Editor’s Letter – September 2013

Issue 89

Originally published in the September 2013 issue

The costs of the financial crisis have naturally sparked political concerns about rewards for companies and individuals in the financial sector. Consequently the industry faces unprecedented restrictions on remuneration and also demands for hedge funds to lower fees.

The rationale for greater political control of pay is that “too big to fail” banks that might need to be bailed out are effectively a quasi-public good. If taxpayers are underwriting the downside then the upside should face commensurate restrictions, the argument goes. Whether or not some parts of the financial sector do indeed need regulated pay, it is not clear if any or all hedge funds should be subject to rules originally designed for large banks.

AIMA’s new policy principles for regulating capital markets – about which we interviewed AIMA Director of Government and Policy Affairs Jiri Krol in this issue – acknowledge the need for regulators to address “too big to fail” systemic risks, but, because hedge funds are small enough to fail, none neededto be bailed out by the state in 2008. And this month’s report from Australia’s regulator, ASIC, saying that “hedge funds pose no systemic risk” is only the latest study to find that hedge funds present little or no risk to the financial system.

Fortunately AIFMD does leave some latitude for national regulators, including the UK FCA, to let at least some firms retain a more flexible framework for remuneration with the FCA's AIFM Remuneration Proportionality Rule. However, the default option is to comply – the onus will be on firms to demonstrate that they satisfy criteria for exemption. These different considerations for LLPs – with still more subtleties applying to delegates – further complicate matters, Akin Gump point out in this issue. Mere inertia here could result in some firms being caught in the net of remuneration restrictions, so interested parties are strongly encouraged to seek advice, and to participate in the FCA consultation process up until 6 November.

Pressure on rewards is also seen in calls for lower hedge fund fees. Chris Schelling, Kentucky Retirement System Absolute Return Director, argues that investing solely based on lower fees can have adverse selection consequences. Schelling cites recent research from Preqin, showing that hedge funds charging higher performance fees generated higher returns – both in absolute and risk-adjusted terms. Schelling argues that net of fee returns are what count and suggests that scarce alpha does not come cheap.

A review of hedge fund alpha generation from the Commonfund Hedge Fund Strategies Group of Connecticut shows the median hedge funds have generated average annualised alpha of 5% over the past 10 years. The top quartile did better, with 10% annualised alpha. Clearly there are hundreds of hedge funds out there generating substantial alpha that helps pension funds, insurers and others to meet their liabilities. The purveyors of this alpha, however, expect the freedom to charge a freely determined market price for their services just as sports-people and show-business celebrities do without let or hindrance.