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Hedge funds stand to gain, but also face oversight

Date: Tuesday, March 31, 2009
Author: Stevenson Jacobs, Businessweek.com

Hedge funds are being offered a sweet deal to help the Obama administration rescue the U.S. banking system: A low-risk opportunity to scoop up soured bank assets that could one day make them a killing.

But the deal could make for an uneasy partnership.

The government also wants to closely police hedge funds, some of which have been accused of placing irresponsible bets that helped trigger the financial crisis. Such regulatory overhaul could reshape an industry known for secrecy and little oversight.

"It's certainly problematic because we don't know where the current political fervor is going to end up," said Kjerstin Hatch, portfolio manager for Madison Capital Management, a $550 million hedge fund specializing in distressed assets.

Several big investors have already voiced interest in joining the administration's effort to buy up banks' bad assets. That task is considered crucial to propping up teetering banks, restarting lending and ending the recession.

But with anti-Wall Street critics seething in Washington and elsewhere, Hatch and other hedge fund managers say they want assurances that they won't be hit with heavy-handed restrictions if they were to take part in the bank-rescue plan.

"You don't want to paint a bulls-eye on your back," said Steven Persky, managing partner of Dalton Investments, a Los Angeles hedge fund that's already invested $400 million in toxic mortgage-backed assets. He wants more details on the government's plan.

"The potential returns are attractive, but you have to be aware, more than ever, about the regulatory risks," he added.

Hedge fund insiders expect the reforms to be the most sweeping since the high-flying and thinly regulated industry's birth two decades ago.

"The era of lack of regulation for hedge funds is over," said Sol Waksman, founder and president of Barclay Hedge Ltd., a firm based in Fairfield, Iowa, that tracks and invests in hedge funds. "The question is how intrusive will the new rules be."

Strict rules would be a new experience for hedge funds, which are large investment pools that cater mainly to the rich. They've long toiled in Wall Street's Wild West.

With high-tech trading models and a gambler's instinct, hedge funds have generated outsized paydays that dwarf those of other investment funds. They've also swelled the ranks of the world's billionaires, making stars out of top fund managers including John Paulson and George Soros.

Unlike mutual and money market funds, hedge funds don't have to register with the Securities and Exchange Commission. That means they don't have to disclose such details as who runs the fund, how much money they manage and what securities they buy.

Hedge funds have fended off past attempts to regulate them. They sued, for example, to overturn an SEC push to register them in 2005. Today, hedge funds are barred only from advertising or courting investors worth less than $1 million or a yearly income of $300,000.

"Basically, nobody regulates hedge funds today," said Nadia Papagiannis, a hedge fund analyst at research firm Morningstar.

That seems sure to change.

The Obama administration is pushing the idea of a regulator-in-chief. That role might be given to the Federal Reserve -- to oversee and, if necessary, take over nonbank financial entities like hedge funds and private equity groups whose failure could upend the U.S. banking system.

Treasury Secretary Timothy Geithner, who is expected to detail the overhaul plan soon, last week urged Congress to enact legislation that would give the government sweeping oversight power.

"One of the key lessons of the current crisis is that destabilizing dangers can come from financial institutions beyond banks, but our current regulatory system provides few ways to deal with these risks," Geithner said during a speech in New York.

The push for reforms coincides with the administration's revamped financial rescue plan. It seeks to entice hedge funds and other investors to buy banks' toxic assets so they'll start lending again.

The plan uses cheap government financing to offer would-be buyers of toxic assets the potential for juicy double-digit returns. Taxpayers are left to shoulder most of the risk.

Hedge funds could sure use the business. A record 1,471 hedge funds -- or nearly 15 percent of the industry -- closed in 2008, with half of them vanishing in the fourth quarter alone, according to Hedge Fund Research. The average hedge fund lost 18 percent last year.

But not all hedge funds fared poorly.

The top 25 highest-earning hedge fund managers got paychecks totaling $11.6 billion last year, industry magazine Alpha announced last Wednesday. The top spot went to James Simon, who took home a cool $2.5 billion.

Some worry that onerous government regulation could bring an end to the good times.

Critics of hedge funds have called for tighter rules on everything from how much the funds should be allowed to borrow, to what kind of securities they can trade and what information they must disclose publicly.

Such reforms are designed to tame what some see as hedge funds' gorilla-sized influence on financial markets. Last year, hedge funds were blamed for causing huge gyrations in the stock market and oil's record run above $140 a barrel.

The hedge fund industry says there's no evidence to support such claims.

"We want to dispel, once and for all, this misconception that the hedge fund industry is opaque and uncooperative," Andrew Baker, chief executive of Alternative Investment Management Association, a hedge fund lobby group, said in a statement.

His group pledged to support calls for more hedge fund transparency. But it hasn't endorsed more stringent reforms sought by some investors.

Many argue that fees charged by hedge funds are out of whack and should be changed. Hedge funds typically charge investors a management fee equal to 2 percent of their assets and a performance fee equal to 20 percent of profits. That's several times the fees charged by mutual funds and most other investment firms.

That fee structure, critics say, disproportionately rewards hedge fund managers in good times while disproportionately hurting their investors in bad times, such as last year's market crash.

"The incentives are completely misaligned," Morningstar's Papagiannis said.

Others caution against over-regulating the industry, saying it could backfire and undercut the government's financial rescue plan.

"You don't want irrational regulation," said Thomas Donaldson, professor of legal studies and business ethics at the Wharton School of the University of Pennsylvania. "Hedge funds know how to trade toxic assets, and that expertise is helpful right now."