The discussion papers released by the UK Financial Services Authority (DP053 and DP054) that have focused on the FSA's potential future regulatory stance with regard to hedge funds, have prompted a great deal of educated response from participants in the industry. They come at a time when many firms in the UK are contemplating the prospect of having to register with the SEC in the US if they are to retain valuable American client relationships. Privately, there remains anxiety, particularly amongst smaller firms, that additional regulatory burdens will be imposed on them, and how much this is going to cost.

The Alternative Investment Management Association has been at the forefront of the industry's response to these papers, and has published two detailed documents covering the issues raised by the FSA, available from AIMA at www.aima.org, or email info@aima.org. The publication of these responses followed detailed discussion between AIMA and its members.

"The level of response has been unique in my experience in AIMA, and it is the first opportunity that anyone in the UK has had to respond generally to the FSA since 2002," says Mary Richardson, associate director at AIMA responsible for legal and regulatory affairs. "It's been the first thorough review of the industry the FSA has had since then, but then our membership has also increased hugely since that time. I think a lot more people now see the merit of getting involved in such exercises. The interest also came as a result of the discussion paper itself."

AIMA has always been proactive in its relationship with the various regulators in Europe, Asia-Pacific, Canada and South Africa that have been watching the expansion of the hedge funds industry since the association was launched over 15 years ago. "We're at a very different point in the evolution of this industry than we were three or four years ago," explains Florence Lombard, executive director of AIMA.

The industry as a whole has in turn become increasingly aware of FSA scrutiny over the past 18 months: the regulator has been visiting prime brokers, for example, in an effort to evaluate counter-party risk, and has been rapidly increasing its knowledge base. There has been a great deal of interest amongst managers to see which areas the regulator would focus on. The establishment of a hedge funds supervision team within the FSA has been received well already, and it is anticipated that this will make the community's relations with the regulator much smoother and more efficient going forwards.

The FSA has also been active, along with other agencies like the European Commission, in attempting to determine the degree of risk that hedge funds might pose to the overall financial system. Its initial concerns, and those of its peers in other countries, related to the LTCM crisis and the possibility that other hedge funds might be covering a similarly dangerous position. Counter-party risk was swiftly identified as a potential problem area, resulting in the aforementioned prime broker visits. Hector Sants, managing director of the FSA, speaking at the regulator's 19 September asset management symposium, told delegates that: "It is our current assessment that the failure of or significant distress of a large and highly exposed hedge fund – or, with greater probability, a cluster of medium-sized hedge funds with significant and concentrated exposures – could cause serious market disruption."

"On the issue of systemic risk, all the reports that have been published to date have acknowledged that there is no such risk in the market today," Lombard explains. She does not rule out a crisis further down the road, but now that oversight of prime brokerage activities looks likely to increase, it should be hoped that such a budding crisis will be headed off by banks and regulators working in cohesion.

Operational risk

Admittedly, a lot of the risks identified by the FSA are not unique to the hedge funds industry. However, many hedge fund firms are still small, with limited operational resources. It is a theme which is difficult to assess accurately on an industry-wide scale, and to evaluate what level of assets are being managed by smaller firms is even harder, particularly given that most of the bigger mandates are either with the larger, more established players, or being run via funds of funds who carry out their own operational due diligence. A regulatory concern? At this stage probably not. Certainly, AIMA does not seem to think so. "Most of the managers who are members of AIMA are definitely not one or two man-band operations," Lombard says. "They are bigger operations than that. Furthermore, most of the investment into hedge funds comes from institutional investors who carry out detailed due diligence into this area."

Sants himself has focused on the risk management function of hedge funds as a potential weak spot, saying that many hedge fund managers are used to having risk management and operational support provided to them, as they frequently come from investment banks and institutional asset management companies. Developing such support when they are used to focusing purely on trading and profit generation is a difficult task, he argues. It is also the case that such firms are frequently launched with a small and concentrated staff base, which raises questions in relation to independent oversight, the 'four eyes' requirement, conflict of interest management, and other issues.

Even were the FSA to consider some degree of retail authorisation for hedge funds, which is something that has been raised in one of the current discussion papers, would operational risk become an issue? Again, AIMA feels that were retail products to be authorised for sale to the general public, it would be the larger groups, with potentially an existing retail fund management operation and associated resources, that would be interested in this market. Smaller boutique managers would remain outside that area of interest. "My feeling is that the first step would be the fund of funds route, as the better access route for retail investors," says Lombard.

