AXA IM Roundtable: the Future of the Hedge Fund Industry

Can the industry rebuild trust and confidence?

Originally published in the July 2009 issue

In late May, AXA Investment Managers hosted a roundtable discussion to discuss the future of the hedge fund industry. Over the course of 90 minutes the panel presented their views and answered questions posed by some two dozen journalists assembled from across Europe. The panel also assessed what the hedge fund industry needs to do to regain the trust of investors and considered the impact of the European Commission’s proposed Alternative Investment Fund Managers Directive.

From AXA Investment Managers Chris Manser, Global Head, Fund of Hedge Funds, and Arnout Snouck Hurgronje, Director, Alternative Investments, hosted the event. The other panellists were Antonio Borges, chairman of the Hedge Fund Standards Board and Henry Kenner, Chief Executive, of Arrowgrass Capital Partners.

What follows is an abridged transcript featuring the main talking points of the discussion.

Panel participants

AS: Arnout Snouck Hurgronje, Director, Alternative Investments, AXA IM
HK: Henry Kenner, CEO, Arrowgrass Capital Partners
AB: Antonio Borges, Chairman, Hedge Fund Standards Board
CM: Chris Manser, Global Head, Fund of Hedge Funds, AXA IM

HK: I think it’s worth saying, right at the start, that I’m not sure the trust is gone. There were two contracts, if you like, between the investors and the managers. One was an economic product. The second one was a sort of social contract. On the economic product, I think the real issue was investors didn’t understand why money was lost, even though it wasn’t lost in such a great proportion compared to other investment vehicles. But the lack of transparency served to encourage suspicion. And I think one of the things the industry has to do to get the trust back is to become transparent: whether that’s a general dialogue with regulators or investors, it is clearly the way forward. The investment community needs to know what it’s investing in and that managers are doing what it says on the tin – which clearly wasn’t always the case last year – and that the product is not simply leveraged beta.

The second issue is the social contract. A lot of managers relied on the small print in the documentation to keep their businesses going rather than necessarily protect investors’ interests. l see more prescription being used in memorandums compared with the cookie cutter template for most funds that launched. I think there will also be a generally broader alignment of interests. But if you perform and you do what you say you’re going to do, then no-one really has a problem with performance fees, but it’s all about long-term performance and not simply year-on-year. Obviously, the regulators picked up on that. I think you’re going to see many things come in, including claw-backs. The days of making 20% one year and losing 20% the next, and the manager still being a wealthy guy, I think that is gone, perhaps, rightly so.

CM: The first point on single manager hedge funds is that we see the industry going through a painful but necessary process of adjustment, which comes after five or six years of very strong growth. Where there were clear excesses – you could call it a bubble – that is now correcting itself and has been doing so over the last 18 months. At the end of this adjustment process, the average quality of hedge funds will be much higher.

As Henry pointed out, investors in funds of funds, or investors going direct into hedge funds, will scrutinise managers more closely to make sure that they’re not just getting leveraged beta, but a fair amount of alpha. On the alpha component, we are very optimistic. In the last 18 months, a lot of capital has left the market particularly with bank proprietary trading. And there is generally an increased trend towards more passive investing. So the opportunity to produce alpha has greatly increased while the capital trying to capture it has actually been shrinking. I think that is a very good environment for hedge funds to thrive. Obviously, the issue of trust is one that’s very close to our hearts, as well. When it comes to single manager hedge funds, I think we have to take a step back and look at the environment three or four years ago when there was clearly a sellers’ market. As Henry put it, you had fund templates that were very difficult to change. Now there’s no way that players like us will accept that. We’re in a much better position to dictate terms and generally make terms as investor-friendly as possible. For us the changes that are needed involve transparency, governance and liquidity. On fees, they are clearly much more negotiable than before.

AB: I want to highlight something I firmly believe in, which is that this is an industry that’s very, very much investor-driven. Hedge funds only exist if investors like them, and they can disappear very quickly if investors move away from them. This is the history of hedge funds. If there is an industry that’s permanently put to the market test, it’s this one. And, therefore, I have no doubt that whatever will happen, it will be as a consequence of changes in investor behaviour. And what we have observed in the last few months is very interesting. There was this terrible panic in 2008, when everybody went for cash and people’s behaviour was not really the most rational, for a good reason, and then investors began coming back, and coming back, already in a significant and very interesting manner.

