering widespread redemptions due to mounting losses.

“The current problems are making people sit up and think about the issues facing the industry,” says Rajiv Jaitly, the hedge funds operations chief at Axa Investment Managers in London.

Regulatory concern is also on the rise due to the escalating power of hedge funds. US Treasury Secretary Henry Paulson in his recent “blueprint” remarks put their potential market impact on a par with investment banks, insurers and retail banks.

On April 15, the US Treasury’s President’s Working Group on Financial Markets released twin guidelines for hedge fund managers and investors. Two separate private sector groups created in September 2007 prepared these reports.

Led by Eton Park Capital’s chief Eric Mindich, the Asset Managers’ Committee, comprising nine other prominent investment individuals, told managers that adopting strong business practices that reflect both industry growth and importance in global financial markets was a “crucial responsibility”. Similarly, the Investors’ Practices Committee chaired by Russell Read, the outgoing investment chief of Calpers, the California Public Employees’ Retirement System, set out an exhaustive schedule of investor and fiduciary issues.

Hailing this effort as “critically important”, attorney Elizabeth Fries, who heads the alternative investments practice of Goodwin Procter, says: “The PWG approach of focusing not only on the management of funds, but also on investor diligence, is significant. The focus on different stakeholders having an interest and a role in monitoring and shaping the industry and its practices will result in a stronger industry, and avoids sole reliance on a narrower ‘self-policing’ by only the fund managers, which would have been less robust.”

But the initiative also drew criticism from the likes of Connecticut attorney general, Richard Blumenthal, who said these guidelines did not go far enough. Amy Burrus of the Council of Institutional Investors said the Washington DC body is yet to take an official stance on these recommendations as some of its members deemed them satisfactory while others thought they fell short.

Finance expert Professor Andrew Lo of Massachusetts Institute of Technology is among the naysayers. More pension fund money pouring into hedge funds requires higher regulatory oversight of the industry. However, he expects to see a strong push from the Democrats next year to bring hedge funds under the thumb of the Federal Reserve.

The Stateside effort came on the heels of a similar initiative by the UK-based Hedge Fund Working Group, members of which now constitute the Hedge Fund Standards Board.

What these efforts will eventually amount to is still unclear, says Andrew Baker, deputy chief executive of the Alternative Investment Management Association.

While widespread adoption of these standards by industry participants may be necessary to assure regulators that enough is being done, they may still decide to create an additional layer of regulations on top, he says. He expects a clearer picture to emerge by year-end. Mr Baker was on Capitol Hill during April to discuss the role hedge funds and private equity can play in overcoming the current credit crisis.

The trade group, meanwhile, is now working to bring the two sets of guidelines into a single document, in keeping with its consistent mantra of “convergence”.

Richard Baker, chairman of the Managed Funds Association and formerly a Congressman from Louisiana, also says where the latest effort would lead the industry remains unclear.

Amid an ongoing monumental overhaul of the rules governing the US financial system, the Treasury will create a new entity called the Conduct of Business Regulatory Agency, and the extent of its control over the workings of individual asset managers and broker-dealers needs further clarity.

Still, he expects Congress to cast a broad net in the next year or two. Once a new government is in place following the US elections later this year, he expects a fresh round of Congressional hearings that in a year or two might lead to a definite outcome about the regulatory fate of the industry.

An interim remedy may be to refine the current US exemptions to the Investment Company Act used by hedge funds by adding an additional ceiling regarding assets under management, according to experts at the New York-based Regulatory Compliance Association’s CCO University. Currently, these exemptions allow for an unlimited amount of assets under management.

While the industry proposals will prove constructive, Mr Jaitly put in the caveat: “They are not a substitute for manager due diligence. There’s no such thing as a shortcut when it comes to operational due diligence.”

The industry could also benefit from cross-border co-operation between the UK’s Financial Services Authority and the Securities and Exchange Commission in the US, experts say. But the likelihood of that happening is a work in progress as both countries have varying rules.The FSA requires managers to register while a similar move by the SEC was legally overturned in the US.

“Cross-border co-operation among regulators is the only format to bring everyone up to the same knowledge level on the key areas of fiduciary and investor protection,” says Joe Seet, senior managing partner at London compliance consultancy Sigma Partnership. “However, as domestic agendas and expectations of regulators are quite varied, this will not be easily or speedily achieved.”