AIMA is at pains to point out the distinction between the US and European industries in this regard. Operational efficiency, Lombard claims, is higher in Europe. Firms are already used to being regulated to a higher degree than they are inthe US. Checks and balances are in place that, until recently, simply did not exist to protect American investors. "We've had less problems here," she says. "The barrier for entry here is much greater. Until now there has been none in the US. Here, to manage one pound, you need to be authorised and regulated just as any other manager. It's a different world, and I think it is really important to look at it from the correct perspective. The system has worked very well here, so why change it? Like all the enlightened jurisdictions, it doesn't matter how much money you are managing – as long as you manage a cent, you have to be authorised and vetted as a "fit & proper" person qualified to manage assets. Once you have done that, you can manage money in any kind of strategy acceptable within that asset management authorisation basket. It is the countries where this kind of regime is in place where you have had less problems."

Increased participation of pension funds in the hedge fund market has to have fuelled regulatory interest in the market. Although hedge fund products are not currently available as a retail investment option, the fact is that many pension schemes in the UK already have either a degree of exposure to hedge funds, albeit small and via funds of funds managers, or are currently considering it. Going forwards, this level of diversification is likely to continue, especially as schemes come under increased pressure due to an ageing population. Although classed as institutional investors, pension funds do represent the long-term investment interests of ordinary people, the man on the street whose interests the FSA has been tasked by government to protect (indeed, DP053 is entitled 'Consumer protection in a rapidly changing world.')

"There are two very different kinds of pension funds out there," Lombard says. "You have the BTs and the Shells of this world, who have professionally managed their assets for a very long time, and have investment teams on board that can assess this kind of product; and there are other pension funds, those that have kept out of this market as they do not have the investment teams on board to assess this kind of investment. I'm not aware of any European pension fund investment in hedge funds reported as having run into any kind of trouble."

The consensus amongst those pension funds prepared to discuss their investment in hedge funds is that they have been pleased with the allocations they have made, and are preparing to increase these. Some in the US may have run into problems, but overall the feedback has been positive.

There is obviously an issue to be addressed here that balances level of risk versus the definition of what a hedge fund actually is. The FSA has outlined this in its questions regarding whether an additional layer of regulation would be required for hedge funds, but should such a layer be introduced, it would have to come up with some kind of hard and fast criteria. At the moment, there are no formally authorised hedge funds per se in the UK, as all regulation takes place at the managing company level rather than the fund level. AIMA has been at pains to point out the existence of regulatory regimes already in place in other EU countries like France, Germany, and Ireland as possible future models for the UK.

Valuations

Touched on in the AIMA response is the issue of valuations, again not unique to the hedge fund industry, but a complex topic for asset management and investment banking all the same. AIMA has already published an in-depth report on asset pricing and fund valuation practices in April 2005, and in its response to the DPs it included an annex with an in-depth explanation and evaluation of the role of independent administrators.

"There are different ways of valuing assets," Lombard says. "I think it is a question of principles and transparency around the valuation process, and as much independenceas possible. It is a very complex issue which we will be looking next year. As part of the feedback which we have received, there is the concern that there is divergence between the valuation of the portfolio and the discrepancy with what the managers feel is the fair value of the portfolio. That is also an issue which will have to be looked at very closely."

Indeed, the FSA itself has mentioned "significant risks" resulting from "weaknesses in asset valuation methodologies and processes related to skill shortages and conflicts of interest," Hector Sants himself thinks these issues are creating considerable potential for ill-informed investment decisions and detriment to market confidence.

The FSA has now received responses to its DPs, and is mulling them over. It is expected to issue feedback on both papers in February. By this time its hedge funds supervision team will hopefully be complete, and will have been in place for several months.

Conclusion

"The business is changing, the UK's approach to regulation is changing and the perception of the industry's importance to UK Plc is changing," says AIMA's Mary Richardson.

There has been increased regulatory work involved for managers over the last few years, and this has been raising the bar in terms of the reporting and compliance costs involved. Given increased regulatory scrutiny, AIMA will be reviewing its guide to sound practices for hedge fund managers and has recently published an offshore alternative fund directors' guide as well. It is part of the association's ongoing effort to work with its members towards enhancing sound practices within the industry. Explains Lombard: "We wish to bring about a more cohesive approach to this in the overall landscape."

For further information on AIMA, or to receive a copy of its detailed responses to the FSA's discussion papers, or its analysis of fund valuation practices, please contact info@aima.org