There has been a change, a rather substantial change, but one, in my view, for the better. What we have seen is that the more superficial investors, the high net worth individuals who invested in hedge funds because it was fashionable to do so, have left and probably will take some time to return. The more sophisticated, knowledgeable, long-term investors, the pension funds, the insurance companies, the endowments, have come back, if ever they left. And they understand now, better than before, the value that hedge funds can provide. I think that’s a very good development. So, we now have a more mature industry, one that’s more robust than before, precisely because investors have changed their views, and even the composition of the investor base has changed, which I find very interesting.

In that sense, it’s a move in the right direction. Clearly, it’s also a move in the direction of more bargaining power on the side of the investor. It’s much more a buyers’ market now, and that’s a good thing. And what we will observe, again, is that it is how the market develops that the industry will adapt to. With the Hedge Fund Standards Board, the industry has decided to assume responsibility for its own development, for its own norms and rules, in the direction of giving investors more say, more influence and more authority, based on transparency, disclosure and governance. I think this is a movement in the right direction, as well. So we have, I think, a transition from what it is, a complete free-for-all to a more structured approach, which brings hedge funds more towards the mainstream.

AS: Let’s open it up for questions….

Q: Mr Borges says that some invested in hedge funds because it was fashionable. Does that mean that hedge funds will be an industry dedicated only to professional investors?

AB: Hedge funds are targeted at professional investors. In that sense they are not to be distributed easily through retail products, other than highly regulated regimes, as they should be, if we’re talking about the common investor in the street. So, in that sense, it’s always professional investors. But what I’m saying is that it is better that the professional investors and the institutional investors, the more knowledgeable, better-equipped, well-advised institutional investors, are actually gaining the upper hand. I think it is in everybody’s interest because the relationship with hedge fund managers becomes more balanced and the industry will have to follow more closely what the investors are interested in, which I think is good.

Nobody’s saying that high net worth individuals are undesirable. But it’s better to have a customer base, an investor base, that’s sophisticated, long-term, knowledgeable and, therefore, has a different attitude.

Q: Do you think all managers are following the same rules?

HK: I think the pressure’s there. As I said the lack of transparency was responsible for most of the problems last year because people lost money and they didn’t know why they had lost money. So, I think investors felt cheated.

CM: To follow on from Henry’s point, I think we can expect that not everybody will follow the full transparency rules. We’re not requiring to see the portfolio on a daily basis. Ultimately, the relationship between an investor and fund manager is still one of trust and has to be one of trust. Even if you do see the portfolio, on a daily basis, or on a real time basis, you still have to trust your fund manager. What investors can expect is for us to get the right level of transparency that is needed to deal with market and operational risks, and to make sure that we are fully on top of what the manager is doing.

Obviously, the level of transparency that you need is still going to be higher than maybe was the norm two or three years ago. We clearly see that managers are, as a whole, much more open to give more transparency, because they understand that, otherwise, they’re not getting assets or are losing the assets that they’re currently managing. An issue could for example be that the manager is not doing what he has told you, like holding some illiquid positions in a portfolio that is liquid, but for that you don’t need to see the portfolio on a daily basis. There are different ways to get to the transparency that you need.

AB: To an extent, of course, transparency has to be driven by what investors really want, and want they want to know. They are essentially interested in managing their own risks, so, they want to know your exposure to risk. But, you know, in certain cases, transparency is completely out of the question. I was, for eight years, in an investment bank, doing mergers and acquisitions. The whole point was secrecy, you had to keep the deal confidential, or else the whole thing might explode. So, if you are a hedge fund that’s event-driven, that’s trying to invest in a particular event that you might have access to information about that others don’t, then that’s a great source of competitiveness: you cannot make that public. Disclosure and transparency are fundamental for investor protection, but they cannot destroy the logic of the business. It’s where the line begins to be difficult to draw.

