Hedge Fund Hot Topics

Expanding markets, evolving regulations

Rod Sparks
Originally published in the October/November 2005 issue

Although the UK's Financial Services Authority is officially on the fence with regard to its future regulation of hedge funds, the overall advance of regulation is likely to continue. According to Hector Sants, managing director of wholesale and institutional markets at the FSA, whilst hedge funds are appreciated as a source of liquidity which enhance the efficiency of capital markets, there is likely to be a "modest move of the dial" towards increased scrutiny and possibly increased regulation of hedge funds.

The FSA has recently taken the pulse of the market in an effort to gauge the correct median for any future regulatory regime, and has circulated two discussion papers. FSA Discussion Paper 054 tackled risk and regulatory engagement. It analyses the risks posed by hedge funds and sets out possible risk mitigation steps, with a view to possible changes to UK regulation. Its sister paper, 053, is proposing that restrictions on marketing be limited to the risk of a product, not its precise legal classification.

"Restrictions on marketing currently depend on the way funds are divided up for legal purposes," says Philip Morgan, a partner with law firm Kirkpatrick & Lockhart Nicholson Graham LLP in London. "There's often no particularly brilliant rationale as to why it should be one way for one, and another way for another. The FSA is looking at this whole area, particularly because there are a number of products which are able to be promoted to the general public where there is an increasing level of risk."

There is a similar effort being mounted on a European wide context, with plans to divide funds into complex and non-complex categories, the latter being intended as more suitable for distribution into the retail market.

The whole issue of increasing availability of retail products that pursue strategies similar to those followed by hedge funds is certainly focusing minds at the FSA. As part of its consultation on hedge fund regulation, Morgan says it has asked for industry comments to try to decide whether to encourage or discourage wider access to such onshore products, and also whether the current restrictions on the marketing in the UK of offshore collective investment schemes (such as the typical offshore hedge fund) – or funds of offshore hedge funds – should be lifted or eased.

"At present, offshore hedge funds may only be marketed in the UK to a limited class of professional or otherwise sophisticated investors," Morgan says. "They may generally only be marketed by FSA-authorised firms."

Currently, the UK regulator sees three main risks presented by hedge funds to investors:

  1. That the greater risks associated with products that have hedge fund characteristics may not be apparent to potential investors.
  2. That investors might be confused by the range of products.
  3. That different regulation for different products may inhibit investment.

The FSA recognises that there are various approaches to the regulation of hedge funds around the world, and that a single-country solution may not be tenable. Its primary focus however is products which are accessible to the UK general public and one example is UCITS 3 funds. These are vehicles which, under new EU rules, can now invest in derivatives for investment purposes, unlike earlier UCITS funds which could only use derivatives for hedging purposes. They can now take short positions, and make use of certain hedge fund techniques. Many of our mainstream hedge fund managers in the UK are looking to convert retail funds into what are effectively hybrid vehicles. One UK fund manager has even called one of these hybrids a hedge fund.

"The FSA has suggested that, to reduce the risks associated with onshore products with hedge fund characteristics, the risk management systems of the UK firms launching those products should be reviewed, and a clearer differentiation of different products be made than at present," Morgan explains.

These funds are certainly an interesting development, and could offer a potent source of competition for conventional offshore funds. According to a recent European Commission Green Paper, the EC itself is keen on finding some kind of harmonised structure for hedge funds that would be acceptable to all member states. In the UK one possibility is the development of an unlisted fund of funds product for the retail market, but the debate on this is currently ongoing.

Valuations and reporting regimes for hedge fund managers and counter-parties are also under scrutiny. The FSA is almost certain to require increased reporting to it by hedge fund managers and under one proposal made by the FSA this could require a sophisticated and costly data set.

The FSA's scope for action is limited to an extent: at the moment it is typically responsible for regulating the fund manager and the prime broker, while frequently the fund itself, and its administrator, will be located offshore.

The FSA recognises this and also understands the internationally-oriented, potentially footloose nature of the hedge funds, but none of this seems likely to hold the FSA back from increasing regulation within the scope of its powers. It is also planning to be fully engaged in international debates on hedge fund regulation so it may influence regulators in other jurisdictions.

Risks that have raised awareness of hedge funds have included high profile market disruption, like that caused by LTCM, as well as "heard behaviour" and a lack of transparency, especially from the regulator's perspective. Hedge funds are also squarely in the FSA's sights when it comes to market abuse: according to the UK regulator's June 2005 discussion paper: "Some hedge funds are testing the boundaries of acceptable practice with respect to insider trading and market manipulation, and, given their payment of significant commissions and close relations with counterparties, create incentives for others to commit market abuse."

Risk scenarios

Management of the potential risk that hedge funds could present to the overall financial system, either in the UK or elsewhere, is another issue the FSA has been exploring recently. The ghost of LTCM still casts a long shadow, including in the UK, where many of Europe's hedge fund managers are based. The potential impact on the stability of the financial markets if a prominent fund, or group of funds, were to run into trouble, or indeed collapse, is a big worry. While the FSA currently sees these risks as small, it is keeping the matter under regular review as the industry develops. The regulator wants to avoid funds within its aegis taking on the level of exposure that LTCM had assumed when it blew up in 1998: $1.4 trillion in gross exposure, and a leverage ratio of 50-1.

"The FSA cannot be certain that other hedge funds do not have similar exposure at present because of the limited disclosure obligations imposed upon hedge funds in the UK," Morgan says.