AB: I think the sophisticated investors will want to understand your risk exposure. Some hedge funds that lost a great deal of money in booming markets took certain bets that might be right or wrong. But investors want to know and they will always demand to be well-informed of your risk profile.

Q: Chris what are you doing differently now than you were eight months ago, especially on transparency? Secondly, you said that it’s a better time to negotiate terms: what are you asking for?

CM: I would say we’re not doing anything completely different, but at the margin, I think, obviously, the environment has changed, and it allows us to dictate more terms. But, in terms of the philosophy, it’s still very much the same. Having said that, the environment is really playing in to our hands, when it comes to getting the right level of transparency with the manager, or dictating some liquidity terms. We very closely looked at the circumstances under which a fund can, for example, suspend redemptions. Obviously, that has caused some issues over the last 12 to 18 months and I think you want to be absolutely sure of the fine print on that. Now you can really negotiate changes in documents with your funds, before you invest. (Getting) independent valuation on some of the less liquid investments or having independent service providers or modifying redemptions are other areas where we’re pushing quite hard. And we will be able to push for clawbacks for certain funds, which historically, I think, would have been impossible. In addition, where we’ve been focusing over the last six to nine months is on the operational risk side. So, we would have a whole set of points or criteria to rate a particular fund and see whether, from an operational perspective, that fund was running an acceptable risk.

Q: How do clawbacks work in practice?

CM: Clawbacks can take different forms but generally lengthen the period which is used to calculate the performance fee which a manager gets. I think it is still a topic that is discussed within the hedge fund community, but a standard may emerge at some point. Clawbacks are more important for strategies that are volatile.

CM: That’s obviously my favourite topic! I think the first statement I can make is that, in my view, funds of hedge funds have clearly emerged as the only way to invest in hedge funds. That might sound quite strong, but I actually think the various models to circumvent paying the second fee layer that have been around for years have actually produced worse results than if people had gone with the proper fund of funds model.

I think the fund of funds format basically has a number of benefits. Clearly, diversification is key to mitigate the risk. Then you really have to be a specialist, because proper risk management only works if you can understand what the individual hedge fund is doing and where the residual risks lie with that hedge fund. The third point is operational due diligence. We’ve seen many instances where losses were incurred by investors that could have been avoided by doing proper operational due diligence.

The second point I’d like to mention is that the average fund of funds last year was down about 20%. But if you look at the better set of managers, they’ve actually managed to protect capital pretty well as a result of adequate risk management and better management of liquidity mismatches. I think investors that have gone with the better fund of fund managers have actually managed to get what they were promised, which is preservation of capital. In a nutshell, fund of hedge funds are continuing to play an important role to both institutional and private investors.

AB: I tend to agree. I wouldn’t say that it is the only way of investing in hedge funds, but it does provide a great dealof value to investors. The point is that hedge funds have become – and this is one of their great attractions – extremely diverse: sometimes complex, sometimes simple, sometimes very low risk, sometimes very high risk. There is a whole panoply of options available for investors, and you need an expert in there to adapt your decisions to your preferences – someone who understands the industry very, very well, someone who can talk to you as an investor and understand also what is it that you’re looking for, and then match the two. And the more diverse the hedge fund industry is, the more complex, the more the value of this specialist becomes apparent.

So, I think that funds of hedge funds do provide an additional service to investors, which is crucial. They also play a role in due diligence and so forth.

They will, I hope, play a big role in enforcing the proper standards for the industry. The complexity, diversity of options, and matching that with investor preferences which also vary a great deal from investor to investor, is quite a demanding job, and funds of hedge funds provide a great deal of value added.

HK: Obviously, we have a fair number of (funds of) funds in our investor base. From where we’re sitting, the normal view is after what happened last year, that it’s probably a doomed industry. Actually I think quite the reverse is going to happen. As hedge fund products become more legitimised, involving more regulatory oversight and more transparency, it’s very clear that the average pension fund or endowment does not have the capability to invest directly. And the only people that can do that are funds of funds. Quite what the fee structure looks like, quite what the pricing model is like, that’s a different conversation, but in terms of the role they’re playing, I think they only get bigger and not smaller.

AS: Thank you. Any questions on this topic?

Q: What do you see in terms of pressure on fees at funds of funds?

CM: We’ve seen very little pressure on fees. In my view, as long as you deliver on expectations, it is much less of an issue, and for those who have under-delivered on expectations or promises, it shouldn’t be down to fees in the first place. People have voted much more with their feet (rather) than given managers a second chance with the possibility of reduced fees. Where managers are given a second chance the practice is quite widespread. I think that’s understandable. But overall, this is a competitive industry, so, fees will certainly gravitate to what investors agree to pay. Having said that, I think it is important to realize that this is a resource-intensive industry.

Q: Have you seen net capital inflows during the last few months?

CM: We’ve seen inflows and we haven’t seen much outflow, even last year. Overall, even last year was great and positive for us. (The inflows) slowed down in the second half, and they’ve picked up again since the beginning of the year. It’s clearly going in the right direction.

As an industry, we’ve still seen a lot of outflows in the first quarter. That was mitigated slightly by some inflows, but the industry itself has still been shrinking in Q1 and our expectation is that it’s going to continue to shrink into Q2 and, from there on, I think, the industry as a whole can grow again. But there were quite a few redemptions still in the pipeline in the second quarter from funds of hedge funds that have suspended or gated redemptions, so investors haven’t been able to get liquidity in their investments, and that is still money that has to flow out as a whole. That certainly took place in the second quarter, and then I think the bulk of it will be gone.

Q: As a general rule of thumb, can you say that the big fund of funds players are the winners in this scenario?

CM: I think if you look at the big fund of funds, they are among the ones who have also been hardest hit by the financial crisis, both in terms of performance as well in terms of money outflows. So, from that perspective, I’m not quite sure. On the other hand, as I said, this is a resource intensive business. You need infrastructure, so, the bigger ones are also one of the beneficiaries of this situation. I would say the big ones that have had good performance will definitely be the winners.

Q: To follow up on that, there are a great many smaller funds of funds; do you anticipate a lot of mergers and acquisitions or funds closing?

CM: I don’t think that there will be a lot of mergers and acquisitions. I think there will be wind-downs over time. If you look at it from a buyer’s perspective, it’s difficult to get comfortable with the dynamics of some of these fund of funds organisations and it’s difficult to come up with a price. So, I think there will be consolidation but not through mergers and acquisitions, more through orderly wind-ups.

Q: Will the more risky hedge funds find it difficult to survive?

AB: I think this issue of risk has to be understood very, very well, because it’s quite important. Some hedge funds actually have very little risk, strategies with very, very low risk, and others are at the other extreme and have very high risk, and it’s for that purpose that they exist. And, of course, if you deal in very high risk, you sometimes go bankrupt, inevitably. Is this wrong? Actually no. It’s very important that you have, in an advanced economy, all kinds of options available to deal with very high risk and also to enable investors that have a preference for that, as a tiny little percentage of their portfolio, to have the opportunity to make investments which are highly risky but also have high returns. For example you have hedge funds that made the bet that Northern Rock would not go bust. Northern Rock went bust, they lost a fortune in one day. You also had other funds that made the bet that Freddie Mac and Fannie May would be saved, and they made billions overnight.

These zero sum game type of options exist in the market. It’s very important that there are institutions ready to make those bets, because that makes the market more complete. It provides investors with more options and, of course, in general, it’s a better way of handling risk for the whole society. Now when everybody’s becoming more risk-averse, as happened over the last two years, high-risk hedge funds will be at a disadvantage – the investors will go away, because the preference for risk has gone down. But, I think, as the preference for risk comes back, they will be, again, in favour. So, this is market-driven, in my view.

Q: Shouldn’t strategies be discussed today from a more ethical point of view? Northern Rock was mentioned. Aren’t there times of crisis when short selling should be forbidden, because it is not fair to provoke bankruptcy? Aren’t some strategies being questioned by public opinion and also by the industry?