Amongst the other risks that have been identified are:

  • Erosion of confidence (caused by a fund's collapse, e.g. LTCM)
  • Liquidity disruption (for example, if several hedge funds were to dispose of a large volume of investments in a particular market segment at the same time)
  • Control issues (reflecting the fact that some hedge fund managers do not have the optimal skill set to create an effective control infrastructure)
  • Operational risk
  • Potential weaknesses in asset valuation methodologies

"In addition to these particular risks, the FSA has also drawn attention to hedge funds' evolving investor base, with increased investment by funds of hedge funds and pension funds, both of which spread the risk of investing in hedge funds into the wider community," Morgan says.

The US perspective

No discussion of the impact of increased regulation of hedge funds would be complete without a visit to the new climate in the US. The statistics speak for itself: 10% of the examinations of investment advisers conducted by the SEC resulted in referrals to the Enforcement Division, and 17% in the case of investment companies (27% in the case of broker dealers).

Until recently, alternative investment products like hedge funds were invariably structured so as to qualify for exemptions from registration under the Investment Company Act 1940 and the Securities Act of 1933. As in the UK, so in the US increased regulatory oversight initiatives have arisen as a result of concerns on the part of the securities regulator. For example, the SEC brought only four enforcement actions against hedge funds in 2000, but there were five in 2001, and 12 in 2002.

"Some of this increase is likely attributable to the enhanced level of hedge fund activity," says Nicholas Hodge, a partner with K&LNG in Boston. "On the other hand, it is possible that dishonest elements are being attracted to this industry because of the relative absence of regulatory oversight."

Other concerns centre on the development of hedge fund businesses by US mutual fund managers. The SEC has raised numerous concerns about the operation of hedge funds and mutual funds by the same firms. The principal concerns relate to the allocation of investment opportunities that are of limited availability. "If a fund manager stands to gain 20% of the profits of a hedge fund but receives only a fee based on assets under management from the mutual fund, the manager has a strong personal interest in allocating the investment opportunity to the hedge fund," explains Hodge.

There have also been concerns raised regarding broker-dealers, particularly the marketing of hedge fund products to investors for whom they were unsuitable. Fears that hedge funds were taking big credit risks, and the trend towards 'retailisation' of hedge fund products have also energised the SEC. In the latter case, funds of hedge funds are being made available in the US via closed-ended registered investment companies, and some mutual funds are themselves adopting long/short strategies.

"We're facing a time of great regulatory scrutiny," Hodge says. "There has been a raft of new regulations introduced in the US in the last 12 months."

For offshore advisers, rules adopted by the SEC in December 2004 have changed the way in which an investment adviser, whose clients include private funds, is required to calculate the number of its US clients for the purposes of determining whether to register under the Investment Advisers Act. Under the rules, an investment adviser whose principal office is located outside the US must now look through the funds that it is advising and count the individual investors as clients. Consequently, some currently unregistered offshore advisers may be considered to be providing services to hundreds of investors, many of whom may be US clients. An offshore adviser is required to register with the SEC if it has US clients, unless eligible for an exemption. For example, the 'private adviser exemption' could apply where the offshore adviser has had fewer than 15 US clients during the preceding 12 months.

There remains, however, a great deal of concern, both within the US investment community, and overseas, as to the practical burden which the new regime will impose on the hedge fund firms themselves. The SEC's new requirements about compliance, for example, require that each firm establish its own tailored compliance program, which must be capable of detecting violations when they occur, as well as dealing with them. The short-cut of simply adopting a boiler plate document and hoping this will suffice is not going to be enough, Hodge says.

"There's been a lot of concern that the regulatory burden will put a lot of smaller investment advisers out of business, because of the cost of complying," Hodge adds. "We are seeing some of the smaller investment adviser firms merging into larger firms as a result."

Even larger firms, however, are realising there is an acute shortage of properly qualified compliance officers capable of assuming this role, and many have yet to recruit suitable officers as a result. The possible option of allowing general counsel to act as de facto chief compliance officer has been explored by firms like K&LNG, but it is being rejected.

Another issue that has raised eyebrows in the legal community is the distinction that the SEC introduced in an effort to distinguish private equity funds from hedge funds: namely that funds with a minimum two-year lock-up clause would be exempted. This has caused some hedge fund managers to explore two-year lock-ups in an effort to avoid having to register under the 1940 Act. The ethicality of this process has been one source of concern, particularly as it relates to the investors in these funds, but in addition, the likely response from the SEC will be to amend its regulations accordingly should enough hedge funds take this route.

Hedge fund managers are still not filing their registration with the SEC, in the belief that the deadline is 1 February. However, this is the deadline for registrations to be effective, a process that usually takes 45 days. Given the anticipated bottleneck that is likely to occur as managers rush to meet the deadline, lawyers are advising that managers file even earlier than 15 December, in other words as soon as possible.

The SEC has made it clear that from February it will be checking on hedge funds to ensure they are complying with registration and compliance requirements. Firms are being urged to address these issues as soon as possible by their legal advisors.

In summing up, Hodge says managers should not panic about the new regime: "The SEC has fortunately recognised the useful role that hedge funds play in the financial marketplace," he comments. "Bear in mind that, despite increasing regulations, there are many things that haven't changed."

This article was taken from a seminar given at the New York office of international law firm Kirkpatrick & Lockhart Nicholson Graham LLP (K&LNG). With over 1,000 lawyers in 12 offices across the US and UK, the firm represents entrepreneurs, growth and middle market companies, capital markets participants, and leading FORTUNE 100 and FTSE 100 global corporations.

K&LNG's Hedge and Private Funds practice represents a full range of funds in all aspects of their organisation, funding and operations. Its clients include hedge, venture and private equity funds, offshore mutual funds, equity, debt and arbitrage funds, and real estate funds. It also works with banks, brokerage and other financial services firms, fund sponsors, advisers, distributors and key investors; as well as custodians, administrators, prime brokers and other service providers.

K&LNG works with multiple segments of the industry, ranging from Wall Street investment banks, all the way through to individuals and private firms.