AB: Well, certainly, but that’s a different issue from taking risks or not taking risks. For example, right now, when saving some banks require that the banks be able to sell their difficult assets, it’s very important that there be investors prepared to buy them. And, of course, by nature, these are quite risky investments. So, the fact that you have people ready to make risky investments can make an enormous contribution to solve problems.

The case against short selling was very much based on the idea people manipulate the markets, that certain investors were manipulating markets through short-selling, and that it is wrong and should not be accepted. Of course, short selling was banned and shares kept going down, so it wasn’t market manipulation, but that was the concern.

CM: The public has to also understand the economic benefit that hedge funds bring to the table for the benefit of financial markets. For me, there are three main benefits. The first one is provision of liquidity. That is what people have realised when the short selling ban was instigated. We’ve seen a drop in liquidity because, for some players, they can’t buy certain stocks or certain quantities of stocks if they can’t, at the same time, sell other stocks short. It’s obviously a risk management discipline and without these trades going through, the market is really lacking liquidity.

The second benefit is price discovery. A lot of hedge fund managers, being highly specialised, try to arbitrage tiny price differences between related securities, so they’re highly price sensitive. I mean, there is a very big price discovery element to what hedge funds can bring to the table.

The third benefit is what Antonio was talking about, the ability to take risk. Again, because of the way a lot of hedge funds are analysing certain trades and transactions, and the techniques they use, hedge funds have historically been the players that have entered the market reasonably early, maybe having been the earliest to come back to certain markets. With obviously weakening hedge funds, the financial markets are losing out on these economic benefits, which I think is potentially quite dangerous and should always be kept in mind when we talk about regulation.

Q: There is a complete shake-up going on in the hedge fund industry. Funds that maybe should take the blame are disappearing with the whole hedge fund industry discredited because of their behaviour. As an industry, how do you prevent these kinds of cowboys taking over again?

AB: I disagree very strongly with you, because I think it’s very important that this be an industry where people can freely enter. If I think I have a good idea and I manage to persuade a few investors to give me their money, let me try it. And there will be lots of investors all the time who are prepared to lend money to these ‘cowboys,’ as you put it, because you never know, ahead of time, whether it will work or not, you cannot tell. This is exactly like Silicon Valley and the technology efforts, you know, these crazy people that start in a garage with some strange idea, most of them fail, but some of them do succeed, and then they succeed very well. I think you have, in the hedge fund industry, even in very good years, even in boom years like 2006, hundreds of hedge funds that disappear. And that is a very important thing – that the market mechanism is there, that the ones that succeed and survive are the good ones that were market-tested. If you are an investor and decide to take a risky option and bet on some cowboy that disappears, that’s your problem, really.

So, the important thing – and this is very, very important – is that we don’t sell hedge funds as bank deposits, as a safe investment (where) everybody feels protected and there is a sense of security, that’s not the idea, that would be very wrong. But we want a very dynamic industry, where people can try their ideas and see if they succeed or not.

(It is pointed out that more than 30% of hedge funds made positive returns even in 2008).

CM: For me, it’s a question of can you prevent investors from losing money, and, no, you can’t. Regulation has to protect investors from rogue behaviour or from unethical behaviour, but it will never stop investors from losing money. And I think this is where our job is. I mean, you can blame us for having lost money last year but I think then we have to look at things in context, and we’ve really gone through quite a crisis situation last year. It’s up to us to choose between the good managers, that have good risk management, and the bad ones with bad risk management or bad strategies, and then, ourselves, overlay that with a risk management process.

But that obviously doesn’t prevent us from losing money. Overall, I still think this is a very good value proposition for our investors. And, maybe, from that perspective, as an industry, we have to take some blame, to the extent that some people in the industry have sold hedge funds as absolute return products whichcouldn’t lose money and, obviously, that was never the case and (those funds) should have never been promoted like that. So, I think we’re, to some extent, also back to education and underselling and over-delivering rather than the opposite.

AB: The important point is that investors should be fully informed and, in fact, they should be in charge, as I said from the beginning. People must not be allowed to mislead investors and offer something that’s not real and, in fact, lead investors into risks they don’t want to take. As you sign up to the standards, you commit to informing investors fully about your risk strategy, about your resolution of conflicts of interest, about your valuation procedures, about your operational management, all kinds, even shareholder behaviour. All kinds of those things are very well defined: you commit to them, and then investors are reassured.

Q: With all the developments of the last year, it’s pushed the hedge fund sector into a sort of institutionalisation. How are you going to attract new players into an industry which has essentially become the active end of the investment management business?

AB: I’m not sure I completely agree with you. What I understood you meant by institutionalisation was that this was an industry which in the past had total and complete freedom and operated without any bounds or norms or whatsoever, and the industry is moving in the direction of having a better framework, which makes it, as I said, more investor-friendly, but gives it a certain framework of discipline, as well, which I think is good. This does not mean that only large institutions operate within this industry, and a very, very important point is to maintain the possibility of having all kinds of new firms emerging, small ones and so forth, to be creative, to check new ideas and see if they succeed or not. This is very important for the future, because the value that the hedge fund industry provides is, to a very large extent, the fact that it is the laboratory of the financial sector. It’s where all kinds of new ideas are tested. And once they succeed, they then are copied throughout the financial industry. Hedge funds are just 1% of the financial system but it’s the leading edge of the system. And that comes from innovation and has to be maintained at all costs.

AB: Well, briefly, number one, there is, of course, a whole review of the regulatory environment of the financial sector that’s been under way for a while. I have to start by commenting that I find it hard to imagine that we could have a better regulatory environment than the one that exists in Britain. I know this is very controversial and many people on the continent don’t like the British system, and many people in the US think that the British system is excessively regulated and too bureaucratic. But to have these broad principles, to have oversight authority, to have the ability to register and to authorise or not authorise hedge funds, and then to delegate the implementation to the market mechanisms is really a wonderful system.

I think that what we tried to put place of with the Hedge Fund Standards Board is a very powerful approach to regulation, because within those principles, we define the standards, people sign up and commit to the standards, and if they don’t comply, then the financial regulator will not sanction them, because they are misrepresenting themselves. So, these are not just soft standards, they’re not just recommendations, they’re actually binding: once you sign up, you have to comply. And that gives the market, and in particular the investors, a lot of say on the enforcement of standards.

The best effort was the G20 approach to try to develop a global set of standards. The Americans, for the first time ever, were willing to sit at the table with us and, of course, everybody as well. So, we’re trying to define a set of global standards. You have to realise that when we talk to the Americans about regulation of hedge funds, they turn to us and say, “oh, come on, don’t waste my time, we have 80% of the industry, we know what we’re doing, we’re not going to listen to anybody else.” And, for the first time since last fall and the G20 effort, they said, “no, no, okay, we’re going to sit with you around a table and we’re going to work together and try to do something that we’ll all be comfortable with.” So, that process was, I think, promising, and was evolving quite nicely.

Then we got the AIM directive. It goes in the opposite direction to what was being tried. Initially it started as a rather constructive and positive effort on the part of the Commission. But then it became part of a political process that actually got out of control, and the final product is really not very commendable. As you may know, because of the elections coming up, because of the fact that there will be a new Commission installed in the fall, because of the very, very particular timing of all of this, politicians from several countries got directly involved in the regulation, in the directive, and the final product has very little resemblance with the initial proposals that the Commission put forward. And it does have some serious drawbacks that we are very concerned with, in particular, the fact that it has very little intellectual foundation.

Even the best studies that were presented over the last few months, like the Lavoisier Report or the Turner Review and so forth, never recommended anything like what’s in this directive, but quite the opposite. So, there is that concern. This is an industry that’s 80% in Britain, and then a little bit elsewhere, so you’d normally expect that the FSA would have a big say in this directive and have a great deal of responsibility. But they were pretty much marginalized and, in fact, the directive concentrates a great deal of power in the Commission, when the FSA could do the job quite well. So, in terms of subsidiarity, which has always been a key principle in Europe, this does not seem to be going in the right direction.

The part that I’m most worried about is the protectionist element, it’s the fact that the directive closes up the European market to third country managers, unless they adopt equivalent legislation, which I find it very hard to believe that the United States will adopt. Their normal practices are so far away from what’s in the directive, that I find it very hard to believe that they will ever adopt anything. They will certainly make some moves – not now, but later on in the year, they will move in the direction of authorisation and registration of hedge funds – but I don’t see them having the kind of prescriptive, detailed regulation that’s in the directive, so they will not be equivalent.

And so the European investors will be deprived from buying American managed hedge funds, which I find very hard to understand. This is really aggressive protectionism, which I think is very bad for the European industry, because no industry can thrive unless it is in a competitive open market.

Closing the market for Europe is a very, very serious problem, which will maybe help the large European hedge funds who will not have so much trouble complying with the directive and will have the market for themselves. But it will hurt the European investor especially. The high net worth individuals will go offshore anyway, and will continue investing wherever they want. I’m not sure this is a desirable outcome, but that will be what will happen.

However, the institutional investors, in particular, the insurance companies and pension funds, will have to abide by the law and will not be allowed to buy from the US, which I think is hard to accept. Of course, if you close the market, then you are more exposed to regulatory arbitrariness, which is very concerning.

I’m also concerned with barriers to entry. The directive applies to just about everybody, even very tiny little funds will be submitted to it, so this will make it more difficult for start-ups and small funds. And, indeed, it may well go in the wrong direction in the sense of creating this false sense of security, because this industry is going to be so tightly enclosed by the regulator, that people will say, “okay, fine, let me invest, I’m now relaxed about it,” which is wrong. This is an industry where, as I said before, we have to have very active involvement of the investors through funds of funds or whatever, they have to be in charge, they have to do the due diligence, they have to impose their conditions on the managers, not the regulators providing a sort of false sense of security to investors, which I think is detrimental to everyone.

There is a good likelihood that a majority of countries will approve the directive, and so we’ll have to work to try to eliminate the most aggressive components of it and work to improve the other ones. And there are some positive elements in there, for example, this idea of a European passport, that allows people to sell anywhere in Europe once they are allowed in one of the countries, that’s a very good idea. But, there are some other quite difficult points which we’ll have to try to minimise.

HK: Well, I agree with everything Antonio’s said. I think, from where we’re sitting, it’s obviously going to allow regulatory oversight which, on one level, is fine. But I think that the dynamic which Antonio hasn’t gone into, is that it’s become a very political issue, and the draft certainly wasn’t drafted very well. It is, frankly, ludicrous. So, it’s going to need to go back to the drawing board in some shape, fashion or form, to get to the point where it’s workable, from where I’m sitting. But it’s not clear to me – Antonio’s closer to this than I am – but it’s not clear to me that there’s necessarily a process for that to happen. So, we could end up with some just bad legislation.

CM: I would start with two observations. The first one is, as Antonio rightly alluded to, the de Larosiere and the Turner Report didn’t mention hedge funds as a source of the financial crisis. Despite that, regulators – and in particular governments are going quite hard against the hedge fund industry, which is a bit surprising. And then the second point is that if you look at the European hedge fund industry, 80% are already regulated, hence, the whole EU directive is trying to regulate the space that has already been quite broadly regulated.

I think managers were generally in favour of registration or regulation, as we see some benefits when it comes to increasing transparency, maybe also strengthening the governance of hedge funds, but I think it’s very important that we’re not killing the golden goose by imposing some bad regulation. And, again, the golden goose is hedge funds providing liquidity for the markets, price discovery and the ability to take risks. Another point that Antonio has already mentioned is, for me, the potential limiting of investor choice. I think there could be significant costs to limiting investor choice through the EU directive. On the good side, I agree with Antonio that for us, as a European manager, it’s clearly a good side-effect that we could have a new passport scheme.

AB: If the directive was to be approved as is, it would make our job redundant. It would also make the FSA redundant, which is one of the things we’re not really happy with, because it is the FSA that’s the most knowledgeable regulator with respect to hedge funds. So, keep in mind, as you read the directive today, it is amazing how it empowers – these are their exact words – “empowers the European Commission” to not just enforce the directive but also to add all the concrete norms and rules that would make the directive applicable, which is normally something that you leave to national regulators. But, in the current format, it all goes to Brussels, which is something that is one of themost worrisome elements.

Of course, they say, this will be part of a lengthy process, there will be consultation with all the other regulators, but the reality is that there will be a great concentration of regulatory power in Brussels, which will make a lot of us redundant. And that’s what I think goes in the wrong direction, in particular to the extent that it reduces the need for investors to be extremely alert and on top of what’s happening, I think that’s not in the nature of this industry.

Q: Do you get support from the UK government? Are they ready to support you in that fight? Or are they rather reluctant?

AB: I think you should ask them. I think that we will get a great deal of support from the FSA and from the Treasury, and we’re going to be working together to try to improve what we can. I don’t think that the UK government will be fighting the Directive: they are very worried with many other things right now.

This is an industry which is almost exclusively in Britain. If you look at competition and so forth, well, there is always a certain nationalist element in these political initiatives, and you have an incentive to use the opportunity to promote your own view and your own companies and your own markets as opposed to others.

Q: So, if the EU directive would be implemented more or less as it’s proposed at the moment, would that have the consequences that many hedge funds would go elsewhere, let’s say to Switzerland, for example?

AB: It depends. I think that’s a likelihood: it could happen that many hedge funds will go elsewhere, Switzerland, or certain Far Eastern countries like Singapore. I don’t think, contrary to what people believe, that hedge fund managers would move to the Cayman Islands or anything like that, because the investors also want a good regulatory environment. If you start a fund in Timbuktu, you will not have many investors. But, the point about this directive is that if you move to Switzerland, you don’t have institutional investors from the European Union anymore. So, this is designed to close the market, and therefore, it makes it extremely difficult for you to get out of the market.

Q: You seem to be very worried about the way the regulation is going to be implemented. Do you think that’s going to kill the hedge fund industry?

AB: I think the main concern is not that this will kill the industry. It will not: I think the large hedge funds based in London will always survive. The opportunity of not having to compete with the Americans, (means) they will be in a stronger position in their domestic market, but the quality of the industry will deteriorate. That’s the concern. In the interests of the market and in the interests of the investors you want to maintain an environment where there is more freedom for start-ups to develop and there’s more competition from abroad to keep the industry as efficient as possible. If we were trying to protect the large hedge funds in Britain, we would probably support the directive. But, in the long term, this is not in anybody’s interests.

Q: One place where there’s a significant offshore industry in Europe is in Sweden; have you had any contact with people there?

AB: Yes, and that will be very interesting, because, as you know, Sweden will have the Presidency of the European Union as of July, so they’ll have an opportunity to steer the debate in some way, and we know the Swedes are extremely worried.

Q: Presumably they’ll oppose this proposal as well?

AB: Well, if it was as it is now, they would certainly vote against, but it doesn’t count – if you have a large number of the large countries behind this, it’s going to happen. So, we will have to work constructively to try to improve the directive.

Q: What do you propose to do as The Hedge Fund Standards Board?

AB: We are going to clarify and explain. We are going to interact and engage with theregulators throughout Europe, and we will use our best access to the data, to the facts, to the research and so forth, to provide a good foundation for our positions. And then we’ll try to find the areas where we can intervene and contribute. We’re not going to get involved in politics, that’s not our mission.

Q: Have hedge funds been made the scapegoat of the financial crisis?

AB: No, I wouldn’t go that far. There is that view of things, but it is true that very few people understand the alternative investment industry, and, in many countries, the alternative investment industry is supposed to be a trouble-maker. It creates difficulties for the local way things are managed and, therefore, it does have quite a few enemies. All the serious analyses of the crisis did not point at alternative investments as a source of the trouble, so, they could never be reasonably made scapegoats.

Many people on the continent realise that there is a very unique opportunity to take advantage of this feeling to really restrict the way the financial sector operates and grows, and that’s what we’re unhappy with. And I think they’re doing this on the basis of what they consider their national interest, which is how Europe has always operated, unfortunately, but that’s how it is.